Monetizing Offset Obligations
Stronghold offers a solution to enable advancing countries to effectively monetize offset obligations due to them from purchases of industrial & defense equipment & services.
Definitions & Background
Offsets - Provisions in an import agreement between an exporting foreign company and an importing sovereign state wherein the exporting company will contribute a negotiated investment offsetting the cost of the purchase. The incentive for the exporter results from the conditioning of the core transaction to the acceptance of the offset obligation. Offset agreements frequently involve trade in defense equipment and services and can go by a variety of other names including industrial compensations, industrial cooperation, industrial and regional benefits, balances, juste retour, and/or equilibrium. Ministries of defense or governments typically have responsibility to regulate and manage contracted offset obligations.
Direct offsets - Agreements directly related to products or services sold. Example:
Norway’s Kongsberg Defense Systems subcontracted work locally and transferred technology to the Polish Navy in support the sale of the Naval Strike Missile Coastal Defense System.
Indirect offsets - Agreements not directly related products or services sold. Example:
Russia’s Sukhoi, transferred technologies to the Malaysian National Space Agency to fulfill obligations related to the sale of 18 Su-30MKM aircraft.
Offset obligation fulfillment - A term of a purchase contract negotiated to award “credits,” an accounting metric specific to these programs. Sellers of equipment and services can receive credit toward fulfillment by negotiating - as part of a purchase contract or after a purchase - a “multiplier,” or an investment incentive that reflects the customer’s desire to direct funding or services toward particular sectors or economic initiatives.
Scale
While not typically reported in annual financial reporting, offset contracts have increasingly become C-suite agenda items. US defense primes enter into an average of 30 to 60 offset agreements each year, estimated at between $10 billion and $20 billion in obligations per year.
Recent data has identified an excess of $180 billion in offset obligations due to Saudi Arabia alone.
Avacent, the international strategy and consulting firm first estimated that outstanding offset obligations would exceed $500 billion in the year 2016. The market associated with these transactions has an annual growth rate of some 9%. In 2021 Avacent projected an increase in offset obligations of $371 billion between 2021 and 2025.
Risks
While offsets facilitate international sales, if the parties do not manage the process effectively, offsets can carry significant competitive, legal, and reputational risks.
Contractors that have acted improperly in fulfilling offset obligations or have proposed programs that failed to produce the intended results have faced penalties, including, congressional inquiries, reputational damage, inclusion on “black lists” of companies restricted from bidding on public procurements in specific countries, and investigations under the US Foreign Corrupt Practices Act and the UK Bribery Act. Reforms to manage the above articulated risks, while welcome, have yet to fully address the issues.
Typical outcome - Typical offset obligations require defense primes to contribute as much as 25% of the purchase price as “economic effect” to the sovereign purchasing equipment or services. Economic effect gets negotiated as the parties attempt to resolve the agreements. Sovereigns rarely receive more the 4% of the purchase price from the defense primes. Defense primes can become saddled with overseeing in country projects in which they have little or no expertise (Lockheed Martin running a fish farm).
Case Study
Fact Patterns:
US$ 15 billion of outstanding offset obligations: Stronghold understood that defense primes had offset obligations (on past sales) due to the sovereign in excess of US$ 15 billion.
Not carried as liabilities: With some variation, defense primes do not record offset obligations as liabilities on their balance sheets. Paying them directly (even if credited for a multiple of a payment) presents significant balance sheet and share price consequences.
Competitive constraints: Outstanding offset obligations place defense primes at a competitive disadvantage on future contracts. Failure to make progress resolving offset obligations can shut out a defense prime from responding to an RFP.
In support of a sovereign, Stronghold offered US$ 7.5 billion for preferred shares in a sovereign established development program.
The offer constitutes a non-dilutive capital raise available in tranches to match investments in diversifying the sovereign's economy. Stronghold’s innovations and proprietary financing solution enables the sovereign to effectively monetize defense offset obligations due to it to make this offer possible.
Transaction Overview
The program:
Issues bond(s): US$15 to US$20 billion senior fully-secured debt instrument(s) of an insurance company to defense primes in proportion to their outstanding offset obligations to the sovereign,
Sets up Collateralized Insurance Reserves,
Purchases preferred shares in a sovereign entity established to distribute financing (terms subject to agreement).
For the defense prime’s participation, the sovereign grants the defense primes fulfillment of their offset obligations.
The sovereign entity established to distribute financing pays yearly dividends on the preferred. Dividend payments cover yearly operational costs and coupons to the bond purchasers.
Value Proposition: The described Program provides defense primes:
Balance sheet stability: purchasers hold a real asset,
Liquidity: purchasers can hypothecate the bond,
Fulfills offset obligations, and
Expected return: delivering a risk premium over U.S. Treasury yield.
Strengthening valuation of the Program bond
Programs prepared for non-regulated entities such as insurance enterprises or banks, have significant flexibility including setting a market interest rate, extending the bond buyers a variable interest in the issuing protected cell, and/or providing the bond buyer with a contracted redemption.
Additionally, a sovereign, in exchange for what it receives can contract with the defense primes for a separate legal right (e.g., export license or contractual market access right).
These features can strengthen the valuation of the Program bond(s) held by defense primes.
No other alternative to delivering US $7.5 Billion to such a sovereign so effectively benefits all parties to offset obligation transactions.