Examination of Witnesses (Questions 100-119)
DR LEWIS
MOONIE MP, MR
COLIN BALMER
AND MR
MARTIN EARWICKER
TUESDAY 21 JANUARY 2003
100. That takes us down in round figures to
200 million. Here we have a discounted value, taking the worse
case scenario in terms of valuing the fixed assets of 200 million,
for which Carlyle has paid 42 million, my calculations in round
figures are that one third of 200 million is something under 70
million, 60 plus million, now are you saying that you think that
Carlyle will have assessed that and rather than pay 65 million
for this asset or stake in this company that because there are
other considerations, uncertainties for the future, they were
not prepared to pay one third of the discounted asset value of
the company?
(Mr Balmer) What I am saying is that I do not think
they did that calculation, I do not think they calculated the
asset value and worked out how much to give us. They calculated
what they thought the company would generate in the way of income
over future years, because that is the return they can get as
future shareholders. I expect that is the approach they have adopted.
Another way of looking at this is to say that if the assets are
worth around £200 million net the Government have received
£150 million for having sold one third of the shares. On
that argument we appear to have made a substantial profit compared
to asset value. I do not look at it that way, that is too simplistic
a way of looking at it. You have to look at this on the basis
that this is a company that will be trading for many years. Yes
it has some challenges ahead, it has a lot of capital investment
ahead of it. As has been indicated, there was a problem over the
size of the pension fund and the company almost certainly would
have to make some contribution to that, that would have factored
in to Carlyle's calculations. In effect Carlyle will have to put
some money into the pension fund in future years rather than taking
the fund exactly as it is today. There are a variety of factors
that are played into this. I do not think it is possible to make
simple comparisons of asset values and net worth at the point
of sale.
101. Is that the best deal that the Government
got, £42 million?
(Mr Balmer) The Government, as I said, has extracted
£200 million from the PPP process and we ran a very healthy
competition, as the Minister described. We had a lot of interest.
We have not disclosed the identity of the individual bidders,
because that is commercially confidential, but I can assure you
it included a lot of the major players we expected to be interested
and that process produced a bid which we thought in terms of the
support of a company and encouraging its future development was
the right bid. It also happened to be the highest bid.
102. Can you then explain us to, because I do
not think we really got to the bottom of this question last time,
why you opted for the balance of debt and equity as you did, between
179 million in loans and £346 million in equity, which in
round figures is 2/1.
(Mr Balmer) We had some interesting discussions both
amongst ourselves, with our advisers and with the company at the
point of vesting as to what the right ratio of debt to equity
ought to be. Our view was conditioned very much by our independent
advisers and our financial advisers. Clearly they are experts
in these matters and they are much more experienced than MoD.
Our view was that it would be a sensible idea to put a substantial
amount of debt in the company as well as equity. As Sir John Chisholm
was saying in the earlier session at this stage of a company's
life it is not at all untypical sort of ratio. It has the value
of sharpening up the company's view of its cash-flow and its ability
to service that debt and therefore of thinking quite hard about
things like capital investment and cash management. Those are
all considerations which our advisers thought we should ensure
were key features of the early days of the company.
103. Why not scrub the loans all together and
invest it all in equity?
(Dr Moonie) Because our advisers advised us against
doing that.
104. Why?
(Dr Moonie) Because in their commercial opinion and
their financial opinion—they are the experts, that is what
we are paying all that money for—their view was that the
company properly constructed would have a balance of debt between
loan capital and equity capital. That is what they thought the
best balance would be.
Chairman: What we are going to have to do is
exchange correspondence on this otherwise we are going to be here
for about 4 hours and be none the wiser. You took us some way
along the road to understanding, perhaps we need a little more
coaching before we comprehend if the MoD has got a good deal out
of this.
Mr Howarth
105. I was just going to deal with future investment,
by giving these large loans to QinetiQ have you not undermined
the rationale for moving from the trading fund, the idea that
privatisation would give DERA access to more funds for the future,
have you not undermined that by having expensive advice from City
advisers or not?
(Mr Balmer) We do not think so. The debt in the company
when the company was created in July 2001 was at the right sort
of level. It is now very much a judgment for Carlyle, amongst
others, as to how much debt the company can sustain going forward.
