3 Management of Incentive Schemes

13.  Share schemes to incentivise senior management are a common feature of private equity deals. They are intended to align the interests of management with those of the investor, which are generally to maximise the growth in the value of equity in the short to medium term. Such incentive schemes are often structured with ratchets that amplify the returns of key individuals when certain performance targets are met.32 In the case of QinetiQ the Department specified that any incentive scheme should encompass all QinetiQ staff.33

14.  QinetiQ senior management were heavily involved in the design of the incentive scheme. In their bid Carlyle initially proposed to set aside 10% of QinetiQ's equity for management and staff. In evaluating the bid Sir John Chisholm wrote to the Department setting out his view that the proportion of equity Carlyle were offering to incentivise management was low and that he wanted the scheme to offer higher rewards for exceptional performance. QinetiQ management held discussions on the incentive scheme with Carlyle before they were appointed preferred bidder.34 The Department failed to put in place any safeguards to manage this serious conflict of interest.35 Following the discussions between QinetiQ management, Carlyle submitted a revised bid. The revised incentive scheme set aside 20% of QinetiQ's equity to management and staff. It encompassed all QinetiQ staff but offered the prospect of much greater returns to the top 245 managers, and especially to the top 10.36

15.  If the Department had restricted the proportion of QinetiQ's equity made available to staff to 10% it could have realised additional proceeds of £76 million. This figure assumes that the incentive scheme would have been structured in the same way but that each group of staff would have received half the number of shares that they in fact did. Figure 2 shows the impact that this change would have had on the value received by each class of shareholder at the flotation.

16.  The top 10 and top 245 managers were selected by Sir John Chisholm based on his views on which members of staff were critical to the success of the business.37 He also proposed the number of shares each of the senior managers would be able to purchase under the scheme, including the level of his own investment. Although the Department did subsequently approve the scheme it did not seek to involve the remuneration committee in the allocation of shares to management and staff.38 The Combined Code on Corporate Governance39 prohibits Directors from being involved in deciding their own remuneration.

Figure 2: Shareholder returns at the flotation if management and staff had been allocated 10% of the equity

Source: National Audit Office analysis

17.  The Department relied on Carlyle to design the management incentive scheme as it believed they were best placed to do so.40 It did, however, approve the final structure of the scheme based on limited modelling of the potential outcomes. The Department did not seek any specialist advice on the design of the incentive scheme,41 despite assuring the Defence Select Committee that it would pay close attention to the risk of managers making large amounts of money from the privatisation.42 It did not consider the possibility of capping returns or of structuring the scheme to ensure management were not rewarded for a general upturn in market conditions.43

18.  Between the 2003 sale to Carlyle and the 2006 flotation the market improved by 80%.44 If the Department had structured the incentive scheme so that the returns of management were not influenced by the improvement in the market it could have realised additional proceeds of up to £9 million assuming that the impact of market growth was clawed back from the returns of the top 10 and top 245 managers and redistributed to the other shareholders proportionally to the size of their shareholdings.45 Figure 3 shows the value of the shares of all classes of shareholder under these assumptions.

19.  The top 10 managers invested £537,000 of their own money in the management incentive scheme. At the flotation these 10 individuals owned shares worth £107 million, 200 times their investment. The top 245 owned shares worth £65 million at the flotation from an investment of £450,000.46 The scale of these returns was far in excess of those received by the Department, Carlyle and QinetiQ staff who invested in the co-investment scheme: they all owned shares worth only nine times their investment.47 Although the senior managers stood to lose their investment if the equity value of QinetiQ did not increase by 1.2 times before a flotation,48 over 87% of the senior managers opted to take part in the scheme. QinetiQ had talented staff, a strong history and was in the process of negotiating a 25-year contract that was predicted to provide revenue of £5.6 billion over its life.49

Figure 3: Shareholder returns at the flotation if market growth had been stripped out of senior management returns

Source: National Audit Office analysis

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32  C&AG's Report, para 2.14

33  C&AG's Report, para 2.15

34  Qq 8, 30-33, 82, 139, 248-259

35  Qq 116, 182

36  Qq 19, 139

37  Qq 128-130, 148

38  Q 57

39  Combined Code - Principles of good governance and code of best practice, May 2000, Schedule B.2

40  Qq 8-10, 59-60

41  Qq 68, 71, 86-87

42  Q 7, Minutes of evidence, The Future of DERA, May 2000

43  Qq 82, 106-108

44  Relevant market indices have been used to calculate the improvement in the market. Indices used are: FTSE Techmark 100, FTSE 350 A&D, SPADE, S&P A&D, S&P 1500 tech hardware, NASDAQ, S&P 500 tech hardware, DJUS technology, DJUS, technology software and S&P systems software.

45  Q 106

46  C&AG's Report, Figure 19

47  Q 19

48  Qq 150, 166

49  Qq 12, 20, 41-42