3.5 The returns referred to above are derived from the bulk of the development taking place on the Peninsula (as seen from Figure 11). EP is, however, entitled to additional returns from a share of AEG's profits made in The O2 Arena and the Waterfront (under the Arena Lease and Waterfront Lease agreements) after priority return to AEG. The expected returns from this source are not covered by the 2002 financial model referred to above and on the basis of commercial advice were not taken into account by EP in deciding to go ahead with the overall deal.
11 | The source of financial returns to English Partnerships | |||||||||||
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Property Development | ||||||||||||
Source | How financial returns are generated | |||||||||||
Minimum Land Payment | As MDL draws down land for development, it makes an index-linked, minimum payment to EP based on the square footage of land drawn down. This minimum land payment is not paid to EP where land is acquired from other existing landowners on the Peninsula (e.g. Quintain and AXA), nor to land used to develop a hotel and land used to fulfil obligations outlined in the section 106 agreement. | |||||||||||
Variable Land Payment | Profits from land developed by MDL, net of allocated costs of development (defined under a separate formula) are shared with EP. Up to 4 million square feet of development, EP shares 15 per cent of profits. Between 4 and 7 million sq. ft, EP shares 20 per cent. Profits from land sold to third party developers is shared between EP (or other owner of land) and MDL. up to 4 million sq. ft, EP receives 40 per cent rising to 75 per cent above 10 million sq. ft (should this much land be sold by MDL). | |||||||||||
| EP is entitled to a share of profits made by Quintain (which is the other main landowner on the Greenwich Peninsula) from the sale of its land to third party developers. Before this mechanism is triggered, Quintain is allowed to make a 13.5 per cent priority return. EP's profits from this agreement are capped (on an index-linked basis). | |||||||||||
Profit share from | EP will be entitled to share in the profits from The O2 in several ways: Arena Profits Share: EP receives 15 per cent of the net profits after AEG has received a priority return on its total investment (subject to a cap) in the Arena. The profit share is paid for 25 years and is payable at the end of each five yearly period. Sale of the Arena to a third party (Arena Disposition Rent): EP receives 15 per cent of any net sale proceeds in excess of a "payout" to AEG, if AEG sells greater than 50 per cent of its interest to a third party within 25 years of completion of the Arena. AEG's "payout" is basically a return of a pro rata share of its investment (subject to a cap) together with a percentage return. Waterfront Rent: EP is entitled annually to 40 per cent of the gross rents and revenues received from the Waterfront less allowable expenditures and less AEG's priority return of 15 per cent on its total investment in the Waterfront. After a specified quantum of space has been occupied in the Waterfront, EP's return decreases to 33.33 per cent. | |||||||||||
Hotel option | A payment for the hotel site next to The O2 which will be at least £3.5 million depending on which of three options is used to calculate the payment. | |||||||||||
Source: National Audit Office analysis | ||||||||||||
12 | The value of EP's financial returns from MDL's development of land on the Peninsula (2004 valuation) | ||
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| Nominal £ million | Net Present value |
Guaranteed Minimum Land payment | 305.4 | 131.3 | |
Variable Land Payment | 273.2 | 98.8 | |
Adjustments, (including share of profits made by Quintain, land acquisition costs etc) | (5.7) | (13.7) | |
Total | 572.9 | 216.4 | |
Source: National Audit Office analysis of valuation by EP's financial advisers, 2004 | |||
NOTE | |||
1 An 8.5 per cent discount rate was used to calculate this net present value (NPV). Using the NPV rather than the nominal figure is better because it takes into account the timing of returns to English Partnerships. Returns generated later are lower, in net present value terms | |||
3.6 The Committee of Public Accounts has previously expressed concern about profit sharing mechanisms, particularly the exposure to risk when the receipt of returns to the public sector is deferred, and about the inherent scope for returns to be undervalued.30 The Committee's 2005 report The Regeneration of the Millennium Dome and Sale of Associated Land recommended that Departments should "attempt to quantify the likelihood and nature of such upsides so as to understand and manage the project and maximise the potential additional benefits to the taxpayer". EP considers that undertaking to produce a robust estimate before now would not have provided meaningful information because The O2 has an insufficient operating history as it has only been open since June 2007. Instead EP focussed its attention on the construction, practical completion and handover of The O2 to AEG. The timing of this exercise will not impact on the level of EP's profit share entitlements which is governed by legal agreements. Developing an estimate is feasible, however, and would help EP ensure that it extracts maximum value from the profit share arrangements in the future.
3.7 The formula for calculating profit sharing and the timing of receipt is prescribed in the respective leases. The contractual agreements negotiated by the parties allow EP full access to the records and accounts of the tenant company (a subsidiary of AEG) responsible for operating The O2. The business of running the Arena and hence the production of accounts must be conducted wholly through the tenant company. EP considers that this stipulation provides for full sight of all relevant revenues and costs. It also considers that is some protection for EP in terms of its profit share from the Waterfront as any disputes about the calculation are subject to review by an independent third party with a decision binding on the parties. The legal contracts also contain protection provisions to ensure intra-group costs are validated and relevant records and accounts are provided. The provisions, however, do not explicitly give EP access to the AEG Group records and accounts which would enable EP to scrutinise and challenge effectively the fairness of costs allocated to The O2 Arena and Waterfront. EP has started the process of agreeing with AEG how it will access information and satisfy itself that fair returns are received. The results of this exercise should highlight whether there are likely to be any future complications arising in terms of EP's access rights.
13 | Illustrative example (no actual numbers included) showing how MDL's profits will be determined and shared with EP on the basis of revenue and expenditure on individual plots of land | ||||||||||||
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Revenue |
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Land Sales Revenue (incl. car parking) | x |
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Interest Income | x |
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Other Income | x |
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Total |
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Common costs |
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- utilities | (x) |
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(x) |
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- Landscaping | (x) |
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- Other Infrastructure costs | (x) |
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- Operational costs | (x) |
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- Shareholder interest | (x) |
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Total common costs |
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Other plot expenses | (x) |
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Landowner variable land payment | (x) |
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- Gross variable land payment | (x) |
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- Affordable housing adjustment |
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Profit before Tax |
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Corporation Tax |
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Profit after Tax |
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Source: Meridian Delta Limited 2007 financial model | |||||||||||||
NOTE | |||||||||||||
The figure illustrates (without using actual numbers) the income and costs against each plot of land that need to be scrutinised by EP to ensure that it gets a fair return from the project. EP will need to ensure that costs incurred are reasonable and consistent with the legal agreements so that profits are calculated appropriately. MDL will bear the increased cost of a change to the way that the percentage of affordable housing is calculated. This is now based on gross external area rather than number of units. | |||||||||||||
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30 See the Committee's 2005 report on The Regeneration of the Millennium Dome and Associated Land (Second report of session 2005-06, 18 July 2005) and The Sale of County Hall (Riverside Building) to Shirayama Shokusan Company Ltd (forty-fifth report 1994-95, 4 December 1995).