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How a bow-tie can smarten up corporate risks

BowtieImagine that you are worried about your infirm mother and want to make sure that you do everything to protect her. If you adopted typical corporate risk management practice, you would identify a risk that she falls over. You would then calculate the impact (maybe a broken bone) and then identify some mitigations, such as putting some cushions around her bed or installing a handrail. All sensible, but not very through. What if the consequence were a significant chance of her dying? Would you then want to do a more comprehensive risk analysis?

Understanding corporate and financial risks is becoming an increasingly important part of any board’s job. Most companies seem to use this same basic format. However, one of the biggest problems in traditional corporate risk analysis is the general, catch-all nature of ‘mitigations’. Anything you do to reduce the risk or ameliorate the impact is classed as a mitigation. This causes glib generalisations and sloppy thinking.

Good risk management has to be very specific and very clear. You won’t protect your mother from falling by saying that you’ll ‘keep an eye on her’. You would need to be very specific about who does what, when and why.

Typical risk analysis in an annual report

The Principal Risk section in an annual report typically has a description of the risk, its potential impact, mitigations and whether the risk is getting bigger or not. I’m not sure of the value of the trend, as it is surely more important to concentrate on size of the absolute risk. However, it’s the catch-all mitigations that are the key and these are usually high-level generalisations;

“Adoption of rigorous policies and processes…”

“Regular performance reviews…”

“Deployment of high quality people..”

These are real examples of ‘mitigations’ of a risk that actually brought down a multibillion pound listed company1. But they are also typical of most annual reports.

The bow-tie model

If you want to see best practice in risk management, look in industries where it is literally a matter of life and death, such as oil exploration, aviation, mining and maritime. They tend to use the ‘bow-tie’ model, which can also be applied to financial and corporate risks.

Hazard: The model starts by identifying a hazard. In our example, this would be your infirm mother moving around. She’s safe in bed, but the moment she gets up she opens herself up to a hazard. That hazard may lead to an event.

Event: This is the moment at which you lose control over the hazard. The hazard is her moving around, but the moment she loses control of her movement, ie she trips, it becomes an event. This is close to the typical corporate idea of a risk.

We now look at causation of events;

Threats: These are whatever might cause the event to happen. For example, the lady might have had a few drinks, or she might slip on some water, or she might have a funny turn.

Preventative barriers: These are things that might reduce or eradicate the threat. This would include some actions that would traditionally be called mitigations. In our example, it might include hiding the sherry bottle, or getting a carer to mop the floor or altering her medication.

And there are the results of an event happening;

Consequences: These are the outcomes from an event occurring. There can never be absolute certainty that barriers will work (ie prevent a threat causing an event). You can never be sure that your mother won’t ever fall over, despite your best efforts. It is important therefore to look at the results of such a failure. In this example, your mother might slip and break a leg or be left unable to call for help. These are not the risks themselves, but are possible results of the risk occurring.

Recovery barriers:  These are things that might reduce or eradicate the consequence. Again, these include traditional mitigations, but are sometimes overlooked as it is often assumed that mitigations will stop any event from happening. In this example, you could put an emergency button on your mother’s wrist or put in cushioned flooring.

And then there are escalation factors;

Escalation factors: Few barriers are perfect. There are likely to be reasons why the barrier might fail. These are called escalation factors and can weaken barriers to both threats and consequences.

This model forces a detailed think through of the risks and how to stop these risks form crystallising and if they do, how to mitigate the consequences. Think about the barriers as gates that stop bad things happening, but the escalation factors sometimes force the gates open.

An example of a corporate risk

Here is an example of a corporate risk, that of poor people management leading to resignations of key people, shown as a bow-tie model;

Bow tie diagram

This model shows the threats that might cause those resignations; uncompetitive remuneration, poor culture, inadequate career development and poor management practices. For each of those threats, the model shows what the company is doing to counter or prevent those threats. It also notes that there is an escalation factor, stress on people, that might exacerbate the threat of poor management, but this itself is offset by the use of in-house counselling.

If there were resignations of key people, the company could suffer the loss of key personnel, difficulty in day-to-day management, having to delay new projects, and putting more strain on remaining employees. To try to avoid or minimise these, the company will: conduct interviews to determine if a counter offer would retrieve the employee; use succession planning to identify replacement people who could be reallocated; use consultants if possible; and identify other personnel at risk who could be offered retention bonuses. The latter could be at risk of financial constraints, but the company addresses this by keeping a contingency budget ready for such an eventuality.

What emerges is a complete story of what dangers the company faces and how it is reacting to all of them. This is a much more powerful analysis than the traditional risk, impact and mitigation model.

This model can be used for any corporate risks and to build the risk register. Quantification could of course be added if required. This would be shown as the severity x likelihood of the risk happening without any barriers and then again with the barriers that are currently in force. In our example, the risk of key personnel resigning might be 80%, and this might be judged to cause £10m of damage, ie an unmitigated weighted risk of £8m. You might conclude that with the barriers in place, the residual risk would be 30% and a likely damage of £5m, giving a mitigated risk of £1.5m.

