“Big does not necessarily mean financially safe” – that’s the verdict of CVR Global Senior Executive Chris Pearson on the demise of Carillion. In this in-depth analysis he explores why one of the UK’s largest construction firms collapsed and calls for the government to form stricter rules on the bidding process for public sector contracts to avoid another repeat.
The story of Carillion’s demise, as it continues to unfold, is both epic and concerning in equal measure.
The manner in which the UK’s second largest construction group, (with an annual turnover for 2016 of £5.2bn), went from an attempted take-over bid of Balfour Beatty in 2014, (now the UK’s largest construction company), to reportedly holding the relatively modest sum of £29m in cash on the day it entered liquidation, provides a stark warning to the construction industry that big does not necessarily mean financially safe; and similarly to government, who, since the early 1990s, have relied on the private sector to deliver large-scale public-sector infrastructure projects.
Whilst there was an expectation in some quarters that Carillion would be placed into administration, the apparently high volume of payable debt due rendered that possibility redundant without a huge injection of capital.
Included at the time were bank debts of £1.3bn (£900m of which was secured), trade creditors in excess of £100m, and Crown liabilities exceeding £75m – and counting. It is therefore unsurprising that a closer look at Carillion’s finances reveals a deficient business-model built upon a tenuous financial base.
Amongst other things, whilst the group boasted a healthy balance sheet, a large component of its value was made up of goodwill (£1.6bn) – an asset with a tendency to quickly evaporate upon a company entering a terminal insolvency process, as Carillion has now done.
Whilst the practice of valuing goodwill in this way may be in line with the going concern principle, the Carillion Board’s decision to declare £82.7m of dividends against profits of £129.5m at a time when accrued current and long-term borrowing costs totalled £96.7m and £592m respectively, now looks imprudent, particularly in the context of the group’s tangible net asset position.
As Carillion itself conceded, it was the group’s underlying illiquidity, or lack of funding options, that seems to have led both PwC and EY to decline requests to act as its administrators. There’s also the matter of the group’s ballooning pension deficit, reportedly estimated to be £587m (or more).
The combination of illusory balance sheet solvency, over-leveraging and poor managerial decision making left Carillion dangerously exposed. This was laid bare in July 2017 when the group was forced to write down the value of 4 major infrastructure projects by £845m, prompting the first of three profit warnings that contributed to its share price tumbling.
Such was Carillion’s difficult cashflow position that by the time the group was placed into liquidation, subcontractors had already been trading on 120-day credit terms for a number of years. This led in part to Carillion’s adoption of a government-backed initiative, the Early Payment Facility, which involved participating banks paying Carillion’s suppliers early in exchange for a fee levied upon the supplier, and ultimately repayable by Carillion. This practice of “reverse financing” alleviated some of Carillion’s cash flow issues, but ultimately exasperated its long-term debt position.
The Early Payment Facility was initially heralded as a mechanism whereby suppliers would have ready access to cash due to them. However, what of the 30,000 or so private-sector suppliers and sub-contractors who carried out the work Carillion was being paid for, let alone the layers of subcontractors that sat in the chain beneath them? Upon Carillion entering liquidation, the Early Payment Facility was automatically terminated, leaving many suppliers unpaid.
Whilst a consortium of UK high street banks has pledged £225m worth of emergency funding for businesses affected by Carillion’s collapse, it remains wholly uncertain what measures will need to be taken to save these businesses, and at what cost in capital and jobs.
For some, particularly those that relied entirely on Carillion as a source of work or those with unpaid invoices stretching back a full 120 days (if not more), the debts owed to them by Carillion may give rise to insurmountable difficulties and threaten their viability to continue trading. Profit margins on construction contracts are notoriously slim; as a result, many of Carillion’s subcontractors may not have sufficient liquidity or a balance sheet robust enough to absorb the shock.
This will leave some private sector subcontractors with difficult decisions to make, particularly if writing off debts owned by Carillion renders them balance sheet or cash flow insolvent. For one, this might leave some directors personally exposed if they do not take the appropriate steps to protect the position of creditors and their company subsequently enters a formal insolvency process. They may also need to shore up cash flow by seeking urgent bank support (probably at the cost of taking on additional secured liabilities) or take drastic steps to reduce overheads, including reducing headcount, as some have reportedly already done.
The wider questions raised about public-sector procurement and the approach taken to awarding contracts also remain unanswered, a matter of some concern particularly given that the sector is well known for facing severe financial challenges from time to time. The poor state of Carillion’s financial affairs is unlikely to be unique within the construction industry.
Although the £845m operating profit write down absorbed by Carillion is said to have precipitated the group’s failure, the fact that no provision had been put in place to hedge against the unforeseen circumstances that led to the write down suggests that either the contracts underlying those projects were not entered into on terms which were ultimately commercially viable or, perhaps more likely, inadequate financial provision was made for unforeseen events when pitching low to win new work.
Possible examples of this may include the discovery of asbestos during work on the £335m Royal Liverpool Hospital project, or difficulties with the heating, lighting and ventilation systems at the £350m Midland Metropolitan Hospital site.
Perhaps these were not isolated events, either? Rumours are emerging that suggest Carillion had a long history of keenly bidding for public sector procurement contracts, which played into the Government’s alleged habit of awarding such contracts to the lowest bidder, invariably one of a few very large companies, including Balfour Beatty, Kier Group and Serco. If this was (and is) the case, it is a practice that appears to provide the tax payer with value-for-money, whilst encouraging the belief that companies of this size are too big to fail; however, the brittle financial base upon which Carillion operated and the rapidity of its collapse indicates that this logic is unsound.
What protections will now be put in place to prevent a scenario whereby another construction and outsourcing giant managing an array of public sector contracts collapses, damaging tens of thousands of businesses and potentially leaving public infrastructure projects incomplete?
In the wake of the financial crisis, The Third Basel Accord introduced a framework whereby banks are required to maintain strict leverage ratios and meet certain minimum capital ratios to ensure that taxpayers are not left over-exposed in the event of a bank’s failure.
A tendering eligibility requirement for public sector infrastructure projects could also stipulate that those bidding adhere to a similar set of standards, by holding a minimum amount in cash (or cash equivalent) assets whilst maintaining a certain leverage ratio. Government could also consider removing some of the barriers that deter smaller contractors from bidding for public sector contracts. This would minimise the domino effect if a contractor goes bust and also avoid a situation where one company is managing projects as disparate as hospital construction, highway maintenance, school meal provision and servicing of accommodation for the armed services – all areas Carillion operated in.
These are however questions for another day. Over the course of the coming months the focus will remain on limiting the damage inflicted upon Carillion’s former suppliers, subcontractors and employees by its collapse and indeed the damage to the wider public as customers.
If your business has been affected by the failure of Carillion, CVR Global has a specialist team of professionals experienced in the fields of business turnaround, advisory and insolvency that can assist.