Written evidence from Professor Adam Leaver[1] (LCC 43)

Public Administration and Constitutional Affairs Committee

Sourcing public services: lessons to be learned from the collapse of Carillion inquiry

Introduction

The collapse of Carillion on the 15th January 2018 was the latest in a line of high-profile outsourcing failures, including the G4S Olympic security scandal, the insolvency of Southern Cross, the NHS IT upgrade failure and the high long-term costs of the Public Finance Initiative (PFI) deals.

These failures have contributed to a sense that the legitimacy of the outsourced state is in the balance; there is now a strong sense of injustice among various stakeholders who have suffered a loss of income or services from such episodes.

This short submission argues that any reform should engage three core features that emerged from the Carillion collapse:

• First, that any effective regulatory regime must better engage with the ‘financialised’ practices of outsourcing firms, rather than treat them as essentially productionist enterprises.

• Second, the regime must adjust its approach to - and measures of - risk if it is engage with the potential balance sheet volatility that can emerge when fair value/market-based principles of valuation are followed.

• Third, there should be some recognition that this sector is, structurally and behaviourally, less like a market and more like a network. This should change the object of governance away from achieving ‘more competition’ towards ‘building network resilience’. 

1. Understanding Outsourcing Companies As Financialised Companies

Large strategic suppliers like Carillion are financialised businesses with a commitment to create shareholder value. The collapse of Carillion raises questions about the compatibility of shareholder-driven pressures for strong capital growth and high dividends with a tendering process which puts pressure on cost in an activity with a history of uncertain cashflows.

When firms try to make a Return on Capital Employed of 10-12% from contracts which may yield only 3-5% - or even 1% in the case of Carillion’s central government contracts - outsourcing firms may use forms of financial engineering to square this circle.

Outsourcers are therefore not just project and contract managers, they are products of accounting and law innovations designed to maximise shareholder objectives. These innovations we term ‘financialised’ practices.

These financialised practices carry their own risks and can lead to dysfunctions on the blind-side of regulators.

Many financialised practices use law and accounting interventions to bring forward future income and minimise the present costs of liabilities, within the parameters permitted by prevailing accounting rules. This can increase the distributable funds available to maximise short-term shareholder value.

For example, Carillion booked contract revenues and costs on the basis of the proportion of total costs accrued to date relative to the estimated total cost of the contract. Where this was difficult to estimate, they booked revenues and costs based on forecasts of what they believed the total profitability of the contract would be (see p.95-97 in 2016 accounts). Annual profit figures were thus partly speculative in the sense that they were based on expectations of future income; and ultimately bore little relation to net operating cashflow (see figure 1). Between 2012 to 2016 Carillion’s accumulated post-tax profit was recorded as £668.9 (*£611m using the restated figures), even though it generated net operating cashflows of just £166.4m (*£29.9m, in the restated figures) over that time period. It then paid out £398.4m (*£370.9m in the restated figures) in shareholder distributions over that time; which was 59.6% (*60.7%) of total accumulated net profit, but 239.4% (*1240.5%) of accumulated net operating cash.

Figure 1: Carillion’s reported earnings, net operating cashflow and shareholder distributions, 2012-2016 (£m)

Source: Company accounts, various years

Note: these figures differ from those in the House of Commons briefing paper because we use a net rather than gross cashflow from operations figure. The net operating cashflow figure is a closer comparator to the net profit figure because it also accounts for financing costs and tax paid.

Note: ‘Net operating cashflow’ = Cash generated from operations minus financial income received/paid, acquisition-related costs and taxation payments.

Note: ‘Dividends paid’ includes dividends paid to equity holders of the parent and to non-controlling interests

*Note: the restated 2016 figures were published in the September 2017 earnings update.

These shareholder return metrics are often also the metrics used to determine board bonuses. At Carillion, for example, the dividend policy was linked to earnings per share (EPS) growth; EPS growth was also one of the central targets which triggered executive bonuses. It is within that context that the dislocation of profit from cash in figure 1 took place.

The governance system around outsourcing therefore requires some recognition that the nature of the firm is changing. Outsourcing firms are no longer just a productionist ‘going concern’ (if they ever were). They are now also a kind of financialised ‘portal’ – a site within which income can be moved through time and space to maximise distributions in the present[2].

This time-shifting of income carries medium to long-term risks. Carillion’s ability to pay dividends in excess of its net operating cash, was funded by debt which hollowed out its shareholder funds and left it critically exposed to impairment risks (BEIS/W&P Comm 2018; Mor et al 2018). Many of these risks were not immediately obvious until Carillion’s £845m writedown of its contract values in July 2017.

