1. The budget for defence research fell by 40% in real terms between 1992 and 1998, limiting the ability of the Defence Evaluation and Research Agency to maintain the breadth of its expertise. QinetiQ has been successful at finding new sources of revenue to balance the decline in research spending and has increased its turnover by 48% since 2003.
2. The restrictions that prevented QinetiQ from engaging in defence manufacturing contracts were lifted in April 2008. If QinetiQ is successful in winning more contracts to supply the Department there will be greater scope for conflicts with its important role of advising the Department on the procurement of equipment. The Department needs to actively manage the operation of the Compliance Regime to protect the independence of QinetiQ's advice, which is critical to UK defence interests.
3. The sale to Carlyle was conducted in 2002, when market conditions were poor and before the future of QinetiQ's most significant long term contract, accounting for about a third of QinetiQ's revenue, had been agreed. The Treasury had agreed to credit the Department's budget with £250 million if the sale was completed before 31 March 2003. The Treasury should avoid creating incentives to press ahead with privatisations when conditions are unlikely to maximise longer-term value to the taxpayer.
4. The Department negotiated the terms of QinetiQ's most significant contract, the Long Term Partnering Agreement, at the same time as conducting the sale of part of the business. Bidders would have been unable to place an accurate value on QinetiQ and Carlyle were subsequently able to negotiate a reduction in the value they ascribed to the business. Departments should settle the terms of significant contracts before entering negotiations to privatise public sector businesses.
5. The Department weakened the competition by eliminating bidders at an early stage in the process, including the only trade bidder. It also appointed a preferred bidder with major price sensitive issues outstanding, turning a competitive process into one of negotiation. Departments should maintain competition until significant price sensitive issues have been resolved.
6. The Department executed the flotation well, assisted by the involvement of the Shareholder Executive. The Shareholder Executive provided valuable experience and expertise, which helped protect the Department's interests where these were not aligned with those of Carlyle and QinetiQ. Departments should take advantage of the available expertise by involving the Shareholder Executive in future privatisations.
7. QinetiQ senior management received £200 for each £1 they invested whilst the taxpayer received just £9. QinetiQ management negotiated their own incentive arrangements before Carlyle were appointed preferred bidder, without making the Department aware of this serious conflict of interest. Such profiteering at the expense of the taxpayer is not something this Committee would expect from former public servants. In future privatisations Departments should prevent management from having discussions on incentivisation with investors until a preferred bidder has been appointed and the basic structure of the incentive scheme agreed.
8. Sir John Chisholm, the then chief executive, was allowed to propose the allocation of shares to senior QinetiQ management without the oversight of the remuneration committee. The Combined Code on Corporate Governance, which QinetiQ committed to follow, prohibits directors from being involved in deciding their own remuneration. Departments should ensure that directors in any company to be privatised are not able to propose their own incentives without independent oversight.
9. In relying on Carlyle to develop the management incentive scheme the Department failed to protect its interests. The resulting scheme gave management returns far in excess of what was necessary to incentivise them. Specialist advice could have explored ways of limiting returns to management, for example capping returns or stripping out the impact of favourable market movements on the growth in value of the company. Departments should seek appropriate advice on restricting returns under incentive schemes.
10. The Department allowed QinetiQ to reimburse Carlyle's bid costs without validating them. It is well precedented for the acquired company to refund the successful bidder's costs in private equity transactions where the whole business is sold, but in this case the Department retained a majority of the shares, and it had also made clear to all bidders that such costs would not be reimbursed. The Department should require bidders to meet costs which are their responsibility; and where they are not, it should validate costs before meeting them.
11. The Department could have received £90 million more than it did from the privatisation. It sold Carlyle 2.5% more of QinetiQ than they had asked for in their bid, allowed management to influence the design of their own incentives to the detriment of the taxpayer and did not consider excluding the impact of the improvement in the general market from the returns management received.
12. The Department successfully ensured that the taxpayer benefited from the growth in the value of the business by initially selling only a minority of shares, in recognition that it was unlikely to maximise proceeds in the prevailing market conditions. This approach was in line with earlier recommendations from this Committee. The strategy of bringing in a strategic partner to develop the business in advance of a flotation had some benefits and Department's should consider repeating this in future privatisations.