Examination of Witnesses (Questions 20-39)
DAME PAULINE
NEVILLE-JONES,
SIR JOHN
CHISHOLM AND
MR GLENN
YOUNGKIN
TUESDAY 21 JANUARY 2003
20. Can I just tell you what the Minister said
to me? "When QinetiQ was vested as a plc on 1 July 2001 the
Ministry of Defence required it to purchase its assets from MoD
with a combination of equity and an obligation in the form of
interest-bearing loan notes to pay a further £150 million.
The £50 million has been paid as part settlement of the outstanding
loan notes". So basically there is another £100 million
to come from somewhere. That is what the Minister is telling Parliament.
(Mr Youngkin) I believe, and I am sorry if I am not
correct here, that had to do with the vesting process itself and
was the original arrangement between the Ministry of Defence and
QinetiQ. I apologise: I am not able to answer that question.
(Sir John Chisholm) Clearly, Mr Howarth and Mr Chairman,
the authority on this subject will be the Ministry of Defence
rather than ourselves, but if I can just point you in the right
direction what you are relating to there is the cash receipts
that the Ministry of Defence have got as a consequence of this
transaction, and I believe in the response that you got what it
said was that the cash receipts are made up of £50 million
that has already been received by the Ministry of Defence from
the company.
21. From QinetiQ rather than Carlyle?
(Sir John Chisholm) Indeed, and another £150
million still to come as a consequence of this transaction. Some
of that will come from the equity that Carlyle put in and some
of it will come from realising the debt that the Ministry of Defence
already had in the company.
22. What does that mean, realising the debt
that the government already had in the company?
(Sir John Chisholm) For instance, there is around
£100 million of debt that the company already owes the Ministry
of Defence, and when that is paid off the Ministry of Defence
receive £100 million.
23. Can you quantify what that is for?
(Sir John Chisholm) It is part of the structural debt
which was put in, an accounting transaction in other words, which
was put in at the time of vesting. No cash changed hands.
24. It was just an accounting formula. So what
is Carlyle then going to do in terms of further investment, because
it is much trailed in your submissions and, indeed, the case is
made that Carlyle brings not only support to the management but
investment too. Can you share with us, Mr Youngkin, exactly what
the investors in Carlyle are looking at pulling into QinetiQ between
now and whenever flotation takes place?
(Mr Youngkin) Yes. For the time being our investors
have committed the £42 million. I think part of the opportunity
is the fact that we do have a very extensive set of investors
and as the company seeks to commercialise its technology and seeks
to grow there is a ready-made set of investors who will know the
company and appreciate the company and who will be there should
the company need additional resources, but for the time being
the limit of commitment is £42.2 million.
(Sir John Chisholm) Perhaps I could just amplify that:
Carlyle brings not only its own money but also Carlyle's reputation
allows us to raise other money. In order to fulfil the opportunities
that the company has in front of it and to discharge its liabilities
we have to raise debt. Because Carlyle is backing the company
and because of the reputation Carlyle brings, that debt becomes
feasible. At the moment we can only raise debt by having essentially
an implicit government guarantee. Once we are a private company,
of course, we no longer have that government guarantee but having
Carlyle behind us has enabled us to negotiate with the banks really
rather large and sufficient lines of credit in order to meet the
liabilities and to invest in the opportunities we see in front
of us.
25. And you already have those lines in place
in expectation that all this is going to be formalised?
(Sir John Chisholm) Exactly so.
Rachel Squire
26. Perhaps I can pursue a little further the
question of the liabilities in respect of QinetiQ, and I should
declare that I too have a constituency interest in that I have
at least for a little while yet a small DSTL presence in my constituency
of Dunfermline West which covers part of Rosyth. I also have QinetiQ
(Rosyth) and part of the Defence Diversification Agency which
does seem somewhat forgotten all too frequently in the whole discussion—but
that is another debate. Sir John, when QinetiQ was established
the company's potential liabilities clearly had to be identified,
and also it then had to be agreed whether it was QinetiQ or the
Ministry of Defence which should take financial responsibility
for those potential liabilities. Can you say how the embryonic
QinetiQ management was involved in that task of identifying the
potential liabilities and then negotiating with the Ministry of
Defence over who was going to cover them?