Annual Report

The full model would be too big to include in an annual report, but could be summarised in this way;bowtieannreport.jpg

This format is a useful summary, but the full model is better as a management tool in visualising and explaining the stages of risk management.

Summary

Planning for risks and risk management needs to be done on a detailed and specific level. Generalisations won’t work. Too much risk work that comes to boards is rife with generalisations and bland ‘mitigations’. The bowtie model, developed in industries that deal literally with life and death safety risks forces a proper step by step plan of risks, management processes and actions that either reduce the risk and ameliorate the impact if the risk crystallises, as well as understanding reasons why those actions might fail. This model has a great deal to offer companies in sharpening up their understanding and presentation of corporate risk management.

 

Simon Laffin

1 The risk was ‘Contract management’ and the company was Carillion plc. These quotes are from their last (2016) annual report.

 

 

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Carillion – What can we learn?

Carillion vans

The collapse of Carillion was a tragedy, especially for its 45,000 employees and 25,000 pensioners. In an earlier article, I looked at its last Annual Report to see if there had been clues that could have tipped readers off to the impending catastrophe. Since then, we have had Select Committee hearings and their January 2018 turnaround Business Plan has been released. This now gives quite a bit more colour to understand better what happened and what lessons can be learned to improve corporate reporting.

This was a business with a yo-yo strategy and difficult execution

In 2009, Carillion had a strategy review, which concluded that it should halve the size of its UK construction business and double the size of its Middle East and Canada businesses. By 2013 however, Carillion changed its strategy again, and stopped bidding for work in Canada (other than PFI) and would no longer bid for traditional construction work in the Middle East (unless export finance was agreed). However, it seems that the die was cast and long-term contracts already signed in Canada and the Middle East proved fatal in 2018.

It wasn’t just a faulty strategy that was the problem. Its rescue Business Plan1 in Jan 2018, concluded; “The Group had become too complex with an overly short-term focus, weak operational risk management and too many distractions outside of our ‘core’”.

When things went wrong, they appear to have gone wrong quickly

Carillion signed off its Annual report in March 2017. At that time, cash was ‘…broadly in line with the budgeted position for the first couple of months of the year…” (recalled Keith Cochrane2, then a non-executive director, later Interim CEO from July 2017). At the AGM on 3 May 2017, Richard Howson, Cochrane’s predecessor as CEO, announced3 to the markets that; “trading conditions across the Group’s markets have remained largely unchanged since we announced our 2016 full-year results in March.”.

However, at ‘the beginning of May’2 the board learned that the internal reporting of contracts had been incorrect, with management accounts netting off receivables and payables, and therefore reducing the apparent cash risk. The board then commissioned the external auditors (KPMG) to conduct a review of the accounting. This concluded that the published accounts had correctly grossed up the amounts, but that the internal reporting was wrong. This, however, sufficiently unnerved the board that it then commissioned a second report from KPMG, initiated “around the end of May2, to examine the cash recoverability of its largest contracts.

This second KPMG review: “driven largely by a deterioration in cash flows on a number of major contracts, which occurred particularly as we went through Q2” (according to Keith Cochrane2) concluded that there needed to be an £845m provision made.

The provision was announced4 to the markets on 10 July 2017. The auditors5 concluded this some four months after signing off the original accounts.

The business had major risks that weren’t clear from their Annual Report

Zafar Khan, Carillion’s short-lived CFO from January to September 2017, told the Select Committee2;

If you look at the 2016 annual report, and if you look at the key risks identified within that, my view is that the setbacks and issues that we experienced in 2017 were largely related to the risks that we had set out in the 2016 annual report. What was not anticipated at the time was the number of risks that crystallised in the end, and also the quantum of the impact that we had to deal with.”

However, it seems that 6 to 8 long term contracts came to a scheduled end in 2017, but this had not been flagged in the 2016 annual report6. Khan explained2;

“Another factor that I do not think has been given enough attention is that, going into 2017, we had a number of large-ish contracts in our UK construction business that were coming towards completion…We had a good pipeline of opportunities…”

The top risks disclosed in the annual report were;

  1. Work winning
  2. Contract management
  3. Pension liability
  4. Brexit

But the risks that seem to have brought the company down were in fact;

  1. Contract management
  2. Working capital management
  3. Excessive cash outflow breaching debt facilities

All of these are of course linked, and stem from the fundamental problem of poor contract management. Carillion’s stated6 mitigations of the contract management risk were;

Adoption of rigorous policies and processes for mobilisation, monitoring and management of contract performance. Regular performance reviews…Independent peer reviews of contracts…and contract health checks undertaken by internal audit

These mitigations don’t sit easily with admissions now being made by directors.

Long term construction contracts are difficult to manage

Long-term contracts have many complexities and risks, not least as changes are made over several years with cash flow trailing. Keith Cochrane explained2: “If you take the Qatar job…this is a job that had doubled in size. It had 2,500 design variations to it, and essentially we were not paid for 18 months prior to the business failing.”

