Robin Niblett
Director, Chatham House

The proposed tie-up between BAE Systems and EADS appears to be gaining senior political support in the UK. However, non-committal comments to date from French President Hollande and German Chancellor Merkel confirm that negotiations over the terms of the merger have now entered their most sensitive phase. Depending on how the negotiations go, the UK's coalition government may be confronted with a most unexpected and intriguing challenge: whether or not the government should acquire its own stake in the merged company. 

The proposed merger between the two companies has a number of attractions from a UK perspective. A tie-up with EADS would reconnect BAE to the still lucrative civilian aerospace market which it exited, perhaps ill-advisedly, six years ago. It would reduce BAE's exposure to a US defence market that is on the verge of a serious contraction and link it to new sources of financing.

The merger should also lead to a reduction in the relative size of the interests that the French and German governments will hold in the company. This is a critical element, given that declining European defence budgets over the coming years will require smart defence programming that is as free as possible from national political bias. 

The German government has its own reasons to support the merger. The new company would give Germany access to the US defence market, which will remain the largest in the world even as it contracts. It would link German industrial ingenuity and jobs to an expanding global defence market, which it finds hard to sell to currently given national restrictions on its defence exports.

Importantly, German leaders also appear to believe, like their UK counterparts, in the benefits of minimising political interference in the company. But the German government would probably only accept lowering its interest in the merged company if the French share was reduced proportionately. 

The French government, however, is unlikely to cede easily its rights as a major shareholder in EADS in return for the sort of a 'golden' share that the UK government has in BAE Systems. This would permit France to block a hostile takeover of the new company, but would prevent it from influencing decisions on what and where the merged company would produce. France has long sought to retain national control of its aerospace and defence industries both for their value to the national economy and as a means of extending the country's international influence.

The French government will likely use the current negotiations, therefore, to secure specific rights to influence strategic decisions of the company. It may even seek to maintain a share in the merged company proportionate to its current individual holding of 15%. 

In this case, the German government would likely be forced to do the same. It was already in the process of taking a more direct stake in EADS prior to the merger announcement, in order to match the French government. The German government may also be influenced by the fact that Germany is not currently projected to host one of the merged company's two main headquarters. 

Given these French and German perspectives, the risk exists that the crown jewel of the UK defence sector could be absorbed into a merged ‘BEADS’ that contains strong French and German government stakes. Irrespective of the business logic of the deal, this outcome could jeopardize future British defence interests and jobs. The merged company's access to the US defence market might be badly compromised - and Conservative backbenchers could rightly criticize the government for selling out Britain's defence industry to continental European control. 

Such an outcome would present stark choices for the British government. It could block the merger if France and Germany insist on retaining significant government stakes. Or it could accept a dilution of its influence over the future of the UK's defence and aerospace industry in return for the deal's putative benefits. 

An alternative approach would be for the UK government to acquire its own stake in the merged company. No doubt, the Treasury would be aghast at the idea. But the government already owns large stakes of several UK banks, and the defence industry has always been 'sui generis', combining as it does a mixture of state and business interests. 

As a formal shareholder, the UK government would be in a strong position to fight Britain's corner over key decisions. It might also allay some of the US concerns about the perceived risks of the size of the French and German government shareholdings in the merged company. 

The idea to create one of the world's largest defence and aerospace companies is indeed a 'bold' move, as Airbus CEO Tom Enders put it last week. It would offer its participating countries the opportunity to repeat the success of Airbus in other sectors, such as air defence missiles and unmanned aerial vehicles, while reducing their exposure to the ups and downs of the defence and civilian aerospace markets. But if the UK wants to be a core partner in this initiative, then it may find it needs to commit to a more continental European approach to its success and buy itself a stake in the new company.

Also read:
BAE-EADS Merger: Possible Implications for UK Defence
Expert Comment
Andrew Dorman, September 2012