Hedge Funds Are the Good Guys In Carillion Debacle

(Bloomberg) -- A plague on all their houses (plus their second homes, and buy-to-let properties)! A report by U.K. lawmakers on the causes of Carillion Plc’s collapse finds fault with almost everyone involved in Britain’s system of corporate governance. Management, non-executive directors, auditors, advisers and regulators are subjected to varying degrees of opprobrium.

The report’s key recommendation — that the government should consider breaking up the big four audit firms to eradicate conflicts of interest and cosy complacency — will doubtless send shockwaves through that profession. In addition, the ease with which Carillion was able to hide its true debt position from most investors suggests a review of accounting rules is necessary.  

But, to my mind, the report underplays the fact that some people did spot that Carillion was mismanaged and that its accounts painted a flattering picture of its financial health. Years before its collapse, hedge funds — and at least one sell-side analyst — were of the view that Carillion finances were unsustainable.

Hindsight’s a wonderful thing, but those big short positions (at one point more than 30 percent of the shares were loaned out) should have been a warning for customers and suppliers. They should also have prompted auditors and directors to ask more probing questions too. 

To recap, the report details how Carillion, a London-listed construction and outsourcing firm with more than 40,000 employees, embarked on a debt-fueled acquisition spree, paid out bountiful dividends to investors but neglected its obligations to pensioners and suppliers, thus becoming a “giant and unsustainable corporate time bomb.” 

That bomb detonated last year year when Carillion wrote down the value of its contract book by more than 1 billion pounds ($1.35 billion) – the equivalent of more than seven years’ profit – and later entered compulsory liquidation. Shareholders have been wiped out, suppliers stand to lose huge sums, and the pension plan is about 800 million pounds in deficit.

It was inevitable that the failure of a key government contractor would draw intense public scrutiny, but the speed of Carillion’s demise was especially alarming. Less than a year passed between KPMG signing off on the annual accounts — the 19th year in which it didn’t qualify its audit opinion, according to the MPs’ report  — and Carillion pulling the plug. 

While management insisted the problems had arisen suddenly and weren’t forseeable, short-sellers had long been sending a very clear message to Carillion’s auditors that they weren’t doing their jobs properly. 

True, hedge funds such as Bodenholm Capital AB and Coltrane Asset Management LP didn’t scream the reasons for their doubts from the rooftops. And yes, they stood to profit from their bets. But the size of those bets suggests Carillion’s problems weren’t impossible to diagnose.

At least one sell-side analyst cottoned on too. In March 2015, almost three years prior to liquidation, UBS analyst Gregor Kuglitsch published a note highlighting how the company extended payment terms for suppliers to flatter cash flows and its use of so-called “reverse factoring,” a type of supply chain finance. In essence, this meant Carillion could delay cash outflows to suppliers. Those who wanted to get paid quickly got paid by Carillion’s bank, not the company.

Kuglitsch argued that the liabilities related to Carillion’s early-payment facility – which later increased to as much as 500 million pounds, according to Moody’s — should be treated as “quasi-debt,” and thus Carillion was more leveraged than it was letting on. At the time, Carillion was telling investors the ratio of net-debt to ebitda was less than one times. But with various adjustments Kuglitsch estimated it was about four times. That worried him because Carillion didn’t have many “hard assets” (and lots of goodwill.)

Carillion also had a habit of reporting much lower net debt at the end of the financial year than the average net debt over the whole of that period, Kuglitsch noted. His conclusion was that a “profit shortfall” was likely at some point. 

At the time, UBS was a bit of a lone voice,  but the assertion clearly touched a nerve. It was raised in a Carillion board meeting — finance director Richard Adam described the analysis as “disappointing.” Short-selling subsequently increased, MPs note in their report.

Of course, it would be better if executives lived up to their responsibilities, auditors weren’t craven, and accounts provided investors with a transparent picture of liabilities. Carillion’s supplier finance facility was included in “other creditors” and was thus largely ignored by investors.

Nevertheless, the Carillion saga shows that short-sellers and analysts can provide a crucial check on management’s sunny impulses or aggressive accounting, and don’t always deserve the disdain that’s directed their way by the Elon Musks of the world. 

In January, a handful of British MPs tabled a so-called early day motion calling on the government to tax short-sellers, arguing that they provide “no economic benefits whatsoever to the U.K. economy.” This is patently false. Perhaps if the government and Carillion’s directors paid more attention to the short-sellers, its collapse could have been avoided.

  1. In fairness, KPMG did warn about the risks of assumptions related to revenue-recognition and profits on long-term contracts and the large amount of balance sheet goodwill.

  2. Only one other analyst had a sell recommendation on the stock.

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