Are businesses too big to fail?

The collapse of Carillion in January 2018 marked the largest construction bankruptcy in British history. The inquiries into the collapse pointed towards the board as the chief architects of the disaster, with auditors also in the firing line.

Carillion, perhaps due to the importance of its contracts and the size of its revenues, had been considered too big to fail. But that was of no comfort to the 43,000 people employed to provide services across the defence, education, health and transport sectors, who subsequently found their jobs at risk.

The collapse has been a common tale in this market for a long time, believes Henry Stannard, partner at OC&C Strategy Consultants.

“You have publicly listed businesses that report in aggregated profit and loss (P&L) where there’s a high premium placed on organic revenue growth and those businesses are effectively run as siloed organisations,” says Stannard. “There may be dozens of operating companies that are essentially run independently, with independent finance teams.”

Within such a business, these small business arms are running multi-million pound contracts, but with little central oversight.

“It’s a bit like every manager at Tesco having control over what his store sells, how it is stocked, how much they charge, how they price an invoice to clients and so on. These are organisations that exist on low margins, where there’s a high premium on organic growth, with quite limited central ability to command and control.”

Beyond that, outsourcers were being asked to do more for less. Government had decided outsourcers had been ripping them off – not true, says Stannard, as the large revenues mask the tiny margins. So they decided to demand big discounts, a lot more capital expenditure into contracts and payment by results. That made it difficult to effectively bid on contracts, particularly on the basis of results based payment. On that basis, you cannot know what results are achievable and, if greenfield outsourcing, it is impossible to determine how well the service is being delivered currently.

And, despite all that is being said about SME procurement, these contracts are always limited to a small pool of businesses with a big balance sheet.

“So not only have you got a naturally relatively risky, low margin industry, you’ve got a loaded contract, a customer base that is being hard bid on price, where your ability to understand the risk of that tender is low,” adds Stannard.

This model might be able to survive while a business is growing, but isn’t sustainable and the warning signs were clearly visible for some time. Carillion became “focused on turnover to drive the very large, amorphous beast that was created”, says Julie Palmer, regional managing partner at corporate restructuring specialist Begbies Traynor.

The company began issuing profit warnings in July 2017, with three being put out within a five-month period. Palmer says that, at the time, the stock market wasn’t as jumpy as it is today, so the impact wasn’t as great as it might have been. But speculators had the company in their sights.

Hedge funds were short selling Carillion’s shares. This involves borrowing shares from other investors in exchange for a fee and selling them if they believe they can be bought cheaper, with the difference being the fund’s margin. At one point in summer 2017, a quarter of Carillion’s stock was being shorted not only by hedge funds but by BlackRock, the world’s largest asset manager. Everybody was at it.

Complex financing arrangements indicated that traditional sources of credit were drying up as it struggled to service those debts. In the months between September 2017 and its collapse in January 2018, they rose by more than 50% to almost £900m.

The idea that Carillion was too big to fail was simply wishful thinking. Its influence into some of the most politically sensitive funding projects – schools, hospitals and more – meant that no one, particularly the government, wanted to consider the possibility.

Yet the government began to tackle the problem and develop a ‘plan B’ the year before the collapse. This involved drawing up a parallel strategy to ensure the contracts Carillion tendered for were contained in a separate vehicle with a suitable partner. Then, if a contract failed, a replacement was readily available that was up to speed with the contract.

The government was certainly seeking to mitigate the risks of a collapse, but there wasn’t enough ministerial oversight to understand just how bad things had got for the outsourcer. Carillion’s model was no longer fit for purpose. It was out of place and running out of time, says Palmer.

When the collapse came, it was catastrophic. Companies like this would be expected to enter into a managed, pre-packaged administration process. Instead, an emergency application was made to the courts on a Sunday evening with the company being placed into compulsory liquidation on the Monday morning.

Interserve is another giant outsourcer that failed this year. While many parallels have been drawn with Carillion, this is a very different situation, sharing similarities with the recent examples of FlyBe and Debenhams.

“It was opportunistic to use the insolvency procedures in a way that cleared out the shareholding position, as there was a feeling that there was a business that could survive in some form in all three cases. The insolvency process was the best way of stripping out the value and leaving some other parts of it behind,” says Palmer.

This is bad news for the shareholders, for whom there is no value once entering insolvency. However, while a restructure under administration is painful, it is quick. And what is left of the business can continue, saving jobs in the process, says Palmer.

The collapse of Carillion may not have been apparent to all, but those working with and for the outsourcing giant will also have seen the warning signs.

Many who work with large, established businesses think everything will be alright in the end, but businesses should treat all debtors the same, regardless of the size of the company that they’re dealing with. A key warning sign that things aren’t right is delays in payment, says Caroline Sumner, technical and education director at R3, the insolvency and restructuring trade body.

“If your contract provides that your payment terms are 30 days and you are at a point where the company’s taking 120 days to pay you, that should be a fairly strong warning sign that things aren’t as they should be,” says Sumner.

Yet many businesses – and small ones in particular – feel that they haven’t any power to demand payments and just carry on for fear of losing a customer. Actually, that’s exactly what businesses should do.

