Building Japan's First Next-Generation Global Defense Prime
Shifting powers on the global stage - impacting a >$1T global market - requires the timely creation of a new-age defense Prime in a country now "embracing defense" & without a "home-grown champion"
Across numerous dimensions, the Japanese government is now increasingly recognizing & addressing the country’s “most severe & complex” security environment in decades, with 86% of Japanese feeling there’s a danger that Japan will be drawn into a war
Japan plans to spend ~$315B over the next 5 years on defense & national security, aiming to reach ~2% of GDP, up from a recent historical, informal cap of 1%
Loosening defense export restrictions by the Japanese government expands the viable addressable market for Japanese defense companies to >$1T of annual military & security spend among Japan’s allied & friendly nations, many of whom are now actively seeking defense supply chain & production diversity
Since the end of WWII, Japan’s defense industry has been decimated, with a significant percentage of the country’s current defense spending flowing abroad, creating a timely, critical & attractive opportunity for a next-generation, globally competitive domestic “defense champion” to emerge
A uniquely Japanese global defense technology Prime: Act I) consolidating, modernizing & globalizing defense industry SMBs; Act II) develop innovative, new-age defense technology products in service of Japan, its allies & other friendly nations
Before diving into the focus of this post, I’d first like to provide some general background context, which encouraged & underpins much of the below discussion:
While not often openly shared to-date, a strong & enduring interest in geopolitics, military history & modern war planning greatly pre-dates JBI’s public display of affection for Japan, software & SMBs, dating back to my time at university in Washington D.C. When not tending to general life & work matters, I am often buried in books, white papers & podcasts breaking down past military campaigns or explaining the complexity of leadership regimes driving today’s global powers. So, the opportunity to tie Japan, software & SMBs together within the broader geopolitical & defense realm - and hopefully into one’s life’s work - is pretty exciting, to put it lightly!
While I know many may disagree, including plenty of Japanese in Japan, over the years I’ve arrived at a rather non-consensus perspective regarding Japan’s future: in short, over the coming decades, Japan will experience a relative economic, entrepreneurial & technological “renaissance”, which will allow the country to re-assert itself as a leader on the global stage
Importantly, this envisioned “resurgence” is meant to be compared to the current expectations held by most regarding Japan’s “tomorrow”: namely, a generally risk-averse, inward-focused population that will endlessly decline across numerous measures until Japan becomes a largely irrelevant former global power, primarily celebrated for being a wonderful tourist destination
With more globally-aware, digital-native Millennial & GenZ Japanese coming to power across the political, business, military & cultural spheres over the coming decades, these new-to-power, relatively more “risk-open” leaders will usher in a new way of governing, growing & powering Japan into the future. These relatively more optimistic & ambitious generations will not sit by idly, watching the world’s now 4th largest economy - comprised of a highly educated, hard-working workforce, underpinned by a strong rule-of-law within a high-functioning society, with immense know-how across several critical industries and much else - wither into a non-entity on the global stage
With the additional “tailwind” of expanding, “high-quality”, controlled immigration into Japan - already at ~3M primarily working-age foreign nationals living in Japan today & set to grow to ~10% of the population by 2070 according to internal government statistics (a ~5x increase, reaching a similar to percentage to that of the U.S. today) - a capable, sufficient overall talent pool will be available to help power the resurgence of Japan’s global prominence & vitality
Lastly, please do keep in mind throughout this piece that I am certainly not a geopolitical, military nor a war planning expert…in spite of however much I may pretend that I am!
Shifting Balance of Powers Ushering in a Renewed Focus on New-Age Defense
An entire post could be dedicated to the fast-changing nature of modern warfare today. Suffice to say, technology & “asymmetric weaponry” is playing an ever greater role, shifting the “fulcrum of success”, in some aspects, to the i) speed & quality of innovation; and ii) speed & scale of production (i.e. munitions, weapons, etc.). To succinctly highlight the degree of change occurring on the modern battlefield, we can look no further than to Ukraine today:
“90% of wounded Ukrainian soldiers who have made it to a stabilization point have been hit by a [first-person view] drone or by explosives dropped by a drone.” - Kyiv Post
With this new warfare reality in mind, it may be instructive to first briefly touch on the world’s largest defense spender and one of Japan’s closest allies, The United States, in the context of the global threat space and the broader defense industry.
For those even passively aware, it should go without saying that China, Russia, North Korea & Iran have dramatically elevated their military posture in recent years. In some cases, these efforts have had a seemingly explicit aim to pursue longer-term expansionist goals. Depending on one’s perspective, the current and potential threats posed by the leaders of these four countries in particular represents a significant ongoing risk to global stability and security. This uptick in aggression & ambition has, unfortunately in some cases, been impossible to ignore by the rest of the world. This has, in turn, prompted noticeable recent changes in how the world’s leading military, that of the U.S., is approaching security, defense & modern warfare. In short, the days of the U.S. military operating with a force structure primarily designed for short, decisive wars reliant on overwhelming military strengths and technological superiority are over.
