Shock, horror - private companies can go bust

What a lot of tosh has been spouted about the collapse of construction company Carillion last month. So much that I thought I ought to join in (sorry it's taken a while).

The saga will rumble on for a long time - the appearance of the former Carillion board members before a joint session of the House of Commons Work and Pensions and Business committees this week being just the latest round.

I was driving on the Monday that the news broke and listened to an enormous dollop of tripe on BBC 5Live, some of it from Lord Adonis who really should know better. Actually, he probably does but was trying to make political capital for Labour out of it.

The two biggest concerns while I listened that day were for the jobs of 19,000+ people in the UK (Carillion employed at least as many in other countries by the way) and why the government had awarded contracts to a struggling company. The point about the risk to companies that supplied Carillion started to be made later in the day when I'd got back in the car.

Companies going bust isn't fun and is very unsettling for everyone concerned. But if the work is needed then other companies will pick it up and, as there really isn't much spare capacity anywhere in the economy at the moment, those 19,000 people will essentially all be needed. After all, if they aren't, then there wasn't enough work for them anyway and there was a different problem. So I can empathise but most of these worries will turn out to be no big deal. (Apart from pensions - see below). The "creative destruction" of capitalism acts here to place the work with better managed companies. The people who lose their jobs are the directors. Mind, it looks as if they'd done the best they could to soften that blow in advance, including paying themselves some fancy bonuses having removed clawback terms in the event of the company going bust, but recently departed directors will find that there is no company left to complete payment of their golden goodbyes. Still, this is an area the government may well usefully look into.

The question of why Carillion continued to win contracts when it had issued profits warnings started to be asked immediately. I'm not up to date with the latest interpretation of stock exchange rules but when I was with a FTSE 250 plc the rule was that a profits warning should be issued if the company's forecast profit for the next period (half year for our company, quarter for the largest plcs) deteriorated by more than 10%. So though a profits warning might mean a company has tilted into loss (as Carillion had) it doesn't necessarily mean that - it can simply mean that a company is going to make a smaller profit than expected.  Moreover, just because a company makes a loss in a financial period that doesn't mean it is about to go under. These rules exist to ensure that all investors have the benefit of a fair market, reducing the risk of insiders knowing share price sensitive information not available to everyone. Companies hate making profits warnings because the market reaction is predictable and brutal - the share price typically halves in an instant; witness the impact of the latest profit warning by Capita last week which had almost exactly that impact, even though the company is still expected to make nearly £300M profit in the year (the forecast had been £400M).

It doesn't take much to hit profit - generally a small difference between two big numbers - by 10%. I recall nervous days in the run up to a half or full year result when the company couldn't be certain it would meet the expected profit having decided a warning wasn't necessary. And the difficult days following a warning when investors were understandably apoplectic. And the attempts to talk down the market expectation of the company's performance, in an attempt to avoid the need for a profits warning, while not frightening the horses. And the opprobrium when the result fell just short of 10% below forecast, meaning that there should have been a profit warning when one hadn't been issued. ("You have destroyed sentiment" was the term the a major shareholder used, I seem to recall).

I recall the advice given to the company the first time it had to give a profits warning - the "rule of two". This was to get all of the bad news out into the open because the market reaction wouldn't be any worse. But it was coupled with a comment "of course managements never do admit to all the problems". So it was with the company I was with: eventually, over a period of years there were several profits warnings but the second did follow the first quite quickly. Just as Carillion had two very close together last year, only two months apart (which does seem careless).

Anyway, the point is that a profits warning is a long way from meaning that a company is about to go bust, though it's very uncomfortable for the management and often leads to changes in senior personnel, usually the CEO or the finance director.

So I was gobsmacked that Jeremy Corbyn was dumb enough to run with this point in PMQs two days later, saying that because there had been profits warnings then further contracts shouldn't have been let to Carillion. Theresa May simply made the same point that I had been saying to anyone who would listen (ok, that would be Mrs H who has no choice): not proceeding to let the contracts to Carillion would probably have sunk the company sooner.

Indeed, if Carillion had put in the best bid and had convinced the people responsible for letting the contract that they were a sound, going concern then they probably would have sued if the contract had been let to another supplier. Yes, I know it turned out that the company was on the edge but that isn't always easy to tell: reputable auditors hadn't challenged the going concern issue. The government might have been briefed that Carillion was flaky but that it was better to take the risk on them surviving by continuing to place contracts with the company rather than being accused of driving the company under by not giving it the contracts when it had bid the best price. You can just imagine the headlines in that scenario. And Corbyn's reaction.

So who really does lose out as a result of Carillion's collapse? Well firstly, the shareholders, but that's a risk shareholders knowingly take. As well as those evil speculators casually disparaged by the left, Carillion was a large company so quite a few pension schemes may well have held Carillion shares. They ought to have been sufficiently diversified for the hit to be slight, but I suspect some invest in all major companies without too much analysis, like tracker funds do.

