Carillion: From hindsight to foresight 

What Carillion teaches the project profession about managing risk through the supply chain

As the Parliamentary report into the collapse of Carillion, a major UK multinational construction and facilities management company, states, this was not an ordinary collapse. And it wasn't an ordinary company either.

The report declares: "Carillion’s collapse was sudden and from a publicly-stated position of strength. It went into liquidation in January 2018 with liabilities of nearly £7 billion and just £29 million in cash. Yet it had paid a record dividend of £79 million and large bonuses to senior executives for performance in 2016.

"Furthermore,"

• Carillion left a pensions liability of around £2.6 billion and its schemes are set to be the largest ever hit on the Pension Protection Fund (PPF), which is partfunded by a levy on other pension schemes.
• Carillion also owed around £2 billion to its 30,000 suppliers, sub-contractors and other short-term creditors, of whom it was a notorious late payer. Like the pension schemes, they will get little back from the liquidation.
• Carillion was a major strategic supplier to the UK public sector and had around 450 construction and service contracts across government."

A company with approximately 43 000 employees, plus many more employed through it's supply chains, Carillion had pension obligations to around 27 000 members. It was the 2nd largest construction company in the UK and it's work included the public and private sector, including internationally in Canada and the Middle East, and covered construction work from road building to hospital building.

The opening paragraph of the parliamentary report sensationally claims that "its business model was a relentless dash for cash, driven by acquisitions, rising debt, expansion into new markets and exploitation of suppliers. It presented accounts that misrepresented the reality of the business, and increased its dividend every year, come what may. Long term obligations, such as adequately funding its pension schemes, were treated with contempt. Even as the company very publicly began to unravel, the board was concerned with increasing and protecting generous executive bonuses. Carillion was unsustainable. The mystery is not that it collapsed, but that it lasted so long."

With hindsight, construction giant Carillion’s collapse in January should not have been a surprise to its customers or suppliers. As has now been widely reported in the press, the warning signs were written all over its financial statements during the few years before, and better due diligence would have flagged this up.

And yet, this was all but glossed over in multiple procurement exercises which selected the firm, turning a situation that could and should have been contained into the epic fiasco we have all now heard about.

This sobering situation was the subject of an APM workshop presentation delivered jointly by Dr Jon Broome, Deputy Chairman of APM’s Contracts & Procurement Specific Interest Group, and Philip Reese, Chartered Quantity Surveyor and a Chartered member of the Chartered Institute of Procurement & Supply.

Broome and Reese identified the types of due diligence that could have uncovered  the early warning signs of Carillion’s troubles and offered practical steps customers and suppliers can take to protect themselves from similar mishaps in the future.

Ultimately, taking Carillion’s lessons to heart can greatly improve the success of procurement projects, the overall project itself, as well as safeguarding customers, contractors and suppliers as well as the broader economy.

Widespread fallout

The impact of Carillion’s insolvency in January 2018, with debts of £1.5 billion, has been momentous:

• While many of its FM services continued uninterrupted, work on some construction projects is still on stop, including building work on two large hospitals and numerous other public-sector projects including schools, which at the time of writing were still no closer to being completed. Fourteen NHS trusts were affected.
• Subcontractors and other firms reliant on Carillion’s supply chain were exposed with many losing significant sums of money, with some not surviving;
• More casualties may include suppliers of materials, goods and services, subcontractors, workers (pensions) and customers:
   - Some 11,638 Carillion jobs in the UK – 64% of the total – were transferred to other employers. Of the rest, 2,332 – 13% of the total – were made redundant, while 3,000 are still employed by Carillion.
   - The firm's pension liabilities – £2.6bn at the end of June 2017 – will have to be compensated through the Pension Protection Fund;
• The current cost to taxpayers is £148 million, the National Audit Office (NAO) has reported.

The immediate lead-up

Shocking revelations continue to emerge in the press all the time in the wake of the various public enquiries into various aspects of the company, its audit arrangements and the wider culture of the industry and its approach to cost cutting.

For instance, despite being signatories of the Prompt Payment Code, Carillion were “notorious late payers” who forced standard payment terms of 120 days on suppliers. Parliament heard that major credit ratings agencies believed that Carillion's accounting for their early payment facility (EPF) concealed its true level of borrowing from financial creditors.

