Last week, the UK’s second largest construction company collapsed after losing money on major contracts and running up huge debts of around £1.5bn.
Carillion went into liquidation on 15 January after rescue talks with its lenders and the government failed to reach a deal.
Carillion’s demise will cause disruption throughout the construction industry, with Carillion’s smaller private sub-contractors likely to be worst hit.
So, how do businesses avoid the domino effect that could hit Carillion’s creditors?
1. Strategic business planning
Profitability is key; businesses should operate under a robust business plan, recognising the work that will bring them profit.
The foundation of every business is its business plan. Carillion’s business model has left little to be desired. Carillion operated their contracts on such thin profit margins that out of their (circa) 450 global contracts, three or four unprofitable contracts managed to topple them and the balance sheet into insolvency.
Despite their aggressive expansion in the early 2000s and seemingly conservative approach to risk, between 2012 and 2016 the company’s net debt to equity doubled, according to Bloomberg data. The first of three profit warnings came on 10 July 2017 when the company shocked the market with a £845m writedown on contracts.
Carillion’s problem was that it relied on large contracts which became less lucrative than it initially thought. As these contracts underperformed, its debts soared to £900m.
Carillion found itself in a position where banks were refusing to lend and it needed money fast to pay its suppliers and maintain sufficient cash-flow. The race to chase turnover began. In an attempt to relieve cash flow problems, Carillion incentivised senior managers to continue bidding for contracts at unrealistically low profit margins, chasing and acquiring cash in return for big bonuses.
The company’s position became increasingly desperate. Carillion had to win major public contracts, such as HS2, as it was relying on the upfront cash handed to the winner of the contract in order to cover more pressing demands for payment. With no regard to profitability Carillion was just limping to its next crisis point.
Risk management; businesses should not succumb to market pressures
Increased competition to win public private partnership (PPP) contracts has led to firms such as Carillion tendering on very low margins in order to win work. Aggressive bidding to secure contracts left no margin for delays and cost overruns.
Contingency planning and future proofing
Carillion racked up £375m worth of debt on just three large PPP contracts in the UK due to project complications, overruns and penalty notices.
Carillion should have negotiated with its lenders to allow room to manoeuvre in the event of disputes. A classic example of this is the development in Doha, where it is reported that Carillion are awaiting payment for a year’s work.
No business should let lenders or suppliers dictate their business strategy because of delayed payment and the pressure on cash-flow that brings. Contingency planning and cash reserves would allow manoeuvrability, but Carillion was running on empty.
Carillion’s shareholders received increasing dividends throughout 2015 and 2016. Clearly, given the financial pressures the company was facing it should have focused on its core operations and ploughed as much money back into the business as possible, rather than declaring dividends.
2. Cash is King
With Carillion, the main indicator of cash-flow problems was the extension of payment terms to their suppliers of 120 days, double what is generally accepted in the industry.
Industry sources said that since July’s profit warnings, many subcontractors would have insisted on more stringent terms, exacerbating the flood of cash out of Carillion and slowing down progress on site, where payments were delayed.
Having exhausted usual lines of finance, Carillion had to turn to reverse factoring, asking banks to settle £350m of supplier invoices to ensure progress on site and so essential contracts could continue.
3. If it is broke – do fix it
Given the volatility of this particular market, construction companies need to learn to admit when their business plan is not working and seek advice to adapt.
If Carillion had sought advice sooner they may have avoided liquidation. The directors’ duties to act in the best interests of the company raise questions about whether Carillion ought to have stopped bidding on unprofitable contracts, adjusted the value of bad contracts and attempted to restructure the business.
Balfour Beatty spent £17m restructuring their UK business, selling off the unprofitable facilities management division, employing new leadership and refinancing its existing facilities. Serco also turned itself around, avoiding unprofitable work and asking shareholders to bear the pain.
Construction firms should be realistic, not optimistic, in relation to profitability of work. No business should leave restructuring to the last moment, or continue to trade if insolvent!
Given the political climate and the facts of the case, it is very likely that Carillion’s directors will face serious questions about their conduct.
Lee Ranford is a partner, and Thomas Bond and Hannah Edwards are associates in the insolvency team at Russell-Cooke solicitors.