The Looming Crisis in the Private Provision of Public Services Close Parallels with the Systemic Failure of Banks

The collapse in January of Carillion PLC, the UK’s second largest construction and outsourcing company has attracted considerable media coverage. Carillion was principally engaged in public sector contracts to build (and in some cases operate) hospitals, prisons, roads, and part of the new high-speed rail link between London and Leeds.

Mainstream media rightly reported many unpalatable aspects of the collapse: aggressive accounting, suspension of pension fund contributions, the company’s rapid growth by acquisition. However, they generally missed the parallel with the story of systemically important financial institutions. The truth is that companies such as Carillion, Capita, G4S and MITIE now manage such a large slice of UK public services that the failure of more than one raises the spectre of the armed forces being deployed to keep schools open. Unfortunately, all these companies might be in financial trouble because, just like large banks, it is impossible to assess their health or lack of it by studying their financial reports and accounts.

Background – 25 Years of Privatisation of UK Public Sector Procurement
Since the early 1990s, all British governments have embraced public-private partnerships as the preferred construction procurement method. The initial appeal of such partnerships was an accounting trick whereby the payments were expressed as conditional upon service provision, and hence the long-term liabilities did not appear on the public sector balance sheet. They came on balance sheet in 2012, but the procurement method persists.

However, the privatisation of public sector infrastructure quickly changed the industry. So great was the volume of business, and so complex was the tendering process that initially consortia of building companies and facilities management companies were formed to pool resources and submit joint tenders. This form of collaboration was designed to show strength, to demonstrate that projects would be ‘delivered’ on time and to the desired standard. But it also resulted in mergers and acquisitions. Carillion was particularly aggressive in this regard, buying rivals such as Mowlem and Alfred McAlpine (construction) and Eaga (renewable energy), but overpaying to such an extent that it subsequently booked substantial write downs against both values.

Media Outrage
The mainstream have focussed on two main points. Firstly, even though Carillion’s share price fell steadily since hedge funds began short selling shares in 2015, the fall accelerated when it warned in July 2017 that its net worth would decline by GBP 845 million, almost doubling its debt, and when it published two subsequent ‘profit warnings’. Yet, the British Government kept awarding it major new contracts. By early 2016, the company’s shares had the notorious distinction of being the most short sold shares on the UK’s main public exchange, strongly implying that its financial problems were obvious even from its accounts. 30% of its shares were on loan to speculators who profited handsomely by selling the borrowed shares in the hope of repurchasing them for lower prices or even nominal prices, if they maintained their positions until the liquidation announcement. Even though generous dividends were being paid to shareholders in 2016 this shorting gathered pace, implying that speculators did not trust the accounts. How could the public procurement officials and government ministers review and approve privatisation contracts with this company when so many warning signs were flashing?

The media also reported that other speculators were gambling on a taxpayer bailout. It was well known that a number of government departments were lobbying ministers to bailout Carillion. With 450 public sector contracts in the hands of this company the disruption to public services if it was allowed to fail would be too great. This company, it was argued, had become Too Big to Fail. Furthermore, there was a recent precedent for a bailout. The UK’s railway system was privatised in the period 1994-96, in a “vertical” manner. One company (which itself failed and was nationalised in 2002) took ownership of the rails and tracks, another three companies acquired the rolling stock, and about twenty companies won contracts to operate the trains. In 2017 the two operators of the East Coast train line from London to Edinburgh, Virgin Trains and Stagecoach were bailed out; they were losing money because they had misjudged the net profits they anticipated to make when they won the operational contracts in 2015, an auction to replace a failed predecessor. Even though, in the transport sector, both companies operate many other public services profitably, their appeals to the UK Government’s Department of Transport succeeded and they were allowed to ‘hand back’ their contracts three years early in 2020. Put differently, UK taxpayers have given up the right to receive from these two solvent private enterprises about GBP 1.4 billion. Unsurprisingly the relevant minister issued a flat-out denial that the early termination constituted a bailout, but Stagecoach’s 10% share price surge on the back of the announcement exposed the silliness of this denial.

