INTRODUCTION AND SUMMARY OF CONCLUSIONS
AND RECOMMENDATIONS
1. The Royal Armouries originally entered into a
PFI-type contract with Royal Armouries (International) plc ("RAI")
in December 1993. Under this contract RAI were to build a new
museum in Leeds which would allow the Royal Armouries, then based
principally in the Tower of London, to display a greater proportion
of its collection. (The collection itself remained—and remains—in
the Royal Armouries' ownership). The Royal Armouries agreed to
contribute £20 million to the £43 million cost of construction,
with RAI meeting over £14 million and Leeds City Council
and Leeds Development Corporation £8.5 million.
2. Once construction was complete, RAI was to operate
the new museum for 60 years. In return RAI would retain all the
income the museum generated from visits by the public. Once the
new museum opened in March 1996, however, visitor numbers were
so low that it never made enough money to meet its operating costs
and the costs of servicing RAI's debts. Consequently, by early
1999 RAI's cumulative losses were estimated at £10 million,
despite two refinancings by RAI.
3. As part of the second refinancing in 1998 RAI's
bankers, the Bank of Scotland, advised that it would not be able
to make additional funding available to RAI after July 1999 if
the financial problems persisted. Withdrawal of the Bank's support
after that date would have resulted in RAI becoming insolvent.
4. In response, therefore, in July 1999 the Royal
Armouries negotiated a revised deal with RAI which ensured that
the museum in Leeds remained open. Under the re-negotiated deal
the Royal Armouries took over responsibility for running the museum,
while RAI retained responsibility for the provision of catering,
car parking and corporate hospitality services at the museum.
5. On the basis of a report by the Comptroller and
Auditor General, the Committee took evidence from the Department
for Culture, Media and Sport, the Royal Armouries and RAI on the
negotiation of the original commercial deal in 1993, on the forecasts
for visitor numbers, on the re-negotiation of the deal in 1999,
and on the extent of risk remaining with the private sector under
the terms of the revised deal.
6. The key findings to emerge from our examination
of these questions are:
- Although RAI were being remunerated under the
terms of the original deal for taking on the commercial risks
involved in operating the new museum, the Department effectively
bailed the company out to the tune of over £10 million
when it ran into financial difficulties and faced imminent insolvency.
RAI's shareholders have benefited as RAI have remained solvent
despite the original deal's failure. This contrasts with the PFI's
underlying philosophy that the private sector is paid for taking
on risks. If a department is unwilling to accept the consequences
of those risks being borne by the private sector, it should not
transfer these risks in the first place. It can only damage the
PFI if the private sector is given grounds for believing that,
if anything goes wrong, risks will be taken back by the public
sector.
- Although there was no Treasury guidance on PFI
available at the time the original deal was reached, the absence
of such guidance does not fully excuse the lack of commercial
awareness and absence of forethought on the part of the Department
and Royal Armouries when reaching this deal. When undertaking
any project with commercial aspects, departments should ensure
that they have access to the necessary skills and business knowledge,
irrespective of whether central guidance is available.
- This case provides further evidence that the
forecasting of visitor numbers for new attractions is very uncertain.
When negotiating deals the eventual success of which is heavily
dependent on the number of visitors, or on the number of users
of the new services being provided, departments need to treat
projections of visitor numbers with due caution, to understand
exactly what it is that consultants are telling them, and to manage
the resulting risks accordingly.
- When faced with the possible insolvency of the
private sector partner, RAI, and the consequent disruption to
the museum's operations, the Department did not appear to have
used the full strength of its negotiating position or sought appropriate
commercial advice. RAI's failure could have constituted a fundamental
breach of contract, thereby placing no moratorium on the Royal
Armouries' ability to get back the museum. In re-negotiating PFI
deals, departments should ensure that they fully grasp the strength
of their commercial position as well as their legal rights so
that they are well placed to get the best possible deal for the
taxpayer.
7. Our detailed conclusions and recommendations are
as follows:
On negotiating commercial deals
(i) There had been a
lack of market interest in the deal when it was put out to the
market and only one bid had actually been received. Tussauds,
when withdrawing from the competition for this project, had expressed
concern over the practicality of the proposals for joint working
between the public and private sectors in certain areas. The operating
specification which was to detail those areas where such co-operation
and joint working was required was not agreed subsequently. The
Royal Armouries were not given access to RAI's financial records
and there were disagreements between the two parties over issues
which were of fundamental importance to the museum's future. Departments
should be aware of such warning signs that the deal being negotiated
will not eventually be sustainable (paragraph 16).
(ii) Before signing the contract, the Department
and Royal Armouries had taken comfort from assurances from their
financial advisers, Schroders, that the deal on the table was
the best available from the market at the time, given the deal's
parameters. However Schroders had been involved for almost two
years in putting this deal together and therefore might not have
been in the best position to provide the objective assurances
that were being sought. No other advisers had been approached
to cast a more detached eye over the deal proposed. In considering
future deals, departments should get impartial advice on the merits
of a proposed deal before it is signed (paragraph 17).
(iii) Under the current guidance the Department
would have had to consider at the very start of the project what
would happen at the contract's end. On this deal the Royal Armouries'
ability to terminate the contract and take possession of the museum
due to RAI's insolvency was limited for two years. This compares
with the more general practice on PFI deals where departments
seek to protect their positions by having immediate access to
any assets involved should a PFI contractor become insolvent.
Departments need to consider in advance how they will eventually
exit from deals should this prove necessary (paragraph 18).
