Carlyle sees opportunities in defense and aerospace

FORTUNE -- The aerospace and defense industry is poised for merger and acquisition activity, thanks to shrinking defense budgets in the U.S. and the UK and a rebound by airlines. Industry bellwethers like Boeing (BA, Fortune 500) and EADS, the parent company of Airbus, say they're looking for growth through acquisitions. Meanwhile, Europe's top defense firm BAE Systems may sell off its aerospace unit, and Boeing chief executive James McNerney recently said that defense spending cuts are cutting into profits.

Fortune turned to Adam Palmer, a managing director at the investment firm Carlyle Group, to understand the challenges and opportunities in this large, far-reaching, and politically-charged sector. Palmer, who is featured on Fortune's 40 Under 40 list this year, is one of the firm's most successful investors in aerospace, defense, and government services.

And while Carlyle is now a broadly diversified firm, its early successes were in aerospace and defense deals, an area where its Washington, D.C. roots (founder David Rubenstein worked in the Carter administration and former Defense Secretary Frank Carlucci was on the firm's payroll during its early days) gave it a leg up over New York City rivals.

Defense is such a hot topic right now. What's going on in that space for investors?

The number one word in the defense industry right now is uncertainty. The transactions being announced by large cap defense companies show that they're trying to grow and create profitability in a marketplace likely to be flat to declining in the foreseeable future. In this environment of tightening budgets, even the defense budget is under pressure.

The companies most exposed to troop deployment levels are going to have a harder time than those focused on technology and services, but the market is valuing them all the same right now. I think there are companies being unfairly beaten up right now, and I'm trying to find a way to capitalize on that.

What companies are you looking at right now?

It's difficult for me to talk specifics, but I will say that I'm interested in all of the announcements you hear about major defense companies selling assets. Big players are trying to build up cash positions or reposition their portfolios to weather the coming downturn from tighter defense spending.

Companies that focus on technology are interesting for strategic acquirers, since tech remains an important piece of any defense company, even the traditional hardware or equipment makers.

Money is flowing to anything that has to do with defense technology or cyber security systems. The recent announcement that Lockheed Martin is selling its tech-related business [EIG], is a perfect example.

Defense is cyclical. When it was out of favor in the mid-1990s we made several investments in the space that fared well. Eventually, people realized that peace wasn't going to reign around the world and that governments would still need defense equipment.

Similarly, defense budgets in the international community are also under pressure.

Commercial aviation also seems to be a bright spot in this space.

Yes, of the three pieces of the sector - commercial aerospace, general aviation, and defense - we're seeing the commercial aerospace side recovering the fastest from the financial crisis. Airline profits are growing and so are the values of these companies, so as consolidation in this space picks up it will be a seller's market. Acquirers are going to have to pick their spots carefully. Transaction values are far higher than I expected for this point in the cycle, and it's having a domino effect in the aircraft order and after-market supply chains.

But I think that general aviation is a much more interesting topic. The U.S. is the world leader in business jet manufacturing and the industry was hit rather hard during the financial crisis. Signs of recovery are slow and for the near future general aviation remains the wild card, likely taking longer for demand to return for new aircraft.

With so much corporate M&A happening, can private equity firms get in on the action?

The debt markets are open again, which is a short way to say that there's a lot of money available for corporations that want to raise money and for traditional LBO firms. This is a very active marketplace. Things haven't returned to the level of 2007 and 2008, but it's like 2004 when strategic buyers were shopping for growth and building portfolios, and guys like me were opportunistic.

We've been focused on commercial aviation assets since the financial meltdown, when these asset values fell off a cliff. We didn't find a company to buy, so instead, we worked with our distressed debt team and found people who could move nimbly through the minefield. So far, working with our new partner RPK capital, we've acquired several aircraft and continue to look for more. Given our broad mandate to invest creatively, we are better positioned to take advantage of this situation.