Small Business, Enterprise and Employment Bill

Written evidence submitted by Robert May (SB 42)

Small Business, Enterprise & Employment Bill: "No Worse Off"

This letter comments on the sections of the Bill relating to the pub industry. It expresses my own views, concerns and opinions, and should not be taken as a representation on behalf of Enterprise Inns plc, or of the RICS.

1 Curriculum Vitae

a. I am Robert May. I hold a Master’s degree in Land Economy and I am a Fellow of the RICS.

b. I have worked as a pub property manager and property director undertaking, inter alia, pub asset and rental valuations since 1979, mostly employed by pub companies. I was self-employed between 2004 and the end of 2006 acting for both publicans and pub companies.

c. I was a member of the RICS trade-related property group (TRPG) between about 1996 and 2013. This group sets valuation standards for all RICS members specialising in all property types where the assessment of open market value relies upon an understanding of the trading potential of each site. This includes hotels, nightclubs, casinos, golf, garden centres, care homes, some restaurants and other specialist property types, as well as pubs. I chaired the TRPG between 2000 and 2009 and served on the Valuation Standards Board of the RICS (VSB) for that same period. The VSB sets and monitors the standards for RICS members undertaking all real property valuations worldwide. The scope of that Board has recently been extended to include going concern Business Valuations as well as Real Property Valuations.

d. I am currently employed as National Rent Controller of Enterprise Inns plc.

2 RICS Pubs Working Party

a. After the 2009 BISC report the RICS convened a special working party to review RICS Guidance for valuers undertaking pub valuations in the UK. I was a member of that working party, alongside a wide cross-section of pub valuers acting for or working for both pub companies and pub lessees/operators. The membership included campaigners and representatives of campaigning groups; notably Simon Clarke, David Morgan and Garry Mallen.

b. The group completely rewrote previous RICS guidance and the wording of a new Guidance Note was agreed unanimously. It was published in December 2010 as RICS GN67/2010 "The capital and rental valuation of public houses, bars, restaurants and nightclubs in England and Wales". Its status as RICS Guidance is strongly advisory but not mandatory. If a member departs from this guidance and is then subject to an allegation of negligence the member will need to explain why they decided not to adopt this recommended best practice.

3 Section 36(4) of the Bill expresses a principle that "that tied pub tenants should not be worse off as a result of any product or service tie".

a. "Not worse off" requires a definition of what or whom "Not worse off" is measured against. I think the draughtsman may have missed out the words "than a free of tie tenant of the same premises at a specified date". Those words should, in my opinion, be added to the end of this section.

b. A definition along these lines appears at 62 (1) when the Bill defines "parallel rent assessment", but that definition also seems to be too narrowly. It proposes that the free of tie agreement is to be on all the same tenancy terms apart from the tie, which means that most of the tied Special Commercial or Financial Advantages (SCORFA) differences that are written into customary tied lease and tenancy terms (not Full Repairing, lower fixed rent cost, upward/downward rent reviews, easy exit terms, insurance, tech services, one order/one delivery, guaranteed long-term discounts, management of operators’ legal compliance, cellar and heating maintenance and any other contractual service ties provided by the lessor) must be assumed also to be delivered to the hypothetical FOT operator by their commercial lessor, therefore rendering them no longer SCORFA available only to tied tenants.

c. The commercial lessor of a free of tie lease would have no business reason to offer the free of tie lessee any of these concessions and services. It would be irrational for them to incur these costs with no return of value, so that form of free of tie tenancy does not exist in the open market. In a free of tie agreement the only return on the lessor’s capital and management time will be a fixed rent with periodic rent reviews.

d. A core principle of RICS valuation practice is that the valuer does not make the market; the valuer is a score-keeper. The valuer is expected to base his or her opinion of value on an understanding of supply and demand in the open market, the terms of leases that are usually available in that market and the rent or capital value evidence arising from the willing buyer and willing seller or willing lessor and willing lessee haggling to a successful conclusion. If the Bill is intended to constrain tied pub lease rents using a formulaic adjustment from the open market for free of tie leases it is vital that unadjusted real-life open market evidence of free of tie rents exists. As stated at para 3(c ) above, the customary terms for free of tie pubs leases are completely arms-length; including for example a full repairing liability, upward-only rent reviews, no break clauses, no ancillary services as well as no supply tie. That is the only real-life evidence valuers will be able to assess as a basis for comparison with tied rents.

