Unwinding Carillion’s collapse and its wider implications

Turmoil ensued in the wider market through a domino effect on the extended supply chain, and the murky reality behind the workings of the company was exposed. Carillion had been operating effectively like a Ponzi scheme, propped up by more and more debt against a holding of mostly intangible assets. Financial statements belied the firm’s inescapable fate through aggressive Enron-style accounting. The collapse has left billions of pounds in public sector contracts outstanding and tens of thousands of workers’ livelihoods and pensions in limbo, along with a deeply precarious future for thousands of subcontractors.

Carillion’s demise underscores not only the chronic failings of PFI and the perils of outsourcing provision and management of public services to private firms, but also exposes the prevalence of the same decadent dynamics that hurled our global economy into crisis a decade ago. This includes corporate short-termism underlying managerial and shareholder value myopia in markets ruled by a handful of big players, as well as failures in accounting oversight by the Big Four (Deloitte, PwC, EY and KPMG), all of whom were involved in Carillion’s demise in some way. It also highlights the persistence of dubious relations between the state and private entities. Indeed, little has changed in this regard since the crisis era. Moreover, the case of Carillion reflects the increasing reliance of modern firms on intangible assets and the dangers of doing so.

A legal Ponzi-like scheme

Carillion’s operating model became premised on aggressive hoarding of new contracts in race-to-the-bottom bidding that grossly underpriced the true costs and risks associated with finishing projects, in order to secure the funds needed to pay lenders and suppliers. Essentially, it was running a legal Ponzi-like scheme.

Debt increasingly piled up to plug the holes left by a wobbly cash flow in the context of big low-margin and long-horizon contracts, shrouded in uncertainty stemming from external developments. Risks were compounded by the wider net of uncertainty cast by Brexit. At the time of collapse, Carillion was working on 450 public sector contracts. One of the most pressing questions around its downfall has been why the government continued awarding the crisis-ridden firm more contracts, including two HS2 rail-link deals worth £1.3 billion in July 2017, knowing that it was mired in financial difficulties.

Digging deep into the company’s accounts, signs of a troubled cash flow can be traced back to 2011. Cash flow problems were exacerbated by disputes with several UK public sector clients around the demand for higher payments than contractually agreed upon—such as the road project with Somerset council—and over the quality of service delivery—such as with Swindon’s Great Western Hospital. Delays in payments led to severe shortfalls in cash and thereby an increasing reliance on debt to meet the day-to-day running of the company.

Doubling down on off-balance-sheet debt

In 2013, Carillion introduced the controversial “Early Payment Facility (EPF)”, under the intention of supporting the government’s Supply Chain Finance initiative launched the year before. The scheme was purported to be “a mutually beneficial agreement” that would allow for greater flexibility in cash flow management by enabling suppliers seeking early payment to be paid directly by Carillion’s partner banks (including RBS, Lloyds and Santander), conditional on Carillion’s approval of the invoices and a fee to be paid by the subcontractor. The fee rose in tandem with the number of days in advance of the scheduled bill that the payment was being requested.

Six months on from rolling out the scheme, standard payment terms—the duration that Carillion awarded itself until it had to pay suppliers—were extended to 120 days. Uproar erupted over the change in terms. This was more than double the original terms in some cases and ran counter to the government’s “prompt payment policy” that sought to encourage contractors to commit to paying suppliers within a 30-day window. The move forced subcontractors to rely on the EPF as the only route to payment ahead of the four-month waiting period, which meant relying on expensive bank financing to stay afloat. The scheme was never aimed at being a two-way street; it was there to serve Carillion, to enable it to shore up its working capital by facilitating unabated borrowing off the balance sheet, in addition to its mounting on-balance-sheet debt.

Moreover, it appears many suppliers might have been unaware that the use of the EPF amounted to taking out short-term loans, with the bank charges being equivalent to accrued interest. The loans would only be cleared once Carillion made payment. Carillion’s poor track record on payments prompted the representatives of subcontractors to lodge complaints to the government to stop awarding contracts to the outsourcing firm; their calls, however, went unheeded. Carillion’s subsequent collapse left thousands of subcontractors stranded with millions missing and the burden of repaying banks.