As Sir John Chisholm was telling you earlier, having the backing
of a company like Carlyle means that the company can have much
better access to capital markets than they would have had as a
trading fund or when they were wholly owned by the Ministry of
Defence.
Mr Howarth: I think we understand that.
Mr Roy
106. Minister, when you sold the share to Carlyle
for the 33.8% how did that figure come about? Did you have a top
range or a bottom range in mind?
(Mr Balmer) If I could lead, Minister. The first consideration
was that we did not think we would get full value for this company
if we sold it completely at this stage. We are quite clear that
this company has a lot of growth potential and we think the taxpayer
should share in that. So on the one hand we wanted to get the
company, having access to private capital, the freedoms of the
marketplace, but, on the other hand, we wanted to share in its
future growth. That suggested to us that we should be looking
to sell less than half the value of the shares if we could. As
Mr Youngkin was telling you earlier, we deliberately encouraged
the market to approach us with different views. We did not give
a precise figure, we indicated we would be interested in a range
of views and so different people talked to us and gave us slightly
different propositions. We ended up saying that round about a
third would be—
107. When you asked for those views, was that
because you wanted less than 50%?
(Mr Balmer) Yes. We indicated to the people in the
market place that we thought it would be in our interest to sell
less than 50% so that we would get more value when we had a subsequent
sale of the rest of our shares, and our negotiations with Carlyle
homed in on a figure which has ended up being just under 35%.
There was no magic formula that said exactly where it should be
and, as Mr Youngkin said earlier, he would have liked to have
had more of the equity because he can make more profits by doing
so. Conversely, we wanted to hang on to it so that we could make
more profits. It was a negotiation where we wanted to give Carlyle
voting control so that they control the company subject to our
compliance regime arrangements but we retained the higher value
shareholding, so the shareholding has been arranged so that they
have a majority of voting shares and we have the great majority
of value in shares.
108. Are you able to tell us the top amount
that Carlyle was looking for?
(Mr Balmer) No, I do not think we ever homed in on
a particular number. 35% became the point around which we were
negotiating.
Mr Roy: Thank you.
Syd Rapson
109. Good afternoon. In establishing QinetiQ
you have had to identify the company's potential liabilities and
whether the company or the MoD ought to take on the financial
responsibility for them. Were there any areas in particular where
you did not accept the experts' suggestions?
(Dr Moonie) I think by and large that was done by
general agreement. We have to recognise that these are contingent
liabilities and therefore may never come to pass. However, had
they been loaded over to the company as opposed to being retained
by ourselves then they would have acquired a notional value and
that would have been produced for any buyer that was prepared
to pay for the company. We have retained what we think is a sensible
proportion of the liabilities on a contingency basis and I have
to say, the amount the Chancellor has been asked to stump up for
them is very small indeed.
110. So there was no disagreement on the expert
advice coming from Mr Balmer?
(Mr Balmer) At two stages we had to negotiate. We
negotiated with the company, when we created it from the trading
fund, in deciding what liability would be vested in the company
and what would be retained in the MoD and of course there was
inevitably some disagreement around the margins of that. The expert
advice we got both from our financial advisers and from our lawyers
was reflected in the outcome. Separately, as part of the transaction
negotiation with Carlyle we have had to look again at some of
these liabilities and again there has been a negotiation with
Carlyle which went on for quite some while because inevitably
they were looking to have as few liabilities as they could and
we were looking for the converse of that. Again, the balance we
have struck here, which has been driven very much from our perspective
of what we perceive to be value for money calculations, reflects
the advice from our financial advisers and our lawyers. The one
area where we had originally hoped to have more liabilities in
the company are in certain areas which we thought could be insured,
particularly on some of the longer-term liabilities. We had hoped
the insurance market would be more responsive and our advice from
our own advisers was that we should put liabilities into the company
so they could then take it to the insurance market and try to
get it insured. It turned out that some of those were just too
difficult, particularly after the 11 September 2001, the insurance
market got a lot more cautious in many areas and so we found that
we could not put as many liabilities as we had hoped to do on
the company and that is why we put a Departmental Minute in front
of the House for approval in July of last year, to reflect the
fact we had taken back some liabilities that we had hoped to lose.