Secondly, all the members of the Carillion final salary pension scheme will lose out under the rules of the PPF, the Pension Protection Fund lifeboat for bust final salary pension schemes. Most existing pensioners will continue to get 100% of their pension but will generally get smaller increases in future: service before 1997 doesn't get indexed and post 1997 service can only be increased by a maximum of 2.5% a year, even if the scheme rules provided for higher increases. Current employees and employees who have left the company in the past (so-called deferred members of the scheme) will get 90% of their expected final pension if they were due to retire at 65 and also reduced increases thereafter. There is a "but". The scheme won't pay out to anyone above a cap, which is currently £38,505 for people taking their pension at age 65. If they were due to retire earlier the cap is lower, £32,770 at 60 for example. And they only get 90% of the cap. The cap applies to people drawing their pension, so someone who has retired aged say 60 would find their pension reduced to £29,493 even if the pension they had been receiving was much higher. Cases like that have been highlighted in the press previously.

Now I accept the cap affects people with substantial levels of occupational pension, requiring the employees or ex-employees to have final salaries of around £70k p.a. or more. While that's a pretty good wedge, to put it in context it's only what a train driver earns. There will be a significant number of  managers and technical experts whose pay would have exceeded that. (I'm not talking about directors or the most senior managers here, whose pay would have been much higher again). It will be a very unpleasant shock to a number of current and former senior project managers for example. The Telegraph gave examples last year, including a former accountant with Turner and Newall who was one month from retiring on a pension of £50k p.a. when the company went bust. His capped pension from the PPF is £20k.

There are knock on victims of the Carillion pension fund collapsing.  The collapse of yet another final salary scheme means a smaller pool of active final salary schemes will have to carry the burden of higher premiums for the PPF. The PPF was created by the government but is funded by a levy on companies with final salary schemes. Bigger PPF premiums  will hit companies already feeling pain from having to make increased contributions into their pension scheme. These companies already pay a PPF levy of over £600M a year, as well as having the additional cost compared to some of their competitors of funding their final salary schemes. And, as more and more of these schemes expire - BHS and Carillion have been biggies but there have been plenty of others - the point may come where the PPF isn't viable and pressure would fall on the government (and taxpayers) to bail out any further schemes going under. This isn't close at the moment - the PPF is sitting on a few billion quid - but as more companies subscribing to the PPF fail and fewer pay in I can't see any other than that one day the money will run out, or the scheme will become completely unaffordable to the remaining companies.

The third group of losers are the companies who were suppliers to Carillion, many of whom will have had invoices outstanding and so will not get paid for goods or services which have been supplied. This could cause serious problems for small companies especially.  In a case I had personal experience of, the company was offered an important chunk of work sub-contracting to a prime contractor on a large construction project. The prime contractor had a reputation for paying late and we had other reasons reason to believe it was dodgy. We made representations to the end customer, a quasi-governmental body who had effectively made us a nominated supplier, asking to work directly for them. We failed, so plan B was to front load the payments profile so that we weren't owed money at any point. Fortunately our initial milestone payment, to cover equipment we had to buy up front (which we didn't actually need to do) was plausible and was not challenged. The prime contractor did indeed go bust during the contract. Without our gambit to protect ourselves our company's annual profit would have been hit by 10% at a stroke. Very few companies are in a position to insulate themselves this way.

Of course, companies can insure against bad debts. Premiums for a whole business can be steep but, while more affordable on an invoice by invoice basis, the simple fact is that Carillion's smaller suppliers will have had neither the negotiating muscle to get advantageous terms nor feel that they could afford to insure against a large customer defaulting. It seems likely that some companies will be dragged under with Carillion, though the government has arranged for credit for small Carillion suppliers with banks.

A fourth group of losers are the customers for the facilities Carillion was building, like the Royal Liverpool Hospital, which will be delayed for a year. Mind, it was going to be delayed anyway because Carillion had found that eight cracked beams were going to need to be replaced, adding £20M to costs. This discovery has been described as tipping Carillion over the edge**, coming on top of delays to the £550M Aberdeen by-pass contract and difficulties in convincing the Qataris that 2022 world cup related building work had progressed enough for the next payment to be made. This last item had £200M of cash trapped. So Carillion had what I recall being called a "WIP mountain" because of contract delays, WIP being work in progress, i.e. work done and money spent but not yet able to be invoiced and collected as income. Carillion had become notroious for this - it had £1.7bn of "receivables" - work done but either not yet invoiced or invoiced and not paid - in 2016, up from £1bn in 2011. This wasn't the only warning sign - Carillion had specialised in over-paying for acquisitions and then having to make write-downs, for example. And it had been getting increasingly bad at paying its suppliers, though it had eased that and massaged its balance sheet at the same time by implementing an early payment facility, which allowed suppliers to get paid early in return for a small fee to the bank, shifting the debt Carillion owed its suppliers to the banks. This facility had swelled by a factor of over 3 between 2013 and 2016 - another warning sign.