Richard Howson gave an example2 of Crossrail. The initial contract was for £30m, but by the end of 2014 costs were £90-£100m, with Carillion having been paid only £76m. The final revenue was eventually agreed at £100m and the rest of cash received at the end of the contract.

Zafar Khan put it bluntly2: “Carillion has some quite large contracts…and cash flows on those can change over a short period of time.”

Carillion had to finish long-term construction contracts as it got full payment only at the end, and on many contracts, if it walked away the client could appoint another contractor thereby also losing performance bonds. Carillion didn’t have the right to suspend work on the Qatar contract. The Qatari client, in dispute with Carillion, appointed another contractor in June 2017 to complete the works at Carillion’s cost, also jeopardising its £54m performance bond.

But Carillion contributed to the problems

Philip Green, the Chairman, admitted2; “There were some examples where negotiations around the contract itself were done too quickly, and the lesson learned was that if we had spent longer on the actual negotiations, some of the risks may well have been able to be mitigated.”

Carillion found it difficult to collect cash due on some of its contracts

Keith Cochrane said2; “…as it (the group) sought to exit from certain key markets and start to refocus itself on its core, that required us to take a different perspective on our ability to collect outstanding receivables in those markets.”

But then he suggested2 operational issues:

‘…there was a lot of focus on reported debt across the business. Was there the same focus on collecting cash, day in, day out…?”

There were concerns about the accounting

The new CFO, Emma Mercer, appointed in September 2017, told the Select Committee2 that she saw: “slightly more aggressive trading of the contracts” than in her previous experience.

“As part of Keith’s strategic review, we had changed the way we were looking at some of the services contracts, and that resulted in an increased position at the end of September, in terms of an additional £200m of provision.” Confusingly, the interim results7 published that month, described this provision as having “minimal impact on cash

Emma Mercer explained2 about contract accounting;

“…you have to exercise judgement over all sorts of things: when the contract is going to get finished; how much we are going to receive; if we are claiming against anybody; what entitlement we may have…both the number of contracts we were taking judgement on and the size of those judgements had increased….when we saw the deterioration…because we were already at a more aggressive position, it was very difficult to withstand those deteriorations on those projects.”

The numbers were huge

The May 2017 contract review led to an £845m provision being made. Of this, £375m related to the UK and £400m related to Canada and Middle East, particularly in Oman and Qatar. The Qatar contract alone owed £200m.

In total Carillion wrote £1.1bn off against its contracts, including £215m related to service contracts. In 2017, net debt increased by £850m, £1.1bn higher than expected. It used £834m working capital (of which £371m related to 9 construction contracts). Average net debt was £886m. It then projected1 to use another £234m working capital in 2018 and 2019, including £325m related to nine construction contracts. On top of this, it planned for another £131m cash restructuring cash costs in 2017-19.

Carillion ran out of cash and debt facilities

Carillion tended to focus on ‘cash conversion’, ie underlying cash inflow from operations divided by underlying cash from operations. This seems a strangely static snapshot view for a business based around long-term contracts with complex cash flows. The ‘cash conversion’ over the three years to 2016 was 119%, 104% and 117%, appearing to show a healthy cash generation. But year-end net debt was actually flat over that period at £219m. Underlying cash from operations of course excludes all the bad news; pension top-ups, non-recurring items, interest, tax and capital expenditure.

Reducing net debt was stated as being a key objective in the 2016 annual report, but the amount of net debt wasn’t then given as one of its 14 key performance indicators. Furthermore, focusing on year-end net debt was of little value when you realise that average net debt was more than double this.

In the 2016 annual report, debt facilities were stated as £1.4bn. With only £85m to mature in 2017 and additional funding secured after the start of the year, facilities should have been still around £1.4bn when Carillion went into compulsory liquidation. On 30 June 2017, Carillion had net debt of £571m. We now know1 that average net debt during 2017 was £886m. In December 2017, it announced8 that it had got agreement to defer covenant testing (probably net debt to Ebitda) until April 2018, suggesting that it was at least close to breaching them. Net debt actually rose by £791m in 2017, driven by £834m of working capital outflow.

Using nearly £800m of cash on top of a year start net debt of £200m, would imply a year-end net borrowing of about £1bn, against £1.4bn of facilities. If you add the cash outflow to the 2016 average net debt of £587m, this suggests a pro-forma average debt of £1.4bn. It therefore is easy to imagine that their peak debt outran their facilities of £1.4bn. The fact that the average net debt at £886m was so much lower than this implies that there was a serious ‘run’ on working capital towards the end of the year.

So what lessons are there for reporting from the collapse of Carillion?

Companies should be more balanced in writing about themselves

The Strategic Report must, by law, contain a fair, balanced and comprehensive analysis of the company’s development, performance and financial position.

I suspect that there is a growing practice of annual reports being written by professional writers, thereby becoming increasingly an arm of the PR/communication industry. Carillion’s text in its annual report boasts about pretty much every aspect of their business. This is little different to most annual reports. But in Carillion’s case, ex-directors are now making statements that do not sit comfortably with what the board wrote so recently in the annual report.

