The Carillion File – Continued
This is the second article in a discussion regarding the Carillion Group (“Carillion”). The first article containing background to Carillion can be found online at http://smallbusinessinsolvency.ca/2018/01/22/the-carillion-file/
Due to the size and complexity of the matter, the article has simplified some of the issues for the sake of both brevity and ease of understanding.
Explaining how a large multi-national company goes bust.
How did a large international company such as Carillion, which was diversified across continents with differing government contracts, become insolvent?
There are always several forces in play, and the Carillions of this world will continue to operate just as long as more government contracts keep rolling in. Failures cannot simply be ascribed to “the economy”. In no particular order, the forces bringing down large companies with government contracts include government budgets, government ideologies and profits.
To understand how a large multi-national goes bust, one must look at how governments substantially provide infrastructure nowadays, and the associated risks with their methods.
The old maxim, live within your means (or at worst, don’t spend more than you have available in liquid funds) seems to have been forsaken by many, if not most, governments with supposed free market economies in recent years. Government economic policies have been called everything except what they actually are; overspending.
You will recognize the terms; stimulus, investment, support for a troubled industry, support for a troubled region, infrastructure dividends, budget variances, realizing asset values, etc., etc. These euphemisms get worse in election years, and when there is no economic logic, then governments resort to the phrase “it is the right thing to do”. To be fair, a democratically elected government is absolutely free to overspend, and sometimes economic necessities demand it in the short term, but there should also be a corresponding plan about how to recover, before the overspend occurs.
Public Private Partnership projects or P3s
In recent decades governments have therefore sought ways to provide infrastructure renewal and maintenance, but without the ongoing overhead of the government publicly employing huge numbers of unionized workers. Publicly employed workers often also come with additional long-term costs of defined benefit pensions. These pensions will continually, and exponentially, rise as the number of pensioners grows, cost of living increases are applied and ex-employees live longer.
To provide infrastructure without a huge embedded government operation, governments landed on “Public Private Partnership projects”, also known as P3s.
In a P3, the government contracts a private party, to provide a public service or project, and the private party assumes all the financial, technical and operational risks. The risks to the private party are substantial, but as with all risk, the rewards can also be substantial. Due to the size and nature of the contracts, competition can be scarce.
Governments benefit because they do not have to carry the cost of financing the infrastructure, nor the cost of countless public-sector employees, and when contracts are put out for transparent real tenders, the government can be said to be getting the best possible deal. The contractor will be required to provide the finance to conduct a project, albeit often with government guarantees. Government therefore does not have to carry the full cost of financing infrastructure ahead of its delivery.
Governments have also taken to social engineering society by the adoption of particular projects, or of certain contractual terms, that add cost and time to the completion of the contract. Again, let me be clear, a democratically elected government is at liberty to impose such terms because they have a mandate from the electorate. Examples of these additional terms are too numerous to list in this article, but some demands that have now become standard would amaze many people. These additional terms can be extremely onerous, but the government can claim to be passing the cost of these on to private corporations, rather than to the taxpayer directly, and the terms are supposed to be for the greater benefit of society. A government’s attribution of cost can be discussed elsewhere at length in other politico-economic forums.
Failure to comply with the contract terms, including the ideological clauses and target dates, can result in heavy fines to the private contractor, thus recovering funds for the governments, or political allies. The last US administration actually directed some large fines to politically aligned non-profit organizations that were not even stakeholders to the projects in question, and therefore did not recover funds for the taxpayer.
Nonetheless, contractors line up to bid on government projects because there are lots of the projects, the projects can last for several years and many of them are for large sums of money. Given the volume of the projects available, and promise of more projects, the profit margins may be relatively thin even if the price is for a large sum and all terms are complied with and the delivery date met.
As noted above, the size and nature of the projects can limit the number of possible contractors and some governments will attempt to spread the work around so that all contractors stay in business and the governments are not reduced to dual or single suppliers. This avoids the political fall-out from being seen to drive a company into insolvency with the consequent loss of jobs (as is happening to the UK government because of the Carillion liquidation). A larger number of available suppliers also means that a government should be able to drive a better bargain.
The limited pool of contractors capable of providing a service of the size required by many government infrastructure projects therefore require a continuing and increasing body of work. Just as long as a contractor continues to receive additional projects, at slightly increasing prices, then it will continue to operate and be able to pay the costs of its on-going operations. As soon as there is a slow-down in infrastructure spending, project allocation or in project winning, then the drop in profits is relatively rapid.
If infrastructure projects are reduced, then it becomes a game of musical chairs with each contractor bidding lower and lower for the fewer available projects. In the end, the hope is that a competitor will be knocked out before the contractor expends all its reserves, and suddenly there will enough chairs for everyone again.
Carillion did not maintain a high enough level of new and profitable infrastructure projects, and therefore, they are now insolvent.
The governments’ budgets were not sufficient to provide Carillion with sufficient new contracts. The additional terms limited its profits on many projects, and Carillion’s reserves were insufficient because past profits had already been dissipated, whether by losses or dividends.
Thus, we come full circle and the three forces have ensured Carillion’s failure.
- Government budgets determine what projects are to be contracted for in the next budget, and the amounts allocated.
- Government ideologies add costs and limitations to the contractor’s operations.
- Profits – Contractors are accountable to their owners, the shareholders. Shareholders invest for profit and/or capital, and increasing company profits are what they demand. Increasing profits are required for rising dividends and share prices.
Without the three forces in harmony, insolvency will ensue.