Since Carillion PLC’s unexpected liquidation in last January, fallout from the news has rattled Britain’s construction industry and put the hundreds of companies that worked with Carillion at risk. While many smaller suppliers have been taken to the brink by Carillion’s collapse, on March 23rd, it was reported that Vaughan Engineering was set to be Carillion's first major supply chain casualty. Fast-forward another two months, and Vaughan Engineering's failure left unpaid subcontractors and suppliers with bills totaling more than £9m.
Construction is the most outsourced sector in the UK and Carillion outsourced 90% of its business. When Carillion, the second largest construction company in the UK, buckled under the weight of a whopping £1.5bn debt pile, the collapse had significant impact on the entire construction industry as many feared a domino effect amongst Carillion’s third-party network. How did this happen? And, more importantly, could Carillion’s suppliers, lenders, customers, and partners have potentially seen it coming in time to act?
Three consequences of Carillion's collapse
The effects of Carillion's failure have been be felt by investors, lenders, and suppliers alike. Here are three examples of the devastation Carillion left behind:
- Carillion’s collapse left almost £1 billion of debt, more than £500m of pension deficit, and nearly 30,000 unpaid subcontractors.
- After liquidation, Carillion ceased making payments to the banks, leaving suppliers with unsecured loans that belong to them, not Carillion. This unexpected consequence comes in addition to losing a key client.
- Banks were left with massive exposure, specifically Royal Bank of Scotland (RBS), Santander, Lloyds, Barclays, and HSBC. HSBC has already reported a $500 million hit in loan impairments due in part to Carillion.
Rapid expansion & complicated supply chain financing
Following the financial crisis when work was scarce, Carillion aggressively went after public sector contracts, often underbidding, to keep cash rolling in. Many contracts were commissioned under the Private Finance Initiative (PFI) in which contractors pay the cost of building up front while the government repays them over several decades. The contracts that Carillion underbid for had low margins to begin with, forcing the company to accumulate large amounts of debt. Several of those projects also came with unforeseen costs down the road, particularly three public sector projects (Liverpool & Birmingham Hospitals and the Aberdeen bypass) that hit snags at the same time and prompted management to liquidate.
To add to the complexity, most of Carillion’s contracts were subcontracted out to other companies. In order to ensure it could pay creditors and flatter its own cash flow, it committed to a Supply Chain Finance scheme, or “Early Payment Facility” (EPF) in 2012. This agreement allowed Carillion’s smaller suppliers to access credit more easily; banks sent invoice payments to the supplier earlier than the payment terms, knowing payment was coming from the larger company. Essentially, this immediate advance of payment by the banks was cheap debt that would only be discharged when Carillion made its payment. Within six months of starting this initiative, Carillion extended its standard payment terms to 120 days, meaning EPF was the only way to get payment earlier than that, drawing in more suppliers and getting banks like HSBC further exposed to Carillion credit.
Was Carillion’s fate foreseeable? Financial health as a key risk indicator
The only key risk indicator (KRI) that foretold Carillion’s fate before the consequences of its practices caught up with the company was overall financial health. After a catastrophic write down of an eventual £1 billion after S1 2017 earnings because of the two hospitals and bypass projects, Carillion’s Financial Health Rating dropped drastically – from an FHR® of 61 (Low Risk) down to 23 (High Risk) – four months before liquidation. Even without reading the tea leaves from Carillion’s expansion and financing practices, the 38-point drop in Carillion’s FHR prior to collapse signaled there were extreme problems at the company that required answers. Anyone working with Carillion needed to take immediate action to mitigate their own risks. For a closer look under the hood of Carillion’s financial health, download the company’s Financial Health Rating report here.
In a very competitive industry with many shared key suppliers, Carillion’s collapse and financing scheme will place a huge burden on suppliers’ shoulders. The UK construction industry wasn’t very financially strong to begin with; the average FHR is 40.5, (0-100 scale on which a rating below 40 is High Risk). According to Supply Chain Dive, “there is the potential for major industry disruption, and one bankruptcy or liquidation could drag the whole system down.” A volatile market creates even more obstacles for the companies in this industry, which is why managing the risk of your supply chain is so critical.