“The less you get paid and the more credit you incur, the more likely you are to enter into financial difficulties yourself,” she says. “Cashflow is one of the key areas that needs to be managed effectively for any business, regardless of size.”

Another alternative is to take out insurance, which can be expensive, particularly for smaller businesses.

Angus Dent, CEO of peer-to-peer lending firm ArchOver, urges small businesses not to dismiss insurance out of hand, but to consider what would happen to your business if a major client went bust.

“When we trust too much in a company’s longevity or size, we’re making an understandable but risky mistake,” says Dent. Investments and contracts can go bad but that doesn’t mean businesses can’t take steps to protect themselves.

“Just like Carillion didn’t have to accept those tough contracts, SMEs should not accept contracts where there’s a risk that they won’t be paid or where there aren’t measures in place to protect them against losses.”

BW: Workplace Experts is a private office refurbishing business that carries credit insurance to protect a default that could jeopardise the future of the company.

“Occasionally we’ll get clients where we may have concerns about their financial viability or that they don’t have a payment mechanism within the UK,” says director Anthony Brown.

In those circumstances, BW seeks funding of an escrow account, an upfront payment, a bank guarantee or relies upon its credit insurance. Another area that may see some growth following the failure of Carillion is the use of invoice factoring.

“Even a 50% return on a book of business in a timely manner is better than the uncertainty of non payment from a major customer. It may be the difference to ensuring a sustainable future as an organisation,” says Brown.

Information is a critical tool in managing risk and forewarned is forearmed if you are seeking to protect your business, particularly for the SME.

“Local knowledge is key,” says Sumner, who recommends joining local chambers of commerce for information on the ground about businesses to be avoided.

Though the management and auditors have received most of the criticism for Carillion’s demise, government procurement has also come under scrutiny. Those appointing providers must consider a range of factors in addition to price when selecting suitable suppliers, says Mark Robinson, chief executive of Scape Group.

“Unrealistically low bids can not only lead to collapse, but also to poor deliverables in terms of project quality, investment in the local economy and a fair deal for suppliers on the ground,” he says.

“The public sector should not be accepting bids without making informed decisions based on a wider cost benefit analysis or clear evidence of ethical supply chain engagement.”

The trouble with government procurement is that it is a rather fragmented and vague entity in its own right. The largest buyers – defence, transport, and more – operate in a relatively uniform way, but around half the outsource market is made up of local government and that covers 150 unitary authorities.

Stannard says that there are good examples of outsourcing, but the Office of Government Commerce, designed to co-ordinate government procurement, has been a failure. And, while the early days of PFI may have offered rich pickings to providers, no one is ripping the government off.

“The government has benefited from vendors that really need the work, and there’s always one or two vendors who act in an economically crazy way by a lack of management oversight or strategy,” he says.

Stannard added that the government needs to consider carefully what it asks vendors to do and what value they can add that the government cannot. “It must be as much about what it wants, how it will pay for those services, how to set the contract and how to ensure the service is what is required.”

The collaborative relationship the government has with the water companies is a good example of how this business can be conducted, says Stannard. They have performance targets and operate on tight margins, but it is very clear what the vendors can and cannot control – unlike many of the outsourcing contracts where the provider will not make any money. Sometimes, there’s just no stopping it.

There are lessons for business, too. Aside from paying heed to warning signs when they are apparent, Stannard believes that risk management must operate across the organisation, not simply within finance.

“There must be an operational view of risk management, both in bidding and in contracts. And that has to start with centralised functions, common reporting standards, rigorous operational diligence and review of contracts.”

Businesses could learn useful lessons from the manufacturing sector, which very tightly controls costs, revenue base, pricing and invoicing, he adds. Unfortunately, there will be more failures, because there are always factors that cannot be completely controlled. However, bad management is one of the most common causes of structural problems and that can be dealt with. Carillion failed to adapt to its new environment and paid the ultimate price. If your model is declining – or equally growing – the business needs to be properly funded to support that growth or needs its own cash reserves to accommodate that, Palmer says.

“I feel the old-fashioned mantra that turnover is vanity, profit is sanity and cash is king holds true,” she adds. “Sometimes, it’s a question of sticking to your knitting and being fairly selective about the opportunities to work with a fundamentally sound business".

£1.15bn
Carillion reported half-year losses of £1.15bn in 2017 and was struggling under nearly £900m of debt. The company was forced to issue a string of profit warnings after a review of its construction contracts found them to be much less valuable than previously thought, resulting in a £845m write-off.

41
In July 2017, CreditSafe decreased Carillion’s credit score from 94 to 41, says David Walters, Creditsafe’s head of data. Such a reduction in score would indicate a reduction in credit available falling from £73.8m to just £16.1m.

£29m
With no more credit available and just £29m available in cash, the business could no longer operate and it collapsed in January 2018.

2,221
By the end of April 2019, the number of redundancies due to liquidation had reached 2,221, while 11,093 jobs had been saved. This does not cover those working via subcontractors, but more than 3,700 employees have been retained to deliver services until such time as those contracts cease or are transferred to another provider.

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• Are businesses too big to fail?
  Business & Management Magazine, Issue 275, June 2019

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