4 Parallel Rent Assessment (PRA)

If this is intended to be a comparative assessment of the tied trading potential of the business, gross margin, operating costs and then the split of net profit between rent and lessee net earnings, compared with an hypothetical free of tie letting on customary free of tie lease terms, the PRA should be carried out in accordance with International Valuation Standards and with RICS Guidance on the valuation of property by the profits method. The latest version of the RICS Valuation - Professional Standards ("the Red Book") was published in January 2014 and includes sections on the valuation of Businesses and Business Interests and on Valuation of Individual Trade Related Properties. These mandatory rules have world wide application to all RICS members. The valuer is required to identify "Market Participants" and to understand how they would interact with the supply of businesses and business interests available to buy or lease in the open market. The Red Book provides two definitions that are relevant to the proposed Parallel Rent Assessment, as follows:

Personal goodwill (of the current operator)

2.9 This is the value of profit generated over and above market expectations that would be extinguished upon sale of the trade related property, together with financial factors related specifically to the current operator of the business, such as taxation,depreciation policy, borrowing costs and the capital invested in the business.

Reasonably efficient operator (REO)

2.10 This is a concept where the valuer assumes that the market participants are competent operators, acting in an efficient manner, of a business conducted on the premises. It involves estimating the trading potential rather than adopting the actual level of trade under the existing ownership, and it excludes personal goodwill.

5 So does the drafting of this bill propose that the actual tenant is to be no worse off, or a hypothetical REO should be no worse off?"

a. I attach a graphical risk/reward illustration taken from evidence to the MMC during their investigations, which remains relevant now. For this purpose, it can illustrate two issues:

- The difference between the meaning of "no worse off" for the actual tenant and for the Reasonably Efficient Operator

- The instability of the concept of "no worse off" over time.

b. Actual tenant vs REO.

The point at which we can determine that the tied publican is no worse off than a free of tie one is the point where the lines all cross on this graph. That assumes there is a single fair maintainable wet trade (FMT) to be derived from the operation of the pub. Using the RICS definitions above the FMT should be the level of wet trade achievable by a competent operator, operating in an efficient manner, which excludes personal goodwill.

c. The graphic then shows that the risk line is steeper for a free of tie operator than for a tied one. This is because the higher expected free of tie rent is a higher fixed cost, with no instantly-variable tied "wet rent". When trade goes bad, the free of tie lessee reaches a higher level of break-even sooner and is therefore likely to go bust more quickly than the tied publican, but when trade booms the free of tie lessee makes more money than a tied publican because the latter shares some of the value of their extra volume with the pub company landlord in the form of an increased "wet rent" as delivered tied volume grows.

d. Thus the free of tie lease package is riskier for the publican but the rewards for success can be greater. So long as the actual publican happens to trade at the same volume as the REO, a valuer may be able to show he or she is actually in simple terms "no worse off" because that is the point on the operating profits graph where both the free of tie and tied trade align and from which the respective open market rental valuations will be derived by any valuer who follows RICS guidance. But this equivalence falls apart if the actual tenant trades above or below the assessed FMT volume:

i) If the actual tenant sells 50 barrels per annum more than FMT, the FOT lease line climbs more steeply than the tenanted line, showing that the extra 50 barrels will make the FOT lessee more incremental profit than the tied lessee will. The ACTUAL tied tenant will be worse off.

