At year-end 2016, Carillion Plc was, per its annual shareholders report, “one of the UK’s leading integrated support services companies, with a substantial portfolio of Public Private Partnership projects, extensive construction capabi lities and a sector-leading ability to deliver sustainable solutions.” The company had projects o ngoing in the UK, Canada and the Middle East with revenues to the tune of £5.2 billion, net asse ts of £729 million, a market capitalization of just over £2 billion, and a workforce of around 43,000 e mployees, including 19,000 in the UK. Carillion had the distinction of having clocked dou ble digit growth figures since 2010, in substantial part through acquisitions since 2010, g enerating revenue through 3 lines of business: support services, project finance and construction services. The company’s 2016 accounts, published on 1 March 2 017, presented a promising business outlook. On the back of those results, it paid a re cord dividend of £79 million on 10 June 2017, and awarded hefty performance bonuses to senior exe cutives. On 10 July 2017, just four months after the accounts were published, the company anno unced a reduction of £845 million in the value of its contracts via a profit warning. This subsequ ently was increased to £1,045 million in September 2017, equivalent to the company’s previou s seven years’ profits combined. Carillion’s collapse was sudden and from a publicly-stated posi tion of strength, Carillion plunged into compulsory liquidation in January 2018 with liabili ties of nearly £7 billion and just £29 million in cash! Carillion’s insolvency remains a major scandal in t he UK, if not the largest. In addition to wiping out its shareholder’s capital, the company’s demise left in its wake: unfunded pension liabilities of £2.6 billion, with respect to 27,00 0 recipients, the largest hit ever to the UK’s Pens ion Benefit Guaranty Corporation; 30,000 unpaid subcont ractors who are owed £2 billion; and uncertainty with regard to 450 service contracts be tween Carillion and various UK governments, with an initial estimated cost of just under £150 m illion to ensure continuity of services. Prima facie, the collapse of Carillion can be attri buted to a range of factors, some as naïve as defunct corporate reporting to as sinister as mi smanagement of pensions and conflicted financial audits. This report envisages to investigate and quantify e ach of these areas in turn, in a bid to apply these and other financial indicators to other contractors in the UK to pre-empt Carillions in the making. The report also intends to suggest best practices for corporate governance, workplace rights and the outsourcing of public services and c ontracts, apart from analyzing the UK government’s handling of the liquidation process. INTRODUCTION 2 On 15 January 2018, Carillion Plc, declared insolve ncy to the House of Commons and the Official Receiver started to liquidate its assets a nd contracts shortly after. The insolvency of Carillion will cost UK taxpayers anything between a n estimated £148 - £223 million, although this is subject to a range of uncertainties and it could take years to establish the final cost (The Nation al Audit Office, 2018). Anticipated are wider costs to the economy, Carillion’s customers, staff, the supply chain and creditors. Interestingly, the Inso lvency Service notes that this was the first example of a public limited company continuing to t rade while being wound up. Carillion’s collapse has triggered several Parliame ntary investigations and inquiries by: the Work & Pensions and Business, Energy & Industrial S trategy Select Committees, focusing on Carillion’s corporate governance and the consequenc es for its pensions schemes; the Public Administration and Constitutional Affairs Select Co mmittee and Committee of Public Accounts, focusing on the lessons for government outsourcing more generally; and a hearing of the Liaison Committee (The National Audit Office, 2018). The ex amination of the company’s insolvency proceedings will provide valuable insights into fai led corporate processes, centered around faulty accounting practices and an acute lack of understan ding and management of risk by both Carillion Plc and the UK government. These are important less ons for CxO executives, construction managers, project managers, risk managers and advis ers. The company predominantly operated in low-margin in dustries within highly competitive markets with inherent risks (Chapman, 2018). A larg e element of Carillion’s contracts were government construction and facilities management c ontracts. The collapse was the most spectacular corporate failure in recent memory. The company was described by the House of Commons as “an unsustainable corporate time bomb, c haracterized by the increasingly reckless pursuit of growth with scant regard for long-term s ustainability or the impact on employees, pensioners and suppliers” (House of