111. So in the discussions with Carlyle, trying
to apportion the contingent liabilities, are you able to share
with us what specific areas Carlyle wanted the MoD to retain the
risks of? It might be sensitive information, I recognise that,
but are there any areas in particular where they really wanted
the MoD to take on the risk?
(Dr Moonie) Do you mean areas that we did not take
on in the end or—
112. Where they wanted the MoD to take on more,
yes.
(Mr Balmer) There were some provisions within the
company's accounts where they are expecting to make a payment
for one or two activities which they think will mature. We took
the view that probably they will spend less than the provision
in their accounts. If we left the provision in the accounts Carlyle
would have given us exactly that amount less cash for the company,
that was clear. Instead we have relieved the company of that liability,
we have taken it onto the MoD's balance sheet so when these liabilities
mature we will pay for them, but we will pay less than we would
otherwise not have received from Carlyle. There is another category
of liability to do with the pension fund where the nature of almost
all pension funds in the market this year has meant that the valuation
at any spot point is less than it was when the fund was created
Carlyle's perspective is that they are not interested in taking
over a pension fund with a big liability. We had quite a long
discussion and debate with them at that point and in the end we
have taken on some contingent liability in that area, although
we think we have so structured that liability that provided the
markets do recover to a sensible amount we should end up not having
to pay anything more on that account. Those were examples of the
sorts of areas where we have negotiated.
Syd Rapson: Thank you very much.
Mr Howarth
113. Can I move on immediately to ask you, on
the pensions issue, how much you have quantified that liability
remaining with the MoD?
(Mr Balmer) This was difficult because the valuation
of a pension scheme is more of an art than a science, as I have
discovered and any two actuaries will give you different views.
We are advised by the Government Actuary's Department; obviously
Carlyle and the company are advised by their own actuaries. It
was common ground at that point in time when we were looking to
do a transaction towards the end of 2002 that the market had moved
sufficiently from when the fund was created in July 2001 that
it is undervalued for its liabilities. Quite by how much was a
matter more of judgment than of precise science, but we agreed
with Carlyle, coming from two different directions, that a figure
of about £70 million was probably not an unreasonable assessment
of the lack of value in the pension scheme. It was also clear
to us that it would be quite wrong simply to pay £70 million
into the pension scheme. That value reflects a current view of
the stock market. Over a longer period of time people would take
a different view. So we both agreed it would be quite wrong simply
to top up the scheme at this stage. In the end we have split that
£70 million in two ways: first of all, we have agreed that
a negotiated sum of about £25 million will be put into the
pension fund over the next few years and our proceeds from Carlyle
have been reduced by that amount, so Carlyle will have to pay
£25 million more than the figures we were discussing earlier
because they will have to ensure that that pension fund is topped
up by those amounts. In addition to that we have taken a contingent
liability for the remaining £45 million and this reflects
our judgment, although we cannot be certain, that if the markets
recover over a reasonable period that £45 million will not
be a hole anymore, it would not need to be topped up. At the point
when we come to sell our shares or in five years' time, whichever
is the earlier, we will do another calculation on an agreed formula—I
will not take you through the formula, Chairman, because even
I go cross-eyed looking at it—and we will revalue the pension
scheme at that point and to the extent that it is still undervalued,
we will top it up to a maximum of a further £45 million.
Our judgment is that probably we will not have to pay any of that
or, if we do, it will be a small amount.
114. Does that mean that those people who are
currently employed in QinetiQ will continue to enjoy the kind
of pension arrangement they had when they were in the public sector,
that this is the mechanism by which you are maintaining that and
that new employees employed by QinetiQ plc will have the benefit
of a pension scheme that is drawn up by the new company with all
the difficulties that are associated with the private pension
market today?