While not entirely “caught on its heels”, the U.S. military and defense industry are by no means in a place today to expeditiously adapt to & address all aspects of the fast-evolving global security landscape. For example, the U.S. Coast Guard recently embarked on its largest shipbuilding effort since WWII. This plan is encouraging to see, however, U.S. naval shipbuilding capacity has dwindled from 21 shipyards shortly after WWII to just 8 today, with the commercial shipbuilding industry experiencing a similar decline. Compare this situation with that of China’s, who presently enjoys 50x to 300x the military shipbuilding capacity of the U.S. In a modern naval battle in the Pacific, the side capable of refreshing its entire naval fleet within 1 to 3 years will undoubtedly have an advantage over the other who requires 10, 20 or 50 years to do the same.
“China is currently building the equivalent of the entire [British] Royal Navy every two years.”
Clearly, there is much work to be done in modernizing and revitalizing the U.S. military and the U.S. defense industrial base. To that end, and while certainly not a panacea, there has been a recent surge in private risk-capital & entrepreneurs beginning to help accelerate this process in the U.S., as partly evidenced in the below chart:
However, unlike in decades past, the U.S. cannot - and is increasingly preferring to not - shoulder this responsibility predominately on its own across the global stage.
Importantly, this reality extends, perhaps most pressingly, to the U.S. defense industrial base & supply chain. Deputy Secretary of State Kurt Campbell recently commented that the COVID-19 pandemic highlighted "that some of these supply chains on the military side are so narrow and easily clogged that we are going to need to have more capacity in play.” He further added, specifically as it relates to Japan:
“We [the U.S.] see Japan as an underutilized resource. Japan's manufacturing as a percentage of GDP is twice what the United States' is. Japan has a very impressive industrial base, but it's underweighted on the defense side.”
Similar commentary can be found in the recently, and first-ever, published U.S. National Defense Industrial Strategy:
“Our global supply chains are critical components of our defense industrial ecosystem, yet they are vulnerable, particularly in their sub-tiers…proactively developing, growing, and sustaining multiple, redundant, production lines across a consortium of like-minded nations is imperative for the U.S…the DoD must develop a networked cooperative framework that enhances defense industrial output by working with allies and partners to de-risk supply chains and advance our ability to engage in co-sustainment, maintenance, repair, and overhaul.” - U.S. National Defense Industrial Strategy, 2023
Evolving Priorities in Japan, with Allies Shifting Supply Chain Focus to Japan
“Among national security specialists, there is a sense of a gathering threat. One official argues that Japan faces a more dangerous environment than any other G7 nation — because it has China, Russia and North Korea as close neighbors.”
Japan has increasingly embarked upon - at the “quiet” urging of the U.S. - a reinvigoration of its defense capabilities over the last decade, and especially so more recently. For the sake of brevity, three examples are worth noting:
Japan’s Self-Defense Forces (“SDF”) - the name by which the Japanese military is referred - has seen its area of operations expanded, allowing it to engage under more circumstances, and is being encouraged by the Japanese government to modernize its range of actions, including an improvement to its counterstrike capabilities, to make it a more formidable fighting force
In December 2022, Japan published three unprecedented & critically important documents: i) the National Security Strategy; ii) the National Defense Strategy; and iii) the Defense Buildup Program
The passing of a law(s) in 2023 to establish a new permanent joint command, aptly named Japan Joint Operations Command (“J-JOC”), tasked with overseeing all three branches of the military and set to be officially launched at the end of March 2025. Importantly, J-JOC will further enhance effective cooperation & collaboration with the U.S. military.
“…we announce our intention to bilaterally upgrade our respective command and control frameworks to enable seamless integration of operations and capabilities and allow for greater interoperability and planning between U.S. and Japanese forces in peacetime and during contingencies…these initiatives elevate our defense ties to unprecedented levels.” - joint statement by U.S. President Biden & Japanese Prime Minister Kishida, April 2024
So, change is clearly afoot in Japan, however, why exactly is the long-time pacifist Japan rapidly adopting a more “forward-leaning” defense posture of late?
While a proper answer to this question is undoubtedly multi-faceted & complex, one primary potential threat is arguably of utmost importance to Japan: the Chinese Communist Party (“CCP”).
“In the three years since he's been in command, Aquilino [former commander of the United States Indo-Pacific Command until May 2024] says China has built more than 400 aircraft, 20 major warships, and doubled its missile inventory.”
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To provide a rough idea of the likely growing “sense of urgency” with which the Japanese government, military & intelligence services are seeking to address the potential threat of the CCP, let’s walk through a “worst-case” scenario for Japan:
Let’s first assume that the CCP decides to invade Taiwan at some point over the next decade, and let’s also assume that the CCP is successful in doing so. Very shortly thereafter, the People’s Liberation Army Navy (“PLA Navy”) - China’s navy - will then have a highly credible opportunity to enforce an effective blockade of Japan. This would be disastrous for a democratic Japan, if only due to the country’s heavy reliance on imported energy, with upwards of 89% of its total energy requirements coming from abroad. Moreover, much of those energy imports are sourced from the Middle East and transported by sea predominately via the Taiwan Strait. As a result, the CCP would then have de-facto control over Japan in this scenario, without ever needing to theoretically fire a single shot at or in Japan. Assuming this scenario has even a small degree of plausibility, helping to defend Taiwan from a Chinese invasion is arguably just as much of a fight for Japan’s own existential survival.
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Now, I am no military planner and there are, of course, a multitude of other factors that would play into how or if this scenario would ever occur in reality. However, the key takeaway remains: the increasing potential threats posed by an expansionist CCP - not to mention Russia (e.x. the Kuril Islands dispute) & North Korea - are not to be taken lightly by Japan.