An annual report is never going to be an impartial review. What organisations, including regulators and politicians, ever write impartial reviews of their own performance? This is difficult to legislate for, but it may be appropriate to hold directors to account if something goes seriously wrong that is not discussed as a risk in the annual report.

Discussion of risks needs to be integrated into the whole report

The risk section in the annual report is of little use. Carillion is typical in that it lists ‘top’ risks and then gives mere platitudes about mitigation. The mitigation section gives no feel of the real risk, or the ability to avoid or reduce the impact of the risk occurrence. As is standard practice, its declared risks are listed together in a few tedious pages. There is insufficient information for the reader to become better informed, even if bothered to read the whole thing.

The key to risk management is to integrate it into decision-making, not ghettoised as a separate activity or schedule. Annual reports would be much more informative if they tackled each risk together with the relevant business activity or segment. For example, the section on construction contracts could have had a discussion of their inherent risks. At the very least, every risk should have a discussion of how the company reduces the chance of the risk happening (“avoidance”), how it will know when things are going wrong (“detection”); and how it would react if the risk did crystallise (“mitigation”)9. Risks also require numeric quantification as well as words.

Cash needs to be taken even more seriously

Carillion’s use of cash conversion (underlying operating cash flow/underlying operating profit) was not fit for purpose. It excluded too many cash items and did not reflect the complex cash flows of its long-term contracts. It’s impossible to define a single cash metric for all businesses, but companies should think hard about how to communicate cash effects. Carillion could have shown segmental cash flow and return on capital. This might have provided some warning about the cash flow characteristics that eventually proved fatal.

There is far too much emphasis on year-end cash. Businesses fail when their peak cash usage breaks through facilities. Companies should be more explicit about average and peak debt, and explain why if this differs significantly from year-end levels.

The viability statement was introduced to give some comfort on future cash flows and debt over a period longer than a year. Regulators have tended to fixate on the length of the look forward, but actually this misses the point. As a result, half of Carillion’s viability statement6 is justifying its looking forward only three years. But this business didn’t start to deteriorate years later. It apparently started the month after annual report stated6;

“On the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.”

It’s clear that without some quantification of the assumptions made and scenarios tested, the viability statement assurance is of very limited value.

Conclusion

The Carillion annual report is a very typical one, glossy smooth talk and adhering to the rules, regulations and corporate governance requirements. However, it is also an example of the inadequacies of such reports. It fails to convey adequately the risks that the business was running, its volatile working capital and long-term working cash flows.

Some changes that would help in reporting are;

  1. Companies need to more balanced about their company, talking about downsides as well as the wonders. Boards should take back writing and editorial rights from copywriters.
  2. Strategy and segmental performance sections should discuss risks, cash flow, and capital employed. The current risk section should be broken up and risks tackled in the relevant section of the body of the report.
  3. Discussion of the risk appetite should be integrated into the strategy section.
  4. Discussions of risks need to be more detailed, covering at least avoidance, detection and mitigation, with numeric quantification.
  5. The going concern and viability reviews should require more detail and quantification of how they have been stress tested.

This isn’t just about the annual report. This would also help to focus board discussions and potentially alert directors to looming issues. Risk management has to be a major part of every management and board discussion, not just a periodic review by a committee and internal audit.

 


1 Carillion Business Plan January 2018

2 Business, Energy and Industrial Strategy and Work and Pensions Committees; Oral evidence: Carillion, HC 769, Tuesday 6 February 2017

3 RNS issued 3 May 2017

4 Trading Statement 10 July 2017

5 The FRC has opened an investigation in relation to KPMG’s audit of the financial statements of Carillion plc. The investigation will cover the years ended 31 December 2014, 2015 and 2016, and additional audit work carried out during 2017.

6 Carillion Annual Report 2016, published March 2017

7 Carillion Interim Results 29 September 2017

8 Carillion RNS statement 22 December 2017

9 This methodology for reviewing risks is discussed in my blog

Carillion – a salutary reminder on due diligence

Carillion Annual Report cover

Carillion has entered the pantheon of cursed companies following its recent failure. Politicians and the media have worked themselves in another fit of righteous indignation about greedy management and incompetent boards. The search is out for people to blame, shame and even prosecute. Regulators, sensing the flow of the political wind, are climbing on the bandwagon and looking for blood.

Non-executive directors are reasonably enough feeling nervous. They are at the centre of corporate crises such as this. Already some Carillion directors have had to resign from other roles and the non-execs will be contemplating an enormous black mark on their CV’s. Being a non-exec in this form of collapse can be terminal for any career.

Do your due diligence

One lesson for non-executives is to do careful due diligence before you contemplate joining a board. Another lesson is that non-executives need to be sceptical of what they are told around a board room table, applying due diligence principles to what they see and read.