(Mr Balmer) When the company was created we had to
create a new pension scheme and people had the option of not transferring
their previous service into the new scheme, but the new scheme
had to be broadly comparable to the Civil Service scheme, that
is what the law requires and that is what we put into place. So
the individuals were entitled to a pension that was broadly similar
to the Civil Service scheme. What we have just been talking about
is the value of the fund that is necessary to ensure that they
will be paid their pensions. So their entitlement has not changed
since 1 July 2001 and it did not change very much compared to
the Civil Service scheme that was remarkably similar and we have
been discussing with Carlyle how we can ensure that the scheme
is properly funded going forward.
115. Going back to what Mr Rapson was asking
about in terms of availability of commercial insurance for the
contamination, I am intrigued, I have to say, that the MoD has
accepted this liability whereas in another case which I know of
the MoD are refusing to accept liability where even unexploded
ordinance has been found. All the arguments Sir John eloquently
advanced earlier on would apply, but perhaps you and I can discuss
that privately later. Can I ask you, Mr Balmer might be the appropriate
person, how much would Carlyle have sought to reduce their contribution
for their stake in the company if they were not given the indemnities?
Can you put a figure on it?
(Mr Balmer) I could not put a figure on it. I am not
sure that they could either. What is clear is that if we had given
them no warranties, no indemnities at all they would have had
a major problem in trying to work out how much they had to aim
off for those liabilities themselves and they would inevitably
have been cautious and prudent. I could not attempt to value it.
What we have been able to say in informing Parliament of the contingent
liability that we have taken on is we have put caps on many of
them, for instance on the pension scheme we have a cap of £45
million, and some other liabilities we have put a cap on. We have
been unable to quantify the contingent liability. You could say
that Carlyle would be looking at the converse of all of that and
would have been uncomfortable themselves maybe having a cap at
certain points but they would have had to form a judgment. It
is clear, and I have certainly had this discussion with Carlyle,
that they would have wanted a substantial reduction in the amount
of money they would have to pay had we not offered the warranties
and indemnities we put in the agreement.
116. Reference has been made earlier to the
25-year partnering arrangement with the Ministry of Defence and
QinetiQ. To what extent was this necessary to help persuade QinetiQ/Carlyle
to invest £150 million, as we heard from Sir John earlier,
in these facilities and what assurance have you given to QinetiQ
and Carlyle you will continue to use them after the three-year
period covered by the MoD indemnity?
(Dr Moonie) Clearly, looking ahead there has to be
considerable uncertainty about the overall degree of use. One
of the major problems we have had with testing and evaluation
ranges over the past decade or so, maybe longer, is the largely
unpredictable but sustained fall in use by the Ministry of Defence.
We retain a very large estate for training and evaluation, probably
far too great—
117. You retain what?
(Dr Moonie) We retain a very large, in physical terms,
estate for training and evaluation, probably larger than we would
honestly say we would need, therefore in order to reduce overall
costs we should try to rationalise that wherever possible.
118. The trouble is once you have lost that,
Minister, the idea of opening up a new range anywhere in the UK
would be—
(Dr Moonie) I fully agree with you, that is why we
are going to have to be very, very careful in the way we go about
things. The fact remains through modern methods of testing—much
more use of simulation than we used to do—we do not need
the same number of ranges as we did in the past. The main point
is that in order to get a proper deal with a facilities manager,
we need somebody who runs it for a more extended time, that is
why we are looking at the deal on roughly the length of time we
are talking about. This is in order that they can make a reasonable
return on investment they have put into it in order we can get
a reasonable saving on our costs in future.
119. Can I ask a final question, I am not sure
this is an appropriate place but reference has been made as to
the extent of advice which the Minister of Defence has received
from a number of financial operators in the City. I think that
it would be of interest to the Committee to know just how much
has been spent on this exercise, not only in terms of the advisers
that you have hired but also in terms of the time spent by QinetiQ
staff in doing the allocation, the division between the retained
business in DSTL, Mr Earwicker may be able to advise us on that,
and QinetiQ. Perhaps you could tell us that. Whilst you are working
that out, can I say I am not alone and nor is Llew Smith alone
in being concerned that this Departmental Minute was lodged on
17 December in the Library of the House of Commons which was the
day before the House rose for the Christmas recess. There were
14 days in which any Member of Parliament could lodge an objection—
(Dr Moonie) Can I stop you there—
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