“By choosing not to defend Taiwan, Japan can minimize short-term losses but risks the tremendous long-term cost of irreversibly weakening its regional security posture…accepting China’s control over Taiwan would effectively mean also accepting Japanese subordination to Beijing. If this prospect does not constitute a threat to Japan’s national existence, then nothing does.”
In support of the broader perspective of Japan facing a worsening regional security environment, the Japanese government has itself said as much in its National Security Strategy document released in December 2022:
“Japan’s security environment is as severe and complex as it has ever been since the end of World War II…[with] the free, open, and stable international order…now at stake with serious challenges amidst historical changes in power balances and intensifying geopolitical competitions.”
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While the Japanese government is seemingly quite aware of the fast-evolving regional threat landscape, the Japanese populace is, in fact, not too far behind. 86% of those polled in a 2022 survey feel there is a danger that Japan will be drawn into a war vs. 72% in 2011.
Moreover, a record ~87% of Japanese "do not feel friendly" toward China, according to a Japanese government poll conducted during September & October 2023.
All the while, the CCP is certainly not helping itself with regards to China’s public perception among the Japanese people…quite the opposite, in fact:
“Once the country of Japan is tied to the tanks plotting to split China [i.e. defending Taiwan], the Japanese people will be brought into the fire.” - Wu Jianghao, China’s Ambassador to Japan; May 2024
A Dire & Immediate Need to Revitalize Japan’s Decimated Defense Industrial Base
“Japan’s strategic position in the [Asia] regional security framework helps make it a magnet for global defense corporations. These advantages include Japan’s political stability, a robust defense technology foundation and a significant defense budget.” - Nozomu Yoshitomi, a retired Major General with the Japan Ground SDF & professor of risk management at Nihon University
To initially frame the current realities of Japan’s defense industrial base, let’s take a quick look at the leading Japanese defense industry companies. While slightly dated, the below chart details the top 10 largest domestic defense contractors of Japan’s Ministry of Defense as of FY2021 [note: “% of total” refers to the company’s defense revenues as a % of its aggregate revenues].
A few things to note related to the above chart, as well as more generally:
Mitsubishi Heavy Industries has the largest domestic defense industry exposure, with $459M in defense industry revenues, representing just 25% of aggregate revenues
The degree of defense demand dependence (i.e. the % of defense-related revenue relative to a company’s overall revenue) is approximately 5%, on average, across Japanese companies with any defense related revenues. Said another way, the Japanese defense industry sorely lacks - and is in significant need of - economies of scale & associated cost efficiencies
Compare this to the U.S., where the defense sector accounts for ~90% of major defense contractors’ total sales
Japan’s defense industry represents ~1% of Japan's total manufacturing production, or ~¥3T (note: the U.S. equivalent is between 2% to 4%, depending on what is included), with a focus on small production runs of large product ranges (i.e. inefficient)
Unlike the U.S., U.K. & China, Japan does not have any nationalized defense factories. All that is procured by the country's Self-Defense Forces is manufactured and supplied by private-sector companies
This is set to change - on a seemingly small-scale & case-by-case temporary basis - given recent legal amendments in Japan, whereby the Japanese government can nationalize struggling defense equipment manufacturers
The number of Japanese companies withdrawing from the defense industry has exceeded 100 in the past 20 years, including large companies such as Komatsu (2019), Daicel (2020), Yokogawa Electric, Mitsui E&S Shipbuilding, and Sumitomo Heavy Industries (2020)
“According to the Stockholm International Peace Research Institute's latest report in December [2023'], only four Japanese arms manufacturers ranked among the top 100 global companies. Japan also ranked among top arms importers, mostly of costly U.S. arsenals.” [note: Japan is home to the world’s 3rd largest manufacturing base…]
Critical to highlight is that as a result of the above, a meaningful percentage of Japan’s defense spending - and thus tax dollars - are flowing to foreign, and primarily American, defense companies. As a point of reference, defense imports specifically from the U.S. increased to ~20% of overall purchases by Japan’s Ministry of Defense, up from 8% in 2010, which is likely to only further increase in the foreseeable future.
That being said, domestic defense companies are gradually “answering the call”, with Mitsubishi Heavy Industries, for example, recently announcing plans to double its defense related sales to around ¥1T in three years [note: presumably this includes space & aircraft related revenues, which MHI includes alongside its defense revenues], and to increase the number of defense division employees by around 30% from the current 6,000. While commendable, such efforts are, unfortunately, just barely scratching the surface.
Of course, it makes sense for a country’s defense industry to have been more or less gutted when operating inside a historically (post-WWII) constitutionally-mandated pacifist country with onerous defense export controls. This has left the Japanese defense industry woefully underfunded & underdeveloped, often selling products with high prices, powered by aging technologies. Given this historical context & the related Japanese cultural views towards “war”, many Japanese companies have highlighted the reputational risks if too openly involved in the defense industry (note: which is something our to-be-born, next-generation Japanese defense technology company - which we’ll soon discuss in greater detail - should lean into).
As touched upon earlier, however, change is afoot across numerous dimensions in support of a stronger security & deterrence posture by Japan, closely followed by a reemergence of Japan’s defense industry.
