2 Conduct of the Privatisation

7. In 1997 DERA proposed a range of options for addressing the risks that declining research spending posed to the business. DERA management recommended either franchising DERA's work to academic laboratories or bringing in private investment through part privatising the business. They pointed out that only the part privatisation option would generate significant proceeds12 but did not highlight the potential for management to receive financial incentives as a consequence of private investment in the business.13 The Department accepted DERA's recommendation without independent validation despite this potential conflict of interest.14

8. The decision to sell a stake in the business to a strategic partner was taken in early 2002 when the market for technology stocks was poor. QinetiQ had only been trading for six months and it was unclear how it would fare in the private sector. Although the Department had decided that QinetiQ would provide test and evaluation services under a long-term contract,15 the terms of this contract had not been agreed.16 At that time the test and evaluation work accounted for approximately one third of QinetiQ's revenue.17 Sir John Egan, the then Chairman, believed that the poor market offered an opportunity to develop QinetiQ in the public sector, thereby realising more value for the taxpayer.18 By instead deciding to sell a stake in QinetiQ at a difficult time the Department created the potential for Carlyle to profit from the recovery of the market.19

9. The 1999-2002 Comprehensive Spending Review assumed that the part privatisation of DERA would be completed by 31 March 2002 and would generate £250 million for the defence budget; any money raised in excess of this would be returned to the exchequer. The Treasury agreed to credit the Department's 2002 budget settlement with the £250 million receipt as long as the sale was completed before 31 March 2003.20 This arrangement created pressure to complete the sale to a strategic partner.21 The sale was eventually completed on the same day the Long Term Partnering Agreement was signed, 28 February 2003.22

10. The Department began the formal sale process on 8 March 2002. It received 16 expressions of interest from potential strategic partners only one of which came from a trade bidder, SERCO.23 QinetiQ management strongly objected to trade bidders and the Department rejected SERCO's expression of interest on the grounds that their proposal was weaker than the other potential partners. The 12 bidders that were taken forward were all private equity firms.24 The Department weakened the competition by rejecting SERCO's proposal at this early stage when it would have been helpful to keep a different type of bidder in the process.25

11. Carlyle were appointed preferred bidder on 4 September 2002 when there were still two major price sensitive issues outstanding. The Long Term Partnering Agreement was still being negotiated and the treatment of QinetiQ's significant pension deficit had not been resolved. The Department did not attempt to negotiate the treatment of the pension deficit during the competition.26 Appointing Carlyle preferred bidder with these issues outstanding allowed them to negotiate a £55 million reduction in their valuation of QinetiQ.27

12. The Department nevertheless conducted the subsequent flotation well28 and achieved a higher price than QinetiQ's shares have been trading at for most of the time since then.29 The interests of Carlyle, QinetiQ management and the Department were all aligned in respect of maximising the share price but the Department had additional objectives, such as protecting UK defence interests and guarding against an overdependence on QinetiQ.30 The Shareholder Executive, established in 2003, supported the Department throughout the flotation and ensured that the Department's interests were protected.31