The time-shifting of income also affects the normal hierarchy of claims upon a firm’s income/assets. Here shareholders and the board get paid first, but the hollowing out of the firm may mean creditors (lenders, subcontractors) have few claimable assets to recover, particularly if much of the asset base is goodwill. Pension fund beneficiaries also lose out if their fund is in significant deficit.

Any new regime should consider ways of maintaining the proper order of claims where shareholders are residual claimants, not principal beneficiaries – which is the case when dividends are effectively paid from future income brought forward. This is in the interests of shareholders too in the long-term – the experience of Carillion illustrates that such practices can end up eroding capital, leading to insolvency from which shareholders lose their whole stake. A new regime that seeks to protect capital is essential.

2. Fair Value Accounting & Balance Sheet Volatility

The financialised strategies above take place within a particular accounting context.

One of the most important developments within large outsourcing firms is the growth of goodwill. Goodwill is what an acquiring firm records on its balance sheet when it pays more for a target company than the value of that firm’s book price. Most large outsourcing strategic suppliers have been acquisitive and so have relatively high levels of goodwill as a proportion of total assets (Appendix 1).

The growth of goodwill owes much to changes in international accounting rules just over a decade ago. Prior to 2001 under FASB and 2004 under IFRS, it was a requirement that goodwill be amortised (depreciated) over a maximum of 40 years. This changed with the accounting rules FAS142 and IAS36 which abolished amortisation, and instead made goodwill subject to an annual fair value assessment, which means goodwill is only impaired when its fair value is deemed to be less than its carrying value.

Over the tenure of the average large outsourcing CEO, goodwill acts as a form of double counting: when a firm is acquired, the future cashflows from the purchased entity are capitalised on the balance sheet as goodwill. But the actual cashflows from that acquisition are then recorded each year without any corresponding reduction in goodwill. This gives CEOs the option of building cash mountains (capitalising income twice) or putting earnings to some other use. Given the shareholder value context above, CEOs have tended to distribute. This tendency has occurred at a time when shareholders equity buffers are in decline in many large outsourcers (Appendix 1).

If growth stalls or interest rates rise, double counting goes into reverse: firms restructure current operations, which can result in large exceptional items. But they should also impair their goodwill to reflect the diminished future cashflows arising as a result of those restructurings. This can lead to large writedowns at precisely the point that firms’ operating performance is least able to accommodate them. When firms are highly levered, there may be inadequate equity redundancies to soak up the impairment losses; or firms will be forced to recapitalise through share issue at precisely the point that the market doesn’t want to buy shares. Firms may even be reluctant to impair their goodwill, despite weakening economic performance.

It remains to be seen whether such a reluctance was evident in Carillion’s acquisition of Eaga. Eaga’s net asset position was valued at £-30.7m (negative £30.7m) by Carillion when it paid £298.4m for the company. In accounting terms, this meant that Carillion booked £329.1m as goodwill on its balance sheet as Eaga became Carillion Energy Services (CES) – a wholly owned subsidiary of Carillion. The acquisition was not a success. As figure 3 shows, CES lost money in almost every year it operated. Much of that loss came from exceptional items - restructuring costs within the subsidiary, such as the waiving of intergroup loans on some of CES’s own subsidiaries. Despite this dismal performance, goodwill was not impaired.

Figure 2: Carillion’s published valuation of Eaga, 2011.

Source: Carillion company accounts, 2011

Figure 3: CES Profits 2011-16

Source: CES company accounts, various years

Goodwill accounting may lead to an increase in balance sheet volatility; these are problems of ‘pro-cyclicality’ similar to that in financial services. Regulators should be sensitive to this because apparently healthy firms can hit liquidity or even insolvency problems in a relatively short period of time if they are levered on the future and the future begins to diverge from the expectations embodied in present valuations. For current goodwill valuations to hold, the future needs to be stable and predictable. Outsourcing firms are carrying a lot of goodwill at a time when the world is becoming anything but.

The governance architecture needs to consider how to manage balance sheet volatility risks in a low margin, intangible asset heavy business. It will need new measures of risk to manage the likely outcomes of large impairments.

3. Outsourcing Markets or Networks?

For some time the go-to solution for addressing sectoral failure by successive governments has been ‘more market competition’. But government needs to be honest with itself about the extent to which this sector can truly be turned into a normal, functioning market.

Within financial services, following the work of Andy Haldane, there is an acknowledgement that certain types of economic activity organise on a network-like rather than a market-like basis. This changes the objectives of regulation, which is to build network resilience, avoid contagion risk, introduce system redundancies or fire-breaks and curtail too big to fail problems.