Japan’s growing defense budget:
2022: ¥5.4T (~$35B), or ~1.1% of GDP
2023: ¥6.5T defense budget (~$42B), a ~20% YoY increase
By 2027, the Japanese government plans to increase spending to ~2% of GDP, which would ~2x the current budget
September 2023: Japan To Become Third-Largest Military Spender By 2027; Plans To Spend $315B Over Next 5 Years
“The Defense Buildup Program aims to attract new entrants and established players in the defense industry ‘by improving the longer-term predictability of procurements, offering subsidies for industrial facilities and cyber defenses, and strengthening information and industrial security’”
October 2023: Japan passed the Defense Production Infrastructure Enhancement Act, which provides “support for diversifying supply sources, increasing the efficiency of manufacturing equipment, strengthening cybersecurity, financial support for business succession, and the purchase and management outsourcing of equipment by the government”
January 2024: U.S. to coordinate defense supply chains with Indo-Pacific partners
“The U.S. will advance "friend-shoring" or reliable manufacturing networks with partners regarded as political and economic allies. The document cited Australia, India, Japan, South Korea and Taiwan along with the U.K., Canada, the European Union, Israel and Mexico.”
Note: from the perspective of wartime logistics, it is optimal to acquire then needed arms in a given conflict area from the closest production base (i.e. Taiwan → Japan)
April 2024: US ambassador to Japan says boosting arms industry ties is key to stronger security alliance
“The countries will now look at what Japan can co-license, co-produce and co-develop”
E.x. Japan will export Patriot interceptor missiles produced by Mitsubishi Heavy Industries under license from Raytheon & Lockheed Martin to the U.S.
Dec 2023: “Revisions to the implementation guidelines threw open the door for exports [from Japan] of not just defense equipment components, but finished products, as well as lethal weapons to a much wider range of nations. For example, now, not only can finished products be exported, but defense equipment can be shipped to any nation that has a licensing agreement with Japan to manufacture domestically…further discussions will be held within the ruling coalition from early next year about allowing the export of finished products developed jointly.”
April 2024: Japan, U.S. to Reform Defense Command Structures; Moves Aimed to Enhance Mutual Cooperation
“Japan and the United States will convene a forum on defense industrial cooperation to bolster joint production systems amid tight production situations in the United States”
“Japan hopes to expand sales channels for the domestic defense industry, which have been limited to the SDF, and strengthen its production base”
April 2024: DoD: AUKUS Partners Consider Cooperation With Japan
It is said that Japan is quietly seeking to join AUKUS Pillar II, a tight security alliance between the U.S., United Kingdom & Australia - the current & only three members of AUKUS - who aim to trilaterally develop & provide joint advanced military capabilities
Already, it is known that the Australians will receive nuclear attack submarines from the U.S. as well as medium-range air-launch cruise missiles
While it may not happen in the near-term, Japan’s addition to the group is likely to remain on the table - with the Americans apparently acting as a louder advocate than the Japanese themselves - though it will require a more proactive & “updated” Japanese military (e.x. active naval patrols within its near-sphere of influence & significant improvements to its cyber & data security capabilities)
In addition to “tightening up” its intelligence apparatus, Japan is also actively exploring the launch of a more comprehensive security clearance program for both the public and private sector, similar to the one in the United States. At present, Japan effectively has no such system in place. In fact, a mere 130k public sector and 3,444 private sector individuals hold any type of security clearance in Japan (~0.11% of Japan’s population) vs. ~4.25M individuals holding any type of security clearance in the U.S. (1.3% of the U.S. population). Doing so will further bring down the barriers for Japanese defense companies to interact with and sell defense products to global allies & friendly nations
Avery new ~100-person research department within the Ministry of Defense’s Acquisition, Logistics and Technologies Agency (ATLA) received initial funding in Japan’s FY2024 defense budget. This newly formed group, temporarily named the “Defense Innovation Technology Research Institute”, is closely modeled after and influenced by the U.S. Pentagon’s “Defense Innovation Unit” (DIU) and the U.S. Defense Department’s “Defense Advanced Research and Planning Agency” (DARPA)
Its primary aim is to support innovation in key technology areas largely via public and private collaborations, focusing on identifying and developing “breakthrough technologies”, with an eye to rapidly operationalize viable projects
Global defense manufacturers are increasingly shifting their Asia regional headquarters to Japan:
United Kingdom-based BAE Systems relocated its supervisory functions from Malaysia to Japan in late 2023
United States-based defense company Lockheed Martin is relocating its Asian strategic hub from Singapore to Japan
Other companies, including U.S.-based L3Harris Technologies, Thales of France and Turkey’s STM, also are increasingly interested in Japan offices
Japan + U.S. Security Alliance Driving Collaborative Defense Industry Integration
We’ll refrain from diving much further into details of the increasingly tight alliance and security relationship between Japan & the U.S. To summarize, coordination & cooperation between the two nations is as close & deep as it has ever been.
