The last few weeks has seen significant coverage in the press about the failure of Carillion, the construction and facilities management group. The ramifications and costs are significant, not least to the employees who have been made redundant and face financial uncertainty with pension amounts coming into question, but also the many small businesses owed monies which they are unlikely to collect.
A full analysis of the group’s failure is outside the scope of this article, although it will no doubt provide extensive material for case studies for years to come. It is however interesting to apply some of the techniques and considerations that were included within the Level 4 Risk and Regulation in Banking course content to identify learning points that reinforce some of the course content and aid future understanding.
The analysis of credit risk, i.e. the assessment of the probability of a loss arising from extending credit, relies on an evaluation of both the qualitative and quantitative aspects of the borrower and the environment in which it operates. A review of the industry sector and business model are useful starting points to provide context against which to evaluate the level of risk in the business environment, key success factors and the core competencies and resources (financial and non-financial) required to manage them. The primary aim is to assess the extent to which the business is able to generate sustainable cashflow sufficient to meet its liabilities, including its financial commitments.
Carillion entered into large contracts for long-term public and private sector customers, such contracts are generally fixed-price in nature. This type of business tends to be highly cyclical and prone to cost and time overruns that can erode profit margins and lead to cashflow pressures. Disputes with the client over the quality and completeness of work done are commonplace adding further to costs and leading to delays in payment, again, affecting cash flow. Financial guarantees are often required leading to significant off-balance sheet liabilities. Furthermore, public sector work is subject to the vagaries of spending constraints and government policy, and ‘buyer power’ which can lead to slim margins.
The key success factors revolve around the ability of the business to assess each project, understand the costs and cashflow implications and price accordingly. The work then needs to be carried out in accordance with the agreed specification and in line with the assumptions that were made at the time the contract was entered into. This needs robust management controls to; assess the risk against the board’s risk appetite and to have a framework in place that is able to highlight potential problems affecting both the profitability and cashflow. Reporting and escalation processes need to be in place supported by warning indicators to highlight developing problems at an early stage.
Because of the inherent risks outlined above, the industry risk is high and as such banks will manage their positions by limiting the amount of exposure through concentration limits based on both the borrower and internal credit rating and sector limits which ensure adequate portfolio diversification.
Strength and depth of management is arguably the most influential aspect determining the success of a company. In this case, the strength around pricing, risk and control were critical success factors. However, assessing the ability of management and internal resources to match the identified challenges is almost impossible short of commissioning an independent report, which would only be undertaken in exceptional circumstances. Instead, it is necessary to form a view through an examination of available information.
A starting point is to review the balance, experience and track record of the senior management and board. Meeting the management can help to learn more about the business, controls and strategy at first hand. Mostly however analysis is restricted to a review of the historic financial statements to provide evidence of performance through absolute and trended ratios, noting that these are historic, lag indicators.
In Carillion’s case, the last audited accounts of the group, as at 31st December 2016, included a section on operational risk management highlighting the principle risks and controls. Taken at face value these seem reasonable although it is not possible to understand the effectiveness of the controls or indeed the underlying culture towards risk management from the accounts alone. The external auditors’ report was clean, signed off on 1st March 2017.
The most striking aspect of the balance sheet was the amount of goodwill, which had arisen from previous acquisitions. Net assets as at the end of 2016 were £730m, intangible assets at the same date amounted to c£1.7bn. The group’s net tangible assets were therefore nearly £1bn negative – to support a business with revenues in excess of £4bn operating in a high-risk sector. The accounts also evidenced falling profit margins, increased debt levels, a sizable and increasing pension fund deficit and worsening terms of trade.
Overall then, some warning signs and questions over both trends and absolute balance sheet strength which combined with the industry risk assessment indicate an above average risk profile.
In July 2017 the group announced provisions of £845m against poor performing construction contracts. In the subsequent interim accounts, to the end of June, a further £200m was raised leading to overall losses of £1.2bn for the period. A further profits warning was announced in November at which time the group also advised that it was likely to breach its banking covenants at the year end. By January the group did not have sufficient cash to continue to trade and advised that it had been unsuccessful in its attempts to raise additional short-term support. As such the board had no choice but to take steps to enter into compulsory liquidation with immediate effect.
The size and speed of the deterioration was perhaps the most surprising aspect of this case. Various press reports suggest that the banks were largely relegated to spectators until very late in the day because the group had seemingly not breached the covenants of its revolving bank facility, notwithstanding the significant deterioration announced in July 2017.
The 2015 audited accounts refer to the extension of the maturity of their main £790m revolving bank facility from March 2018 to November 2020 ‘on more advantageous terms, reflecting the strength of our position and reputation in the bank debt markets’. At that time, the group’s market position appeared robust and they were regularly winning high profile government contracts and the financial position also appeared relatively benign.
The issue then is not necessarily whether the lending decision itself was sound but the extent to which the facility terms provided the safeguards to allow the banks to control the situation and support the business in the event that there was a material deterioration in trading and cash flow performance during the 5-year term of the facility. The outcome suggests that the covenants were not sufficiently robust to kick in early enough to save the business. The dilemma for banks in negotiating term facilities is striking the right balance between the commercial market terms that have trended towards ‘cov-lite’ facilities and the underlying risk profile of the borrower. In the final analysis this comes down to a matter of judgement and the question that the banks may now be reflecting on is whether the pendulum has moved too far in favour of the client.