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Reforms needed a year on from Carillion to make supply chain viable

Out-Law Analysis | 05 Feb 2019 | 2:13 pm | 7 min. read

ANALYSIS: A year on from the collapse of construction giant Carillion the effects are still being felt and we should not rule out the possibility of another construction company of this scale going out of business.

The fallout from Carillion going into liquidation has been enormous: companies in the supply chain have continued to go out of business; banks' measures to make more funding available have had a limited impact to date, and lending criteria are tightening further.

The situation could improve if the public sector uses its influence to drive improvement in working practices and if reform of industry payment terms is pushed through.

When Carillion entered compulsory liquidation on 15 January 2018 it shocked the industry. This was the UK's second largest construction and services company with 40,000 employees; revenues of over £5 billion, and hundreds of contracts for government-controlled public sector projects.

Because of the scale of its operations and the government's requirement that critical services at hospitals, schools and prisons would continue, Carillion was placed in compulsory liquidation with the Official Receiver as liquidator. PWC were appointed as Special Managers to assist the Official Receiver to provide scale, resources and expertise.

The immediate concerns for companies relying on Carillion's services were increased cost and disruption to projects.

But the problem was more long-term for the many companies which supplied Carillion or had work subcontracted from it.

Carillion owed £1.3bn in senior debt, had a pension deficit of more than £600 million and owed its 30,000 strong supply chain £1.5bn. It is likely that there will be negligible or no return for unsecured creditors in the liquidation, given the shortfall faced by the secured lenders.

Impact on the supply chain

In the immediate aftermath of Carillion going into liquidation a number of suppliers which had significant revenues tied up on contracts with Carillion or which worked almost exclusively for the construction giant also filed for insolvency, directly citing Carillion’s demise as the cause of their failure.

The government and the main UK clearing banks all published schemes designed to prop up and support the supply chain by making further funds available, but the measures in many cases have not worked.

Insolvencies in the sector have doubled in two years. According to Dun & Bradstreet data published in November 2018 construction insolvencies in Q3 2018 reached 677, compared with 340 in Q3 2016. The increased numbers in 2018 remained steady, with 662 being recorded in Q1 and 688 in Q2 2018.

This wasn't all to do with Carillion – Brexit, payment terms and availability of funding also played a part. But the collapse of Carillion exposed the vulnerability of the construction supply chain and, in particular, the critical issue of the timing of payments down the supply chain.

Carillion’s supply chain was so big that we may not yet have felt the full effect of its failure. Further insolvencies are likely to follow.

Payment terms

In times of financial distress, stretching your suppliers is a common tactic to aid immediate cashflow problems. However, Carillion’s suppliers had been pushed out to 120 day payment terms via supply chain finance, multiplying the magnitude of the impact of Carillion’s insolvency on those worst placed to absorb it.

Industry bodies have called for standard payment terms across the industry to avoid 120 day payment terms. Retentions are also often the subject of disputes at the end of a project. In a recent survey, 71% of firms in the supply chain said that they had experienced late payment of retentions in 2018.

Reform of payment terms and the use of retentions in the industry continues to be debated by parliament and some changes are likely, but ensuring that firms are paid on time and with certainty that they will receive the full value for their work is a pre-requisite to the industry overcoming the significant problems faced by the supply chain.

State of the market

The construction market generally has continued to be under considerable strain in the last 12 months. Margins across the sector remain at historically low levels around 2%, but in many cases are lower. Brexit and the fall in the value of the pound and increases to the minimum wage have pushed labour and materials costs up, whilst employers continue to push for the cost of projects to come down.

Problems for Interserve and a number of the Tier 1 contractors suggest these factors are being felt at the top of the market, as well as in the supply chain.

A recent industry survey by RICS in Q4 2018 has revealed that the expectation in 2019 is for margins to continue to fall over the next 12 months and for the financial position of construction companies to worsen further. Whilst the demise of Carillion is the most striking evidence of this sentiment to date, and will no doubt have attributed to its negativity, the Brexit referendum result will also be a major factor.