More specific to the defense industry, Japan and the U.S. recently established a new consultative body, the Defense Industry Policy Coordination Council, to promote industrial collaboration related to defense equipment. Part of this effort aims to expand the scale of U.S. military equipment that can be maintained and repaired in Japan, with deeper integration across the entirety of the two countries’ defense industrial bases as an ultimate end-state. A few relevant quotes may best serve to further highlight this partnership:
“To leverage our respective industrial bases to meet the demand for critical capabilities and maintain readiness over the long term, we will convene a Forum on Defense Industrial Cooperation, Acquisition and Sustainment (DICAS) co-led by the U.S. Department of Defense and Japan’s Ministry of Defense to identify priority areas for partnering U.S. and Japanese industry, including co-development and co-production of missiles and co-sustainment of forward-deployed U.S. Navy ships and U.S. Air Force aircraft, including fourth generation fighters, at Japanese commercial facilities, in coordination with relevant ministries.” - White House Press Release: Joint Leader’s Statement of the U.S. & Japan, April 2024
…the National Defense Industrial Strategy (NDIS) released by the U U.S. Department of Defense in January 2024…recommends an increase in the supply chain visibility, investment in excess production capacity, and international defense production cooperation. The fact that the NDIS calls for cooperation with allies and partners in addition to its emphasis not only on the quality but also the quantity and redundancy of defense production represents in a sense an opportunity for Japan, a latecomer to exports, to participate in the U.S. market”
“The cooperation will not be limited to repairing U.S. naval ships at Japanese private shipyards but will also envision the co-development and co-production of munitions, planes and ships in the future…the U.S. sees huge potential to "integrate" Japan into America's defense industrial base.”
A Timely Opportunity to Build a Uniquely Japanese Defense Technology “Champion”
To set the stage, if you will, let’s first briefly outline some of the more significant, current “hurdles” which i) prevent a more vibrant overall Japanese startup ecosystem, that, mind you, has been growing & accelerating over the past decade; and ii) which will impact - both negatively & positively, depending on where one “sits” - the creation of a next-gen Japanese defense technology Prime (note: “Prime” refers to a handful of very large companies that hold contracts for major U.S. Department of Defense systems & programs)
Culturally, Japanese tend to be relatively more risk-averse and consensus-driven vs. their counterparts in the U.S., for example. While these facts in and of themselves are not necessarily negative, they do constrain a higher velocity of new startup formation (& “destruction”) + limit the speed of execution & degree of competitiveness of Japanese technology companies more broadly, particularly on the global stage. Largely because of this, Japan has a relative lack of:
Entrepreneurs, let alone “quality” entrepreneurs
Innovative, fast-moving, global corporates comfortable with & capable of valuable “fast-failing”, and all that comes with that (i.e. talent “well-versed” in & eager to embrace such work environments)
Among the entrepreneurial ranks & active startups in Japan today, I would argue it is fair to categorize the whole lot (yes, there are exceptions) as follows:
Technology entrepreneurs are young…frankly, “too young”, in most instances. Anecdotally, the majority of startup founders in Japan launch their businesses while in their 20’s or early 30’s. Contrast that with the U.S., where various sources suggest ~16% of startup founders launch their companies in their 20’s, while 23% are over the age of 45
Age & experience do matter on multiple levels, including in having a more developed sense of self-awareness, more deeply honed skill-sets, greater credibility & more industry know-how (which can also be a limiting factor…), among much else
In part due to the immediate above, most startups in Japan are relatively “simplistic”. Said another way, building the next HR SaaS app tends to be more attractive & viable vs. attempting to pursue more sophisticated, ambitious and / or complex opportunities, the latter of which often offering more substantial upside in terms of real-world, lasting impact & enterprise value creation over time (i.e. a next-gen defense technology company)
While the relative sophistication of VCs as a whole in Japan also acts as a bit of a “challenge”, there are several local firms who have certainly “broken away” from the pack in this regard & can compete with global peers. Also worth noting, the Japanese VC industry AUM matches that of the Japanese private equity industry today (i.e. there is ample domestic risk-capital in Japan to fund truly ambitious startups requiring substantial funding over time, before even mentioning the growing availability of relatively cheap & plentiful venture + bank debt for Japanese startups):
Alright, so, what exactly are we building?
At a high-level, there are two core opportunities that this to-be-built future Japanese defense technology “champion” can pursue. Perhaps uniquely in Japan, a very strong case can be made that this single company can and should address both:
Consolidating, modernizing & “globalizing” Japanese defense industry SMBs
Identifying, developing & selling globally new-age defense technology products
Specifically in Japan today, executing the first (“#1”) is critically complementary - if not out-right necessary - in order to execute the second (“#2”). Said another way, it is arguably not possible today in Japan to assemble the required “puzzle pieces” to execute #2 from the outset, at least with any statistically significant probability of scalable success. From raising sufficient capital, to attracting & aggregating the “right” type & amount of talent, to having any clue of what to actually build, to having the proper manufacturing capabilities in-place, to the needed preparedness of the Japanese government & MoD…building what can become a truly scalable, globally leading defense technology company from Day 1 (i.e. #2) - beginning today in Japan - is a moonshot of a moonshot. Of course, one can try - never say never - but the risk-reward equation is virtually all-risk…with no need to assume such risk so early when the ability to gradually de-risk #2 can be done with far less risk, competition & sophistication, all while building powerful & enduring foundational advantages, via #1.
