Written evidence from Professor Colin Haslam and Dr Nick Tsitsianis[1] (LCC 29)
Public Administration and Constitutional Affairs Committee
Sourcing public services: lessons to be learned from the collapse of Carillion inquiry
STRESS TESTING OUTSOURCING COMPANIES USED BY THE UK GOVERNMENT
Contents
Responses to the Carillion Collapse
Financial characteristics of the corporate outsourcing business model
Key financial operating characteristics: stress testing large corporate outsourcers
Background
UK Governments have sought to generate value for money (VFM) and transfer risk from outsourcing the construction of infrastructure assets, facilities and services management to private sector companies. The arguments supporting this strategy have been that contracts with the private sector will generate savings and efficiencies and that risk can be transferred from the public sector to private sector. The UK Government now spends roughly £200 billion of taxpayer’s funds to service these contracts annually.
The advocates of outsourcing view contracting out as a way to reform public services, improve efficiency and generate value for money. Outsourcing contracts are routinely announced in the press along with the claim that millions will be saved. However, the extent to which these contracts are delivering value for money and reducing costs is difficult to assess because contract details are generally withheld on the grounds of commercial confidentiality.
A further complication is that local and national government agencies are contracting with outsourcers that consolidate many contracts into portfolios. These are often large conglomerates or specialist firms, some of which are British companies, others subsidiaries of foreign multinationals or private equity holding companies. This accumulation of many contracts within a few large firms forces national and local government agencies into a dependency relationship because they no longer have the operating capacity to deliver public services. This dependency is reinforced because many outsourced contracts are for the provision of foundational economy services such as health, adult care, social welfare, and household waste management that are essential for a civilised life and need to be sustained into the future (Haslam, 2015).
Responses to the Carillion Collapse
The collapse of Carillion on the 15th January 2018 drew attention to the stability and viability of large companies that bundle up many contracts for infrastructure and services provided for central and local government agencies. Serco’s[2] Group Chief Executive, Rupert Soames, reacted to the collapse of Carillion by arguing for a new set of ‘guiding principles’ to govern the contractual relationship between Government and corporations managing public sector contracts (Serco: Stock Exchange Announcement, 2018). These are summarised below:
We should strengthen transparency in public contracting. This means that for large contracts for public services, which are not commoditised, which do not impinge on National Security, and which do not include significant amounts of intellectual property, the presumption should be in favour of open-book accounting, in which the Cabinet Office and National Audit…... We call this the “Transparency Principle”.
Both suppliers and the Government should have the right, on payment of an agreed break fee, to exit a contract at pre-determined intervals. We call this the “Orderly Exit Principle”. The purpose of this is to give both Government and supplier the ability to exit contracts which are not working out as intended.
Suppliers of sensitive contracts should be obliged to lodge with Government a “living will”, being a set of arrangements to facilitate the transfer of a contract back to Government or to another supplier if required. This would significantly reduce the operational risk to Government of supplier failure. This is the “Security of Supply Principle”.
Government and suppliers should agree to abide by a mutually-agreed code of conduct, which would set out expected standards of behaviour from Government and its contractors. This would involve the Government agreeing not to impose punitive or unfair terms and conditions or transfer unmanageable state risk; and suppliers would agree to maintain certain metrics of financial stability; pay their sub-contractors in a timely fashion; and adequately fund their pensions…… We call this the “Fairness Principle”.
The first three of these ‘guiding principles’ focus on managing an open and orderly ‘contractual’ relationship between Government and the private sector. The fourth principle the ‘fairness principle’ sets up the need for a broader reform to the governance arrangements surrounding contracts established between Government and outsourcing provider(s). On the one hand this would involve companies offering to maintain financial stability, pay contractors on time and adequately fund pensions. On the other it would require the UK Government to agree ‘not to impose punitive or unfair terms and conditions or transfer unmanageable state risk’
These principles are primarily focused on managing ‘contracts’ and modifying ‘governance’ arrangements surrounding these contracts.
