What investors, industry could gain from the Navy’s big bet on private equity

By Nick Wilson  / October 31, 2024

The Navy is in the early stages of a novel plan to funnel private money into the submarine industrial base. For the private equity group tapped as the service’s partner in this effort, tax incentives, enduring demand for submarines and a tenant-focused business model make this foray into shipbuilding a low-risk venture with promising returns.

The Navy announced the new “public-private collaboration” in September, partnering with the United Submarine Alliance (USA) Qualified Opportunity Fund LP -- a private-equity fund managed by Connecticut-based investment group CapZone Impact Investments LLC -- in what one service official described as a “really big swing” at harnessing private capital for the submarine industrial base.

With early buy-in from neighboring shipyard Austal USA, CapZone’s USA Fund purchased 355 acres on Pinto Island in Mobile, AL from Alabama Shipyard. Renamed the Mobile Naval Yard, the property will be used to expand industrial base capacity, likely through submarine module fabrication, according to the Navy.

To finance development at the yard, CapZone must persuade investors to join USA Fund. Its ability to connect private money with Mobile Naval Yard infrastructure projects is the key to the venture.

“We're enlarging the sources of capital for Navy by using a fund structure,” CapZone CEO and co-founder Al Puchala told Inside Defense last month. “Most people do deals in defense. We've done a fund that's doing a deal because we can bring in other capital and the Navy now gets that force multiplier.”

“It's a different way to match the capital markets,” he added. “Because some people only want to invest in infrastructure or only want to do housing or only want to do venture. We can actually bifurcate or separate out investment opportunities to match and get as many sources of capital to support Navy's larger plan.”

According to Whitney Jones, the Navy’s submarine industrial base program director, partnering with CapZone could unlock a new strategy to activate large sums of private money in concert with government aid.

The partnership is “a big way to demonstrate what we see in terms of the value of having private capital run alongside congressional dollars and sustaining something well beyond a president's budget,” Jones told reporters last month. “This is the opportunity to do that, and I don't think this is a single thing, a single instance of this working. I think this opens the door for this being a new way of us looking to do business well into the future.”

USA Fund and its investors will take advantage of a tax incentive created in 2017 by the Tax Cuts and Jobs Act. In fact, CapZone was formed in May 2018 specifically to utilize this incentive, which offers tax breaks on money invested in Qualified Opportunity Zones, or census tracts designated as economically distressed by the Treasury Department.

By drawing private money to real estate, infrastructure projects and other business ventures in these zones, the legislation is meant to facilitate economic development and job creation, according to the Internal Revenue Service.

There are nearly 9,000 opportunity zones across the U.S., including the Mobile area where CapZone’s newly acquired yard sits. Opportunity zones are a good fit with the defense industry’s long-term needs, Puchala said, because investors must park their money in the project for at least 10 years to take full advantage of the tax incentive.

In the near term, Puchala said CapZone will move to rapidly develop Mobile Naval Yard. As the yard’s owner and manager, CapZone plans to rent workspace to defense contractors that it hopes to draw to the property with new shipbuilding-related facilities.

“We decided that the right approach, in this case, is to buy the infrastructure layer. Because infrastructure is the enabler of other companies, whether it's transportation infrastructure or technology infrastructure or housing,” Puchala said.

With its shipyard infrastructure, CapZone aims to attract three types of tenants, Puchala said, starting with previous property owner Alabama Shipyard, which will continue its maintenance business on the land. The company does repair work, mostly on Military Sea Lift Command and commercial vessels, using 11 buildings and a single drydock already on the property.

The second tenant group will consist of submarine industrial base companies “that are going to do things the Navy wants,” he continued, such as building submarine modules. Navy officials previously said construction of a new module fabrication facility on the property will begin in 2025, indicating Austal will operate the facility once completed, though Puchala and Austal both told Inside Defense no specific plan has been finalized.

Lastly, the fund will host the “other” category of tenants to perform varying industrial base functions that could include additive manufacturing, training, testing and the establishment of a “campus of innovation,” Puchala said.

Navy officials have also discussed plans to break ground on advanced manufacturing and regional training facilities on the property in 2025.

Great potential, few details

For the Navy, the partnership with CapZone is intended to marshal greater capital at greater speed to attack the problem of sub-par submarine output and reach a desired production rate of at least one Columbia- and two Virginia-class boats every year.

Presently, both programs are over budget and months behind schedule as industry struggles to adjust to heightened demand and grapples with labor shortages and supply chain issues. The Pentagon has already dedicated large sums of government money to the problem, with the Navy’s fiscal year 2025 budget projecting $11.1 billion in submarine industrial base aid over the next five years.

Public-private partnerships are not new to the Defense Department or the Navy, said Bryan Clark, Hudson Institute defense analyst and senior fellow, pointing to existing collaborations between the private sector and government focusing on chip and explosives production.

CapZone itself has already worked on defense industry initiatives in opportunity zones, including a workforce housing project that constructed 200 apartment units in New London, CT near General Dynamics Electric Boat’s Groton, CT shipyard.

What is new about the USA Fund effort, Clark said, is the utilization of private capital to expand production in the shipbuilding industry, where builders and suppliers typically make their own infrastructure investments or receive money directly from the Navy to upgrade or expand facilities.

Tapping into private capital, he continued, could help bolster the submarine supply chain, which includes many small companies producing specialized components with few customers outside the Pentagon.