Alright, a quick breather after that…
Now, to ground things a bit & provide some tangible context to grasp what exactly is being suggested, one can think of this envisioned next-gen Japanese defense technology Prime as a combination of two U.S. peers:
While both Hadrian & Anduril may be enjoying the benefits of being two of the more higher-quality “first-movers” in the rapidly emerging, and already sizable, defense technology space in the U.S., such “first-mover” advantages would accrue to our hypothetical Japanese “Hadrian + Anduril” to an even greater degree, in large part due to a lot of the reasons outlined earlier. To briefly re-highlight some of those:
A decimated Japanese defense industry with zero dedicated defense companies
A Japanese government actively encouraging the revitalization of Japan’s defense industry, and almost certainly hoping for one or more “domestic champions”
Global nation-partners seeking greater integration with Japan’s defense industry
A relative lack of entrepreneurs, let alone any pursuing anything substantial - or perhaps at all - in the defense technology arena
So, it is not far-fetched to suggest that the reputational, know-how, talent, sales & overall business momentum / advantages of this truly “first-mover” next-gen Japanese defense technology company will be extraordinarily hard to match domestically over time. Of course, “the devil is in the details”…execution is & will be everything.
A Technology-Enabled, Globally Minded Defense Industry SMB Serial Acquirer
Frequent readers of Japan Business Insights will recall I’ve been a very strong & vocal proponent of the SMB acquisition opportunity in Japan since 2019 or so. Over the ensuing years, I’ve inspired, advised and helped capital raising efforts of a few private SMB acquisition vehicles active in Japan today. I’ll refrain from rehashing the details of this SMB acquisition thesis here and will instead direct you to a few previous JBI write-ups where I discuss this topic in more detail:
That said, I will share a few subsequent learnings of mine regarding this particular opportunity that I’ve since first-hand observed while living in Japan:
While the scalability of this financing is an open-question, it is indeed viable to acquire SMBs in Japan at 90%+ loan-to-value ratios & 1-2% interest, all while being “cov-lite”
There are numerous existing, publicly-listed SMB serial acquirers in Japan today across several verticals. Some of these companies have scaled to market capitalizations in the billions of USD. So, the model is active here, works here and has been proven to resonate with SMB sellers
An industry agnostic approach to SMB acquisitions may allow for meaningful individual wealth creation to a point, though industry specialization is arguably necessary to truly scale and, importantly, to “side-step” over time what is a virtually 100% brokered market today with very high deal fees
Now, let’s refocus our attention back to the Japanese defense industry…
There are >10k SMBs in Japan today active within the defense industry, primarily specializing in parts and components. Most of the these SMBs have <300 employees, with a meaningful number selling essential defense technologies / products or acting as sole-source suppliers.
Important to note, unlike the consolidation which occurred in the U.S. and Europe in the 1990s and 2000s (e.x. the number of U.S. defense Primes went 51 to 5 today), there remains significant fragmentation across Japan’s industrial defense sector. For example, there are more than five companies producing major defense electronics systems, three companies producing military helicopters, and four companies involved in naval shipbuilding
To an extent, competition is certainly welcomed in any supply chain. However, the high degree of fragmentation within Japan’s defense industry, alongside numerous other factors, has to-date actually served to limit the overall size of the industry profit pool, allowed for significant inefficiencies (i.e. costs & talent) across the board and has discouraged innovation. At first thought, this may seem counterintuitive in ways, though particularly with a number of SMBs across the defense industry supply chain acting as sole-source suppliers, scale economies are sorely lacking, which has “trickle-down” impacts on industry wages, talent quality, R&D investment capacity & so on
While on the topic of profitability, and to reinforce the above assertion, the Japanese government is currently developing plans to ensure adequate and predictable profitability for defense industry companies of all sizes, largely to limit the continual withdrawal of companies from the defense sector. More specifically, reforms are underway to raise the average operating profit margin from 8% to 15% across the entire defense industry:
To provide a further data point regarding the degree of fragmentation, let’s use ShinMaywa Industries as an example:
The company specializes in transport aircraft and industrial machinery. Specifically related to defense, ShinMaywa maintains 1,000 supplier relationships involved in making fighter jets and tanks and about 7,000 engaging in the production of destroyers
Critically, a core element of the SMB acquisition thesis in Japan is the rapidly aging cohorts of SMB owners, which is worse than anywhere else globally. More specifically, surveys completed by Teikoku Databank have found that ~25% of SMBs in Japan have owners over the age of 70. Applying this percentage to ShinMaywa’s destroyer supply chain would suggest that just this supplier base alone requires at least some degree of consolidation of 1,750 SMBs
Of course, such an SMB aggregation strategy will greatly benefit from close partnerships & coordination with existing large defense industry companies as well as the Japanese Ministry of Defense, the latter of whom is set to explicitly support business successions when potential “industry withdrawal” is likely.
A “Global DNA” from the Outset
Unlike few other industry verticals in Japan, a dedicated defense industry SMB serial acquirer will need a competent global sales capability from Day 1, especially in light of much of what was discussed earlier. To summarize & expand upon some of that, the Japanese government is now actively encouraging SMBs within specific segments of the defense sector to export to customers in friendly nations. The core reasons for the government’s push is largely twofold: i) allies such as the U.S. are, in effect, requesting tighter integration to bolster and diversify their own defense industry supply chains; and ii) increasing global sales will expand the profit pool available to Japanese SMBs, thereby improving Japan’s defense industry’s sustainability and ultimate quality. Notably, it is widely expected that additional defense export bans will be gradually lifted or greatly reduced moving forward.