ii) If the actual tenant sells 50 barrels per annum less than FMT, the FOT lease line falls more steeply than the tenanted line, showing that the missing 50 barrels will make the FOT lessee lose more profit than the tied lessee will. The ACTUAL tied tenant will become better off than FOT when beer volume shrinks (which is the long-term on-trade beer market trend). This supports the London Economics Report (December 2013) conclusion that this intervention is likely to make the tied model in a declining on-trade beer market too risky for the pub companies to continue with it. See page 13 of that report for their comment:

"We do consider that a key risk to BIS in relation to this policy is exactly how such assessments will be carried out in a transparent way that is not overly reliant on assumptions that may not materialise or change over time."

e. The instability of "no worse off" over time.

Let’s assume that the crossing point in the attached graph is a fair maintainable beer and cider volume of 200 barrels as at September 2014. Then assume that this was supported by off-invoice discounts of £60 per barrel from the pub company. In order to enhance earnings for both parties the pub company agrees to increase discounts to £120 per barrel so that the tied publican can promote certain brands of beer to his customers at a lower price in order to increase volume, and the end result is that by Sept 2015 the actual volume has grown to 250 barrels. Is the tied tenant still no worse off? We can’t tell because, although the tied tenant has £3000pa more net income (50 barrels x £60 more tied discount) from the pub company, how much did he pass on to the customers as lower prices? Would the hypothetical free of tie lessee of the same pub also have reduced the retail prices in order to gain an extra 50 barrels of throughput and would his or her free trade suppliers have reduced their beer prices in order to part fund it?

6 RICS Guidance on "No worse off"

a. The RICS Pubs Working Party (see 2 above) addressed this point at para 7.21 of the Guidance as follows

"Comparability between public houses held on different lease terms and with different supply terms is problematic, particularly between the tied and non-tied sectors. There is nothing within this guidance that should result in rents in one sector being set at any advantage or disadvantage to another. In arriving at a market rental value, it is preferable for analysis to be made of transactions relating to similar properties with similar lease terms. Indeed the efficiency of the market relies on transparent market evidence."

b. This follows the decision of Hughes J in Chancery in the case of Brooker v Unique Pub Properties (2009) but remains open to further judicial interpretation. This was the only way the RICS working group was able to reach unanimity.

c. Most practising valuers would understand this to mean that, if there is a plentiful supply of both tied and free of tie pubs to let or to buy on assignment, the bids made by well-advised prospective pub lessees will reflect all the features and benefits of each package in their rental bids. It does not assume that the Dog & Duck is available on either free or tied lease terms; rather this assumes that active bidders would assess available tied terms for the Dog & Duck against the available free of tie terms for the Hare & Hounds and choose the one that gives each bidder what they see as the best overall deal for them. Thus if any tied pub company is asking too much rent with too little drinks price margin their pubs will remain un-let because they will have priced themselves out of the market. Alternatively if a pub company offers their pubs at very cheap rents it is likely that competitive bidding for those "bargain pubs" will push the final agreed rent up to the general market level.

d. The existence of a tied pubs code of practice is just one of benefits of a tied lease as compared to a free of tie lease, and the more onerous the terms of such a code the closer the tied rent should come to the free of tie rental valuation. In theory, an exceptionally onerous tied code could make tied leasing so advantageous for publicans that a tied rent would exceed the free of tie rent.

7 Conclusion

I conclude by suggesting that if it is intended that the Adjudicator should follow RICS Guidance on the valuation of pub rents the evidence of open market transactions, especially new lettings of both tied and free of tie pubs, the Adjudicator need only evaluate the available open market evidence to establish whether the tied rents that existing tied lessees pay are "fair". I suggest that there is no need for any formulaic comparative assessment which tries to break down the overall difference between tied and free of tie pub leases into the multiplicity of their differences. I think there are simply too many moving parts for such an exercise to be practical or fruitful.

September 2014