So there were plenty of signs. When Frank Field and his select committee colleagues grilled the former Carillion executives this week they clearly could not understand how the board was asleep at the wheel. But the thing is, the company was at great risk of going under for many years: one industry expert was quoted in the Sunday Times*** as saying that Carillion had been "a slow motion train crash for the last 10 to 12 years". The board had always found a way to avoid disaster. And they probably would have done so again if they could have got the Qataris to agree to make a payment against the work done. The directors will always strive to the very end to keep the ship afloat and will only throw in the towel when at risk of trading insolvently.  Arguably, it is their duty to the shareholders to do so. And so, when these crashes happen, they are big ones, the analogy being a train on a collision course thundering towards the last set of points which could still move up to the last moment. This time they didn't.

The select committee asked the obvious question about why large dividends continued to be paid to shareholders instead of  making up the pension fund deficit. But that would have weakened the company's share price which can have undesirable knock on effects. The Daily Mail's Alex Brummer admirably summarised the problems this causes companies:

A serious problem for sinking firms like Capita is that as the share price tanks, so the covenant to the pension fund becomes less valuable, the debt to equity ratio soars and bank lenders seek to renegotiate agreements. The ground shifts further beneath their feet and recovery retreats ever further into the distance."

Although the select committee tried to give the former Carillion directors a tough ride, I don't think many politicians - and certainly not the admirable Frank Field who was asked to "think the unthinkable" by Tony Blair (but then got sacked) - have the first clue about the issues facing directors of large companies and their so their criticism rang hollow. I accept that the Institute of Directors accused the directors of failing to provide appropriate oversight and said the collapse suggested "that effective corporate governance was lacking at Carillion" but this is very easy to say with hindsight. Yes the directors were paid a lot - the IoD referred to "highly inappropriate" pay packets but so are the directors of every similar company - they are all paid too much. Richard Howson, the Carillion CEO who stepped down last year was paid £1.6M in 2016 including £591k of bonuses. That is less than the preposterous £1.7M that the boss of Motability is getting for sitting on a £2.4bn cash pile and not much else. Unlike Carillion in Motability's case it's ALL public money.

While not claiming to be an expert on how companies fail, I did have experience at group executive level, one rung down from the main board in a substantial plc which had to issue a number of profits warnings and had a very large pension deficit. So I suspect I know a lot more than most MPs would about the problems of managing a struggling company. In such a situation, even if the company is still profitable, suppliers immediately seek to renegotiate terms and banks change their terms of lending. I can recall having difficult discussions with major suppliers who wanted payment up front, which would immediately have drained millions from the company's already under pressure bank account. And those suppliers who have taken out insurance against non-payment find the insurers pull the cover if they think it might actually happen. This has happened recently to House of Fraser and was a contributory factor to the demise of Woolworths, Comet and BhS. When things get really bad the banks send in teams to vet the company - for which privilege the company has to pay at a handsome hourly rate of course - before they will decide to renew the overdraft at higher interest rates.  All, in our case, because the company was saying it would make maybe half the profit that it had forecast a few months earlier. All sorts of problems rain down on management and it is easy to see why the directors try to keep the show on the road, expressing confidence until the very last moment.

One thing you can guarantee - the directors and senior managers at a struggling company will be working harder than almost anyone else as they get besieged by one problem after another.

The company I was with got through these traumas, that time at least. But several years after I had left it did go into administration, due to the pension fund becoming an unsustainable burden. Once free of that (it went into the PPF) a large part of the company is now continuing as a profitable business, albeit with lots of trauma for pension scheme members. But until the final crunch it was a high wire act for many years, just like Carillion. Even as the signs were getting more negative, only the directors (and maybe not all of them when it gets really hairy) know the full situation and how close the company was to failing on previous occasions. I can quite believe that the Carillion directors felt that, with a bit of help to tide them over until the Qatari money came through, they could escape once again. Not that I am suggesting the government should have done that.

So the chap who was CEO until a year ago really couldn't be blamed that much - he wouldn't know anything of what had happened subsequently. And the FD who had been there a few months clearly came into a difficult situation. No wonder these chaps and their colleagues sat in glum silence while the MPs threw the equivalent of rotten tomatoes at them. It was their duty to the shareholders, the employees and the pension fund to keep the show on the road as long as they could, while hoping that the Qatari money turned up, allowing them to live for another day, week or maybe year. Remember they had tried to secure the future by merging with Balfour Beatty (good decision tgat by the Balfour board, by the way), but something else might have turned up. The one thing they couldn't do was say to the world "if we don't get that cash by the weekend we are sunk" else sunk would immediately become a self-fulfilling prophesy. The whole spectacle of the select committee grilling was somewhat unedifying and didn't help to understand how better to deal with these situations in the future.

