1. Supplementary memorandum from the
National Audit Office
Questions 186 to 193 (Mr Richard Bacon): Valuation
of Actis LLP
1. At its hearing on 15 December 2008, the
Committee of Public Accounts asked the Department for International
Development (the Department) about the price paid by incumbent
management for Actis, a fund manager previously wholly owned by
CDC Group plc. The Committee also asked about the relationship
between the amount paid by management (£373,000) and the
first year's reported operating profit for the partnership (the
US dollar equivalent of £4.6 million).
2. The Committee asked the National Audit
Office to provide a note on the valuation of Actis when it was
part-sold to its management in 2004, and the profits generated
subsequently.
BACKGROUND
3. In 1997, the Department for International
Development (the Department) converted the Commonwealth Development
CDC into a public limited company—CDC Group plc (CDC)—in
anticipation of the sale of substantial stake to private investors.
There was, however, little interest from potential investors[11],
and the Department instead decided in 2003 to restructure CDC.
As part of this restructuring the Department established a separate
fund management arm, known as Actis LLP (Actis).
4. The Department sold a controlling stake
in Actis to its managers in July 2004. Thirteen individual partners
and twelve overseas corporate partners, together with an Employee
Trustee, subscribed £373,040 for 60% of the voting rights
in the business, subject also to various governance conditions.
The Department holds 40% of the voting rights in Actis. The sale
terms provided for the management initially to receive only 20%
of any residual profits, or any proceeds from an onward sale of
the business. This would increase to a 60% share after 10 years.
5. Actis's main role is to promote and manage
funds invested in emerging markets on behalf of investors. Its
single biggest investor is CDC itself, which is wholly owned by
DfID. In the new structure established in July 2004, CDC retained
ownership of its existing investment portfolio, built up over
several decades, known as the "legacy portfolio". DfID
agreed that Actis should manage this legacy portfolio on CDC's
behalf for five years extendable to ten years at CDC's option.
The legacy portfolio was valued at £805 million at 1 January
2003.
THE SALE
PROCESS
6. CDC was responsible for implementing
the sale of Actis. To oversee the conduct of the sale, CDC's Board
formed an Independent Committee (the Committee) in early 2003,
comprising board members who had no direct interest in Actis.
The Committee took advice from KPMG and from McKinsey. The Board
was separately advised on remuneration matters by Towers Perrin.
DFID was advised by Treasury Solicitors in relation to public
law, Campbell Lutyens & Co Ltd on corporate structuring and
finance, Field Fisher Waterhouse on commercial law, PricewaterhouseCoopers
on tax matters and the newly formed Shareholder Executive, then
part of Cabinet Office, in relation to corporate structuring and
finance.
7. KPMG, in accordance with terms of engagement
agreed with the Committee on 31 July 2003, undertook an initial
non-binding valuation of Actis on behalf of the Committee. The
valuation was not commissioned to set the price at which someone
would invest but helped guide discussions with Actis's management
over the appropriate price they should pay to purchase Actis.
THE PRINCIPLES
USED TO
VALUE ACTIS
8. Valuing Actis was not straightforward.
In valuing any entity, the valuer must identify the residual earnings
that accrue to the business owners. The valuer must then estimate
how much potential new owners would be willing to pay for the
right to these residual earnings.
9. These calculations were complicated in
the case of Actis because the entity was purchased by its employees.
These owner-employees have access to two streams of income:
a. The amounts they earn from their labour as
fund managers. These amounts should closely reflect the market
rate for similar fund managers elsewhere. The fund managers would
in principle enjoy these amounts whatever ownership structure
they worked under and whoever owned Actis. The rewards for their
labour are not relevant to the valuation of Actis.
b. Their rights to enjoy the residual earnings
achieved by Actis. These amounts represent the dividends the owner-employees
would be entitled to as a result of taking the risk of investing
capital in Actis and so form the basis of the valuation of Actis.
10. The valuation was also complicated because
there were few obvious comparators to Actis. In advance of the
sale, CDC had negotiated fund management fee levels with Actis
that were only expected to cover operating costs and allow Actis
to break even.
11. There are two common methods used to
value businesses for sale:
a. a discounted cash flow approach; or
b. a market-based approach, which multiplies
expected post tax earnings by a multiplier based on the way investors
value other comparable companies.
12. As discussed with the Committee, KPMG
utilised a discounted cash flow basis and also took into account
the level of net assets held by Actis. A market approach to valuation
as a cross-check was not required of KPMG because Actis had not
been structured to generate significant profits. The few traded
funds management businesses identified as possible comparators
were generating profits from assets under management and other
activities.
13. KPMG based its discounted cash flow
valuation on agreed forecasts of the residual cashflows that would
accrue to the new owners of Actis from each part of the business.