Frank Field MP, chair of the Work and Pensions Committee, spoke of Carillion’s “utter contempt for its suppliers” saying, “The company used its suppliers as a line of credit to shore up its fragile balance sheet, then in another of its accounting tricks ‘reclassified’ this borrowing to hide the true extent of its massive debt”.

Rachel Reeves MP, chair of the BEIS Committee, said: “The collapse of Carillion left small businesses and subcontractors out of pocket with many left unpaid for months and facing ruin.”

The consequences of insolvency

There are the harsh economics of distributing insufficient assets (funds) to creditors from an insolvent business. There is a fixed hierarchy of creditors :

• first in line is the insolvency practitioner (in this case the liquidator),
• then follows a long line of preferential creditors, including staff and lenders i.e. the banks
• after which comes the unsecured creditors which are the typically the supply chain, and
• finally, if anything is left, the shareholders.

For Carillion, it seems that the money runs out before you even get to the supply chain.

However, as noted above there is also significant effects going up the project delivery chain to clients in terms of unfulfilled contract obligations : outsourced services potentially stopping and projects coming to a standstill.

The lesson here? There needs to be a contingency plan in place says Jamie Gardner, senior manager at consultancy firm Efficio. Start to challenge delivery partners on what steps they are taking to mitigate against the impacts their financial situation might have. Buyers should also consider what steps they are willing to take to ensure a project is delivered: are they willing to pay subcontractors directly, to subdivide the contract or to change their scheduling or payment terms.

Buyers need to be aware of capacity and pinch points in their supply chains in the event their business needs to find new suppliers to step into a contract. “That’s just good procurement: having buyers have their fingers on the pulse of the marketplace, understanding who is around if they need to get somebody potentially quickly,” said Gardner. 

Every procurement team should know what it needs to do next if something goes wrong.

Lessons in reading the (warning) signs

So how can you spot the early signs that trouble is looming to stop a future ‘Carillion’ happening on your project ? Much can be learned from looking at the problem from the perspective of an amateur investor, Broome explained.

In the case of Carillion, problems were evident from their published accounts, available for free on investment websites without the need to look at the corporate reports, scrutinise the footnotes or buy analyst reports. In the example of Carillion there was no excuse for not knowing they were in potential financial difficulty months if not years before it was reported in the press.

The greater the awareness among customers of this practical obligation of due diligence, and importantly being capable and wiling to act on it, then the bigger the chance of stopping problems before they occur, thereby increasing the success of private and public procurement contracts and ultimately saving a wide range of stakeholders millions of pounds.

"Carillion was allowed to go bust with 450 contracts because no one knew they had 450 contracts. With better data, we can understand the risk and act before disaster strikes.”

Troubling corporate reports

To read between the lines in corporate reports, it’s important to see them for what they are: reports to shareholders on the success or otherwise of a business, based on its financial transactions, assets and the performance of its management.

The financial parts of published accounts have three main sections: The Income Statement (sometimes known as the Profit & Loss Account), Balance Sheet and Cash Flow Statement.

From these, the following questions must be answered in the affirmative: Is the business a ‘going concern’ / are they technically solvent? I.e. Do assets cover liabilities, both in the short term and long term ? Are its accounts ‘prudent’ in the sense of profits not being overstated or recorded too far ahead of being realised? Is the accounting approach consistent over time?

1. Income statements (often called the Profit / Loss Account):

In Carillion’s case, its Income Statement revealed that while it had growing income over the previous five years to 2016 (the last published accounts):

• its ‘bottom line’ earnings or profit was not growing;
• amortisation and depreciation were surprisingly low for a company of its size;
• consistent adjustments – or ‘exceptional items’ - were being made to operating profits (in which case, they are not really ‘exceptional’ !);
• the company had a high interest bill compared to profit.

These incongruities are amber flags in the eyes of any prudent investor. At the very least, they merit further investigation if you are planning to do business with the company; as a potential investor, Broome said he would have already lost interest.

2. Balance Sheets

The next thing to look at is the company’s Balance Sheet. 

In the case of Carillion, you could see that it had an incredibly high amount of intangibles to its total assets: £1670m of £2270m at the end of 2016 which was just sitting there not changing much from year to year. Intangibles can be good if they take the form of brands and intellectual property, but not normally ‘goodwill’: the excess above the tangible value of businesses which have been taken over as, to quote Broome, “this is dead money which can rarely be realised unless those business are sold on. In other words, in reality it is worthless”. If you took these 'worthless' intangibles off the Carillion balance sheet, then it had negative tangible value. I.e. whilst not ‘technically’ insolvent, it was in reality and had been kept alive by accounting tricks – such as the extremely low level of depreciation and amortisation in the income statement – for years.

