Investing in the German Defence Sector – Regulatory Challenges and Opportunities

In this new blog series, we explore key regulatory opportunities and challenges shaping investments in the German and European defence sector, providing critical insights for our clients. Following this initial post on public funding, the series will feature further topics such as foreign investment control, public procurement and export control.

Part 1: Public Funding 

The “Zeitenwende” (“historic turning point”) in German security and defence policy is in full swing. What began in 2022, announced by then-Chancellor Olaf Scholz as a reaction to the war in Ukraine, has gained further momentum in the wake of recent challenges for the transatlantic security architecture. 

Fiscally, the Zeitenwende initially manifested itself in the form of a special fund of €100bn for the Bundeswehr (the German armed forces). Earlier this year, the far more significant step has been taken to largely abandon the rigid constraints of the constitutional debt brake for defence spending. This is accompanied by a considerably increased willingness among the parties of the political centre in Germany to raise defence spending: the current federal government under Chancellor Friedrich Merz supports the goal of allocating five per cent of the GDP in the medium term (composed of 3.5 per cent for defence spending proper and 1.5 per cent for civil defence and military-used infrastructure). Currently, defence spending is at around 1.9 per cent (GDP of 2024). This demand signal, unprecedented in German post-Cold War history, is complemented by new fiscal facilities of the EU. The overall economic effects will be long term. Even if the situation in Ukraine freezes due to a ceasefire or peace agreement: the Zeitenwende is here to stay. 

It is not only established defence companies that stand to benefit from these developments. A broad range of businesses – particularly in manufacturing – are seeing new opportunities, including by repurposing civilian production capacity for military applications. The trend is being accelerated by the ongoing recession in German industry, especially in the automotive sector.

At the same time, companies and investors seeking to ride this momentum will encounter a highly regulated field. In the defence sector, the state is a dominant player in two respects: It is typically the sole customer for end products. At the same time, it creates a tight regulatory framework to protect its sensitive security interests. This poses challenges, especially for companies that have not been active in this field to date.

Public funding poses a particular challenge for foreign companies and investors, especially those headquartered outside the EU: The EU and its Member States have a clear focus on strengthening their own defence industrial base and gaining strategic sovereignty. Depending on the funding scheme and procurement procedure, contracting authorities may therefore disadvantage or even exclude companies from third countries, even from NATO member states and allied nations. The matter of whether exclusion is a real risk and of how to mitigate it through strategic structuring often requires careful legal analysis and should be considered at an early stage, such as when establishing fund or holding structures.

1. Relaxation of the Debt Brake: New Financial Leeway for Defence Spending

First, it is important to distinguish between targeted financing programmes – which often come with strict conditions for companies – and the broader easing of budgetary constraints in Germany. In the wake of the Zeitenwende, Germany has established several fiscal policy instruments that significantly expand the constitutional framework for defence spending:

1. The "Special Fund for the Bundeswehr" (€100bn)

This special fund was established in 2022 and anchored in the German constitution (Grundgesetz) with the aim of modernising the Bundeswehr quickly and comprehensively. It was designed as a separate, credit-financed fund outside the regular federal budget to bypass the constraints of the debt brake. The funds from this one-off facility are already almost entirely allocated to specific projects or contractually committed. Disbursements are expected to be completed by the end of 2027.

2. The Reform of the Debt Brake for Defence Expenditure

A permanent amendment to the constitutionally enshrined debt brake was passed in March 2025. This reform represents the most significant structural change for the long-term financing of Germany's security policy: expenditure for defence and security that exceeds 1 per cent of the GDP is now exempt from the debt brake’s regular credit limit. Thus, the federal government can incur new debt for this excess amount. The scope of this rule is broad, encompassing not only military defence but also civil defence and disaster control, intelligence services, cybersecurity, and support for states that have been attacked in violation of international law. This step creates a permanent pathway for higher defence spending.

3. The "Special Fund for Infrastructure and Climate Neutrality" (€500bn)

Another special fund amounting to €500bn is sometimes mentioned in public discourse in connection with the increase in the defence budget. However, while adopted at the same time as the reform of the debt brake, this fund is not intended for defence expenditure. Rather, it is exclusively dedicated to financing investments in civil infrastructure (e.g. transport routes and digitalisation) and climate protection over a twelve-year period. A reallocation of these funds for defence purposes is not planned.

All these measures merely expand the fiscal policy framework. The allocation of funds and the awarding of specific contracts remain subject to clearly defined procurement projects. Crucially, the new exemption clause in the debt brake does not mean that additional spending will flow automatically. The Bundestag retains its full budgetary sovereignty (the "power of the purse"). The federal government must therefore justify the necessity of expenditure in the annual budget process, and the Bundestag must explicitly approve the corresponding funds in the defence budget (Einzelplan 14). The instruments created thus enable political decisions for higher defence spending but do not replace them. To benefit from increased defence spending, it will hence be important to closely monitor the political decision-making process on an ongoing basis.

2. Subsidy Programmes in Germany 

The bulk of Germany’s rising defence budget will be channelled to companies via public tenders. However, public subsidies could also play a significant role, particularly in supporting defence companies during their start-up and growth stages. While the federal and state governments have long offered various subsidies promoting more general political goals such as digitalisation and innovation, there have so far been very few programmes dedicated to defence. 