It then applied a discount rate to these cashflows to calculate
a capital value. KPMG used discount rates considered suitable
for the area of business, taking into account its riskiness. For
management fees from existing funds, KPMG adopted a discount rate
of 13.2%. For new funds, KPMG used a higher rate of 18.6% to reflect
greater risk of uncontracted potential future funds. This took
into account the difficulty and uncertainty in raising and investing
new funds.
14. In September 2003, KPMG's initial non-binding
valuation of Actis on behalf of the Committee concluded that the
whole business could be valued at between US$3-4 million, equivalent
at that time to £1.8 million to £2.4 million.
ADJUSTMENTS TO
THE INITIAL
VALUATION
15. In November 2003 KPMG were requested
by the Committee to reconsider the valuation of Actis because
the employees were not purchasing the whole company. Instead employees
were purchasing 60% of the voting interest and 20% of the rights
to residual profits (for the first 10 years) and were subject
to various governance conditions (paragraph 16). Furthermore,
KPMG were informed that there was no basis for expecting any cash
distributions of residual profits in the first five years. And
there was no public market in which managers would be able to
dispose of their shares.
16. The Department holds veto rights over
the appointment of the chair of Actis LLP and two non-executives,
the three of whom together make up the Business Principles Committee.
The Department has the voting and consent rights common to all
Actis members and, in addition, the ability to block decisions
in certain areas ("special decisions") and enforce business
objectives.
17. Taking into account these factors, KPMG
valued the interest in Actis to be sold to employees ("interest
valuation") at between US$580,000-$700,000, a 70% discount
on the whole business valuation of US$3-4 million in September
2003. In March 2004, at the request of the Committee, KPMG provided
an interest valuation revised to take account of prevailing exchange
rates—which resulted in an interest valuation of between
£320,000 and £387,000.
18. The Committee agreed that the amount
to be paid by employees on 7 July 2004 for their interest in Actis
should be £373,040. A Trustee on behalf of employees provided
15% of this amount, with 25 partners providing the balance.
Figure 1
PAID UP OWNERSHIP INTERESTS IN ACTIS LLP
|
| £ |
|
| Trustee for Actis employees | 55,950
|
| Actis partners | 317,090 |
| Secretary of State for International Development
| 427,000 |
|
| |
19. The National Audit Office has concluded that assumptions
about revenue and expenses underpinning the valuation were reasonable,
and that the discount rates used in the calculation were also
reasonable. The sale price was not, however, tested through a
competition because, after option appraisal and advice, the Department
and CDC's Board considered that such an approach would have significantly
damaged CDC's management capacity, and risked damaging the £805
million portfolio value (as at January 2003).
20. A competitive process is usually the best way of
getting best value in a sale. Had management been made to compete
against external bidders, and had external bidders shown an interest,
management might have attributed more value to the operational
independence that owning their own business gave them. There might
also have been a strategic value to other bidders from CDC's existing
strong investment presence in emerging markets. In particular
there is value in having CDC as a "cornerstone" investor—an
investor whose £805 million of funds under management demonstrated
investor confidence in providing the Actis team with funds to
manage and who provided fees that would cover most of the running
costs thereby reducing the business risk.
21. The Department, however, considers that a number
of factors meant that this approach was not practicable in this
case. It is not clear that any potential investor would have had
a better track record of managing funds in emerging markets than
Actis' existing management team. The lack of such a record could
have put CDC's existing investment portfolio at risk, particularly
in light of the detailed knowledge that Actis management had of
this portfolio. Any such theoretical buyer would also have had
to take into account that whilst they were buying a 60% voting
interest, they would only be entitled to a 20% interest with regard
to their share in residual earnings. Nevertheless, it is the National
Audit Office's judgement that, wherever feasible, it is better
to test a sale price through a competitive process.
THE 2007 VALUATION
OF THE
SHAREHOLDER EXECUTIVE
PORTFOLIO
22. The Shareholder Executive is responsible for managing
and/or advising on the Government's ownership interest in 27 publicly
owned businesses, including Actis. As part of a value for money
study the NAO commissioned an attempt to value the Shareholder
Executive's business portfolio, comprising some 18 businesses
for which similar private sector firms could be identified. This
exercise, subject to a number of caveats set out in the Comptroller
& Auditor General's report[12],
estimated the enterprise value of the portfolio to be between
£17.1 billion and £20.8 billion as of 30 June 2006.
The report published broad valuations for sectors and none for
individual companies.
23. At its hearing on 27 June 2007, the Committee of
Public Accounts requested the subtotals that made up the estimated
enterprise value of the Shareholder Executive's portfolio[13].
