Not a scandal but a textbook success
Ross Butler says MPs’ criticisms of the sell-off of the former Defence Research Agency are financially naive In America it would have created celebrity entrepreneurs and provided a template for future deals. Instead, the British government’s hugely successful privatisation of the defence business QinetiQ has prompted a political witch-hunt.
The taxpayer made more than £800 million from the deal, far more than anyone dreamed at the start of the process. But a Committee of Public Accounts report on 10 June, following a National Audit Office inquiry, blasted the Ministry of Defence for selling too cheaply, and the company’s management for profiteering from the process of transferring what was originally the Defence Research Agency into the private sector. The Committee’s Conservative chairman, Edward Leigh MP, said the MoD had conducted a preliminary sale to a private equity firm in 2003 ‘like an innocent at a table of card sharps’.
Meanwhile, QinetiQ’s chairman, Sir John Chisholm — who joined the Defence Research Agency on its formation in 1991, and went on to gain £26 million from its sale — stands accused of helping hand the business to private equity on the cheap in return for his cut. ‘It was a one-way ticket to a runaway success,’ according to John Humphrys in a Today interview with Chisholm last week.
The private equity firm in question, the Washington-based Carlyle Group, is famous for political connections acquired by hiring the likes of George Bush Sr and Ronald Reagan’s secretary of defence, Frank Carlucci; the European arm of Carlyle was chaired by John Major from 2000 to 2005. On the face of it, as one Public Accounts Committee member put it, the whole thing ‘stinks to high heaven’.
Yet, in reality, the QinetiQ’s story has been a textbook example of smart privatisation. It was initially spun out of what had by then become the Defence Evaluation & Research Agency in July 2001. The intention was to seek an immediate public listing, but the stock market was unfavourable and the government’s defence research budget, on which the company would clearly depend for years to come, was shrinking. Instead, it was decided to bring in a commercial investor-partner prior to seeking flotation when both company and market were ready.
The decision by MoD officials not to sit on their hands until the stock market revived has received strong criticism from the Committee, displaying remarkable naivety about commercial realities. Furthermore, the Committee has compounded the fiction that Carlyle was handed its 33.8 per cent stake for a song, guaranteeing it an exceptional return when the company eventually did come to market. In reality, a fierce auction among 40 interested parties, managed by UBS, was narrowed to 12 bids, resulting in the Carlyle Group paying £42.2 million for its stake. Most of the underbidders were seasoned players in the competitive world of private equity. I spoke to several at the time, and gathered that their highest realistic growth trajectories and future valuations were not sufficient to make the numbers work. This was no silver-platter gift.
So how could Carlyle make eight times its money when QinetiQ was floated three years later, in February 2006? At the time of the auction, with prospects for MoD work fading, QinetiQ’s managers had vague plans to diversify into fields such as healthcare. But Carlyle encouraged them not to divert from their core expertise but instead to expand into other areas of the defence market and establish joint ventures with larger firms such as Thales and BAE Systems. Carlyle also encouraged (and no doubt opened doors for) the company to launch into the world’s largest defence market, the US. During the period of Carlyle’s involvement, QinetiQ acquired four US defence companies and built up its US revenues from zero to more than $600 million.
That change in QinetiQ’s profile boosted its value to more than £1.3 billion at flotation, making the stake retained by the government worth £800 million. But the National Audit Office was concerned that more money might have been raised from the 2003 sale to Carlyle. The reasoning smacks of hindsight, and misses the vital point that QinetiQ found a private equity partner capable of taking the company towards success. Since the government remained the majority shareholder after the Carlyle deal, extracting the highest possible price at that stage to the exclusion of future growth considerations would have been shortsighted. As a result of Carlyle’s investment, QinetiQ is a fundamentally different business, and today’s valuation bears no relation to that of its pre-Carlyle era.
Two other findings from the National Audit Office inquiry stuck in the Committee’s throat. The first is that Carlyle reduced its offer price after being offered an ‘exclusive’ negotiating position in the 2003 auction. Whether Carlyle’s late price reduction — relating to pensions liabilities and an unsigned supplier agreement — could have been resisted is unclear, although one suspects that UBS investment bankers are not pushovers. What is clear is such hardball tactics are part of everyday life in the world of corporate deals. In attempting to second-guess decisions made in the thick of intense negotiations, the Committee has proven itself the real innocent. But the aspect of the privatisation that the MPs found hardest to stomach was the sheer amount of money made by senior management. By any normal standards, it is astonishing: the top ten managers invested £540,000 between them in 2003; it turned into £107 million at the flotation in 2006.
These gains must be viewed in context: first, the incentive package was more or less standard for a private-equity deal; indeed, it was more equitable than is often the case, since it was offered to all QinetiQ employees. To benefit fully, managers had to achieve a market-standard performance hurdle of 8 per cent compound growth per annum. At the time, that prospect looked remote and many QinetiQ employees failed to take up the offer. The managers effectively had to transform the business: making them put their own cash on the line in return for huge rewards if they perform is a standard private-equity tactic, aligning management incentives with potential rewards for shareholders. The only difference is that in this case it was the government, as majority shareholder, that was the main beneficiary.
But the MPs could not let the subject rest. Chisholm has been accused of manipulating the 2003 sale to line his own pockets — an accusation that anyone who understands the management’s role in a large-scale corporate auction process will find absurd. Chisholm might not be quite the visionary entrepreneur he sees in the mirror, but his success in transforming QinetiQ from a rag-bag of MoD research labs into a highly profitable global business has been met with undue cynicism.
The real issue is that he and the Carlyle Group are guilty of vastly overdelivering — something politicians are so unused to that they assume the assets concerned must have been undersold. And perhaps the government’s need for a scapegoat underscores its embarrassment at having made money off the back of private equity — a sector it has done so much to encourage us to hate over recent years. ‘Carlyle are private equity people,’ said Committee member Austin Mitchell MP. ‘We’re taught not to love private equity in the Labour party.’ It would have been preferable, no doubt, had QinetiQ made an unspectacular lurch on to the public markets and into relative anonymity. No big returns, no millionaires, no need for an inquiry. Next time, that’s probably what will happen.
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