(Sir John Chisholm) First of all, can I say that we
do not forget the DDA. We respond to the DDA and they are a key
part particularly of our interaction with small and medium-sized
businesses. On liabilities, when the company was vested, the issue
of dealing with a very complicated set of potential liabilities
had to be addressed. If this company had been running for many
years we would have built up a track record of the consequences
of those liabilities and the extent to which they are real or
just potential liabilities through a track record of claims. Because
we were not in that position we did not have any of that claims
record behind us, and therefore we had to employ advisers to go
through our business and make an initial assessment at the time
of vesting of what the liabilities of the company were, and then
make an assessment as to the extent to which those liabilities
were economically insurable. The vesting documents made a first
attempt to partition the liabilities in a way which would be optimum
economically for the owner, ie, the maximum extent to which the
liabilities could be taken by the company without forcing all
the company liabilities which became uneconomic to insure, and
because everything that goes to the company just comes back to
its customers, to ensure that not too much of the cost of that
came back to its customers. So that balance was struck as best
as possible, absolutely in the theoretical zone at the time of
vesting, because at that stage we did not have any track record
at all. Since then we have had a year or so of history and experience
and we have now gone through a similar process again as part of
this transaction, where the principal negotiation has not been
between us and the Ministry of Defence but between the purchaser
and the Ministry of Defence, again to address the same set of
liabilities.
27. Picking up on that, therefore, Carlyle then
became involved in the exercise to apportion contingent liabilities,
is that correct?
(Sir John Chisholm) A purchaser inevitably has to
understand the liabilities of the organisation that it is buying,
and it had to understand those and the economic consequences of
those.
28. Can I then ask Carlyle in which areas you
particularly wanted to see the Ministry of Defence retaining the
risk and whether you are satisfied with the final outcome? Indeed,
have you reached a final outcome or are you still discussing who
should cover which liabilities?
(Mr Youngkin) Between the Ministry of Defence and
Carlyle we have concluded our negotiations: we have reached an
agreement. If I could go back and ask them to take more of the
liabilities I wish I could but I have agreed to the position.
Those liabilities that the company has assumed were all included
in our overall evaluation of the business and are part of the
£500 million that we were discussing earlier. We were given
assurances from the Ministry of Defence that we had all the appropriate
information and we were able to be thorough in our evaluation
of those liabilities and we thoroughly understand them. That was
a meaningful part of the work we did over the last four months—to
work through what was a very complicated exercise of vesting to
make sure we fully understood those liabilities that the Ministry
of Defence had agreed to, and to keep those within the company
that the company had agreed to assume.
29. You mentioned earlier that the total value
or cost of the liabilities was £375 million?
(Mr Youngkin) Yes.
30. Can I then ask you this: without the contingent
liabilities that the Ministry of Defence has agreed with you to
retain, by how much would Carlyle have sought to further reduce
their contribution for their slice of QinetiQ?
(Mr Youngkin) Through the course of what was a long
negotiation there were a number of topics where we felt that if
there was a liability that went one hundred% against the company
it would be bad for the company, and the Ministry of Defence took
the position that there was such a low probability of that liability
crystallising that it made more sense, rather than us lower our
purchase price or ascribe more of the liabilities as opposed to
equity, for the Ministry of Defence to assume those particular
liabilities. Through the course of the discussion I cannot highlight
any particular one that was more important than any of the others,
other than there was a discussion that had to do with liabilities
that we felt had a higher probability of happening and which the
Ministry of Defence felt had a lower probability of happening,
and that is the result we reached.
(Sir John Chisholm) What we are trying to describe
here is that there are some liabilities which are almost unknowable.
For instance, many of our sites have been occupied by parts of
the defence community for decades and sometimes much longer than
that and it is just not knowable what has been done on those sites.
If you ask somebody to put a risk value on it, they might put
a very high risk value on that but in practice it is almost impossible
to know when, if ever, it might crystallise. Since it is a liability
that the Ministry of Defence already has, to ask somebody to put
a value on it and pay for that, because that is what the consequence
would be, would be bad value for the taxpayer, so it was liabilities
of that sort that the Ministry of Defence decided, in my view
wholly reasonably, would be better value for the taxpayer if the
Ministry of Defence continued to hold those, rather than getting
an insurance company to try and put a value on it.
Mr Roy
31. I suppose, first of all, unlike the rest
of my colleagues, I have no interest to declare. Unfortunately
we have no facilities or sites belonging to QinetiQ.
