PFI Not to Blame

Carillion Earnings & Cashflow
Despite often vociferous claims by its detractors, Mar Beltran, S&P Global Ratings’ senior director for infrastructure, EMEA, argues the private finance initiative (PFI) model wasn't to blame for Carillion's demise.

 

Until eighteen months ago, Carillion was the UK’s second largest facilities management (FM) and construction services company, and its collapse has precipitated two secondary effects. First, it has severely unsettled the FM and construction markets, causing ramifications for several other players and prompting fresh concerns about the country’s outsourcing of construction services. Second, it has reignited the embers of debate about whether the U.K.’s private finance initiatives (PFI) scheme can survive in the longer term.

 

But is the PFI scheme responsible? In our view, blame shouldn’t be laid at its feet. Despite some weaknesses with the framework, those market players affected should take heed of Carillion’s weak risk management and governance practices. These were embodied in its aggressive pursuit of growth, significant impairments to its construction projects, and its negative cumulative operating cash flow over the past five years (when its use of reverse factoring, a form of supply chain finance is taken into consideration).

 

Aggressive use of reverse factoring Carillion’s weaknesses were apparent some time before January 2018. Yet, clearer since its collapse is Carillion’s extensive use of reverse factoring, which served to aggressively hide a substantial portion of its debt and, therefore, the weakness in its balance sheet.

 

Closely examining Carillion’s working capital shows that the amounts its customers owed for construction contracts (and other receivables and prepayment) grew significantly, which comes as no surprise given the increase in construction revenues during this period. More surprising, however, is the missing increase for trade payables on the liability side. Trade payables averaged between £600 million and £700 million in the period between 2012 and 2016.

 

But then emerges an item named “other creditors”, which almost triples from £263 million in 2012, to £761 million in 2016. This, as the Commons Briefing paper (commissioned by the UK Government) suggests, accounts for reverse factoring. Assuming this to be true, when we adjust Carillion’s debt to consider its use of reverse factoring, its operating cash flow was negative, and its leverage was highly aggressive.


The road to liquidation

Such tactics can only temporarily paper over the cracks. There have been multiple signs along the way: back in May 2013, lobbyists had urged the UK Government to exclude Carillion from any future PFI contracts. The company had been late in paying subcontractors, which it had done by lengthening its payment period from 30 days to 120 days. In July 2016, Carillion’s first-half results showed a strong increase in revenues yet lower operating margins. This, in our view, may indicate that new contracts were becoming less profitable – or even that existing contracts were underperforming.

 

By March 2017, Carillion’s pre-tax profits fell by 5 per cent (compared to 2015 figures) yet revenues were climbing by an annual average of 14 per cent. The company, in turn, announced plans to reduce average net debt. Four months later, Carillion delivered its first of three revenue warnings in four months. The first came with an admission that its much-needed deleveraging target couldn’t be met. Further, it announced its decision to withdraw from the publicprivate partnership (PPP) market – a segment that includes PFI contracts. In the two days following the first warning, Carillion lost 70 per cent of its market capital.


PFI not to blame
At the time of its demise, Carillion was among the UK government’s preferred contractors of construction and FM services on PFI projects. The advantages that such partnerships can produce are well known: debt accrued via PFI projects does not feature in government debt figures. And though the capital investment is not recorded as public spending, they allow for liabilities to be spread over a longer timeframe. This eases investments that may otherwise be unaffordable due to capital constraints. Further, risks are held exclusively by the private sector, while the private sector’s operational and construction expertise enables them to lower costs via the competitive tender processes by which contracts are awarded.

 

What then can the market glean from the case of Carillion? Of course, there are weaknesses and accountability challenges when relinquishing control over critical infrastructure projects. The regular reviews of the PFI scheme typically dredge up similar complaints – from poor procurement practices to the inability to deliver cost savings.

 

Operational PFI projects in the UK remain resilient; construction suffers

The operational PFI projects affected by Carilion’s liquidation remain, to date, largely unaffected pending the satisfactory implementation of remediation plans. This would typically mean replacing Carillion as a counterparty.

 

The largest risk to PFI projects now is the potential costs associated with replacing Carillion as the FM provider. This is especially true if Carillion had either underbid the contracts or if it had underestimated the costs of providing the service in the first instance. Further, uncertainty around seeking
replacements can become exacerbated when the projects have cost overruns. For instance, Aberdeen Roads (Finance), for which Carillion has been among the counterparties, is undergoing construction delays.

 

For all PFI's challenges, however, to blame the financing structure for Carillion's demise is to miss the bigger picture. Arguably, what marked the beginning of the end was the July 2017
profit warning – and the poor decisions taken by its management before this time. Among them, in our view, were the aggressive growth prospects and the lack of a risk management strategy. Management teams seeking lessons to be learnt can instead look to Carillion’s practices rather than its interest in PFI.

 

 

 

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