From ticking time bomb to compulsory liquidation

Cracks in the facade that Carillion had long propagated started surfacing more visibly in July of last year when the company issued the first of three profit warnings on disclosing the dire state of its finances. It announced write-downs of £845 million worth of contracts, suspension of dividend payments, and that debt-reduction targets for 2017 would be missed. July’s profit warning came after four large projects had run into serious structural dilemmas, constraining cash inflow.. Not only prior to the July profit warning but over the years, Carillion had become the most shorted stock on the London Stock Exchange. In spite of all the signs, just four months prior to the profit warning, KPMG signed off on the company’s accounts, failing to flag up the fragility of Carillion’s balance sheet.

The next two profit warnings followed in quick succession. One came in September, and the final one came in November. From the first profit warning until the time of its demise, Carillion’s share prices lost more than 90% of their value. Despite growing strains on the firm’s finances against an escalating debt burden and widening deficit in the pension fund, shareholders were doled out bigger dividends and executives profligate bonuses. Outflows of cash in the form of dividends were found to have exceeded net cash inflows in 2016; dividends were being paid out of debt. In 2012–2016, £376 million was paid out in dividends. The company levered up with more debt to satiate its managerial and shareholder myopia at the expense of its survival.

By the time Carillion collapsed, it had racked up an over £1.5 billion debt load and a £990 million pension deficit, and it held just £29 million in cash. Declined a bailout by the government, the contractor was forced into compulsory liquidation. Going into administration was not an option. As a commentator in the Financial Times pointed out, Carillion was forced to go down the path of last resort in insolvency proceedings, as it had no viable business to sell. Leftover assets were comprised of contracts on which the margins were razor thin or loss-making. The overall value of the assets was so scant relative to the value of its liabilities that there was no viable business to salvage.

A closer look at the balance sheet—it’s all about the intangibles

Carillion’s balance sheet was propped up by a holding of mostly intangible assets, which were almost all goodwill, built up through a run of acquisitions in earlier years. Goodwill is defined as the difference between the price paid for the asset acquired and its underlying value (the book value) at the point of acquisition. This difference in price is meant to reflect the present value of future income streams expected to be generated by the underlying assets of the acquired company. Carillion’s goodwill amounted to a staggering £1.57 billion. This was the asset base against which it levered up. But as Professor Adam Leaver highlights in this insightful piece, leveraging against goodwill is a “dangerous inter-temporal gamble”: a risky bet that hinges on the cash flow from underlying assets being enough to cover the present cost of future liabilities. Unlike tangible assets, at times of crisis goodwill can disappear overnight.

Under standard international accounting practices, the value of the goodwill must be evaluated at least every year. If the market value of the asset associated with the goodwill sinks below the cost at which it was acquired, then it must be impaired—that is, there must be a write-down of the asset on the balance sheet. Even though contracts failed to yield the overly optimistic projected cash flows, indicating the need for impairment to goodwill, the company’s 2016 accounts shrugged off the necessity of doing so. Instead, more contracts were tendered for, no matter how small the margins on them, to keep the Ponzi-like scheme going, and an aggressive accounting approach was employed to keep the illusion of a profitable firm alive. Carillion’s goodwill did indeed vanish overnight, thus leaving it with no meaningful assets and leaving no escape from compulsory liquidation.

An ever-greater reliance on intangible assets is far from being a phenomenon that is exclusive to Carillion, however. Since the mid-2000s, businesses in developed economies started to invest more in intangible assets—Enron was a prime example of this—a trend which then proliferated with the rise of the gig economy. The largely overlooked trend of a shift towards a more intangible economy, as highlighted by Professor Jonathan Haskel and Stian Westlake in their book, “Capitalism without Capital: The Rise of the Intangible Economy”, is contributing to many of the troubling economic and social trends today, including subdued growth, rising inequality and inadequate affordable financing. While intangible assets hold advantageous properties, including scalability and the ability to create spillovers and synergies, the case of Carillion shows how their property of sunkenness can render them useless in the event of a crisis as they are harder to recover value from and cannot be sold off.

