We have dedicated quite a bit of article time and space to the challenges that clients of Carillion have experienced over the last few months. We have published other articles focused on the NAO report into the handling of the company’s liquidation, the inherent risks of rushing towards step-in providers, and how to protect your interests should your supplier not be able or be unwilling to continue providing your services. We believed we were all Carillion’d out, but then we came across an article by Martin McCloskey, ex Group Counsel for a FTSE 50 organisation. This reflected some ‘root causes’ of the Carillion situation that we felt would be good to share so you can add the lessons into your due diligence process.
McCloskey has more than two decades of board-level experience for numerous companies. Today he is a civil and commercial mediator for the internationally recognised ADR Group which specialises in alternative dispute resolution. And there certainly were a lot of disputes that required resolution when Carillion’s collapse dealt such a heavy blow to the 25,000 to 30,000 businesses which were reportedly owed over a billion pounds by the organisation at that time.
Carillion’s Collapse: Reflecting on McCloskey’s View of the Root Causes
McCloskey’s article was an insightful view of some of the root causes of Carillion’s collapse. We have reflected below his key conclusions so that you can build these key principles into any future supplier due diligence process where complex service delivery is concerned:
Mutuality of Obligation
We have written at length about the need for suppliers and clients to act as ‘Intelligent Suppliers’ and ‘Intelligent Clients’. The objective is that each party executes its duties and recognises its responsibilities to the other in such a way as to see the project and its outcomes through to a successful conclusion. Joint behaviours should require the parties to consider and support the needs of the other (at procurement and beyond) and then to work collaboratively to achieve best results. This is the essence of what McCloskey was expressing in his article, with the implied question mark over whether Carillion and/or its suppliers acted in this way and whether this could have impacted on their ability to produce a viable bid.
Public Sector and Construction Industry Procurement Practice
Mistakes happen. Suppliers can make an error or take a strategic stance to win market share and bid low. However, in the case of Carillion, it is reported that a culture seems to have been created that encouraged a ‘race to the bottom’ on price. With public sector budgetary constraints it can be tempting for government agencies to set out their bidding selection criteria to make price their predominant focal point, to go for the lowest bid and cut corners on a true assessment of the suitability of the supplier to deliver on their procurement bid promises. Far from helping the situation, McCloskey suggests that: “Public procurement regulations can exacerbate tender evaluation and supplier selection.” Carillion may have been the sixth large government contractor, owning around 420 contracts in the public sector, but its profitability varied wildly. Some contracts made money, others broke even, but far too many lost money, sometimes considerable sums, according to the NAO report into Carillion.
Private Finance Initiatives (PFIs)
PFIs, also much in the news recently, are designed to transfer commercial and fitness for purpose risks to the parties most able to deal with them. In the case of the public sector, this is often seen as the risk being borne by the private sector. The primary reason for this is due to the potential for “project scope creep and unforeseen project overruns”. In other words, what may have started out for the supplier as a low-margin contract may all too easily end up costing it dearly. The winner in this scenario is usually the company financing the PFI and its co-shareholders. Poor collaboration between supplier and client, errors in calculations at bid stage, a race to the bottom on pricing, and an increase in commercial and fitness for purpose risk is a recipe for very poor outcomes for all involved.
Cash Flow and Working Capital Requirements
The risks of overruns and scope creep, as well as the many other factors that often stretch already limited resources, usually impact on the profitability and, more importantly, cash flow of a supplier’s business. “Simply servicing debt can become a massive burden on the trading of a company seeking to work within its banking covenant tests and juggling operational income and expenditure.” And we know that for some time this is exactly what Carillion was reportedly suffering from; and, in all likelihood, more and more work was taken on in an attempt to dig the company out of its debt.
If a company finds itself in a position where profits are lower than expected or where costs are rising beyond expectation, it could decide it needs more funds quickly. “This can lead to sales teams being given ‘must win’ tender targets that can exacerbate the problem of bid price cutting.” Which in turn is likely to lead to more unprofitable selling decisions being made.
Projects vs Outsourcing Term Contract
As outsourced contracts often last for 25 years or more and involve numerous subcontractors, any small errors in cost calculations at bid stage could result in the supplier having to “suffer the multiplier effect of any pricing errors in an outsourcing contract for its entire term”.
Governance and Management
Even the best organisations can buckle under the immense pressure of running an international business the size of Carillion. Against a backdrop of multiple profit warnings, rising debts, share value freefall, numerous projects in many different countries and all the complexities this brings to the process, it would be no surprise if mistakes were made, errors missed and opportunities to turn aspects of the business around fail to materialise.
McCloskey’s article pulls together all the threads that seem to have unravelled in the last year of Carillion’s existence, the lowball bidding for projects, the volume of projects bid for even after profit warnings were announced, the low margins and the dropping of the management ball which seems to have allowed the company to miss its way. While we all have a degree of ‘hindsight’, there appears to have been a series of preventable errors in practice that led to the eventual ending of this construction giant. Could the business have been turned around at an earlier stage? It’s likely that the time for this would have passed long before the first warning bells rang. I’d highly recommend reading the article that inspired ours – Carillion: Root Causes by Martin McCloskey.
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