The economic uncertainty caused by the UK’s decision to leave the EU and the uncertainty for businesses has undoubtedly led to a slowdown in investment in major commercial projects. There also are now significant skills shortages in the labour force, as many skilled EU workers seek employment elsewhere. This, coupled with increases in the national minimum wage and the national living wage, is driving labour costs up.

Industry specialists Turner & Townsend published a report in October 2018 which predicted that material costs would increase by 5.3% in 2019 and that tender pricing would increase by circa 3% across the industry. Rising costs could cause a further slow down in demand, which would be very difficult for the sector to absorb.

There are also a number of claims arising out of the use of certain cladding materials on high rise developments, which could result in a change in legislation, and it is unclear where the liability for rectification works will fall. However, this could have a significant adverse impact on those operating in this area, and could lead to a large number of claims being brought in respect of the use of cladding.

Availability of funding

According to figures published by Construction News in November 2018 the value of outstanding loans to the construction sector fell by £1.5bn between March 2018 and August 2018, the largest fall over a six month period since 2011. Indeed, since January 2015, lending to the construction sector has fallen by more than 11% from £37bn to £33bn in June 2018.

This would suggest a wider decline in the availability of funding to the sector, beyond just the period following Carillion’s failure. However, it is clear that Carillion’s insolvency and other high profile insolvencies in the sector such as those of Lagan Construction and Lakesmere have led to banks revisiting their lending criteria in the sector. 75% of firms surveyed by RICS said that they were finding it harder to obtain financing, and that this was holding back growth. It is not difficult to understand that the cocktail of Brexit uncertainty, ever decreasing margins and falling demand are an unattractive lending proposition.

Taking the example of commercial office developments, the order book halved from £1.6bn to £800 million in the six months following the Brexit referendum result. Whilst house building numbers remain strong and the infrastructure pipeline is being heavily invested in by the government, if construction firms are not operating in these sectors of the market, it may be more difficult to obtain bank funding and they may not see the benefit in raising new monies to invest in new projects.

New players and new models continue to disrupt the funding market, with inventory and receivables finance products becoming more widely available for the best performing companies. It will be interesting to see how this market matures.

What can be done?

The impact of Carillion's collapse on the supply chain is clear and the worst may be yet to come. The banks have tightened their lending criteria and remain increasingly wary of lending to the sector. Carillion’s competitors have strived, and continue to strive, to manage the increasingly difficult balance between seeking growth and delivering profit for shareholders in an environment where margins continue to be squeezed.

So what action can be taken to ensure that businesses in the construction sector remain viable?

Payment terms - much-discussed reform must happen if the financial position of the construction supply chain is to be secured.

Procurement - the government has a unique role to play in improving procurement practices in the industry, as it is the employer on a large proportion of UK construction, infrastructure and services projects.

For too long it has focused on lowest cost options, driving a market fuelled by chasing turnover with low costs bids. Parties then work out how to deliver projects and services at a profit, once they have been awarded the tender. Inevitably, this had led to the supply chain being squeezed on price and stretched on payment. Far greater emphasis should be placed on value for money and deliverability, in order to drive innovation in the sector; encourage greater collaboration with local communities, and avoid increased costs to the public purse of having to step in if projects get into financial difficulty.

Innovation - investment in new practices and the use of technology in order to streamline processes and increase efficiency is another area which the industry needs to focus on in order to improve margins.

Enhanced contract management - firms are becoming increasingly diligent in their contract management processes, both at the point of awarding a contract and throughout the lifecycle of a project. Enhanced credit checks, due diligence and greater contractual protections against the early signs of failure will be key to ensuring that any such problems can be managed and mitigated early.

Funding - the construction industry represents 8-10% of UK GDP. Funding demand and availability for growth will be vital to ensuring that growth continues in the industry.

Andrew Robertson is a restructuring specialise at Pinsent Masons, the law firm behind Out-Law.com