It further stands out that in 2016, Carillion’s turnover went up by £450 million in the last year and debtors by a non-proportional £400 million (speculatively the result of varying debtor days). At the same time, the amount owed to Carillion went up by £400 million, while the amount owed by it rose by £850 million – reflected in a decreasing Net Value. However, cash increased, raising queries as to how this happened. All this suggests the unravelling was happening over 2016, which was reported in mid-March 2017.

So while an evaluation of Carillion’s income statement threw up several amber flags.

3. Cashflow statements

Comparing Carillion’s Cashflow Statement and Income Statement, Broome pointed out that the free cash flow – the actual hard cash going into the bank account after all business costs, sometimes colloquially referred to as ‘owner’s earnings” – was consistently much much less than the stated earnings - i.e. ‘cash conversion’ was appalling - and did not even cover the amount paid out in dividends. i.e. Carillion was paying out dividends it could not afford.

Finally, Broome pointed out that all these observations ignored the fact that Carillion had a huge pension deficit. How was it ever going to finance that?

Because Carillion was a publicly listed company, all this information was available from investment websites for free. If needed, annual reports with the footnotes and explanations of where these figures came from could also have been obtained for free. For privately owned companies, including subsidiaries, the same information can be obtained from Companies House.

Some financial due diligence caveats:

• Do not see financial statements as the whole truth – they are generally reliable but not perfect. Dig deeper: make further enquiries to validate or investigate your findings.
• Do not see ratios as conclusive but as a guide to drawing conclusions : individually they are brushstrokes, collectively they paint a picture.
• Be heedful of the effects of different accounting policies and valuation methods, for example, the inclusion of goodwill and brand equity, and weed out any cause for optimism bias.
• The need for professional, qualified advice is commensurate with the size of the project. The bigger the project, the greater your risk.
• Be prepared to seek professional help if something doesn’t make sense … or just walk away from dealing with that firm.

Risk and providers

Philip Reese asks, on the selecting of providers: "Do typical industry Pre-Qualification Questionnaires (PQQs) go far enough in establishing due diligence? And importantly, do we pay enough attention to the providers’ responses?"

The Facilities Management Journal recently identified that the UK FTSE support services sector issued 42 profit warnings in 2017 – the most of any sector. Hence, perhaps we should ask ourselves whether we sufficiently assess project package risks – for example those posed by particular suppliers who operate in higher financial risk areas or in sectors which are known to be of higher risk?

Some general considerations when deciding how much time to spend on financial due diligence might include:

• Are the project types in question cash-dependent?
• Will packages have long lead times and perhaps rely on the supplier’s financial stability or access to funding or borrowing to enable the project?
• Is there a choice of providers?
• Is the project deliverable mission-critical? What would happen if the supplier failed?
• Is the provider reliant on a particular customer type? If their customers failed, would they fail?
• If the supplier is heavily reliant on public contracts, what effect would a sudden change in policy have? (for example upon change of government) Could they still exist?

Recently Ernst & Young published “Public procurement risk factors”, which are a series of factors deemed relevant to higher financial risks. A brief look at these identifies many which were relevant to Carillion, including:

• Delays or cancellation of a provider’s other projects
• Who are their other clients and what are their reputations?
• Exposure to pricing pressures, e.g. the 2008 financial crisis
• Heavy public-sector exposure, with unrealistic funding expectations
• Poor internal controls
• Poor profit to turnover growth trend
• Profit warnings
• Potential Brexit impacts
• Slow sector growth
• Increasing competition

Questions have been asked about the risk of concentrating so many contracts and services in the hands of a few, very large companies, while the overall policy of outsourcing has come under scrutiny. So what can procurement learn?

“Buyers need to get better at managing risk and improving their data”, Ian Makgill, founder of data analysts Spend Network, said in a Supply Management article. He explained: “Too much emphasis has been placed on avoiding risks with small suppliers, forgetting that suppliers with multiple contracts could be carrying a much greater, systemic risk.”