Each sub-total was a high level valuation of an individual business
in the portfolio, conducted on the basis of a multiple of reported
earnings or contemporary forecasts. The portfolio valuation exercise
did not further investigate circumstances specific to the individual
businesses. At that time the stock market multiples for broadly
similar businesses were high, ranging from 30 times earnings to
48 times earnings. The valuation used a lower earning figure of
£6 million[14] and
a higher earnings figure of £11 million. As a result a valuation
range of £182 million to £535 million was attributed
to Actis LLP. This valuation range suggested that Actis represented
between 1% and 2.5% of the enterprise value of the portfolio.
24. The earnings figures used, although based on the
partnership accounts of Actis for the year ended December 2005,
and a forecast for the year ended December 2006, did not take
into account the salary and bonuses of working partners that come
out of reported profits. Subsequently, the National Audit Office
commissioned a separate assessment to understand Actis' earnings
figures better, taking into account working partners' prior claims.
This showed, for the reasons set out in paragraphs 35 and 36,
that there were no distributable earnings in 2005. As a result
the valuation using a multiple of reported profits was too high,
and a different approach needs to be taken to any future valuation.
25. There have been no other valuations of Actis since
the sale in 2004.
ACTIS PERFORMANCE
SINCE THE
SALE
26. The essence of Actis's business model is simple.
Its employees manage investments on behalf of investor clients,
who include both CDC itself (through both legacy investments and
its commitments to new funds) and new investors. The investors
benefit when the value of these investments increases. Actis can
dispose of these investments on the investors' behalf, and any
resulting profits providing a defined minimum or "hurdle"
rate is achieved are then shared between Actis and the investor.
27. Actis receives fees from its investors for managing
investments. It passes a proportion of these fees on to the individual
employees responsible for managing investments. Where it disposes
of investments, and providing the "hurdle" rate has
been achieved, it will again pass a proportion of profits to the
individual fund managers. Individual employees are therefore incentivised
to act in the investors' interests because they benefit directly
from increases in the value of investments when they make profitable
disposals. The hurdle rates of return, and the level of carried
interest applicable for Actis's management of CDC's legacy investments,
were negotiated at discounts to market rates.
28. Since the sale Actis has generally performed in line
with the 2004 Business Plan. In two years out of four, both total
income and operating profit exceeded forecasts. Actis has achieved
this outcome largely because of some £12 million of additional
fees generated by investment from third parties. On an aggregate
basis between 2004 and 2007, operating profit was 7.5% higher
than plans. Overall revenue increased by some 4% compared to a
smaller 3% increase in costs.
Figure 2
FIRST YEAR AND AGGREGATE ANNUALISED PROFIT & LOSS
FOR ACTIS LLP
Profit & Loss | P&L in US dollars
| P&L converted to sterling |
| 2004-07
Plan
$m
| 2004-07
Actual
$m | First year
actual
£m
| 2004-07
Plan
£m | 2004-07
Actual
£m
|
CDC Legacy | 98 | 76.3
| 12 | 52 | 41 |
| CDC New Funds | 97 | 90.2
| 8.5 | 51 | 48
|
| Third party fees | 39 | 61.7
| 6.5 | 21 | 33
|
| Other | 0 | 15.4
| 3 | 0 | 8 |
| Total | 234 | 243.6
| 30 | 124 | 129
|
| Total Costs | 193 | 199.5
| 25 | 101 | 104
|
| Operating Profit | 41 | 44.1
| 5 | 23 | 25 |
Note: Operating profit is subject to employee claims (paragraph
27 above and 35 and 36 below)
Source: Actis—summary extracted from partnership
accounts in US dollars, sterling values converted by the National
Audit Office at December year end values each year and rounded
29. While fees from third parties grew significantly,
fees paid by CDC for managing CDC's legacy funds were £11
million less than projected in the 2004 Business Plan. Fees fell
as legacy portfolios were reduced in size by earlier than planned
sale of investments and the return to the CDC of £876 million
of cash out of investment proceeds.
30. The total legacy portfolio gain realised, as at October
2008 and as calculated under the partnership agreement, has been
£959 million out of which the carried interest payable to
Actis has been £83 million—an average profit share
of 8.65%[15]. Actis calculate
that, had the same portfolio entirely consisted of third party
funds, then full market rates—although not appropriate in
the case of CDC—would have generated a much larger carried
interest payment of up to £193 million.
REMUNERATION PAID
TO EMPLOYEES
31. Actis reports annually a range of financial results,
including operating profits. Operating profits are calculated
by deducting relevant expenses from annual turnover. Relevant
expenses include administrative costs and the remuneration of
non UK partners.