On the forecasting of visitor numbers
(iv) As with the Millennium
Dome, the deal for the new museum had foundered because of lower
than expected visitor numbers. According to the Department there
were also a number of other attractions which had received public
funding and were also at risk because of low visitor numbers.
We therefore welcome the Department's attempts to identify, along
with a number of other bodies, good practice when reviewing visitor
projections for proposed projects (paragraph 35).
(v) The actual number of visitors to the new
museum was much less than any of the consultants commissioned
by the Department, Royal Armouries and RAI had forecast. However
those forecasts were based on a certain pricing assumption and
the consultants warned that the actual number of visitors would
vary, depending on the admission price charged. In particular,
MORI appeared to have forecast accurately what actually happened
with its predictions of the level of visitors at the admission
price eventually chosen (paragraph 36).
(vi) Departments should therefore ensure that
they have a clear understanding of what it is exactly that their
consultants are telling them when providing forecasts of future
visitor numbers, in particular with regard to the sensitivity
of those forecasts to different pricing levels. Departments should
assess the reasonableness of these projections by comparing them
with the performance of comparable existing attractions (paragraph
37).
(vii) Departments should also ensure that the
capital structure of a proposed deal is consistent with the riskiness
of the project. If the project involves a high degree of commercial
risk, the project needs to be financed with a high level of risk
capital relative to bank debt. If it is necessary to proceed with
a project in the absence of adequate levels of risk capital, the
sponsoring department should plan for the contingency that extra
funding will be required (paragraph 38).
(viii) The warnings on pricing appear to have
been ignored by RAI. RAI had placed reliance on their own consultancy
advice and had charged a high entrance fee of £6.95. Visitor
numbers had then collapsed. In response RAI had taken a number
of measures to boost attendances, including price discounts and
a programme of major exhibitions. It is surprising that RAI increased
the full adult entrance price from £6.95 to £7.95. One
of the first things that the Royal Armouries had done, on taking
the museum over in 1999, was to reduce this entrance fee to £4.90
(paragraph 39).
(ix) The reduction in the entrance fee appears
to be working, as recent visitor numbers have been up on the similar
period twelve months ago. It is likely that this improving trend
will continue as the Royal Armouries are planning, in line with
government policy, to introduce free admission to the museum in
2001. Despite these actions, the Royal Armouries have prudently
based their future strategy on cautious estimates of future visitor
numbers in line with the museum's past experience in Leeds (paragraph
40).
(x) There were a number of other factors, in
addition to the pricing policy, which contributed to visitor numbers
being less than forecast. The included an increase in the number
of other, competing, visitor attractions and delays in the development
of the Clarence Dock area surrounding the museum. Expenditure
on marketing had also been reduced over time in line with the
planned strategy for the museum (paragraph 41).
(xi) This was a high risk project as it involved
the establishment of a new museum, in a redevelopment area, with
no proven track record of visits by the public. The Royal Armouries
nevertheless had no contingency plans in place, as they considered
that the risk of the project's failure lay with RAI in the private
sector. However, on this deal the business risks ultimately lay
with the public sector as the Department and the Royal Armouries
had been unwilling to countenance the closure of the museum and
had therefore stepped in to rescue the project. In considering
future PFI projects, therefore, departments should consider where
the business risks ultimately lie and draw up their own contingency
plans accordingly (paragraph 42).
On re-negotiating an existing deal
(xii) The Department's
objective was to avoid the museum's closure. Based on legal advice
and statements from RAI and their bankers, the Department considered
that, if RAI had become insolvent, there would have been a two-year
moratorium on the Royal Armouries' ability to get back the museum
and the museum would have closed. There is room for doubt, however,
as to whether that view took full account of the Royal Armouries'
rights in the event of fundamental breach of the contract by RAI,
where no such moratorium would have applied. Faced with similar
situations, departments should be clear both about their legal
rights and the strength of their commercial position, and be prepared
to use those rights and powers aggressively in negotiations (paragraph
45).
(xiii) In negotiating the deal to save the museum
the Royal Armouries and Department commissioned only legal advice.
They did not seek appropriate commercial advice from an insolvency
practitioner, although they were faced with a threatened insolvency.
Departments should ensure that their negotiation team includes
people with previous experience of commercial negotiations and
that they are supported by appropriate commercial advice (paragraph
46).
On ensuring risk remains with the private sector
(xiv) Under the terms
of the revised deal, the public sector has failed to achieve all
the objectives it set itself at the very start for the new museum.
It has nevertheless effectively bailed out RAI, as the public
sector was unwilling in the end to let the risk lie with the private
sector. While RAI have retained responsibility for the debts of
£21 million they ran up when building and operating the museum,
they have also kept the profitable elements of the museum's business,
such as corporate hospitality and car parking, worth in total
over £10 million. In contrast, the Royal Armouries have taken
over the loss making aspects of the museum and will be dependent
on funding from the Department and the income from the lower-than-expected
visitor numbers (paragraph 56).
(xv) The possibility that RAI's shareholders
will still receive some return on their investment, despite the
original deal's failure, may be greatly increased by the introduction
of free access to the museum later in 2001. Free access should
result in greater numbers of visitors to the museum, and consequently
higher income for RAI's car parking and catering operations. Under
the terms of the revised deal, the public sector will share in
these benefits, once RAI have paid off their outstanding debt,
as the Royal Armouries will then be entitled to receive twenty
per cent of RAI's turnover at the museum. Departments should ensure
that they have the right to share in the benefits of any future
windfall gain resulting from any re-negotiated deal (paragraph
57).