Commons, 2018). When considered holistically, the Carillion’s behav ior described in the following sections suggest a clear absence of operating boundaries bas ed on a risk appetite statement and associated risk metrics (Financial Times, 2018). Despite the e arly warning signs that the company was running into significant difficulties, the company either seemed to have a poor perception of the risk it was facing or consciously ignored it (Chapm an, 2018). It was not until the preparation of Carillion’s January 2018 transformation Group Busin ess Plan that there was recognition that the group had “weak operational risk management” (Caril lion Plc, 2018). The current study seeks to understand the gravity o f the situation by focusing on the following broad themes: • Carillion’s role in the market for government servi ces; • Timeline of events that led to the financial deteri oration of the company; • The UK Cabinet Office’s monitoring of Carillion as a strategic supplier; • The strategic intent of Carillion and its board mem bers, and their conduct; • The UK government’s response and contingency planni ng to Carillion’s request for support; • Identification of future Carillions in the making. The investigation assumes a non-evaluative approach and specifically abstains from forecasting the total cost to society or the excheq uer of Carillion’s liquidation against other possible outcomes. Since the annual financial recor ds for the year 2017-18 and 2018-19 are being currently marked to market, only records until the financial year 2016-17 are employed for analysis and representation at an organizational level. The inferences and commentary made is based on analyzing open records of interviews and public tes timonies of key personnel privy to the situation, 3 review of public records of published and unpublish ed data Carillion’s annual reports and announcements, data provided by Carillion to the Ca binet Office, data from financial analysts, data on suppliers to UK central government from the Cabi net Office’s Bravo system, commentary from the National Audit Office and data and information produced by the Official Receiver’s special managers as part of their management of the liquida tion. At times in this investigation, data from different accounting periods or prepared on differe nt bases have been combined based on the assumption of these being broadly comparable but la rgely irreconcilable. CARILLION & THE PUBLIC SECTOR: WHY THEY MATTER? When it collapsed in January 2018, it is estimated that Carillion had around 420 public sector contracts across central and local governmen t, NHS bodies, schools and others, which could be categorized as the following (The National Audit Office, 2018): • Support services, including facilities and energy m anagement, road and rail maintenance, accommodation and consultancy; • Public-private partnerships, including buildings an d infrastructure; and • Construction services, including building and civil engineering. Carillion’s annual financial report declares revenu e of £1.72 billion from the UK public sector for the calendar year 2016-17. Figure 1 depi cts the relative distribution of these contracts for the financial year 2016-17. Figure 1. Estimated value of UK public sector contr acted with Carillion in 2016-17 (Adapted from The National Audit Office, 2018) 4 Carillion’s annual financial report for 2016-17 dec lares that UK public sector revenue represented 33% of its £5.2 billion global revenue in 2016, and 45% of its UK revenue. In essence, the UK public sector represented the most reliable and important source of revenue for Carillion, and in loose terms, Carillion could be termed as an extended Public Sector Undertaking. Figure 2 depicts the relative distribution of Carillion’s se ctor specific revenues. The UK public sector revenue can broadly be observed to be at around 40% and steady over the last four years, although this business declined as a share of total revenue as Carillion’s global revenues increased. Figure 2. Distribution of Carillion contract types and values for the period from 2008 -16 (Adapted from The National Audit Office, 2 018) The Rise of The Private Finance Initiative (PFI): Launched by the ruling Conservative party in 1992, reeling under austerity measures and in a bid to revive the economy after a UK specific recession, the PFI was devised and employed by successive governments to enable the state to fu nd new public infrastructure without the government having to raise the money up front. It w as also envisaged that PFI would transfer construction risk of complicated infrastructure pro jects from the public sector to the private sector. The PFI is a distinctive form of procuring assets f rom the private sector, focused around the creation of a Special Purpose Vehicle (SPV) fun ded by private sector investors (The Public Administration and Constitutional Affairs Committee , 2018). The SPV is responsible for