Most candidates take the financial health of a company, especially a well-known or large one, for granted. This is a dangerous assumption. Two companies that I joined as a non-exec proved to have potentially fatal toxic derivatives. Carillion recruited two new non-execs onto its Audit Committee in the couple of months before going bust.

Read the Annual Report

Although full of guff and regulatory noise, the Annual Report generally should tip you off to issues. In my experience with the toxic derivatives, they were indeed listed in the Annual Reports, but were so surrounded by reassuring jargon that it took several interrogations of the CFOs to confirm their real nature. In fact, the words in the Annual Report are very unlikely to warn you. Despite the regulators attempts to ensure that reports are balanced and fair, they are still largely promotional documents.

I am not attempting here a technical analysis of the Carillion Annual Report. Nor do I wish to criticise the directors (there are many others only too keen to do that). My objective here is to use 20:20 hindsight to look at whether there were clues even in the 2016 Annual Report that could at least have raised questions in non-execs minds, and to offer these as lessons for other non-execs doing due diligence.

The words

Virtually all the text is confident and devoid of doubt, as is pretty standard for most annual reports. However, amongst all the good news, there was one clue: “In 2016, we made good progress in a number of our markets, while managing and mitigating the effects of more difficult trading conditions in others.” Given companies natural reluctance to air their problems, a reader should highlight any cautionary statement like this. The Board will have had a very good reason to include such a comment.

Overall however, you wouldn’t have got much balanced information from the words. Most of the clues lie in the numbers, particularly those that are not discussed in the text.

Revenue

There had been two years of decline in ‘secured and profitable’ orders from £18.6bn to £16.0bn, which possibly was an early sign of slowing growth. Of this £12.2bn was support services. Given that support services annual revenue was £2.7bn, the ‘order book’ looks as if it is adding up all future contracted service revenues. This is therefore not as impressive as it looks. Furthermore, the reader should ask if this future revenue is actually all unconditional or subject to performance conditions.

 Profitability

Underlying operating margin had fallen for two successive years from 5.6% to 4.9%. This should have been of concern. However, given the revenue growth, the business recorded two years of underlying EPS growth from 33.7p to 35.3p. The question therefore is whether Carillion was buying less profitable business, just to keep its growth going.

Long term contracts can be inherently volatile. Costs are generally booked as incurred and revenue – and hence profit – are, broadly speaking, booked on a pro rata staged basis. This is calculated using % contract costs incurred so far against forecast total contract costs times the full contract revenue. If individual contract costs run to plan, there is little problem, but if costs start to escalate, then there can be a big swing from pro-rata profit to whole contract loss. There isn’t much discussion of this in the Annual Report, other than noting the accounting policy and that the Audit Committee had reviewed the accounting and found it ‘reasonable’. There is no way of knowing whether the Committee deliberately used such a mild word to suggest that they were not very enthusiastic about the accounting or whether this was a synonym for ‘true and fair’. Either way, a reader might have queried it. For all the length of the new external auditor’s report, it simply lists all the work they did, without drawing a specific conclusion on this issue.

There was a big increase in non-operating costs from £5m to £40m, excluded from ‘underlying profit’. These were largely redundancy and closure costs. Costs excluded from underlying are always of interest.

Net debt and cash flow

On the one hand, the company seemed happy with its cash flow and debt;

“Cash flow from operations represented 117 per cent of profit from operations.”

“The Group continues to have substantial liquidity with some £1.5 billion of available funding…The vast majority of the Group’s £1.5 billion of funding matures in November 2020 and beyond.”

On the other hand, there is a clue that they are not as happy as they appear to be;

“We will also begin reducing average net borrowing by stepping up our ongoing cost reduction programmes and our focus on managing working capital.”

The year-end net debt ratio to EBITDAR rose from 0.6x to 0.8x. But average net debt was 2.7x bigger than the year-end debt, implying an average net debt to EBITDAR of 2.2x, a very different picture. There is no explanation in the annual report why year-end net debt is so much lower than the average. Maybe there was a consistent big seasonal swing, but this seems unlikely in this industry. In its absence, a sceptical reader might draw the conclusion that the year-end balance sheet was being managed aggressively.

There is evidence of working capital issues as the construction contracts receivables increased by 60% to £615m, perhaps indicative of cash flow problems with such contracts. Other receivables and prepayments also rose by 36% to £750m. Finally, Carillion was having a little trouble in getting paid, with trade receivables that were over 3 months old more than doubled from £25m to £55m. Carillion had managed its working capital by lengthening many payment terms to 120 days. As a result, its trade payables were rising and suppliers were being encouraged to use an Early Payment Facility, whereby they would borrow against their receivable from Carillion to keep their own business going despite such slow payments.

The group’s net debt was growing. Both year-end and average net debt rose by just under £50m, although £68m was due to foreign exchange offset by £34m from selling shares in PPP joint ventures. The report was a little dismissive of the foreign exchange loss, half of which was ascribed to a US dollar private placement debt. This latter was apparently fully hedged, but it is not clear where the corresponding hedging benefit appeared.