Evidence presented at the Work and Pensions Carillion inquiry has attempted to broaden out the issues surrounding the demise of Carillion specifically how the company was managed and the role played by auditors and other agencies in terms their understanding of ‘what went wrong’. In this committee the chair compared it to the challenge of solving of a crime mystery ‘We will certainly channel our inner Agatha Christie to try to solve the mystery of what happened at Carillion’ 7th March 2018. Those giving evidence have generally focused on events in the months leading up to the final collapse. The Chair Work and Pensions Carillion inquiry observing that:
This is the seventh evidence session we have had now into Carillion and what happened and I think this is the first session where anybody has suggested that there was anything wrong in the business before March 2017. That has been quite refreshing, certainly for me and I expect for other members of the Committee
Although considerable evidence has been presented on what went wrong at Carillion. There is a missing ingredient. This we believe is the need to present a summary of the business model that describes the financial activity characteristics and viability risks associated with companies servicing government contracts.
Financial characteristics of the corporate outsourcing business model
The financial operating characteristics of the outsourcing business model can be framed using financial disclosures from annual report and accounts. This approach:
Focuses on mapping out key underlying operating financials (income, costs structure, earnings surplus and cash distribution) and the nature of balance sheets capitalisation. This information can then be employed to assess the extent to which earnings and asset valuation risk(s) pose a threat to business model viability in terms of liquidity and solvency.
Generates key performance indicators relating to: cost structures, cash earnings and its distribution, and balance sheet accumulation ratios for outsourcing companies. These are then benchmarked against the FTSE 100 group to reveal similarities and differences.
Reveals the nature of operating and balance sheet risk characteristics in the corporatized outsourcing business model and forms the basis of a stress testing framework that benchmarks individual companies against the FTSE 100.
A financial analysis of the corporate outsourcing business model reveals high levels of exposure to both: liquidity and insolvency risk
Cash and profit margins extracted from sales are thin and fall well below a FTSE 100 benchmark average.
Weak margins are, however, converted into relatively high returns on equity and capital employed[3]. This we note is explained by outsourcing companies being relatively undercapitalized when compared to the FTSE 100 average benchmark.
The share of cash distributed to pay dividends, fund share buybacks and finance growth through acquisitions is somewhat higher than the average FTSE 100 company
If cash margins are already thin excessive distributions to shareholders leaves a wafer thin cash residual to soak up adverse changes to working capital from onerous contracts. It’s a business model with a high ‘liquidity risk’
Acquisitions supercharged growth in revenues but this had an adverse impact on balance sheet capitalization inflating goodwill and exposure to onerous contracts.
A deterioration in contract income streams will generate asset impairments such as goodwill and contract valuations. These impairments are expensed against shareholder equity reserves. In the outsourcing business model, these shareholder reserves are a weak defence. It’s a business model with high risk of insolvency.
Key financial operating characteristics: stress testing large corporate outsourcers
To illustrate why the corporate outsourcing business model has a high ‘liquidity’ and ‘solvency risk’ we examine the key financial operating characteristics for: Serco, Capita, Carillion and G4S.
These financial metrics are also benchmarked to the FTSE 100 group of companies to generate an understanding of similarities and differences.
This provides the foundation for a stress testing model that starts with the key operating margins in table 1 benchmarked to the FTSE 100
Apart from Capita Serco, Carillion and G4S operate with thin cash and net income margins. But all these companies are able to convert relatively thin operating margins into very strong returns on equity and capital employed when compared to the FTSE 100 average.
Table 1: Corporate outsourcer margins
Cash margin is Earnings before interest tax and depreciation (EBITDA) to total revenue
The NI margin is net income after dividends and tax to total revenue
Cash return on equity is EBITDA divided by total shareholder equity and cash return on capital employed is EBITDA divided by capital employed (long-run debt plus total shareholder equity)
FTSE benchmark is average for years 1998 to 2017, Serco 1993 to 2017, Capita 1993 to 2017, Carillion 1998 to 2016 and G4S 2003 to 2017
The capacity of corporate outsourcers to lever up thin operating margins into relatively high returns on equity and capital is explained by the relatively low level of capital: shareholder equity and long-run debt which is required to generate a financial unit of revenue (Table 2).
