Carillion: unhappy in its own way

Carillion filed for compulsory liquidation on Monday, prompting floods of columnists to rush to display their hours-old knowledge of the UK outsourcing sector and denounce the firm’s borrowing strategy. But what the case proves is that each collapsing company is unhappy in its own way.

  • By Owen Sanderson
  • 16 Jan 2018
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When a company is forced into any variety of insolvency, debt is a problem. If a 100% equity-financed company manages to go bust, there was probably no viable business there in the first place. Not being able to pay one’s debts is more or less the definition of insolvency.

But debt isn’t always the primary cause of corporate troubles, and it wasn’t at Carillion, despite screaming headlines about a “debt pile”, “huge debt”, and a “debt-laden balance sheet”. 

For plenty of restructured firms — Punch Taverns, Phones 4u would be two examples — heroic leverage levels cooked up in the corporate finance lab have a lot to answer for. 

But for Carillion, not so much. Its published total debt to Ebitda was between 3x and 4x for 2014 and 2015, ticking up over 4x (making it, according to the European Central Bank and the US Federal Reserve, a leveraged company) by the end of 2016. The company also had plenty of cash on hand for most of the period, meaning net debt to Ebitda looked very manageable ahead of its profit warning.

Debt (total or net) to Ebitda is a crude, flawed measure of corporate health and vulnerable to manipulation. Contracting companies such as Carillion may carry debt at the level of individual projects or ventures, flattering metrics at group level, for example. But if there was an “early warning” ahead of the firm’s July 2017 profit warning, it wasn’t the size of the “debt pile”. 

The company noted it was “well within” its 3.5x net debt to Ebita covenant at the end of H1 2017.

The big news from Carillion’s July warning was not on the liability side of the balance sheet at all; it was a large provision on the asset side of £845m. This was split between £375m for the UK, £325m in the Middle East and a further £145m. At the time, the company’s net debt was £695m, with total available UK borrowing of around £1.5bn.

There is no need to make the story more complicated than it appears.

Even a company with a perfectly manageable debt burden will get into trouble if its assets are worth far less than it thought. It is not so much the level of debt, as booking a provision larger than net debt in a single half-year, that brought Carillion down.

The firm’s management certainly need their feet held to the fire on how this writedown materialised seemingly from nowhere. 

Fulfilling government contracts isn’t supposed to involve guesswork and wild volatility. The public, employees and suppliers of the stricken firm deserve to know who knew what and when. The FCA is already investigating, and there will be another investigation from the government soon.

Management flop

But Carillion’s problems look like a clear failure of management, not something intrinsically wrong with its corporate financing approach. If a firm’s executives are unable to plan for a huge devaluation of its assets, what chance do its suppliers or creditors have, let alone the government?

This ought to matter to bankers, regulators and risk managers, because the rules for bank lending and capital are increasingly starting to assume that debt really is the main thing that matters.

In the US, the Federal Reserve and the Office for the Comptroller of the Currency have long had their leveraged lending guidelines in place and were joined by the European Central Bank in December. 4x total debt to Ebitda counts as leveraged, 6x total debt to Ebitda is too leveraged, and regulated banks should steer clear.

The Basel Committee, too, is in on the action. It suggested revising standardised risk weights for corporates using leverage measures in 2015, though it dropped the plan in 2016, proposing to use credit ratings instead.

Debt metrics certainly matter to companies, and to credit risk, and they’re a good place to start. The more leveraged a company, the more fragile it can be, and lenders are usually commensurately more cautious. Regulators ought to follow.

But the Carillion affair shows there are no easy answers. Certainly lenders ought to do their due diligence before opening their chequebook, but there’s a limit to what they can possibly uncover. Financial metrics, meanwhile, can be nothing more than a vague guide: a dashboard that flashes when more questions should be asked.

The firm’s woes are those of a tough industry, management failure, simple bad luck, and too much debt to wriggle out of its problems. But the debt was probably the least of those problems.

  • By Owen Sanderson
  • 16 Jan 2018

All International Bonds

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5 Deutsche Bank 43,665.36 159 5.39%

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5 BNP Paribas 1,798.71 8 4.40%

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