However, the group claimed to have ‘a strong funding position’. £1.4bn of funding was available at Dec 2016 (of which £0.7m was undrawn), plus additional funding then secured the following month, gave a total of £1.5bn. The only mention of any debt covenants in the report is in the going concern section, where the board confirms ‘comfort that funding covenants will continue to be met’. In retrospect, a reader might have wished for the details  of those covenants.

The Group therefore continues to have substantial funding…over the medium term’, with only £85m of facilities maturing in 2017. When Carillion went bust, with a reported only £29m in cash, you would have assumed that it had at least £1.4m in debt facilities. It looks as if failure to meet the undisclosed covenant conditions caused facilities to be withdrawn, triggering the eventual liquidation.

Customers

Net promoter score (a measure of customer satisfaction) fell dramatically from +36 to +22, which the company ascribed to ‘challenges of mobilising new contracts’, although there was no evidence that new contracts were growing in number. Anecdotal reports suggested that there was a growing unhappiness with customers and a few high-profile disputes had surfaced.

Segmental profitability

“…the wider outlook for volumes and margins across the (Middle East) region is expected to remain challenging…”

Middle East construction services revenue grew by 19% to £428m, but at a tiny net margin of 1.9%. The commentary recognises the low margin, but point to a further £15bn of contract opportunities, without discussing whether these would be at a higher margin. The segmental analysis reveals year-end net assets employed of £206m, which with an operating profit of £8m, suggest a return on capital of only 3.9%. This assumes of course that the year-end net assets are representative, yet we know that the group’s average net debt is 2.7x higher, so the real return on capital was likely to be lower. It wouldn’t have taken much of a cost overrun for this return to be wiped out. There is no discussion of segmental capital returns in the Annual Report.

Other construction services also grew fast by 21% but at a net margin of only 2.1%, down from 2.9% the previous year. A margin target margin is given here as 2.5% to 3.0%. The Company is able to claim that it satisfies this target by adding in joint ventures where the £9.0m profit share exceeds its £8.9m revenue share. There is nothing like a 100% net margin joint venture to improve reported performance. Mention is made of ‘managing risks in order to deliver our target margins and cash flows’, although there is no further discussion of cash flows. The segmental reporting reveals year-end net assets of £190m. With a profit of £32m, this suggests a decent return on capital of 17%, although this is probably flattered by year-end working capital being below the average.

Recent acquisitions were underperforming. There isn’t any reference to this in the commentary, but buried in the financial review is £15.6m of non-recurring credit. This would seem to be good news, but is in fact a reduction in consideration to be paid for two acquisitions whose EBITDA is ‘lower than the stretching targets agreed’. ‘Nevertheless, these businesses have performed well…’. The report does not define what it means by ‘well’.

The pension scheme

£47m cash pa was being put into the defined benefit pension scheme, whose IAS9 deficit had ballooned to £805m from £394m the previous year. The deficit payments look light, being based on a 15-year recovery period, as a rule of thumb is more like a 10-year period. This was a warning sign that cash payments would be likely to rise significantly at the next triennial valuation (due in 2017). The absurdity of pension accounting rules is that the P&L was actually being charged only £6m (the rest effectively goes through reserves). Unlike many companies that have closed their increasingly expensive defined benefit pension schemes, Carillion kept theirs open for employees when necessary ‘to meet the requirements of work winning’. A reader might ask whether the costs and risks of this were fully built into those contracts.

Goodwill & deferred tax

Carillion had a lot of goodwill on its balance sheet – £1.6bn compared to £0.1bn of fixed assets. The rules say that goodwill has to be justified on whether it can be backed by prospective profit flows. This is a potential double whammy. The reader should note that if performance falters, large potential write-offs in goodwill become necessary, exacerbating the financial pain.

A similar problem exists with deferred tax assets, which were £164m. These can only exist where you are forecasting sufficient forward profits to justify them. Poor performance can lead to these being run down quickly.

Corporate Governance

Carillion appears to have been exemplary in its corporate governance, as described in the annual report. The board fully complied with the governance code. Employee engagement rose from 68% to 73%; employee volunteering increased from 18% to 30%; and the gender balance improved, with 38% of employees being female. The board had an external review of its effectiveness and 29% of the board were female. The previous Remuneration Committee was approved by 80.6% of the votes.

Regulators might note this. If Carillion obeyed all the rules, then maybe the rules are not really the be all and end all to company performance after all. Perhaps Regulators could focus on understanding why companies fail, rather than grandstanding the latest governance flavour of the month.

Risk

The Annual Report boasts that; ‘Rigorous risk management processes that identify, manage and mitigate risk are fundamental to the success of our centralised operating model.

However, this rigorous process did not identify liquidity as one of the top ten Group risks (although the pension liability was regarded as high impact/high risk). The top risk was winning new work, but it didn’t mention the risk that new work might be loss-making or cash consuming.

The new requirement for a Viability Statement was intended to highlight precisely such looming cash crises as Carillion, but stakeholders were reassured;

“On the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment.”