However, last week, the German government coalition agreed to initiate the “Deutschlandfonds” as a new instrument of the federal government to advance Germany’s modernisation by deploying targeted public funds and leveraging private capital to finance key future investments. Through the Deutschlandfonds, particular funding is intended to be provided for investments in VC funds and direct federal equity stakes in start-ups and growth companies in the security and defence industries. The plan is to leverage and supplement private capital for young, in particular technology-driven, businesses. Details of the Deutschlandfonds, including its size, are not yet known, though reports suggest a total volume of €100bn. The specific investment conditions also remain unclear. For the defence sector, we expect a strong focus on German companies with location requirements similar to those outlined for the European programmes below.

In addition, the Federal Agency for Breakthrough Innovations (SPRIND) has suggested creating a dedicated SPRIND.MIL agency to scout, support, and fund the development of critical and disruptive military technologies, with an initial budget of €1bn over five years. The proposed programme would target the rapid advancement of innovative technology, using a unique model to identify, assess, validate, and develop transformative technologies through Red Teaming exercises in collaboration with the German Armed Forces, intelligence agencies, and European military partners.

3. EU Fiscal Programmes to Strengthen the European Defence Industry

In addition to national initiatives, the EU has launched a series of financial programmes to strengthen the European Defence Technological and Industrial Base (EDTIB), promote cooperation among Member States, and enhance the EU’s strategic autonomy. These programmes do not replace national defence budgets but rather complement them by creating incentives for cross-border collaboration and the development of strategically important capabilities. For companies, understanding these programmes and their participation conditions is crucial to benefiting from the available funding.

A common key eligibility criterion is that relevant companies must be established in the EU, posing a challenge for investors and multinationals based outside the EU, including non-EU NATO countries like the US. Executive management and substantial assets at both holding and operating/target levels should be genuinely located in Europe to avoid being perceived as a superficial "front" ("look-through" approach). While financial involvement from non-EU countries is usually permitted, it may still require careful review of corporate structures and, if needed, coordination with authorities. 

Following smaller programmes in direct response to the war in Ukraine like the €500m Act in Support of Ammunition Production (ASAP, now fully allocated), the key instruments are:

1. SAFE: A €150bn EU Loan Instrument for Defence

Adopted in May 2025, the Security Action for Europe (SAFE) is an EU financial instrument designed to accelerate defence readiness. As the first pillar of the European Commission’s 'ReArm Europe Plan/Readiness 2030', the programme is part of a larger ambition to facilitate more than €800bn in defence spending across the EU. It will provide up to €150bn in long-term, competitively priced loans to EU Member States for urgent, large-scale investments in defence capabilities. The EU will borrow these funds on capital markets, leveraging its strong credit rating to offer favourable loan conditions. The primary goal is to finance joint procurement projects, although temporary support for individual national procurement is also possible.

SAFE supports the procurement of a wide range of priority defence products, from ammunition and artillery to advanced air defence and maritime systems. A crucial condition for all projects is a "Buy European" focus: no more than 35% of a product’s component costs may originate from outside the EU, EEA-EFTA (i.e. Iceland, Liechtenstein, and Norway), or Ukraine. Stricter conditions, including the absence of non-EU restrictions on equipment modification, apply to more advanced systems.

The instrument is already in force. Member States must submit their national defence investment plans by 30 November 2025, with the first Council decisions and loan agreements expected by February 2026 at the earliest. Due to its strong credit rating, Germany is unlikely to make use of these loans itself; however, SAFE compliance remains important for German companies whose sales markets extend to other, particularly smaller, EU countries.

2. The European Defence Fund (EDF)

The EDF is the EU’s flagship programme for promoting research and development (R&D) in the defence sector. With a budget of nearly €7.3bn for the 2021–2027 period, the fund co-finances collaborative cross-border projects.

The fund has two main pillars:

• Research Actions: Financing collaborative research projects to develop new defence technologies. EU funding can cover up to 100% of the eligible costs.
• Development Actions: Supporting the joint development of prototypes and new defence products. These projects require the cooperation of at least three companies from three different EU Member States (or associated countries). EU funding is typically limited to a portion of the project costs.

Member States retain control over the procurement and ownership of the developed capabilities. The fund thus acts as a catalyst, not a substitute, for national investment.

The EDF has established the EU Defence Innovation Scheme (EUDIS), a fund targeting SMEs, startups, and scale-ups. It offers dedicated EDF funding calls, coaching, investor connections, and an accelerator programme with financing.

As a general rule, only entities established in the EU or an associated country (currently only Norway) are eligible to participate. The infrastructure used for the projects must also be located within the territory of such states. Companies controlled by third countries (e.g. the US or UK) can only participate if they provide security guarantees, approved by an EU Member State, ensuring that the strategic interests of the EU and its Member States are protected. 

Companies who wish to benefit from this programme should get involved in European cooperation networks at an early stage and actively participate in shaping EDF-compliant project consortia.

There are numerous smaller initiatives at EU level, including the Defence Equity Facility aiming to supply €175m to venture capital and private equity funds investing in innovative defence technologies with dual-use potential.

All EU programmes send a clear signal: companies wishing to benefit from enhanced European defence cooperation must demonstrate a strong presence in the EU or associated countries. For non-EU entities or those under the control of third countries, the hurdles for participation are high and participation is subject to strict security-related conditions. These restrictions should be taken into account at an early stage of any investment, not least as there is significant overlap with the requirements under foreign direct investment law.