This supply network has spent several decades matching its output to the Navy’s relatively modest, post-Cold War submarine demand. Now, it is struggling to meet spiking demand, with some companies unwilling or unable to front the capital needed to upgrade infrastructure and quickly expand production capacity.

“Private capital could come in and strengthen the bottom lines of these smaller companies -- mid-size and small suppliers -- invest in infrastructure for production capacity, help them invest in workforce and take some of that risk by making those forward-looking investments on behalf of the Navy,” Clark said.

“Then the private capital has the wherewithal to wait that decade to get a return on that investment, whereas your individual mom and pop suppliers don't necessarily have that kind of line of credit. So, the value of private capital is really in that supply chain or supply base, maybe more so than in the ship construction yards themselves,” he continued.

However, the venture is not without risk for the Navy. If USA Fund fails to deliver adequate returns and investors decide to back out, the Navy could be forced to pour in additional money to keep the effort alive.

The government “doesn't really have the luxury of pulling out because it's the main customer, [so] it ends up on the hook to own it down the road,” Clark said, though he noted there are likely to be constraints within the agreement on when investors can leave.

Navy officials have also acknowledged risks in the venture, indicating that they have established “contractual mechanisms and authorities that safeguard Navy and national security interests.”

Still, optimism over USA Fund’s potential influence is shared by many suppliers. According to Steven Dobos, president and CEO of component maker Butler Weldments and co-chair of the Submarine Industrial Base Council (SIBC), the establishment of module fabrication and other submarine-related activities at the Mobile Naval Yard is expected to drive increased demand and open other opportunities to suppliers.

“I think it's going to bring us another avenue to sell our products. I mean, if you're going to have another component manufacturer, they're going to be looking for subcontractors and downstream subcontractors in the SIB to help them hit the load,” he told Inside Defense.

While optimistic about the effort, Dobos indicated the Navy and CapZone have shared few details on how work will unfold under the new effort.

As far as suppliers are aware, USA Fund will establish “what sounds to be another module outfitting company, basically Austal and this new fund that they put together which is going to have private equity funding it. But that's still going to be basically another shipyard which we would be able to then, as sub-tier suppliers, help supply into,” he said.

Opportunities for suppliers to become tenants at Mobile Naval Yard have yet to be revealed, Dobos added, and whether supply companies will find it advantageous to work at the yard has yet to be determined.

A natural fit

While the Navy and CapZone have lofty goals for their budding partnership, work at Mobile Naval Yard could be narrower in scope than the far-reaching vision they have presented.

“I think the Navy will need to manage expectations with regard to what this might actually do and deliver, because I think it's really oriented just about getting additional shipyard capacity to Austal,” Clark said, pointing to the company’s growing submarine module production business and its finite yard space.

“This is going to help Austal’s contribution to the submarine industrial base, but it's not going to help the industrial base more broadly, I don't see other suppliers coming in and putting their facilities in this yard,” he continued. “I don't see a pump company coming down there and saying, ‘Oh, we're going to take advantage of this facility or this location to build a pump production plant.’ I don't see that happening.”

Mobile Naval Yard directly borders Austal’s yard, which is scaling up module construction for both the Virginia and Columbia programs in collaboration with General Dynamics Electric Boat.

Earlier this month, Austal broke ground on a new module facility -- module manufacturing facility three (MMF3) -- just across the property line from Mobile Naval Yard. Funded through a $450 million award from Electric Boat, the facility is scheduled to be fully operational within 2026 and is expected to eventually employ 1,000 new workers.

The Navy envisions an additional module production facility, which service officials have called “module manufacturing facility four,” being constructed adjacent to MMF3 on the USA Fund property and staffed by Austal employees.

“The preliminary design discussion is that the additional facility for submarine [module] production will be literally adjacent to where that’s being built,” Strategic Submarines Executive Director Matt Sermon told reporters last month. “So, it’s absolutely additive to the outsourcing plan to get us to the one-plus-two cadence.”

Austal became a limited partner in USA Fund in September, investing $150 million provided by the Navy, a company announcement states. This early investment was intended to serve as “seed money” to get the fund started and help attract additional investors, according to Larry Ryder, Austal USA vice president for business development and external affairs.

USA Fund’s work is a natural fit with Austal’s construction of MMF3 and its growing submarine module business, which is expected to account for 20% of the yard’s jobs within the next few years, Ryder told Inside Defense. “I think the Navy is going to work with the USA Fund and ourselves to have a holistic approach to what capabilities are needed, that complement what we already have here in our facility,” he said.

There are no specific agreements in place for Austal to operate module manufacturing or any other facilities on the USA Fund property, Ryder said. Still, collaboration with the fund is an opportunity to leverage additional land, facilities and capital to grow Austal’s submarine work and create an expanded industrial hub in the area, he continued.

“We're going to build MMF3 on our property here in October. Potentially, there could be an MMF4 on the USA Fund property. There could be a training center to help build the workforce that we need to sustain the strategic outsourcing work we're doing here. There could be additive manufacturing facilities, employee support centers,” Ryder said.

“We don't have any agreements in place, but certainly we think the most efficient and effective use of that facility would be for Austal USA to put our workforce in there [and] operate it.,” he added. “And whether there's a lease structure in place or however the business model develops, we would expect to be part of that.”