 In fact, there was insufficient information in the Annual Report to give a reader comfort on liquidity and viability. Perhaps the regulators need to study this again.

 

Conclusions

There are many cautionary lessons here for a non-exec in using an annual report as part of their due diligence on any company;

  1. Pay limited attention to the words, except where there is any hint of caution or bad news. Accept that boards will naturally enough always accentuate the positive in writing about their business, but apply scepticism yourself.
  2. Always question whether numbers are unconditional. Future revenue and pipeline numbers are unlikely to be guaranteed. Banking facilities can often be withdrawn.
  3. Watch out for specialised accounting, such as long-term contracts. Some rules say that profit must be booked before it becomes unconditional. Do not assume that the accounting rules are designed to protect the investor.
  4. Take a close look at non-underlying costs. They may well be genuinely one-off or technical, but they may still be important.
  5. Cash is king. Businesses don’t go bust because they make a loss, but because they run out of cash, sometimes even when profitable.
  6. To understand the usefulness of borrowing facilities requires you to know not just the amount and maturity but also any conditions under which facilities might be withdrawn. This includes covenants, but there may also be other conditions too.
  7. Study working capital seriously. It is the most likely source of cash problems in a profitable business. If the company is making strenuous efforts to manage working capital, it may be under strain.
  8. Year-end quoted cash numbers are of limited value. Focus on the average balances and try to find out the peak numbers too.
  9. If there is evidence of general or growing customer discontent, treat this as potentially serious.
  10. Segmental profitability matters, but you will probably need to look at the numbers rather than rely on the commentary. Try to understand revenue trend, net margins, net capital employed and cash flows by segment. Check that the business is growing the high margin/return segments.
  11. Underperforming acquisitions are an amber light. Businesses under pressure may seek to alleviate this by acquiring other companies.
  12. Defined benefit pension schemes are now commonly in deficit, not because company contributions have fallen, but because monetary policy has led to very low interest/discount rates. However, higher cash contributions will follow and these are not reflected in profit.
  13. Good corporate governance is very important, but more important is high quality, experienced directors doing a diligent job in the board room. Box ticking governance codes in reality provides little reassurance on company performance.
  14. Risks and mitigations disclosed in the annual report are generally fairly meaningless, and provide no real reassurance. As in Carillion’s case, it’s often the risks that are not mentioned that prove fatal.

 

Simon Laffin

 

NB. All quotes are from 2016 Carillion Annual Report

“Marking our homework” – Why executives resent non-execs

Management scribbles001

 

It won’t be long into your first non-executive job when you start to feel as if the executives resent you. It’s okay. You haven’t become paranoid. They really do resent you. Why?

 

 

 

Being an executive director is a tough job. You work all the hours that the Working Time directive allows, then you opt out and work some more. The market is very tough and competitive, and you end up making numerous difficult decisions. You do this for a couple of months and try to summarise what’s happened and why for the Board. Then a few part-time directors waft in and criticise the papers, ask stupid questions and lecture you about governance. What’s not to hate about that?

 

But being a non-executive director is also a tough role. You are invited to join the board of a company about which you probably know little and possibly in a sector of which you know nothing. You may get a cursory induction programme and then it’s straight into a board meeting. The performance information may be either perfunctory or so detailed that you can’t get any sort of meaningful overview. Management may be defensive, resentful and resistant to questions. You ask yourself, how can I add value to this board?

 

Executives often say they feel that non-execs come to board meetings ‘to mark their homework’. This is very difficult to avoid. Execs usually work very hard and in their heart of hearts, really want the non-execs to turn up and applaud them. There are few things more irritating than having a non-exec appear and come up with a good idea or question the execs hadn’t thought of. Even if it’s helpful, human nature means that you may resent it.

Here are some suggestions to help harmonious board discussions.

For the executive:

  1. Remind yourself that the non-exec is trying to understand your position and making sure that you have thought of all the angles.
  2. Don’t react immediately, but let the board discussion continue. The initial comment, even if naïve, may lead to a useful discussion.
  3. Remember that you are paying the non-exec to be there. Whether you like it or not, you might as well listen to something you’ve paid for!
  4. Pause a while, as what may seem initially as a strange comment from a non-exec may turn out to give a new insight or angle into a common issue. They won’t necessarily use the same jargon as you, but may still understand the problem.
  5. If the non-execs are well chosen and sensible, remember that their comments are likely to be, or at least intended to be, helpful.
  6. Avoid being defensive at all costs, and watch out for sounding defensive.

