Original URL: http://www.theregister.co.uk/2007/11/23/qinetiq_stealth_piracy_pillow_bite_deal/

Watchdog raps MoD over Qinetiq sell-off bonanza

Eyewatering Stealth raid by pinstripe execs

By Lewis Page

Posted in Government, 23rd November 2007 07:03 GMT

Analysis UK gov watchdog the National Audit Office (NAO) has released a damning report into the privatisation of the country's top-secret defence research labs and facilities as Qinetiq.

The report, now available online from the NAO, severely criticises the Ministry of Defence (MoD) and some of the consultants which advised it during the selloff process - who themselves pocketed large fees. (Total spend on consultants was more than £28m.)

Sir John Bourn, NAO chief, said today:

"I believe more money should have been secured for the public purse."

That seems reasonable. According to the report:

The Department has received net proceeds of £576 million from the transaction to date... it also retained a 19 per cent shareholding [in Qinetiq].

The MoD has received £576m for 81 per cent of a business with annual revenues of £1.1bn (on which it makes approximately £120m profits). As the report also notes:

[The MoD is] still by far the largest customer [of Qinetiq], accounting for some 57 per cent of QinetiQ’s revenue in 2006. The majority of this business was awarded without competition.

And it will keep on being awarded without competition, because much of that business relates to operating UK test facilities and firing ranges which are effectively a monopoly which the MoD must use. Indeed, the MoD, as part of selling off Qinetiq, is tied into using these facilities until 2028 under a sweetheart deal called the Long Term Partnering Agreement, worth up to £5.6bn to Qinetiq just for keeping the facilities open. The MoD has to pay more on top when it wants to actually use them. And it's actually even worse than it sounds, because Qinetiq can crank up the price.

The MoD may be exposed to significant price increases... This risk is greater in year ten (and at each subsequent review), as QinetiQ has the right to terminate the contract if it does not agree to the outcome of the price reviews... If there are no other contractors that can supply these services in the market [and in most cases there aren't] QinetiQ may be able to negotiate significant price increases.

One reason that the test-ranges deal was such a big pillow for the MoD to bite was that the MoD has long failed to invest in the facilities and keep them up to scratch.

The LTPA was in part established to address the legacy of underinvestment in the assets used in the delivery of test and evaluation services. To this end, the contract is based on there being £136 million of capital and rationalisation expenditure in the first five years. QinetiQ receives funding for the depreciation of this capital expenditure through the contract.

In effect, then, the MoD still pays to fix up its old test ranges. It does so by borrowing the money from the private sector and then repaying over decades. At the same time it loses ownership of the assets it is paying to fix up.

This is a bit like being an Irish tenant of a rack-renting English landlord before the Republic became independent, paying for any necessary improvements of property you rent at extortionate terms.

Unsurprisingly, the NAO says that "the commercial value of the Long Term Partnering Agreement was not fully understood" by the government.

The NAO beancounters went on to highlight the role of the people who became Qinetiq's top executives.

"It is of concern that the MoD did not seek specialist advice on the incentive scheme, which resulted in the top ten managers owning shares worth £107m," said Bourn.

"This level of return exceeded what was necessary to incentivise management," he added, in dryly understated style.

In particular one can follow the progress of Sir John Chisholm, founder of defence contractor CAP Scientific, who was hired in the 1990s by the MoD to be head of the Defence Research Agency, which formed the core of the Defence Evaluation and Research Agency (DERA) in 1995. Chisholm continued as head of DERA, most of which he subsequently took private as CEO of Qinetiq.

DERA was established in April 1995 and drew together some twelve science and technology offices and the Defence Research Agency ... DERA received the vast majority of its revenue from the Ministry of Defence ... The head of the Defence Research Agency, Sir John Chisholm, who had formerly started the defence software company CAP Scientific, was appointed the chief executive officer of DERA.

Over the period 1992-1998 the MoD’s budget for research fell ... DERA’s chief executive officer proposed a range of options ... Although DERA’s top management could potentially benefit personally from the involvement of private investment, the case [for going private] was not validated by the MoD. The MoD sees no reason why it should have validated this policy decision which was based on analysis prepared by DERA management ...