Looking beyond Carillion: unrest in the outsourcing market

As the aftermath of Carillion’s demise continues to unravel, the extent of the pervasive crisis in the UK’s public sector outsourcing market is becoming ever more evident. On 3 April, the shares of another leading contractor to the British government—Capita—plunged to a 20-year low, making it the worst-performing stock on the London Stock Exchange on the day. Growing concerns over a prospective strategic revamp and a £700 million cash-call on shareholders aimed at reducing leverage triggered the massive sell-off. The publication of last year’s financial performance has also been delayed. However, uneasiness about the outsourcing firm’s prospects has now persisted for some time.

Capita sparked panic in the wider market shortly after Carillion perished, issuing a shock profit warning and suspending dividend payments on 31 January. Capita’s shares lost close to half of their value on the day, plummeting to a 15-year low. Relying on leveraged goodwill, Capita has racked up an onerous debt burden and a big shortfall in its pension fund, while its cash flows have shrunk. The chain of events certainly carries an eerie resemblance to Carillion’s decay. There is one crucial difference about Capita, though, and that is its exposure to the public sector. According to market research firm Tussel, Capita secured more than ten times the number of government contracts than Carillion in the past two years and has the broadest reach of any contractor. While Capita is seen faring better than Carillion, it may only be a matter of time until it also takes a turn for the worst.

It does not end there. Interserve—another big government contractor—has been grappling with more of the same: a giant debt burden, low market capitalization and difficulties in securing additional financing. It too is looking to undergo a major financial overhaul that should be aided by a  refinancing deal with banks. A common pattern found among these contractors is that even after the onslaught of austerity measures on public services, which hit the outsourcing industry hard, they did not typically alter the underlying assumptions supporting their growth strategies, such as their targets on earnings per share, profits and bonuses. This perpetuated a false case for untamed and riskier-than-perceived expansions underpinned by winning more contracts, making more acquisitions and accumulation of more debt, leaving them increasingly financially fragile.

Moreover, a report published by the Information Services Group on 18 April estimated that the collapse of Carillion and its aftermath has caused outsourcing contracts to drop by one-fifth in Europe in the first quarter of 2018. The report projects a “bumpy ride” for the outsourcing market in the months ahead.

The financial folly of PFI

Carillon’s downfall and the ensuing turmoil in the outsourcing market have once again ramped up pressure on the British government to overturn its model of financing large-scale public projects through the Private Finance Initiative (PFI), whose chronic failings long predate the recent unfolding saga.

Under the PFI model, the private sector is commissioned by the government to deliver and manage public infrastructure. The contracted firms borrow upfront to finance the initiatives, and the government then repays the sum plus the interest over the lifetime of the contracts. This contrasts traditional funding methods, whereby the government borrows directly from the bond market or raises the funds through taxation.

Proponents of PFI assert “efficiency savings” and a transfer of risk from the public to the private sector. But the consistently abysmal track record of PFI schemes, in terms of both quality and cost effectiveness, has debunked these long-told myths and shown that outsourcing is in fact a messy, high-risk, and exorbitantly expensive venture. There is no value-for-money in paying four to five times more than the actual worth of the assets in order to create them, as has been the case under PFI.

In an age of record-low interest rates, that private capital is used to finance public goods and services when it is far costlier than the government financing it directly through the issuance of gilts (bonds issued by the British government) is simply a huge rip-off. A damning report published by the National Audit Office (NAO) on 18 January revealed the extent of the mark-up in costs using private finance: doing so can cost 40% more, while conferring no distinct benefits compared to financing by government borrowing. PFI schemes for the National Health Service (NHS) have illustrated this above all else. The schemes have crippled the NHS and starved it of cash, and the NAO has found no evidence of the added operational efficiency that theories championing privatization and outsourcing so strongly assert.

But for decades now, PFI—launched by the Conservatives under John Major’s leadership in 1992 and expanded significantly under Tony Blair’s New Labour—has been cheered on by successive governments, not only due to the belief that the “private sector is more efficient” but also as an accounting ploy to keep debt off the government balance sheet. The debt used to finance public projects under PFI is classified as private sector liability. While the government is freed from borrowing a one-time load upfront, the costs accrued to taxpayers in the long-run are much more monumental, not to mention the potential costs of bailing out companies struggling to manage troubled public services. The rate at which PFI is draining the public purse in an economy that has been beset by harsh austerity measures in recent years—GDP growth in quarter-on-quarter terms came in at 0.1% in Q1 2018, down from 0.4% in Q4 2017—is a cruel irony and one that demands a radical shift in policy.

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