Financial Engineering and Aggressive Accounting
From the already published studies it appears that Carillion’s management gamed accounting rules to the hilt. Just like derivatives contracts in banking, IFRS accounting rules were interpreted to authorise booking much of the profits expected to be earned over the life of construction contracts at the inception of each contract. Prudence no longer features in construction industry accounting.

Of course, the trick to operating a Ponzi scheme is to maintain public confidence as long as possible. In Carillion’s case, it appears that new contracts were chased to generate fake profits that were then used to justify paying dividends to shareholders out of capital, rather than true profits. In the five years to 2016, Carillion distributed GBP 200 million more in dividends than it earned in terms of cash. The 2017 writedowns wiped out the previous eight years reported profits.

In August 2017, the trustees of the company pension fund agreed to the managers’ request that payments into this fund be suspended. We believe that the managers argued that Carillion would fail if the request was denied. The trustees agreed, on the grounds that suspending payments was in the pensioners’ best interests. This is a mistake for which the trustees may yet be held accountable.

As for suppliers, we suspect that many will soon discover that they have fallen victim to one particularly nasty piece of financial engineering. In 2012 the UK Government introduced a scheme to help SMEs receive early payment against their invoices. In essence, the scheme was a taxpayer subsidy to encourage large banks to lend the invoiced amounts to the SMEs based on the high quality credit risk of the invoiced large corporation. Carillion encouraged all its suppliers to use the scheme and extended its payment delays to 120 days. Unfortunately for the suppliers, the bank loans are with recourse, so over the next three months suppliers who think they have been paid a total of about GBP 500 million will be receiving demands to repay these loans to Carillion from its banks.

Conclusion
Even though the mainstream media has been scathing about the company’s senior management, focussing on managers and auditors drawing large remuneration packages whilst workers and suppliers were treated shabbily, mainstream media have not seen the parallels with banks.

Just like banking, the construction industry is highly competitive, and margins are thin. Becoming too big to fail is a perfectly logical strategy, it helps to win business. The problem comes when previously booked profits turn out to be illusory. The roots of the failure lie in the application of accounting rules by compensation focussed managers and auditors, whilst regulators turn a blind eye, or worse: there are strong suspicions that Carillion’s dire July warnings about its future encouraged the government to award it the rail contract a few days later to try and support it.

What should the government do if this crisis becomes systemic? Here is where things diverge with banking. Because banks are supported by central bank liquidity they survive, and the banking crisis disappears from public consciousness. Carillion is unlikely to be an isolated case. A similar company, Capita, issued a profits warning two weeks after Carillion failed. The UK government is facing a major problem. Quantitative easing cannot be extended to this industry. Perhaps some form of stress testing of tenderers for new contracts might be devised.

Perhaps also another parallel with the Great Financial Crisis will play out. Indeed, we expect a steady drip feed of even more unedifying behaviour by senior management and the blindness of regulators. Readers will remember that the GFC was initially played down, the issue was a liquidity shortage not insolvencies. It was not until 2012 that the scandal of manipulating interest rates – “Liborgate” – was picked up by the media.

The official reaction has been predictable. Both the government and the accounting regulator have belatedly announced that they will be investigating allegations of corporate misconduct. The Insolvency Service has been instructed to ‘fast track’ its investigation. We are not optimistic, nothing came of similar investigations into the collapse of Royal Bank of Scotland or Halifax Bank of Scotland.

Source: https://en.irefeurope.org/Publications/IREF-Newsletter/The-Looming-Crisis-in-the-Private-Provision-of-Public-Services-Close-Parallels-with-the-Systemic

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2 replies on “The Looming Crisis in the Private Provision of Public Services Close Parallels with the Systemic Failure of Banks”
  1. Regarding bank failures – there is no need to bail them out.

    Every economy constantly needs new money to keep it orderly and to enable payments to be made on time.

    Simply create enough money to bail out the bankrupt bank and replace the failed board of directors. Reshuffle if necessary but get rid of the bad ones.

    There will no longer be anyruns of the banks and the banking industry will become healthy and companies like Carilllon will not get funds.

  2. says: MrVeryAngry

    Well, if the government was not sticking its nose in all over the place the bulk of these fake contracts to fake businesses (aka rent seekers) would not happen in the first place. In other words tell the Damn’ government to stop spending money.

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