As part of the process of creating Qinetiq, the MoD involved US private equity group Carlyle, who made out like gangbusters - scooping £300m profits after just three years on an investment of £42m. It is, of course, usual for private-equity groups to incentivise management teams with share plans.

"The MoD was not involved in the design of the share incentive scheme although it assessed and approved it," says the NAO. In other words, Chisholm and his fellow execs were allowed to set up the deal with Carlyle. In brief, this was what the private-equity guys and Chisholm's team decided:

All employees could choose to invest a minimum of £500 in the co-investment scheme, and got 40 share options for free [worth £80 on flotation, a bit less now].

The top 245 senior managers were given the opportunity to invest in ordinary equity that benefited from a performance ratchet.

The top ten managers were given the opportunity to invest in ordinary equity that benefited from a double performance ratchet.

The end result of this was that many of Qinetiq's ordinary employees, unable to scrape up £500, got £80. Those who could find £500 to chuck in made a return of £9 for every £1 invested as a result of their hard work in building the company's value up to 2006. Fair enough, one might say.

The 245 managers, on their special deal, made £145 - that's one hundred and forty five pounds for every £1 they invested over three years - collectively coming away with better than £65m, an average of £270,000 each.

The top ten led by Sir John Chisholm, who according to the NAO had pushed the deal through unopposed since the early years of DERA, scored no less than a two-hundred-fold payoff. Chisholm himself, putting down £130k, came out with a cool £25 million worth of shares. Three other executives are specifically named by the NAO: Graham Love, Hal Kruth and Brenda Jones, who made £20m, £13m and £11m respectively.

Much of Qinetiq's value-build in its three years before flotation could be said to have come from the MoD signing up to the 25-year gravy train partnering deal; a lot more came from a bunch of acquisitions in the States, which delivered nearly all the new revenue required to make Qinetiq profitable.

So actually, even 900 per cent for the smallfry seems a bit cheeky, although many won't have been able to get in on it. Twenty thousand percent payola for Chisholm and his top team seems grotesque. In NAO-speak:

We consider that the returns in this case exceeded those necessary to incentivise management.

Then, of course, there's the matter of intellectual property inherited by Qinetiq from DERA. As we noted this week, the company seems to be selling off all kinds of critical military secrets - not least the knowhow required to build stealth aircraft, and interesting spookery electronics.

The MoD says, however, that all the best secrets were kept in the small part of DERA which stayed in the government under the name Defence Science and Technology Laboratories (DSTL). In particular, Blighty's valuable secret access to American military/spook tech (and America's use of crafty UK boffinry) was supposed to be safeguarded in this way, after "concerns expressed by collaborative partners in the US Department of Defense* over the sensitivity of privatising certain elements of DERA".

The NAO report isn't exactly reassuring on this:

Intellectual property relating to international collaboration projects was in most cases transferred to DSTL ... some of the concerns held by... the US Department of Defense* were addressed ...

Presumably a little thing like Stealth wasn't thought important enough to keep secret. Similarly, at least a few neat ideas employed by the British GCHQ and American NSA listening agencies seem to have been OK'd for sale. Or maybe the MoD's efforts to separate DSTL and Qinetiq just haven't worked in the real world. In most cases the secret government labs and the privatised company ones share sites, and boffins can simply walk in and out of each other's offices, canteens etc; though the MoD swears blind that at least they don't share IT systems or buildings anymore.

All in all, another masterful bit of work by the MoD, one really has to say. They didn't just sell off all our secrets and a lot of our assets and get (us) brutally shafted on the deal. They seem to have sold an unknown number of American secrets too, and created a perpetual, leaky, revolving back door through which more critical secret tech can dribble out. ®

*One notes that the US DoD includes the National Security Agency (NSA), the US government's primary code-cracking and comms intercept outfit. The UK equivalent is GCHQ, which is under the Foreign Office along with the spies. It is sometimes said that the NSA has actually been able to learn a few tricks from British electronic spies in recent times.