 

For the non-executive:

  1. Avoid stating the obvious or asking a question implying that executives don’t know their job.
  2. It is tempting to review paperwork and point out errors. If this is necessary, do it privately outside meetings, rather than in board discussions.
  3. I think that it is good practice to ask questions that arise from reading advance paperwork directly of executives before the day of the meeting. This can be in person, by telephone or email.
  4. Questions should generally be asked in board meetings only when they have just occurred to you or will elicit an answer that you would like everyone to hear. If the latter, you could also warn executives in advance that you intend to ask the question and give them time to prepare a good response. This will make them much less defensive as they won’t feel that you are trying to catch them out.
  5. Keep interventions and questions short. The longer you go on, the more pent up anger may build in others.
  6. Don’t confuse asking a question with making a speech. There’s a time for both, but not at the same time.
  7. Try to put important questions or points early in the discussion, rather than dropping them in like a depth charge, just as the Chairman is drawing the discussion to a close.
  8. Use cautious language, with plenty of conditional tenses and get-outs (“I was wondering if…” ,“Perhaps this might be an issue…”)
  9. Offer to meet separately (”offline”) if the discussion goes on for a long time or has generated some unwelcome heat.
  10. Remember that when you leave this meeting, you can go onto other things, but the executives are stuck dealing with the same issues full time until the next board meeting.

 

I have been in executive and non-executive roles on quite a few boards, and even temporarily moved from non-executive to executive on some boards, so I have seen these issues from both sides. I am grateful (and would like to apologise) to all my boards for allowing me to make all the mistakes listed here, and now to write from bitter experience!

 

Board meetings can very sensitive affairs. A good one informs all participants and pools their knowledge and experience to come up with good decisions. A poor meeting just stokes resentment between the various participants. Directors should remind themselves that it’s not an aural exam and board papers are intended to be the genesis for a two-way discussion. There is no marking of papers required!

 

Why do we have corporate governance regulation?

Glasses & newspaperWhat drives corporate governance regulation? Is it media focus, political pressure, or a need to ’do something’?

Or is it sound analysis leading to thoughtful prescriptions? I suspect that pretty much everyone accepts that the answer is somewhere in the former list. Why does it have to be like this?

Evidence-based medicine is a well-established movement in health care. Even the UK Government published a White Paper in 1999 (“Modernising Government”), admitting that it “must produce policies that really deal with problems, that are forward-looking and shaped by evidence rather than a response to short-term pressures; that tackle causes not symptoms”. Sadly this went the way of many well-meaning political initiatives.

The UK Corporate Governance Code starts;’The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.’ Fine words, but how do we know that actually does this?

Corporate Governance regulators have not as yet woken up to the needs of evidence, analysis and proof. There was an outcry about executive pay. They reacted by asking the great and the good as to what should be disclosed, and then mandating it. The result is 30 pages at least in every annual report listing every last detail of directors’ remuneration. Where is the evidence that this has remedied the problem of excessive pay and payment for failure? I can see that investor interest and therefore pressure on boards has had an effect on boards, but such pressure was in fact the driver, not the result, of additional regulation.

Listed company directors now have to put themselves up for re-election every year now. This was because people thought it would be a good idea. Where is the evidence that this would help and where is the post implementation review that shows it was effective in what it set out to do?

Politicians and the media are baying for more diversity on boards. The regulators duly oblige by setting targets for more females. This time there are also claims of a statistical relationship between number of females on boards and good performance. Except that the statistics in fact are pretty dodgy, and fail to show a company performance improving over time as a result of the presence of more women (if you think about it, such a relationship would be quite extraordinary given the complexity of company profitability). Where is the post implementation analysis that shows company profitability in the UK has improved as the percentage of FTSE100 female directors has doubled? I’m not saying that there isn’t a moral or political case for female representation. If regulation is just political, then let’s not dress it up as rules for improved performance.

Would it be so hard to develop evidence-based regulation? This is what it should look like:

  • The original events that led to the ’need for regulation’ are thoroughly analysed, and their causes identified;
  • The theory is tested as to why the regulation will be effective against those causes, and what the possible impacts of the regulation might be;
  • The counterfactual is tested: what would be likely to occur if the policy were not implemented;
  • The impact of the new regulation is measured;
  • Both the direct and indirect effects of the regulation are identified;
  • The uncertainties and other influences outside of the regulation that might have an effect on the outcome are identified;
  • The analysis and tests is capable of being tested and replicated by a third party.
  • The regulation is tested to identify if it ever becomes unnecessary or develops unforeseen consequences.

This is a manifesto for good regulation. None of the current corporate governance rules would satisfy this standard. Yet, given the costs of implementing the governance rules, is it unreasonable for regulators to justify themselves with a bit of evidence?

Put simply, governance regulation should start with an analysis of what has gone wrong in companies, identify regulation to stop this recurring elsewhere, and then check that this is being successful. The analysis into what goes wrong at companies must be far-reaching and insightful, going beyond condemning individual directors and failures of risk management. It needs to look at culture and accept human fallibility.

We all need rules, but the regulators are perpetuating a lie in suggesting that rules improve performance. Football teams couldn ’t play a match without a common set of rules. But you won’t improve Manchester United’s performance by adding new rules to the game. Teams improve with better tactics, advice, and encouragement. Boards are teams too.

This would be the regulators’ toughest challenge. How can they go beyond rules and compulsion, to encouragement, best practice and helping boards? They need to accept the discipline of evidence, the limitations of rules, and open their eyes to the importance of culture and how to foster the right one. And that probably requires culture change at the Regulators themselves.