Now, while this all sounds well-and-good on paper, successfully exporting abroad will not be a mere “flip of the switch” for most all Japanese SMBs. To drive this point home, since Japan introduced the “Three Principles on Transfer of Defense Equipment and Technology” in 2014 - which lifted decades-long bans on exports in five specific categories (rescue, transport, warning, surveillance, and minesweeping) - there has been just one successful example of an export of finished defense goods: a $100M contract for four units of air surveillance radar between Mitsubishi Electric & the Philippines military.
Clearly, due in large part to decades of strict export controls, among several other factors, selling abroad will be a truly “new muscle” for not only Japanese defense industry SMBs, but for foreign buyers of their products as well. As per the below graphic from Stockholm International Peace Research Institute, Japan - the world’s 3rd largest manufacturing economy - does not even land in the top 25 global arms exporters, though ranks #6 in terms of imports, with the U.S. accounting for 97% of its arms imports.
As one would expect, selling defense equipment, parts and weapons to foreign countries involves complex certifications, drawn-out sales processes, frequent communications with numerous stakeholders & occasionally involved negotiations. All of this is only further compounded by language, cultural and, in some cases, generational differences involving a country, namely Japan, where these barriers are inherently quite steep when interacting with global partners.
“SMB suppliers don’t have a strong track record of doing business overseas…many are lost when it comes to doing business directly with overseas contractors…Japanese companies fall short in getting certifications, so even when they have good quality parts, they are not even considered” - Hideki Fukawa, Director of the Defense Industry and Aerospace Division at the METI
To drive home this broader point, just ~5% of all defense products developed in Japan today are currently exported abroad (right axis below).
“Rather than preserving sectors with low demand through fiscal support, the aim should be to consolidate domestic defense demands across sectors and products by integrating various products as well as promoting overseas exports and international expansion, leading to empowering companies to voluntarily make decisions regarding integration and restructuring. In order to make the defense industry sustainable, it is necessary to choose a self-sustaining industry foundation, consolidate its strengths, and incorporate civilian technologies.”
While we won’t discuss specifics in this post, our envisioned next-gen Japanese defense Prime would be wise to “digitize” & “productize” the global end-to-end “go-to-market” sales process for Japanese defense industry SMBs. Not only would this greatly support owned SMBs & foreign customers alike, but it would also act as a powerful “deal-sourcing” & “deal closing” tactic to identify and build rapports with prospective SMB acquisitions.
[Regarding recent changes to Japan’s defense export regulations] Japan also will allow nations to provide the equipment they receive [from Japanese defense exporters] to a third country or region with prior approval…this means the U.S. could send Japanese-made equipment to countries in Europe…policymakers hope such options will bolster Japan's contribution to international security and strengthen its alliance with the U.S.
We also won’t discuss it in this post (some things have to remain a “secret”!), but underlying the entire SMB strategy and supporting a growing portfolio of SMBs should be i) a highly functional, vertically integrated ERP of sorts (e.x. Hadrian’s FLOW); and ii) the gradual consolidation of all acquired, in-house production into several new-build, state-of-the-art manufacturing facilities located throughout Japan.
Developing World-Class, Innovative Defense Technology Products Right at Home
To re-iterate a point briefly touched upon earlier, it is worth emphasizing that the current array of weapons systems sold by the largest defense companies in the world - and mostly purchased by the largest military in the world - are increasingly outdated and cost ineffective in the fast-evolving battle spaces of today.
To use a well-known recent example, some readers may recall the encounters between the Houthis in the Red Sea and the U.S. Navy. In these skirmishes, the U.S. Navy was required to use, I believe, one to two Tomahawk missiles to neutralize the threat. Unfortunately, each of these missiles costs $1.89M per shot…all to take down a single drone, costing somewhere between $20k to $50k. While Tomahawks & the like will always have a place for longer-range purposes, this is clearly unsustainable for the growing number & frequency of close-in engagements.
Of course, there is more to this broader problem than a mere lack of new, innovative weapons for today’s modern battlefield (e.x. entrenched, counter-productive incentive structures in Washington D.C.), though the stark realities playing out in Ukraine alone will, one would hope, force the necessary changes across the board over time.
Given the above, coupled with the current state of Japan’s overall defense industry, the bar has never been lower and the urgency never higher with regards to the emergence of a home-grown, new-age defense technology company capable of building modern defense equipment & technologies suited for current & future warfare. This is especially true when considering recent revisions to Japan’s defense export guidelines in December 2023, which include the following core policy changes:
Important to note: “the current [December 2023] version of the Three Principles and guidelines should be seen as part of an ongoing process aimed at a more sweeping policy change.”. This is encouraging to hear, as further changes are required if Japan is truly serious about elevating its defense capabilities at home. For example, one recommended change would be to mandate a greater use of international standards for defense equipment requirements. Presently, many Japan-made defense products purchased by the SDF have very “Japan-specific” specifications. Eliminating this unnecessary “uniqueness” will help lower development & production costs, while greatly expanding the export potential of newly developed defense products in Japan.