the financing, construction and maintenance of an infra structure asset. The SPV would ideally be expected to borrow from banks and others and contra ct with construction and facilities management companies to commission the asset. The p ublic sector would then be expected to pay back the SPV over the period of the contract (typic ally 25 to 30 years). This payment would cover the cost of the construction, the cost of the maint enance of the asset and the costs of financing the SPV . Not only this system of financing led to asset-liab ility mismatch fueled by short-term borrowing at high interest rates against long-matur ing assets, but also eventually grappled with the 5 power of compounding, dubious accounting standards due to budgeting and laxed accounting standards, tax evasion, asset monetization amongst others leading to much more expensive infrastructure projects than envisaged, in most cas es as expensive as 40% than regular contracts. Till date, more than 700 infrastructure assets valu ed at more £60 billion have been executed via the PFI, some of them still under construction, oft en involving other UK construction giants like Serco, Interserve, Mitie, G4S, Kier and Balfour Bea uty, most of them now increasingly showing signs of distress (Inman, 2018). The Business Case Around Carillion’s Public Sector Contracts: Carillion had smartly capitalized the PFI route to capture market share from less than 1% in the 1990s to gaining one-sixth of all UK public sector contracts by 2016-17 (The National Audit Office, 2018). This was built around a rosy busines s plan which targeted a net profit margin of 4.5% to 5.5% on such projects (Carillion Plc, 2018) . Advisers working for Carillion’s creditors found that its public sector portfolio, which cover ed Carillion’s service and facilities management contracts, was a profitable business, although it h ad become less profitable over time. Operating profit was forecast to reach £9 million in 2017, or 1.4% of annual revenue instead of the estimated £92 million! This was principally attributed to los ses and claims under litigation exceeding £242 million on 4 major projects: the Aberdeen Western P eripheral Route, Midland Metropolitan Hospital, Royal Liverpool University Hospital and H M Prison & Probation Service contract (Table 1). Table 1. Quantitative Analysis of Carillion’s main loss-making public sector contracts (Adapted from The National Audit Office, 2018) Sr. No. Project Expected loss for 2017, as identified by Carillion and its auditors (£m) (Carillion Plc, 2018) Comments/Reasons attributed for Loss (The National Audit Office, 2018) 1 Aberdeen Western Peripheral Route 91 A joint venture contract to design, build, finance and operate a new 58km ring road and associated infrastructure. The primary causes of the losses on the project included: • Project selection – the bid price was very low and there were not enough resources for the project; • Ground conditions – issues with water and peat that were not foreseen and needed more time to rectify; and • Oil pipelines – oil companies had to approve any changes to construction and areas of significant protection. 6 2 Midland Metropolitan Hospital 48 A PFI contract involved building a hospital and pro viding facilities management services for a 30-year term. The reasons for delays and increased costs included: • Critical design elements of the project were 17 mon ths late; • Structural designs were poor; and • Spatial constraints made it difficult to fit all th e plant • machinery necessary. 3 Royal Liverpool University Hospital 83 A PFI contract to build a new hospital, demolish an old hospital and build a car park. In addition to the construction contract, Carillion also won a 30-year facilities management contract from April 2015. The reasons for delays and increased costs included: • A 14-week delay when asbestos was identified; • Material delays to the design of the new hospital; • Structural deficiencies that required repair, due t o poor • design; and • A lack of due diligence undertaken before the construction work started. 4 HM Prison & Probation Service contract 12 A contract originally with the Ministry of Justice to provide facilities management services in 52 public sector prisons in England and Wales. The reasons for cost escalations included: • It being a ‘first generation’ outsourcing contract; and • Inaccurate tender assumptions. RISK MANAGEMENT AT THE GOVERNMENT LEVEL In 2011, the UK Cabinet Office had introduced a ne w strategic supplier management approach, aimed to ensure suppliers fulfill their c ontractual obligations to the central government and that envisaged levels of public service standar ds are maintained. Strategic suppliers, of which there were then 27, were shadowed by 16 crown repre sentatives (normally part-time senior officials with a commercial background), often supp orted by partnership managers (senior civil servants) and who met once