Britain | Cleaned out

Where did Carillion go wrong?

The mistakes that caused the mega-contractor’s demise are common to the outsourcing industry

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LABOURERS building the new Midland Metropolitan Hospital in Birmingham got a rude shock when they arrived for their morning shift on January 15th. They were told to go home; they had been laid off. Meanwhile, in Oxfordshire, the county council was putting the fire brigade on standby to serve school meals. Such were just a few of the immediate consequences of the collapse that morning of Carillion, Britain’s second-largest construction firm, with debts of about £1bn ($1.4bn) and pension liabilities of almost as much again.

The total cost in lost jobs and business has yet to be counted. But another casualty of the company’s capsize may be the business model that went so badly wrong there, and which plenty of other firms in the outsourcing industry share.

Carillion employed 43,000 people worldwide, almost half of them in Britain. It began as a construction company, building everything from the doughnut-shaped headquarters of GCHQ, Britain’s signal-intelligence agency, to hospitals and football stadiums. It later began providing all manner of services for both the public and private sectors, dishing up meals in schools, maintaining bases for the Ministry of Defence, and much else. Many of its projects were commissioned under the Private Finance Initiative (PFI), in which contractors foot the cost of building and are repaid by the government over several decades. Almost all the work that Carillion won was outsourced to subcontractors, who would often sub-subcontract it in turn.

The platoons of small firms that did most of Carillion’s work will thus be most affected by its demise. Rudi Klein, head of the Specialist Engineering Contractors’ Group, representing thousands of engineering firms, estimates that Carillion owed about £2bn to 30,000 or so firms. That does not include the unknown cost of retentions, the cash that Carillion was holding back until companies had finished the job. Many will never get their money, damaging Britain’s slender supply chain. At least the government has stepped in to protect those doing public-sector work; Carillion had about 450 government contracts, constituting about a third of the company’s revenues in 2016.

But it was this work that contributed to Carillion’s undoing, highlighting the basic flaw in its business model. Construction is a perilously low-margin business to begin with. To expand the business and keep enough cash rolling in to pay creditors and shareholders, Carillion’s bosses bid ever more aggressively for public-sector contracts, especially in the wake of the financial crash in 2008, when such work was scarce. That is when three big deals were signed that have gone sour: to build hospitals in Liverpool and Birmingham, together worth £685m, and for a share in a £550m roadbuilding contract in Aberdeen.

All three projects hit snags common to the building trade. In Liverpool, for instance, workers found asbestos on site and cracks appeared in the new building. Under the terms of the deals, Carillion had to absorb the extra costs, on projects that were barely profitable in the first place. The company also ran into trouble in Qatar, where it got into a dispute over a payment of £200m that it was owed for work on the 2022 World Cup. The result was a profit warning last July, after the company admitted to unexpected over-runs of £845m, which sent the share price tumbling. Carillion continued to win business, notably from the government, which awarded it a contract for £1.4bn of work on the HS2 railway even as investors bet on the firm’s collapse. But after more profit warnings, the banks refused to lend it any more.

Public-sector tenders are supposed to consider the quality of bids as well as the price, but in practice contractors have found that “bidding at a low price is usually the best way to win,” says Peter Kitson, a lawyer at Russell-Cooke. Companies bank the upfront payments and hope they can make money by charging for the extra work that nearly always comes with infrastructure projects. If, as happened to Carillion, extra costs arise, the deal can quickly become loss-making.

But Carillion’s management was also culpable. The firm expanded too fast, acquiring businesses that it did not understand. It paid £306m for Eaga, for instance, a supplier of green-energy products, only months before the government cut subsidies that homeowners got for installing solar panels. As Carillion was failing and its pension fund slipping into deficit (see article), shareholders continued to receive dividends and the firm’s boss trousered a £1.5m pay package. Even the Institute of Directors, a business lobby, condemned Carillion’s board for rewriting company rules to protect executives’ bonuses if the company failed. On January 17th the Insolvency Service said that it was stopping all further payments.

Who wants to be a Carillion heir?

Shares in its rivals, such as Serco and Kier, rose after the firm imploded, on the expectation that they would pick up some of Carillion’s business. Yet many of the problems that sank the company are common to the outsourcing industry. Interserve, which has an annual turnover of £3bn, issued two profit warnings last year, following technical problems at a waste-to-energy plant in Glasgow. Not long ago Balfour Beatty, Britain’s largest construction firm, issued seven profit warnings in the space of two-and-a-half years, after accepting too much work at low margins. Construction News, a trade paper, found that last year Britain’s ten largest builders made a combined pre-tax loss of £53m; the average pre-tax profit margin was -0.5%.

And now there is intense pressure on outsourcers to change their ways. The government has launched an inquiry into the Carillion saga. It may also re-examine its procurement processes. On January 18th the National Audit Office published evidence that PFI is a pricey way to fund infrastructure, and that it does not reliably bring benefits. Carillion’s competitors may be glad to have seen off a rival, but they are operating in a troubled industry that is under more scrutiny than ever before.

This article appeared in the Britain section of the print edition under the headline "Cleaned out"

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