The federal government’s relationship with the defense industrial base historically ran through one instrument: the contract. The government bought things, companies built them, and capital to expand capacity came from banks, sponsors, or retained earnings.
That model is changing: the federal government is no longer acting solely as the customer, but increasingly serving as a source of capital and, in a growing number of cases, an equity investor.
Owners of lower-middle-market defense and defense-adjacent businesses should not treat this shift as an abstract policy development. This shift changes how companies can finance growth, fund expansion capex, and positiontheir balance sheets for the next twenty-four months.
What Actually Changed
The Pentagon has already taken equity positions worth more than $1 billion in defense-related companies, including an approximately $400 million investment in a rare-earths producer and a $1 billion stake in L3Harris’s solid rocket motor business. The pace accelerated in 2026 with a $450 million equity investment in Maine-based Elmet Group to expand domestic tungsten capacity for armor-piercing munitions and missile components, as well asa nearly $264 million package of awards and financing for critical materials, chemicals, and testing capabilities. That package included $174 million of equity financing for an Alcoa refinery in Australia to produce gallium.
More consequentially, Congress is moving to formalize this role. The Senate version of the FY27 National Defense Authorization Act would expressly authorize the Office of Strategic Capital to make equity investments,establish a dedicated defense equity investment account within the U.S. Treasury, and require congressional notification and ownership and conflict-of-interest reviews. The draft confines the equity account to critical minerals, materials, chemicals, and batteries, focusing the authority on defined supply-chain chokepoints.
The pattern behind those headlines matters: the government is directing its equity tool toward upstream materials and other strategic chokepoints, not the broader supplier base. Most lower-middle-market companies should not ask whether the Pentagon will acquire a stake in the business. They instead should ask which other federal capital tools fit their capabilities and position to compete for them.
Why This Matters More in the Lower Middle Market
The lower middle market is where much of the defense supply chain operates: forging shops, precision machining businesses, specialty electronics manufacturers, and component suppliers that may be too small to self-fund a facility expansion but too important to a program of record to fail without consequence.
Capital-market structure has historically constrained these companies. Defense-manufacturing capex is lumpy, qualification cycles are long, and conventional lenders discount contracts that the government may modify or terminate for convenience. As a result, a generation of founder-owned suppliers has operated below its production potential—not because demand was lacking, but because capital for capacity expansion was unavailable on reasonable terms.
Federal capital programs are designed to close that gap, and most provide non-dilutive financing.
That changes the economics for a private-company owner considering a recapitalization or growth-equity round. Capital that funds capacity expansion without diluting ownership is, in nearly every scenario, less expensivethan equity. The same programs give a private equity sponsor a credible value-creation lever: financing a portfolio company’s expansion while preserving the equity upside.
How Lower-Middle-Market Companies Actually Access Government Funding
Four practical pathways are available, differing materially in scale, structure, eligibility, and execution risk.
- The Office of Strategic Capital Credit Program (loans and loan guarantees)
OSC offers direct loans ranging from $10 million to $150 million to U.S.-domiciled public and private companies, including U.S. entities with foreign ownership, for projects aligned with technology categories covered by the FY24 NDAA. Those categories include microelectronics, advanced manufacturing, space launch, quantum technologies, edge computing, and dozens of other priority areas.
The eligibility rules are consequential and often misunderstood. OSC generally excludes early-stage or pre-revenue companies unless a creditworthy sponsor guarantees repayment. It also excludes projects for which the federal government would be the sole end user and projects whose repayment depends primarily on federal grants or contracts.
OSC is therefore not a vehicle for financing defense contracts. It is an industrial-capacity lender that expects a credible commercial revenue base to support debt service. Dual-use businesses—companies serving both defense and commercial customers—are the natural fit.
- Defense Production Act Title III (non-dilutive capacity funding)
Title III remains one of the most underutilized tools in the lower middle market. Instead of purchasing an end product through a conventional procurement contract, the government funds the industrial capability required to produce it through cost-sharing agreements, direct investments, purchase commitments, or support for equipment and facilities.
Awards typically range from approximately $5 million to well above $100 million, with many falling between $10 million and $50 million. Recent examples illustrate the profile: approximately $11.4 million for a California manufacturer to establish space-based traveling-wave-tube amplifier capability and approximately $7.1 million for an Ohio company to establish domestic production of space solar-cell cover glass. These are specialized private suppliers—the companies that make up much of the lower-middle-market defense industrial base.
Two execution considerations deserve attention. First, many Title III awards require cost sharing or matching funds, making financial readiness essential. Second, smaller companies often strengthen their candidacy by teaming with a prime contractor or participating through a consortium.
- Industrial Base Analysis and Sustainment (IBAS) and consortium awards
IBAS supports smaller, more targeted industrial-base initiatives, often through the Defense Industrial Base Consortium, which issues periodic solicitations against defined capability gaps. Recent focus areas have included secure processors, rare-earth magnet manufacturing, forging, and RF systems, with individual funding ceilings ranging from the low single-digit millions to the high single-digit millions. The program also expresslyencourages teaming arrangements.
IBAS can be the more practical entry point for a company that is not ready to pursue a nine-figure capacity project. Although the awards are smaller, successful participation can establish performance credibility andstrengthen subsequent applications.
- SBA lending for smaller needs
Participating lenders originate SBA 7(a) loans of up to $5 million for working capital and smaller equipment purchases below the OSC threshold; the agency does not lend directly. The program is less strategically differentiated than the defense-specific alternatives, but it may be the right-sized instrument for a defined capital need.
The Strings Worth Understanding
Federal capital is not free of obligations, and owners and sponsors should diligence it accordingly. Federal capital carries reporting requirements, multi-year performance commitments, and, increasingly, dual-use expectations. Programs intended to onshore critical capabilities often require the resulting capacity to support more than one government customer, creating a strategic constraint as well as a compliance obligation. Where direct equity is involved, the proposed NDAA framework adds ownership reviews, pre-disbursement conflict-of-interest screening, and congressional notification.
A sponsor evaluating an acquisition should treat existing federal funding in the target’s capital structure as neither a red flag nor an endorsement. It represents a package of covenants, obligations, and strategic commitments that requires the same underwriting rigor as any other instrument in the capital stack, including a clear assessment of the consequences of a change of control.
What Owners and Sponsors Should Do Now
The practical takeaway is straightforward: lower-middle-market defense suppliers have access to a broader set of capital tools than they did three years ago, yet many remain underutilized. The principal barriers are familiarity, application complexity, and the absence of a disciplined mapping between a company’s capabilities and the government’s priority technology areas.
That gap creates an actionable opportunity. A supplier that secures non-dilutive federal capital for capacity expansion can emerge as a more valuable enterprise: greater throughput, stronger strategic relevance, and an improved equity story without the dilution otherwise required to fund growth.
The government has made clear that it intends to finance critical segments of the industrial base. Companies that need capital must now identify the appropriate program, develop a credible investment case, and align their growth plans with the government’s capability priorities.
Arsenal Enterprise Capital partners with lower-middle-market defense and national security businesses to unlock operational value and long-term growth. To learn more about our investment approach, contact our team.