A. The genesis of the PPP policy arose from the dramatic fall in MoD funding for defence research (down 40% between 1992 and 1998) after the end of the Cold War which threatened the future viability of DERA. In DERA's corporate plan 1998-2003, the Agency presented five options to address this situation, and identified a PPP as likely to provide the greatest returns to HM Treasury. It is not clear whether MoD consider the sixth option of restoring the defence research budget-which is a very small fraction (2%) of the total defence budget-to its former level, though MoD has since admitted in its 2006 Defence Technology Strategy that the current level of UK defence research is too low. The MoD's decision to adopt a PPP for DERA was included in its Strategic Defence Review published in July 1998; its Comprehensive Spending Review for 1999-2002 planned that the PPP would be complete by April 2002, and would yield £250M for MoD with any excess going to the Treasury. This plan created a tight schedule for implementing the PPP, but simultaneously gave the MoD little direct incentive to maximise the financial proceeds [1.6].
B. It is astonishing that the MoD did not judge it necessary to consult the British defence industry [1.4] prior to its decision to adopt a PPP for DERA. That industry's ability to supply first-class equipment to the UK armed forces, and to succeed in export markets, has traditionally relied on new technology which was created by DERA and its predecessor establishments and was transferred gratis to industrial companies working on MoD equipment projects.
C. It is equally astonishing that, despite acknowledging the divergence of interest between the MoD and DERA management, the MoD neglected to validate the DERA analysis supporting PPP [1.4]. Treasury rules stipulate that any such policy decision should be supported by an investment appraisal covering all of the consequential costs and benefits (including for example likely future revenue from intellectual property [1.21]).
D. It must be presumed that the management of DERA, when it originally recommended a PPP to Ministers, explicitly advised that adoption of this policy might yield rich financial rewards for DERA's top managers. At that stage the managers were civil servants and subject to the civil service code of conduct. (Sir John Chisholm's evidence to the NAO says [2.2] that he advised MoD in early 2002 of potentially large returns to senior managers, but his evidence to successive HCDC enquiries was less explicit).
E. Later, during the PPP process, the senior management of Qinetiq had to strike an appropriate balance between generous remuneration for themselves, low prices for their customers and good returns on their shareholder's capital employed. Most of Qinetiq's customers at that time were in the MoD, which also held all of the shares. This apparent divergence of interest was exacerbated by the MoD which chose to involve Qinetiq closely in the privatisation process. In particular, Qinetiq was involved in
- evaluation of applications from potential bidders [2.7, 2.10];
- management of the data submitted by those bidders [2.10];
- comparison of the final two competing bids [2.12];
- negotiation of the Board's own incentive package with at least one of the bidders before it was selected as the preferred bidder [2.15]; and
- valuation of the LTPA, following which the Carlyle Group negotiated a reduction (which the NAO considers was not sufficiently justified) in the price it paid for shares in 2003 [Annex 5].
These were the circumstances in which Qinetiq's 10 senior managers were in February 2003 able to invest £0.54M in shares which were worth £107M at flotation in January 2006 [Fig.19]. It is more surprising that the responsible MoD Ministers and civil servants allowed those managers a 19,900% return on their investment. The MoD appears to have pursued the policy objective of PPP without much regard for economy with public funds (despite the example of Comax in 1997 and the warnings of potential fat-cattery from HCDC and others).
F. The MoD claim that the remuneration committee need not have been involved in decisions on the incentive scheme for Qinetiq's senior management should be compared with the 2000 edition of "The Combined Code on Corporate Governance" produced by the Institute of Chartered Accountants; MoD itself approved the allocation of shares without independent scrutiny because it considered its interests to be aligned with those of the Carlyle Group [2.16, 2.17]. Perhaps their short-term financial interests overlap to some extent, but the MoD does have some additional responsibilities (such as the UK's national security).
G. The NAO Report [4.7] concludes that the MoD has received net proceeds of £576 from the privatisation, taking account of its costs of £76M incurred during the privatisation process. However before the privatisation, during the division of DERA into two parts (each with independent computers, communications documentation security and administration), the MoD incurred costs of £19M while DERA, DSTL and Qinetiq incurred additional costs of £68M between them [4.9]. Furthermore DSTL now plans to relocate some of its divisions, to achieve a greater physical detachment from Qinetiq, and expects that relocation to cost some £92M. Since most of the revenue of all of these organisations comes from the MoD, and all of these expenditures arose from the PPP policy, it would be reasonable to reduce MoD's net proceeds by the total of 19 + 68 + 92 = £179M plus some fraction of the (unspecified) costs incurred by Qinetiq during privatisation [4.9]. A proper investment appraisal of the privatisation of Qinetiq should also include any differential between the future prices likely to be paid by the MoD for Qinetiq's services (in research, project support, and test & evaluation) and the cost of the same services delivered by a government establishment.
H. It was only several months after the MoD had decided to adopt a PPP for DERA that the Department set up the DERA Partnering Team to consider how the PPP might be implemented, and also consulted UK industry, trade unions, academia and allied nations (notably the US) on the likely consequences [1.8]. These consultations lasted some 2 years and reduced the period available for meaningful negotiation before the April 2002 deadline. This may partly explain why MoD allowed the Carlyle Group to negotiate down the price it paid in 2003, and why MoD agreed to reimburse Carlyle's bid costs of £16M without verification or validation (despite an earlier statement that it would not do this [2.34]).
I. The NAO's advisors have valued Qinetiq as it stood in 2003 at about £100M more than the PPP valuation. Between PPP and flotation Carlyle shares increased in value be £332M, and the Qinetiq managers" shares increased in value by £172M [Fig.19]. Both of these sums are small beer compared with the Northern Rock deficit but if the MoD had, by better judgement, retained even a fraction of them for its own use it could have afforded a lot more body armour for its soldiers.
J. The NAO's study was inevitably focussed on identifying the lessons to be learned from the privatisation of Qinetiq, so that future privatisations might yield better value for money to the taxpayer, rather than with allocating blame to individuals for any of the faults in that process. Its recommendations include:
- the public sector should have a full understanding of the business to be sold;
- the management should not arrange their own incentive scheme; and
- that non-executive directors appointed to protect the interests of shareholders should not participate in employee share schemes
Hardly rocket science!