Isn't there a fifth group, the taxpayer, I hear you say. Surely the exchequer will now have to pay a lot more to complete the contracts? Maybe, though not necessarily. If, as I suspect, Carillion were bidding low, then the eventual cost may not necessarily be any more than if Carillion had not been given the contracts and they had been awarded to other, higher price bidders at the outset. This won't be known for some time, though whether we ever get told I rather doubt.

Jeremy Corbyn has of course tried to make hay from the collapse, in his ususal spectacularly economically ignorant way, saying " if these are public contracts we should be the manager and not have a middleman like Carillion creaming off the profits"*. One doesn't really know where to start with Jeremy as he is so far off the planet he is hardly in the solar system. But Carillion obviously wasn't charging enough for its services or it wouldn't have gone under. And given the fancy salaries that university vice-chancellors and council chief executives pay themselves, the pay levels of senior people probably wouldn't be materially different if the contracts were managed by the public sector.  And public sector procurement, for example the Ministry of Defence or Network Rail, has an outstanding record on delivery to cost and time - outstandingly bad. Given the notorious inefficiency of the public sector (see The Not For Prophet, 27 October 2017), there is no reason to believe the total cost would be anything other than a lot higher.

Indeed, PFI deals involving construction, like many of Carillion's, are proving so risky that few companies will bid for them any more. The operational phase of a PFI contract is generally low risk and so is a cash machine for the companies who run them. But companies will be even less inclined to bid for the risky construction phase if there isn't an operational phase afterwards to pretty well guarantee getting their money back. Why should they take that risk, Jeremy?

I despair of the Tories who don't seem willing, let alone able to defend capitalism from Corbyn's nonsense. It was left to the Sun to say " Jeremy Corbyn’s clueless on Carillion because he despises job-creating private firms"; "the Labour leader sees the private sector, which feeds the families and pays the rents and mortgages of 84 per cent of all UK workers, as the tool of a wicked capitalist conspiracy" and "Labour's failure to land a glove on the Government over the Carillion collapse exposes its utter cluelessness. Its more sensible MPs support private firms running public services because they generally do so efficiently, which is why Labour once encouraged it."

Quite. However, I suspect Jeremy's childlike diatribes probably go down well with a large chunk of younger folk. Us oldies may have to relive the 1970s in order that the youngsters can experience the fact that full blooded socialism never (as in never, ever, anywhere in the world) works for any other than a brief period of time before everything inevitably goes to rats. Then maybe they will understand like we do.


P.S. Carillion was formed when Tarmac demerged into two companies in the 1990s. At the time I was on the board of a joint venture company with Tarmac being one of the other players. The Tarmac technical director (who I remember telling a wicked joke about Joan Collins definitely not appropriate for here) explained to me the logic of the split: Tarmac were going to keep doing the long, straight flat things like roads while Carillion were going to do the things that got built upwards, like buildings and bridges. So the fact that Carillion built Liverpool FC's new main stand fits. But not the fact that, when I joined a railway business I found Carillion was a major player on the railways.....

I recall telling the JV partners about my company's first profit warning, in confidence after the markets had closed the day before the announcement was to be made. The Tarmac guy, soon to be with Carillion, said "no big deal, we've had lots of those...."

Sources:
https://www.theguardian.com/politics/2018/jan/18/corbyn-on-carillion-well-end-outsourcing-racket-in-rule-change
http://www.constructionenquirer.com/2018/02/06/cracked-beams-at-liverpool-hospital-sparked-carillion-collapse/
The great Carillion con trick: Sunday Times Business, 21 January 2018
Alex Brummer, City Editor, Daily Mail 1 Feb 2018
https://www.thesun.co.uk/news/5366796/corbyn-clueless-on-carillion-opinion-sun-says/
Carillion's 'highly inappropriate' pay packets criticised:  https://www.theguardian.com/business/2018/jan/15/carillion-highly-inappropriate-pay-packets-criticised
Former Carillion directors branded delusional at MPs Q&A: https://www.theguardian.com/business/2018/feb/06/carillion-director-mp-executives-collapse
http://www.dailymail.co.uk/news/article-5355225/Boss-car-scheme-disabled-1-7million.html
House of Fraser faces cash squeeze, Sunday Times Business 4 Feb 2018
My company pension paid £70,000 - now it pays just £17,500. The Telegraph 16 March 2016