every 6 weeks to discuss the performance of each strategic supplier and assigned each a risk rating per the guidelines established in the Strategic Supplier Risk Management Policy (ratified in November 2012) (UK C abinet Office, 2012). Figure 3 depicts this process and how risk management was undertaken. Carillion’s Risk Management as a Strategic Supplier : Figure 4 depicts the risk ratings as allocated to Carillion, Plc from 2012 through to 2018. Carillion’s risk ratings were changed several times even before 2017, due to the following recurrent concerns: 1. Delayed payments to suppliers : Under the Public Contracts Regulations 2015 publi c sector buyers must pay prime contractors within 30 days an d must ensure that their prime contractor includes equivalent 30-day payment terms in any sub -contracts through the supply chain (The 7 National Audit Office, 2018). Carillion reported th at, on average, it was paying its suppliers 45 days after the invoice date for most months duri ng the period 2012-2017, while almost one third of invoices were paid more than 60 days later . Figure 3. UK Government Strategic Supplier Risk Man agement Policy (Adapted from UK Cabinet Office, 2012) 2. Poor performance on key contracts : Carillion’s risk rating was green for most part b etween August 2013 and January 2016. In February 2016 it i ncreased to amber, following poor performance on a Ministry of Defence facilities man agement contract esp. the HM Prison and Probation Service contract (The National Audit Offi ce, 2018). As stated earlier, the Cabinet Office monitored Car illion’s financial health as part of its strategic supplier management and flagged Carillion ’s increasing debt and pension liabilities in the first half of 2017. Carillion’s serious financial d ifficulties were subsequently substantiated by the second half of 2017, when Carillion issued a profit warning on 10 July 2017, followed by another with its half-year results on 29 September 2017. The size of the profit warning of 10 July 2017 came as a surprise to the Cabinet Office as it severely contradicted both the information and c ommentary Carillion had given it up to that point; the publicly available financial information that the Cabinet Office employed for fact checking and the expectations of the capital market (UK Cabinet Office, 2012). While the Cabinet Office spoke to Carillion on 11 J uly to discuss the bizarre profit warning, it subsequently increased its contact with Carillion over the next few months and by December it spoke to the company nearly every day i n a bid to enhance contingency planning in case of a possible failure (The National Audit Offi ce, 2018). 8 On 17 November, Carillion announced that by the end of the year it expected to breach the terms on whi ch it was lent money and had made cumulative provisions totaling £1.1 bi llion by the end of 2017, towards future losses. Figure 4. Risk ratings allocated to Carillion from 2012-2018 per the Strategic Supplier Risk Managemen t Policy (Adapted from UK Cabinet Office, 2012) 9 THE INEVITABLE COLLAPSE: A TIMELINE Post the surprise 10 July 2017 profit warning, the UK Commons Office inducted 8 Cabinet Office and UK Government Investments officials as Carillio n ‘insiders’, forcing Carillion to grant them access to financial statements and proprietary info rmation needed for a forensic analysis, resulting in the re-evaluation of key facts. A timeline of th e resulting events is depicted in Fig 5. Figure 5. Timeline of Important Events affecting Ca rillion, Plc during 2017. (Adapted from The National Audit Office, 2018) 10 PREVENTING CONTAGION: CONTINGENCY PLANNING Post the surprise 10 July 2017 profit warning, the UK Commons Office inducted 8 Cabinet Office and UK Government Investments officials as C arillion ‘insiders’ to ensure greater transparency in exchange of and for access to vital information, apart from helping monitor the situation on a day to day basis. Between July and December 2017, Carillion’s financi al situation continued to worsen. Prima Facie, a number of reasons could be attribut ed for this, including a hardening of attitudes among lenders, leading to withdrawal of existing li ne of credits and other lending facilities; tougher and harder negotiation tactics from an increasing p osition of strength exercised by potential suitors and existing customers of Carillion’s assets leadin g to delay in cash flow realization along with increasing cases of below fair market value realiza tion; and suppliers who wanted shorter payment terms (<30 days) for continuation of services (UK C abinet Office, 2012). UK Parliament, the Lenders and Carillion’s Business Audit: The 8 Cabinet Office and UK Government Investments officials, termed as Carillion ‘insiders’ inducted on 11 July, started to enhance government contingency plans for the possible failure of Carillion on 20 July. Acting swiftly, th e UK Commons Office appointed law firm Dentons on 24 