While not outright suggesting that Japanese defense technology startups blindly pursue a “copy & paste” approach in building “clones” of U.S. peers - which has more or less been the case across some of the Japanese startup ecosystem to-date - there is arguably a valid need for domestic defense technology companies to develop “at home” some of what the Japanese military is currently or may in the future acquire from abroad. More generally, defense related end-product-categories where the Japanese i) need to scale procurement; and ii) can likely excel at developing portions or all this equipment domestically, include:
Integrated air & missile defense technologies (“IAMD”)
Offensive missile technologies, including medium-range surface-to-air, hypersonic & directed energy weapons
Autonomous command-and-control technologies, specifically for underwater & ground purposes
Sensor, tracking & other detection products
Dedicated drone carriers, or the like, given Japan’s shipbuilding capabilities
As argued earlier, our next-gen Japanese defense Prime is not in a position to confidently know what is “best” to build in terms of new-age defense technology products from Day 1. However, we can confidently state that the focus should be on technologies & products with one, or ideally both, of the following features:
Dual-use: catering to both military & private-sector purposes
Asymmetric: relatively cheap to build & can be plentifully produced
Such products act as a potent counterweight, if you will, to enemies capable of mass-producing warships, missiles, shells, etc. at a hard-to-mimic pace & scale (i.e. China)
Relevant to note - particularly for a non-expansionist Japan focused more so on deterrence & true defense capabilities - is the general rule of thumb in the military world that one needs 3x as much force to take a position versus defend that position. So, the “wartime cost-curve” of “tomorrow’s” likely battles almost certainly benefits Japan and its predominately liberal democracy allies & friends
For brevity’s sake, we’ll hold off on diving further into other aspects of this innovative “Act II” of our future next-gen defense technology company. Citing Anduril to-date as an exemplary role model for this business should provide enough high-level context with regards to the envisioned scope, aims and ideal image of success.
An Act “2.5” To Solidify A Generational Global Japanese Defense Prime
As highlighted earlier, the defense technology industry in the U.S., most of all, is exploding. Almost certainly, the largest, most innovative and most successful defense companies of the future will be founded in the U.S. The same can be said, of course, for globally leading technology & software companies of the recent past.
Perhaps unsurprisingly, many U.S. technology & software companies have been unable to successfully expand into Japan, particularly on their own. Groups like Japan Cloud - whom I admire & have discussed in prior JBI posts - have built a highly successful business focused on supporting global software companies with the difficult task of entering & scaling in Japan.
As you can likely guess by this point, a “Japan Cloud” for global defense technology companies seeking to sell to the Japanese military and broader public sector could be a potentially interesting opportunity. While not in any dedicated nor expansive fashion, Japanese telecommunications company Docomo is already supporting such efforts, specifically with U.S. defense tech company Skydio.
Perhaps stating the obvious, however, business success in Japan, particularly for foreign corporations, requires patience & a deep awareness + respect of the norms, complexities & challenges of Japanese culture, general business practices…and the Ministry of Defense’s unique procurement process.
Particularly for a future “home-grown” defense technology “champion” in Japan - with the then-strongest reputation, relationships & market awareness domestically - this “Japan Cloud” opportunity would be a compelling, relatively “light-weight” complementary business…one which is likely to gradually shift away from the Japanese trading houses:
“Previously, engagement of an appropriate trading house was seen as an essential prerequisite for entering the Japanese defense market. This reflected the requirement for Japanese government contracts to be with local entities. Most overseas defense companies did not set up local companies, although a small number have done so in the last few years”
“Given the appetite for Japanese export and two-way trade, there is an increasing emphasis to be placed now on working with Japanese partner manufacturing companies, to identify appropriate benefits in Japan and elsewhere and this may limit the utility of a trading house.”
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To close (I know, finally!), I would like to briefly discuss one last very important topic, which loosely ties back to the opening section of this post. More specifically, talent and the younger generations of Japanese who will lead Japan over the coming decades in ways those currently in power are presently not and, frankly, cannot.
While the above discussed SMB focused “Act I” may require a more “modest” degree of execution & complexity, all things considered, building a world-class, comprehensive, innovative defense technology Prime in Japan will require exceptional talent, in every sense of the word. Population concerns notwithstanding, with the world’s currently third-largest industrial base powered by a hard-working, well-educated workforce of ~57M, Japan is intrinsically highly capable of building a world-leading modern defense Prime.
However, in order to do so, what is most needed - and what our defense technology company discussed herein will help to unleash - is a powerful, enduring “call to action” among Japan’s best & brightest, willing to embrace the vision of a stronger, safer & more successful Japan of the future…a vision only made possible by solving audacious problems - alongside friendly global peers - that truly matter & that can greatly benefit future generations of Japanese to come.
Notably, there was no mention of “defense” or anything of the sort in that “call to action”. That said, “defense” will be intrinsic to the specific vision laid out in this post. And, of course, not everyone will find building defense products to be appealing.
However, just as Millennials & GenZ in Japan today are actively redefining “risk” and embracing change in ways meaningfully different than their parents, a self-selecting cohort of (perhaps “quietly”) patriotic, young Japanese professionals will likely find the prior stigmas associated with wars of the past to be less relevant to them in today’s evolving world and may find the challenging work to ensure the enduring safety & stability of their beautiful country and society to be an opportunity unlike few others available to them in Japan today. “Unleashing” this awareness, appreciation and boundless innovation within such talent will be the primary task of the early team gladly shouldering the responsibility to build Japan’s first next-gen global defense Prime.
While one such early team member may already be in-place (😏), I happily welcome any others open to offering insights, support, pushback or whatever else - both in Japan & among its friendly global peers - to help further explore & build this exciting new company. So, please do reach out!
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