NAO hands out further criticism of Government – but ultimately Carillion was a failure of management

Writer,

Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

Today it is the turn of the National Audit Office to unpick and quantify the cost of the Carillion debacle. The NAO hands out further criticism of the Government’s efforts to monitor the financial health of central government’s sixth biggest supplier by value, suggesting it did too little too late to properly monitor the risk posed by its reliance on Carillion and make appropriate contingency plans.

There are several injured parties here, most notably the taxpayer, customers and suppliers, employees, pensioners and finally investors:

  • The taxpayer. The NAO’s weighty report quantifies the likely cost of Carillion’s liquidation to the taxpayer at £148 million, including legal and consultancy bills, VAT, payroll to staff and payments to subcontractors. This is less than initial estimates made by the Cabinet Office of £314 million to £374 million, helped by how in some cases joint-venture partners have picked up the tab for ongoing projects, although the report does admit it could take years for the full and final bill to become apparent.
  • Customers and suppliers. The ripple effect could take some time to work through here. FTSE 250 index member Galliford Try has warned of additional cash outflows relating to a joint-venture project it had with Carillion, cutting its dividend and launching a £157 million rights issue to plug the gap. Balfour Beatty has also warned of a cash hit, this time £105 million to £120 million relating to a road project in Aberdeen where Carillion was its partner, although boss Leo Quinn has also suggested that the failure of a competitor that had been very aggressive on price may benefit his firm in the long run. In addition, local ‘papers continue to report on how Carillion’s failure has in turn put its suppliers out of business, including Norfolk flooring firm Polydeck and Ireland’s Sammon Construction. Moreover, work has stopped on some projects including two PFI hospitals, notably the Midland Metropolitan Hospital.
  • Employees. Carillion had over 18,000 employees in the UK at the time of its failure and 2,332 were made redundant (and another 1,113 left of their own free will). Hopefully they will all be able to find new positions, while some 3,000 people remain with the firm, continuing to provide valuable services to customers and 11,638 had kept their job after a transfer to a new firm.
  • Pensioners.  According to the Pensions Advisory Service, multiple pension schemes (17 at least) are still in the so-called “assessment period” so the trustees are still administering them, not the Pension Protection Fund. There is no set time for how long the assessment period can last, but it can leave people in limbo for a long time, as they cannot transfer out any funds. Ultimately, those pensioners who had a defined benefit (DB) plan will receive 100% of their benefits if they are already of normal pension age. Those who had not started to draw benefits will get 90% of what they would have been due, although this could be subject to a cap and protection from inflation could be lost too.
  • Investors. The collapse in Carillion’s share price will have hit some investors hard, especially those who had been drawn to the stock by the 18.45p-a-share dividend that had been paid in 2016 and some analysts had initially expected the company to pay in 2017. However, a brief analysis of Carillion’s cash flows would have revealed that the firm had only generated enough cash to cover its dividend once in six years, after it had met such important expenses such as interest, tax, capital investment and pension top-ups. As such, there were risks related with such an investment and all investors know that in the event of a smash, shareholders are at the very bottom of the pecking order of creditors and are thus likely to get nothing back.

 

Creditor rankings in the event of bankruptcy

1

Liquidator

2

First debenture (secured fixed charge)

3

Preferential creditors (staff)

4

Second debenture (secured floating)

5

Unsecured creditors (HMRC, trade)

6

Subordinated, unsecured loans (high-yield ‘junk’ debt, PIBS)

7

Mezzanine debt (Payment-in-Kind, ‘PIK’ toggle)

8

Preference shareholders

9

Ordinary shareholders

Government failings

Besides identifying those who will lose out in the wake of Carillion’s demise, the NAO report identifies three failings at Government level, both central and local.

  1. The manner by which central and local authorities were caught off guard by Carillion’s descent into financial chaos. In fairness to both local and central Government, the stock market was also caught out by the scale of the profit warnings issued by Carillion in 2017, as evidenced by how its shares plunged from well above 200p in December 2016 to 14p by the time of their suspension in early 2018. Even though the Cabinet Office completed its contingency planning in January, it only began the process last July, despite warnings about short-selling of Carillion’s stock and its financial health, and the Government never gave the company a ‘high risk’ rating. Moreover, 16 of 26 public bodies failed to provide costed alternatives to Carillion in the event of its failure.
  2. The way in which Carillion’s local authority contracts were much more profitable than its central government ones. This could be down to the mix of business carried out, but the NAO states that Carillion was making a meagre 1% operating margin on facilities management to the central authorities and 13% to 15% on local government contracts. This hints at a lack of joined-up thinking, and perhaps expertise, at local level, in contrast to the buying power of central government.
  3. The lack of adequate central Government monitoring of a firm which had some 420 contracts with the UK public sector. The Cabinet Office did not have a crown representative overseeing a strategic supplier of vital public service contracts from July to October 2017, obliging the Director of Markets and Suppliers to take over the monitoring role, for which the requirements were ultimately changed to a person who had expertise in corporate restructuring.

We've been here before

While the Government has clearly not covered itself in glory here, the ultimate responsibility rests with those who were running the company.

Its complex structure, acquisitive history, thin profit margins, lofty debt levels, enormous pension deficit and unusually high (and ultimately unaffordable) dividend yield all flagged the company as an accident waiting to happen. The real problem is that we have been here before.

Even after 26 years of debate over how companies are run and for whose benefit still rages on, with investors seemingly no better protected now than in the early 1990s, given that a FTSE 250 firm has just been able to go broke in plain sight.

The current Corporate Governance code dates back to Sir Adrian Cadbury’s 1992 report Financial Aspects of Corporate Governance, which looked into issues such as the composition of management boards and accounting systems.

The irony is that Sir Adrian’s work was commissioned by the Financial Reporting Council in the wake of the collapse of the Bank of Credit and Commerce International (BCCI), Maxwell Communications and Polly peck to improve governance and try to prevent similar scandals.

These articles are for information purposes only and are not a personal recommendation or advice.


russmould's picture
Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.