August to advice on legal aspects of the contingency plans for the anticipated liquidation of Carillion, Plc and its subsidiaries (UK Cabinet Office, 2012). The Coordinating Committee of the UK Cabinet Office and the Lenders had commissioned FTI Consulting to produce an independent business r eview of Carillion in October 2017. This review remained in draft form as it was still subje ct to agreement with Carillion’s management, and hence was never shown to lenders or the Cabinet Office. The bone of contention was FTI Consulting’s analysis of Carillion’s capacity to wi n future business and the profit margins achievable, which Carillion’s management vehemently opposed and believed was too pessimistic and overstated Carillion’s capital needs. This draf t established the following inferences (FTI Consulting, 2017): • Carillion’s true past trading position and cash gen eration reporting were dubious, because of Carillion’s focus on enhancing the reported leve l of profitability and net debt; • Management notoriously concentrated too much on sho rt-term profitability at the expense of long-term viability; • Carillion’s dubious trading position and aggressive procurement had jeopardized liquidity, and most of £140 million of emergency funding, with sensitivity analysis indicating a shortfall of £495 million in just the emergency fun ding by August 2019, a 3 folds increase; • Additional lending or capital infusion was deemed h ighly risky while the extensive pension liabilities remained an overhang; • Carillion’s business plan was too optimistic about uncertain items such as disputed claims against customers or other contractors, and the wil lingness of private sector customers to give Carillion building work in the short term; Since July 20, the UK Cabinet Office had been persu ading Carillion to do its own contingency planning. However, Carillion explained to the Cabinet Office that given the complexity of the business, its apparent immediate focus on successful restructuring and a lack of funds, it was unable to do meaningful contingency p lanning (The National Audit Office, 2018). 11 Instead, Carillion recused itself and engaged Ernst & Young(EY) for contingency planning in November 2017. Post the second profit warning, as a last resort on its part, the UK Cabinet Office appointed PricewaterhouseCoopers(PwC) on 17 September to advi se on contingency planning and dealing with the consequences of Carillion’s insolvency. Th e Cabinet Office, with the help of PwC, undertook an options analysis at the beginning of J anuary to decide whether to support Carillion. Over the course of a week, working with the Cabinet Office and HM Treasury, PwC produced high-level estimates of the costs of each option on a ‘rough order of magnitude’ basis. Both the consultants ultimately looked at two scenarios in s ome form or the other: liquidation; and the carving out of parts of the company for sale, with liquidation for the rest (The National Audit Office, 2018), with the possibility of extracting j ust 7 pence worth of value for every pound of lenders capital! Contingency Planning post the Second profit warning : On 20 July 2017, the UK Cabinet Office called toget her Carillion’s customers in central government departments and asked them to provide in formation on their contracts, including whether they had contingency plans, in the event of a collapse. Following Carillion’s second profit warning, on 29 September 2017, the Cabinet Office a gain asked for revised contingency plans for key central government contracts and set 17 Novembe r as the deadline for submitting contingency plans, covering legal, financial and operational op tions on a contract-by-contract basis (The National Audit Office, 2018). Ultimately, the Cabinet Office received 65 continge ncy plans (corresponding to an equal number of active projects) from 26 public bodies an d in consultation with PwC and EY , pegged the estimated cost of contingency anywhere between £233 million and £678 million depending on how the following were accounted for: • Termination payments to Carillion; • Loss of productivity and degradation in level of se rvice owing to transferring responsibilities to new providers; • Anticipated increase in staff costs, including mana gement time; • Cost of Re-procurement; • Higher prices and Premiums of alternative providers ; • Purchase of new IT infrastructure with no pricing p arity; • Cost of legal and insurance services. LEARNINGS & CONCLUSION Though the UK parliamentary investigations and UK C abinet Office inquiries referred to highlight a number of failings in management practices esp. i n the science of risk management and corporate governance, Carillion only exacerbated the situatio n by curating a portfolio in highly competitive markets where margins are notoriously low. This case study though trying to piece the differen t pieces of this story scattered over an extended timeline, has not attempted to record