77. The failure of Carillion did not exclusively arise from its public sector business. However, while we do not have information to suggest that any of the other major outsourcing firms are currently at risk of failure, many of them have had to make announcements of restructuring to the stock exchange:
• In 2014, Serco "issued a number of profit warnings, culminating in making provisions for losses and write-downs of £1.3bn, equivalent to 20 years of accumulated profits". Serco says that "had banks not agreed to give us time to raise extra capital," they "would have gone bust."177
• In 2016 and 2017, Mitie published several profit warnings and downgrades to their balance sheet.178
• Announcing Interserve's 2017 results, Glyn Barker, its Chairman, said that the company was affected by "unprecedented levels of disruption and faced a number of significant challenges" in 2017 and described its financial performance as "extremely poor".179
• On 31 January 2018, Capita announced a £700 million rights issue and a series of other measures designed to "to strengthen the balance sheet".180
78. These difficulties flow, in part, from the way that the Government has contracted out. Karl Wilding spoke about similar issues in the charitable sector and said that "the risks to the charities and therefore to the system here come from, again, the style of procurement".181 Nick Davies argued that in some cases companies pursued a strategy of "land and expand", where the company wins a "contract that might not be particularly profitable" and then negotiates changes.182
79. Private sector companies can also respond to low margins via expansion. According to Sir Amyas Morse, contractors get into a "hamster wheel effect" "where you are always taking on new contracts".183 He argued that these contractors, faced with declining margins, report profits as they recognise the "initial profit" when they successfully tender for a contract and then just keep reporting new profits after new contract wins.184 Sir Amyas said that companies on this hamster wheel "don't see … whether the underlying profitability of these contracts really justifies … [their] business."185 These companies, as Professor Haslam has said, relied upon extra contracts not only to drive reported profits but also acquisitions which "supercharged growth in revenues".186 In Carillion's case, the House of Commons Library said that Carillion had followed this model and had been "£845 million too optimistic about its contracts".187
80. These companies were driven by their need to generate returns for shareholders and business growth. The House of Commons Library said in its report on the collapse of Carillion that the firm had "paid out £333 million more in dividends than it generated in cash from its operations in the five and a half year period from January 2012 to June 2017."188 Both Professor Haslam, Dr. Tsitsianis and Professor Leaver argue in their submissions that some of these companies have used "financial engineering" to create returns for shareholders.189
81. Professor Haslam and Dr Tsitsianis also argued that this led to these companies taking on more onerous contracts and holding more goodwill on their balance sheets than most companies.190 Carillion's treatment of goodwill (the difference between the purchase price of a company and the value of its net assets) has been criticised. The joint report by the BEIS and Work and Pensions Committees said that Carillion had "propped up its balance sheet" using goodwill.191
82. The Government agreed that recently "all the household names" in the sector had struggled and had "in the last year or two changed their management, changed their strategies" in response.192
83. Some of our witnesses argued that these poor results were due to poor management or to the sectors that contractors were involved in. Phil Bentley of Mitie told us that Carillion's problems were due to their construction contracts.193 Mr Bentley also argued that "it is up to us" as contractors to work out whether a specific contract was affordable or not.194 Paul Davies asked us why the Government "would do it any better than the private sector when you already have credit analysts and lenders and so on" analysing whether companies like Carillion will collapse.195 The Government argued that the Boards concerned were responsible for their companies: the Minister said that "we are not directors of those companies; we are important customers of those companies."196
84. Despite this, witnesses suggested that the Government could have done more to protect itself through better due diligence on the balance sheets of its contractors, especially in the contest of the new contracts awarded to Carillion. Professor Haslam suggested that the Government needed to conduct much more sophisticated due diligence of the providers that it was engaged with.197 Sir Amyas Morse agreed that the Government should do more stress testing on its suppliers.198 Sir Amyas Morse said that when contracting and, especially, transferring risk, "the credibility of the counterparty really matters."199 Professor Leaver suggested in particular that the Government should assess the amount of goodwill held by suppliers on their balance sheet compared to their net asset position.200
85. The Cabinet Office told us in correspondence that their current due diligence for contractors differed depending on the size of the contract. On smaller contracts the tests would be "limited to a turnover test and a test of ratios to determine solvency".201 On larger contracts, the contracting authorities will "draw up more complex tests that require better data and more sophisticated analysis". On the HS2 contract, the Cabinet Office told us that HS2 Ltd applied" quite detailed tests on the financial capability of Carillion" which included tests of their "turnover, net assets, liquidity, gearing and interest cover" and they "reviewed Carillion's Dun & Bradstreet Failure Score".202
86. Some of the Government's contractors developed unsustainable business models over recent years, underbidding for contracts, recklessly acquiring other businesses and maintaining high bonuses and dividends. For example, Carillion's balance sheet, before its failure, was propped up with high risk construction contracts and high valuations of goodwill, arising from overpayments for acquisitions. The directors and shareholders of the companies involved are responsible for this. Share prices, buy, hold or sell recommendations and public statements are a poor guide to the long term security of companies. Shareholders can accept higher risks for an equity rate of return and can exit at short notice. Government is in for the long term and cannot take such risks with public money or with the security of public services. The Government as the major customer of these firms is responsible for the services they supply and consequently needs to ensure that its contractors are able to deliver those services sustainably. As Ministers are accountable for the resilience of services, they cannot be blind to the risks that the companies delivering those services hold.
87. The Government should improve its due diligence processes to understand the resilience of the cashflow and financial position of its partners. In 2017, the Government still awarded contracts to Carillion despite the weakness of the company's balance sheet on the basis of "quite detailed tests on the financial capability of Carillion". The Government should urgently review its due diligence procedures on the contracts awarded to Carillion. The Government should commit to announcing its findings from this review in its response to this report.
________________________________________________________________________________
177 Serco LCC0022
178 Mitie Trading Update (September 2016), Mitie Trading Update (January 2017), Mitie Trading Update (May 2017)
179 Glyn Barker Chairman's statement (April 2018)
180 Capita, Update on Capita's transformation, capital structure, funding and trading outlook, January 2018
181 Q704
182 Q465 (Nick Davies)
183 Q7 Liaison Committee 7 February 2018
184 Q7 Liaison Committee 7 February 2018
185 Q7 Liaison Committee 7 February 2018
186 Professor Haslam and Dr Nick Tsitsianis LCC0029
187 House of Commons Library Briefing Paper Number 8206, The Collapse of Carillion, March 2018, p. 18
188 Ibid. p. 19
189 Professor Haslam and Dr Nick Tsitsianis LCC0029, (Professor Leaver) LCC0043
190 Goodwill is an accounting estimate on the value acquired by a firm when purchasing another firm over and above the value of the assets acquired. Professor Haslam and Dr Nick Tsitsianis LCC0029
191 Business, Energy and Industrial Strategy and Work and Pensions Committees Second Joint report of Session 2017-19, Tenth Report of the Business, Energy and Industrial Strategy Committee of Session 2017-19 and Twelfth Report of the Work and Pensions Committee of Session 2017-19, Carillion, HC 679, p. 13. J. Ford 'Carillion's troubles were shrouded in a fog of goodwill' Financial Times, 18 June 2018
192 Q757
193 Q633
194 Q640
195 Q606
196 Q807
197 Q473
198 Q551
199 Q551
200 LCC0043 (Professor Leaver)