Whilst the jury is out as to its success in finance to date, it is worthwhile considering which metaphor to use when trying to understand the problems of outsourcing. There are many overlaps with finance:

i)                    There are a small number of large, strategically – perhaps systemically - important suppliers

ii)                 These large suppliers co-ordinate a complex sub-contractor network, who are dependent on the smooth operation of the payment system.

iii)               There is a form of contagion risk in this network, which is transmitted through the payment system and the labour market, rather than through exposures to trading assets. Many subcontractors are thinly capitalised and cash constrained, and so are dependent on the cashflows from large suppliers. When the cashflows stop abruptly, this can lead to domino-like collapse through the supply chain.

iv)                Domino-like collapse of subcontractors create other negative externalities: lost jobs can have devastating effects on communities and lead to a downward spiral of demand which hampers growth. These effects may be concentrated in particular regions.

4. Preliminary suggestions

In light of the above points, here are some preliminary suggestions:

• If the problem is partly that regulators did not understand what Carillion was doing when it hollowed out its equity buffers and paid dividends in excess of its net operating cash, a braver, more sceptical, better-informed and more interventionist Financial Reporting Council and Pension’s Regulator is essential. There must be a better understanding of the financialised strategies firms employ to increase distributable funds through balance sheet innovations.

• If the problem is partly that the time-shifting of income inverts the normal hierarchy of claims on a corporate surplus or corporate assets, new conditions could be placed on would-be contract bidders which protect firm stakeholders from the queue-jumping of others. Prohibiting companies from bidding for government contracts if their pension deficits are above a threshold is one possibility; placing conditions which restrict dividend payments in the event that a winning bidder has large pension deficits is another.

• If the time-shifting of income to improve shareholder value metrics and trigger board bonuses erodes capital, there is a moral hazard problem because the State is effectively taking on a series of contingent liabilities when it awards a contract, as the Carillion debacle demonstrates. As Appendix 1 shows, other large outsourcing firms are reducing their equity buffers. There is an argument to be made that large outsourcing firms, because of their systemic position at the centre of a network and the contagion risks that arise, should be required to hold regulatory capital to prevent destabilising payouts which erodes capital. This may increase the amounts bid for contracts by outsourcers in the tendering phase. But this should broadly mirror the costs of the contingent liabilities currently born by the State; and should serve to improve the efficiency of the State’s ‘make or buy’ decision making as these true costs become more transparent.

• New ways of conceptualising and measuring risk are also important. Quick ratios can only go so far. If the cause of Carillion’s collapse was contract and goodwill impairments – both of which have valuations linked to expectations - then measuring ‘futurity risk’ (the risk that future events do not materialise in a manner that is consonant with the expectations embodied in those valuations) becomes an important object of regulation. This could include (see Appendix 1 for examples):

• A ‘weightlessness test’ which looks at the percentage of total assets accountable for by goodwill. This: i) is a measure of futurity: how much of the firms’ present value is accountable for by goodwill, i.e. the net present value of future cash flows, over and above book value ii) examines what might be recoupable to future creditors in the event of bankruptcy; where goodwill is inseparable from the firm as it ceases to become a going concern.
• A ‘goodwill impairment test’ which divides goodwill by shareholder funds. This gives some sense of how much intangibles would have to be impaired to wipe out shareholder funds completely. A high multiple means a relatively low impairment would bankrupt the firm.
• A test for ‘contract impairment risk’ which looks at the relation between net income and net operating cashflow. A positive figure suggests a firm is over-booking profit, a negative figure means a firm is cash generative despite what is reported in the P&L.
• A ‘distributional affordability’ test which adds dividends and buybacks and assesses whether those distributions are affordable out of net operating cashflow.

• Whilst changing international accounting standards is beyond the scope of the committee, requiring large outsourcers to supply additional forms of reporting is not. Preparing accounts which include these alternative measures of risk might be another option

• Consider breaking up the contracts put out to tender. If the value of contracts are large, it will only benefit large, diversified companies who have the resources and reach to put together credible bids. This is a problem when those same large companies are also vulnerable to insolvency risks on a small number of contracts because of their balance sheet structure. The breaking down of contracts into smaller sums will encourage new entrants – perhaps more specialist, regional players and create more ‘firewalls’ in the sector.

• Consider a broader interpretation of what constitutes the ‘most economically advantageous tender’ (MEAT) by revising the Treasury rules. If governance changes are to involve a more fundamental rethink about the nature of the partnership between public and private sectors, and where the legitimate boundaries between them should lie post-Brexit – then it may be sensible to consider what forms of work and what working conditions the State would wish to nurture from the money that it hands out.

June 2018

Appendix 1: Alternative Risk Measures: Serco, Capita, Atos, G4S and Carillion; derived from Leaver (2018) ‘Outsourcing Firms And The Paradox Of Time Travel’, SPERI blog, February 2018 http://speri.dept.shef.ac.uk/2018/02/12/outsourcing-firms-and-the-paradox-of-time-travel/