every aspect of Carillion’s debilitating company behavior. Carillion’s fall from grace can be principally attr ibuted to failed corporate governance, obfuscated construction contracts and a general sense of negle ct towards risk management with the following aspects playing second fiddle: 12 • Much of Carillion’s growth was achieved through acq uisition, backed by questionable amounts for “goodwill”. When Carillion tanked, all the accumulated “goodwill” was ultimately reduced to zero; • Well into 2010, Carillion adopted what has been ter med ‘aggressive accounting’, a practice of declaring revenue and profits based on optimisti c forecasts, before the profits have been realized (Chapman, 2018), a fallacy in the science of accrual-based accounting practice. Not only this need the future forecasts to be accur ate but also to come true eventually, no of which unfortunately happened; • This aggressive accounting led to inflated dividend distribution. In the five years from 2012 to 2016, Carillion paid out £63 million more in div idends than it generated in cash from its operations, an absolute no-brainer! • Carillion’s true past trading position and cash gen eration reporting were dubious, because of Carillion’s focus on enhancing the reported leve l of profitability and net debt; • Management notoriously concentrated too much on sho rt-term profitability at the expense of long-term viability; • Carillion’s business plan was too optimistic about uncertain items such as disputed claims against customers or other contractors, and the wil lingness of private sector customers to give Carillion building work in the short term; • Carillion lacked integrated Management Information Systems and management (at most levels: lower, mid and senior) lacked adequate fina ncial information to manage the business. (FTI Consulting, 2017) Carillion’s lender s found the “presentation and availability of robust historical financial informa tion”, such as historical unit prices, cash flows and profitability, to be non-existent or bogu s; • Carillion vehemently rejected opportunities to inje ct equity into the growing company and instead adopted a debt laden spending spree. Over t he eight years from December 2009 to January 2018, Carillion extended its borrowing from £242 million to an estimated £1.5 billion more than five times the value at the begin ning of the decade i.e. a CAGR of 40%; • Carillion’s board ever since its existence were sup ported by, rather reliant on the Big 4 of the accounting worlds: Deloitte, PwC, EY and KPMG a s Carillion’s internal auditors or in an equivalent capacity. Though the role of such int ernal auditors was to provide a review of and assurance that an organization’s corporate g overnance, internal control and risk management processes are operating effectively (Cha pman, 2018), seldom was this observed with the Big 4. They seemed to wake up to the gravity of the situation only when the UK Cabinet Office stepped in; • The UK Government’s monopoly and transfer of risk t o the private sector, gave it considerable negotiating power as the only buyer in the markets that Carillion operated in. Not only did the UK government stipulate the risk t o be absorbed by bidders, set prices and standards of quality, but also grossly misunderstoo d the cost of services they sought and hence had a general attitude of denial towards chan ge orders (At the time of liquidation, Carillion had in excess of 3,500 change orders pend ing on just the HS2 project); • Carillion’s dubious trading position and aggressive procurement had jeopardized liquidity, and most of £140 million of emergency funding, with sensitivity analysis indicating a shortfall of £495 million in just the emergency fun ding by August 2019, a 3 folds increase; • Additional lending or capital infusion by both the UK government and potential suitors was deemed highly risky while the extensive pension liabilities remained an overhang; 13 Already baffled by the humanitarian and social cris es of Carillion’s collapse, the UK government has rejigged its Strategic Supplier Risk Management Policy in 2019 to apply the learnings from Carillion’s liquidation and pre-empt future collapses. As of the first quarter of 2019, a few major contractors have started depicting tren ds reminiscent of the events before Carillion’s first profit warnings. These contractors are Kier and Eiffage, who have be en picking up the slack on the HS2 behemoth post Carillion’s exit. Both contractors ar e reeling with limited cash flow visibility and have followed similar aggressive accounting procedu res as followed at Carillion, with speculation rife about having already partially booked profits until FY 2022 on a few key accounts in their current and past balance sheets. Interestingly, Car illion’s demise has negatively affected Balfour Beatty, the UK’s largest construction firm, which e xpects to take a £45m hit just from the Aberdeen Highway contract.