(Dame Pauline Neville-Jones) We must try and find
one for you.
32. Please consider it the first priority if
you ever want to expand in the west of Scotland. There is plenty
of area available for expansion. I would like to focus on the
ranges and test and evaluation facilities that you have. We know
that the Ministry of Defence, for example, would pay compensation
to you if they no longer required those facilities in the next
three years, but I would like to know if the proposed investment
that you have depends on continued on-going use by the Ministry
of Defence, or is there an alternative plan with sufficient third
party interest to help in the viability of those sites, ie, does
someone else intend to use them?
(Sir John Chisholm) Mr Roy, on the whole, for our
test and evaluation facilities the only viable customer is the
Ministry of Defence or the Ministry of Defence's direct suppliers.
It is one of the difficulties of operating those facilities that
they tend to have very high fixed costs. As a proportion of their
total costs, usually more than 80% of the costs of providing service
on those sites is the fixed cost of being there and keeping the
site safe and all of that, and the only credible requirement is
from the Ministry of Defence or the Ministry of Defence's suppliers.
So on the whole our plans for the sites are wholly tied up with
our negotiations with Ministry of Defence customers, and those
customers themselves are pressing us hard to give good value for
money services to them. They will have budget squeezes to deal
with and they look to us year by year to provide them with the
same or better services for less money. So what you will see in
relation to, for instance, our facilities in the west of Scotland
is us responding to that pressure from our customers.
33. And when you are responding to those customers,
whom you are speaking to on a year-to-year basis, do you separate
them and say, "Look, this facility is there; you can use
it over the next five year period"? How far along the line
did you look? Short term? Long term? Medium term?
(Sir John Chisholm) That is a very good question.
Because of the high fixed cost of the facilities they are just
not feasible unless you have a long term relationship with your
customers, because in order to provide them with a good value
for money service you have to invest and you cannot unless you
know where future income is going to come from, and therefore
a key part of what we have been doing over the last year is persuading
our customers that a long term relationship with us is much better
business for them, and of course makes it feasible for us to provide
it.
34. How much is that investment?
(Sir John Chisholm) There is an investment required
of the order of £150 million in those facilities over the
next few years.
35. And those are all facilities within my constituency!
Also, to what extent is the investment contingent on the indemnity
provided by the Ministry of Defence? How much does that weigh
in your mind when you are looking at the pounds and pence for
investment?
(Sir John Chisholm) You used the word "indemnity"
there and I am taking that as relating to the liabilities. There
are elements of the liabilities, as I explained to Mrs Squire,
that we could not possibly take on—or we could but we would
have to charge an impossibly high insurance sum which would make
it uneconomic, because we simply cannot know what was done on
those sites over many years. So there are elements where the best
value for money solution is the one which has been reached where
the Ministry of Defence in a sense self-insures in relation to
some of the unknowable liabilities. There are other elements of
the liabilities which, because they are the sort of things you
would expect a well-managed contractor to take on, we do take
on.
36. So the £150 million for the facilities
of the investment is over how long a period?
(Sir John Chisholm) That will go in over literally
the next two or three years.
37. So in a maximum of three years there will
be £150 million?
(Sir John Chisholm) I am not going to commit myself
immediately to three years but it is over the next two or three
years. There may well be a small tail beyond that.
38. But we are not talking ten?
(Sir John Chisholm) No. The bulk of it needs to go
in soon in order to be able to reduce the cost of the facilities
to the Ministry of Defence. The Ministry of Defence customers,
and there are many of them, are demanding of us to reduce our
costs and the only way we can do that is by spending money of
that order in order to invest in rationalisation and modernisation.
(Dame Pauline Neville-Jones) Substantially upfront.
Mr Howarth
39. Forgive me for going back on these accounts,
Mr Youngkin, but QinetiQ's published accounts show it has net
assets of £312 million as at 31 March last year. You are
buying a third stake in a company which has net assets, net of
all its liabilities, of £300 million plus. I still do not
understand, and I do not think others here do, why you are paying
£42 million for a third stake in a company which has net
assets of £300 million? That suggests you should be paying
at least twice what the company was paying for the privilege of
sharing in this great national British treasure.
(Mr Youngkin) Mr Howarth, the best way I know to answer
this question is to describe how we assigned a value to the business—
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