32. Operating profit is subject to a series of deductions
to remunerate UK based partners, as follows:
a. Profit share on disposals of the legacy portfolio and new
investments (paragraphs 5 and 26).
b. A fixed profit share, representing the "salary"
and benefits of the working partners.
c. Short Term Incentive Plan payments.
d. Notional interest on capital contributions.
e. Lastly, and only if any earnings remain unallocated, amongst
the working partners and the employee trustee[16]
(together, initially 20%) and DfID (initially 80%). DfID's share
of these net profits reduces to 40% at the end of 2013.
33. This order of priority reflects the incentive-based
remuneration structure put in place to reward Actis employees.
The Department placed limits upon carried interest payments to
individuals both within one year and in aggregate limits on carried
interest payments, in respect of the legacy portfolio, as set
out below:
— no individual should receive carried interest
payments in an aggregate amount that exceeds £3,000,000;
and
— no individual should receive an amount in excess
of £500,000[17]
in any one accounting year, save that the excess may be carried
forward.
34. PricewaterhouseCoopers, on behalf of the National
Audit Office, examined documentation provided by the Remuneration
Committee of Actis for the period from 2003 to 2007. This documentation
covered the entitlement of the working partners to a fixed profit
share ("salary" and benefits) and bonus under the Short
Term Incentive Plan against a target of matching the 60th percentile
of market rates for comparable employment positions. Benchmarked
against market data, the Remuneration Committee found that Actis
was below the target level allowed and the documentation made
available to PricewaterhouseCoopers supported this conclusion.
RESIDUAL PROFITS
AVAILABLE FOR
DISTRIBUTION
35. To date, the remuneration of Actis working partners
through the incentive payment structure has fully absorbed the
reported operating profits. In particular, after the deductions
set out in paragraph 32 there were no residual profits available
for the Department (who have a right to 80% of the residual profits)
or the other owners of Actis, including staff represented by the
Employee Trustee, (who have a right to 20% of the residual profit).
36. In 2005, for example, Actis statutory accounts reported
in US dollars operating profits equivalent to £7.2 million
after administrative expenses and taxes. The administrative expenses
already included about £5.5 million of payments for overseas
partners but no payments for UK partners. Under the partnership
agreement, all operating profits had to be applied to the working
partners first according to the agreed priorities. In total, £12.7
million was paid to the UK and overseas partners, with about 40%
relating to their profit share arising from sale of the investments
held in the legacy portfolio, and the balance fully absorbed by
their fixed profit share (or "salary" and benefits)
and amounts earned under Short Term Incentive Plans.
CONCLUSION
37. This note has explained the background to the sale
of Actis and set out the relationship between operating profits
and residual profits.
It shows that:
a. Valuing Actis is not straightforward. It has few comparators
and was not expected to make significant profits. In addition,
because it has been purchased in part by its employees, any valuation
needs to distinguish between the amounts managers receive as workers,
and their residual rights to profits.
b. The valuation approach adopted in 2003 was reasonable,
although it may not have taken into account elements of value
that could only be tested through a competitive process which
the Department did not consider feasible in this case.
c. Since the sale, Actis has performed well. It has increased
both its funds under management and its operating profits.
d. In consequence, the employees have received remuneration
in line with the incentive-based remuneration approach adopted
by Actis.
e. In practice, the remuneration paid to employees has absorbed
all operating profits, meaning that there is no residual profit
to distribute, either to the Department (who have a right to 80%
of any residual profit) or the employees-as-partners and staff
(with a right to 20% of any residual profit).
f. As a result, the reported operating profit of $8 million
in 2004 (equivalent to £4.6 million) is not a meaningful
guide to the reasonableness of the £381,610 paid for a stake
in the business. Operating profits are all absorbed by incentive-based
remuneration, which would accrue to the employees regardless of
the ownership structure for Actis.
23 February 2009
11
Ev Q69 Back
12
The Shareholder Executive and Public Sector Businesses
HC 255, 28 February 2007-Appendix 3 decribes the portfolio valuation
commissioned from Accenture by the National Audit Office Back
13
House of Commons Committee of Public Accounts The Shareholder
Executive and Public Sector Businesses 42nd Report of Session
2006-07, HC 409 Back
14
Actis financials are reported in US dollars and have been converted
at £0.5507 =$1 (rate at 30 June 2006) Back
15
The CDC base case in 2003 envisaged a total gain of about £250
million (US$450 million) generating carry of about £16 million
(US$28 million). The gain has been about four times greater and
the carry five times greater. Back
16
The Employee Benefit Trust holds a nine per cent ownership interest
in Actis on behalf of members of staff who are not partners and
who do not benefit under the partners' profit share and incentive
plan provisions. Back
17
The stated limits are adjusted each year in accordance with the
retail prices index. Back
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