The major corporate outsourcers invest £24-£42 to generate £100 of revenue compared to the average FTSE 100 that invests roughly £100 of capital to generate £100 of revenue.
Table 2: Corporate outsourcer capital intensity
Capital intensity is how much shareholder equity and long-term debt is employed to generate a financial unit of revenue. Total capital intensity is shareholder equity and long-term debt employed to generate revenue.
It has been claimed that the major outsourcers have distributed a greater share of their profits to shareholders.
Corporate outsourcers do generally distribute more of their cash from operations compared to the FTSE 100 benchmark group
This leaves corporate outsourcers with a very slim residual cash margin, after distributions to shareholders, to finance working capital (table 3)
Table 3: Cash distribution by corporate outsourcers
Cash distribution is the average share of cash from operations (EBITDA) paid out to shareholders as Share Buy backs, Dividends and Cash Acquisitions. FTSE benchmark is average for years 1998 to 2017, Serco 1993 to 2017, Capita 1993 to 2017, Carillion 1998 to 2016 and G4S 2003 to 2017
Major corporate outsourcers face a persistent ‘liquidity’ risk.
Residual cash from operations, after distributions to shareholders, is wafer thin and this working capital easily compromised if there are adverse changes in receivables and payables on contracts. Repairing working capital involves putting pressure on suppliers -delaying payments- and/or bringing forward receivables such as factoring these out.
Table 4: Shareholder equity reserves and goodwill risk in major corporate outsourcers
We have taken the latest end year for the FTSE 100 group of companies that report goodwill, total assets and shareholder equity. Also the latest year’s disclosures for the corporate outsourcers.
Major corporate outsourcers face a persistent solvency risk.
A deterioration in earnings from contracts will increase the probability of asset value impairments because these are based on the value of present and future estimates of cash earnings.
Goodwill impairments and / or adverse contract valuations will be expensed against shareholder equity reserves.
Corporate outsourcers operate with thin equity reserves relative to the value of goodwill and contract assets. If these asset values are impaired equity reserves may be insufficient to prevent insolvency.
Capita, for example, has made adjustments to the value of contract receivables and payables and this significantly eroded shareholder equity reserves. After this adjustment the ratio of goodwill to shareholder equity now stands at a very high ratio of 6:1. This means that just a 15% impairment of goodwill would completely wipe out shareholder equity.
Secro has not been immune to asset value impairment risks. In 2014, making an asset write down of roughly £1.3 billion that was made up of: onerous contracts £447.1m, a £504.6m impairment of goodwill and intangibles and the balance an impairment of £347.3m for other charges. In just one year shareholder equity reserves moved from a positive £1.1bn to a negative £66 million.
Summary
The outsourcing of public sector contracts with private sector corporate outsourcers promised value for money and a transfer of financial risk. The central objective has been with assuring that Government agencies are sustaining value for money from outsourcing contracts. Less attention has been paid to the financial viability of the large corporate outsourcing business model. These companies are governing institutions in their own right. But the accumulation of many contracts within a few large company’s forces national and local government agencies into a dependency relationship because they no longer have the operating capacity to deliver public services. This dependency is reinforced because many outsourced contracts are for the provision of foundational economy services such as health, adult care, welfare, and household waste management that are essential for a civilised life and need to be sustained into the future (Haslam, 2015).
It is now essential for Government to stress test the financial viability of companies that are responsible for the provision of infrastructure and services that support the UK’s foundational economy.
The financial viability and sustainability of the large corporate outsourcing business model has been severely tested after the collapse of Carillion.
The corporate outsourcing business model operates with wafer thin residual cash margins such that changes in receivables and payables from ‘onerous’ contracts could quickly compromise liquidity.
The corporate outsourcing business model operates with thin shareholder equity reserves. These reserves are weak defence against adverse trading income and asset impairments triggered by ‘onerous’ contracts and not a strong buffer against insolvency.
April 2018
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