“Public bodies also need to manage contracts better – too much effort is put into the up-front procurement and too little into managing contracts. Carillion was allowed to go bust with 450 contracts because no one knew they had 450 contracts. With better data, we can understand the risk and act before disaster strikes.”

How much diligence is due?

In view of these risks, buyers need to sharpen up their due diligence. No provider should be considered “too big to fail”.

So, at which point does due diligence come into play?

• Before issuing Pre-Qualification Questionnaires (PQQs)?
• As part of the PQQ itself?
• Or after a tender process (but hopefully prior to awarding contracts)?

Whose PQQs should you use? Can we outsource the process to credit agencies? What freely accessible data can we obtain from Companies House or the media? Are the PQQs, we use company-specific, industry-standard or issued by accreditation bodies? Are PQQs a one-off exercise used to 'whittle down' a bid list, or are they used more productively as part of continuous improvement and development of a supplier relationship/understanding of a supplier over time?

PQQs come in different shapes and sizes, but all share common general aspects. The private sector generally has more flexibility to mould their PQQs than perhaps the public sector might have, but ample opportunity should exist to perform adequate due diligence in whatever sector we operate in.

Important topics covered by private company PQQs relate to understanding the company itself (ownership and registration); details of any conflicts of interest; details of directors (to establish authority to transact); understanding staff make-up and staff turnover, understanding their client base (including client turnover and references); trading history; lost contracts; financial history (insolvency, court orders, tax obligations and directors’ history); credit agency checks; projected financials; acceptance of payment terms; subcontractors; and banking details. It is typical to request copies of 2-3 years’ financial statements or audited accounts to enable the sorts of investigations which Broome highlighted earlier.

In the public sector (but also available to the private sector) the industry-standard BSI 91:2013 PQQ for construction procurement (updated late 2017) is intended to reduce duplication of efforts and is free of charge from the BSI online shop. Core modules include financial information and details about business and professional standing, while optional ones include environmental, quality and diversity information. To be eligible for pre-qualification under this standard, suppliers must demonstrate that they have the governance, qualifications and references, expertise, health & safety, environmental, financial and other essential capabilities, to the extent necessary for them to be considered appropriate to undertake work and deliver services for buyers.

Various other industry standard PQQs are available and are regularly undertaken by accreditation bodies. These are focused predominantly on health and safety but also touch on business viability.

It’s important to avail yourself of the limitations of whatever type of PQQ you choose to rely on. For example, the Publicly Available Specification 91 (PAS 91) does not remove a buyer’s obligation to make further enquiries about a supplier’s capabilities to satisfy specific requirements for projects, nor does it address the capability of the assessment providers to carry out reliable assessments of suppliers. In other words – don’t just rely on the fact you have sent out a PQQ. Make sure that you or someone else you delegate the task to, actually receives, reads and ensures they understand what the information they receive back from the supplier is saying. The PQQ asks for the supplier to submit their financial statements, BUT, you need to read it! Don’t just “tick the box” when the mail arrives.

In reviewing the PQQ responses received, is attention given to how current they still are? Are the responses scored, and how is that done? What simple, specific questions are asked? (Yes/No or meeting thresholds) Are all different grades of risky and less risky packages afforded the same level of due diligence? The message here is to focus your resources.

Positive legacy of Carillion

If we are prudent, the abovementioned learnings will be the true legacy of Carillion. To take them on board, companies need to develop the appropriate competencies, skills and relationships, including contracts and procurement management, governance and standards.

This was the first of a series of seminars by the Contracts & Procurement SIG on spotting the warning signs of provider insolvency, taking practical steps to protect your organisation and project, and dealing with the practicalities of liquidation. Further workshops will focus on contract drafting and risk mitigation, contract management and ongoing due diligence, dealing with insolvency, contracting strategies, as well as competence and professional standards. To find out more about forthcoming events, visit our website.

APM Guide to Contracts and Procurement

APM Guide to Contracts and Procurement: For Project, Programme and Portfolio Managers offers a basic understanding of ‘how to’ procure sub-project works and to manage delivery through the phases of the procurement life cycle.

APM Contracts and Procurement Specific Interest Group

The C&P SIG exists to promote and disseminate knowledge, understanding and best practice of contracts and procurement in a project environment. It aims to become a lively and constructive debating forum which takes existing best practice and helps make it better. The SIG wants to disseminate this knowledge, understanding and better-than-best practice through a variety of accessible means.