After Carillion: Public sector outsourcing and contracting Contents

5The effect of Government monopsony on the private sector

The health of private sector contractors

77.The failure of Carillion did not exclusively arise from its public sector business. However, while we do not have information to suggest that any of the other major outsourcing firms are currently at risk of failure, many of them have had to make announcements of restructuring to the stock exchange:

78.These difficulties flow, in part, from the way that the Government has contracted out. Karl Wilding spoke about similar issues in the charitable sector and said that “the risks to the charities and therefore to the system here come from, again, the style of procurement”.181 Nick Davies argued that in some cases companies pursued a strategy of “land and expand”, where the company wins a “contract that might not be particularly profitable” and then negotiates changes.182

79.Private sector companies can also respond to low margins via expansion. According to Sir Amyas Morse, contractors get into a “hamster wheel effect” “where you are always taking on new contracts”.183 He argued that these contractors, faced with declining margins, report profits as they recognise the “initial profit” when they successfully tender for a contract and then just keep reporting new profits after new contract wins.184 Sir Amyas said that companies on this hamster wheel “don’t see … whether the underlying profitability of these contracts really justifies … [their] business.”185 These companies, as Professor Haslam has said, relied upon extra contracts not only to drive reported profits but also acquisitions which “supercharged growth in revenues”.186 In Carillion’s case, the House of Commons Library said that Carillion had followed this model and had been “£845 million too optimistic about its contracts”.187

80.These companies were driven by their need to generate returns for shareholders and business growth. The House of Commons Library said in its report on the collapse of Carillion that the firm had “paid out £333 million more in dividends than it generated in cash from its operations in the five and a half year period from January 2012 to June 2017.”188 Both Professor Haslam, Dr. Tsitsianis and Professor Leaver argue in their submissions that some of these companies have used “financial engineering” to create returns for shareholders.189

81.Professor Haslam and Dr Tsitsianis also argued that this led to these companies taking on more onerous contracts and holding more goodwill on their balance sheets than most companies.190 Carillion’s treatment of goodwill (the difference between the purchase price of a company and the value of its net assets) has been criticised. The joint report by the BEIS and Work and Pensions Committees said that Carillion had “propped up its balance sheet” using goodwill.191

82.The Government agreed that recently “all the household names” in the sector had struggled and had “in the last year or two changed their management, changed their strategies” in response.192

83.Some of our witnesses argued that these poor results were due to poor management or to the sectors that contractors were involved in. Phil Bentley of Mitie told us that Carillion’s problems were due to their construction contracts.193 Mr Bentley also argued that “it is up to us” as contractors to work out whether a specific contract was affordable or not.194 Paul Davies asked us why the Government “would do it any better than the private sector when you already have credit analysts and lenders and so on” analysing whether companies like Carillion will collapse.195 The Government argued that the Boards concerned were responsible for their companies: the Minister said that “we are not directors of those companies; we are important customers of those companies.”196

84.Despite this, witnesses suggested that the Government could have done more to protect itself through better due diligence on the balance sheets of its contractors, especially in the contest of the new contracts awarded to Carillion. Professor Haslam suggested that the Government needed to conduct much more sophisticated due diligence of the providers that it was engaged with.197 Sir Amyas Morse agreed that the Government should do more stress testing on its suppliers.198 Sir Amyas Morse said that when contracting and, especially, transferring risk, “the credibility of the counterparty really matters.”199 Professor Leaver suggested in particular that the Government should assess the amount of goodwill held by suppliers on their balance sheet compared to their net asset position.200

85.The Cabinet Office told us in correspondence that their current due diligence for contractors differed depending on the size of the contract. On smaller contracts the tests would be “limited to a turnover test and a test of ratios to determine solvency”.201 On larger contracts, the contracting authorities will “draw up more complex tests that require better data and more sophisticated analysis”. On the HS2 contract, the Cabinet Office told us that HS2 Ltd applied” quite detailed tests on the financial capability of Carillion” which included tests of their “turnover, net assets, liquidity, gearing and interest cover” and they “reviewed Carillion’s Dun & Bradstreet Failure Score”.202

86.Some of the Government’s contractors developed unsustainable business models over recent years, underbidding for contracts, recklessly acquiring other businesses and maintaining high bonuses and dividends. For example, Carillion’s balance sheet, before its failure, was propped up with high risk construction contracts and high valuations of goodwill, arising from overpayments for acquisitions. The directors and shareholders of the companies involved are responsible for this. Share prices, buy, hold or sell recommendations and public statements are a poor guide to the long term security of companies. Shareholders can accept higher risks for an equity rate of return and can exit at short notice. Government is in for the long term and cannot take such risks with public money or with the security of public services. The Government as the major customer of these firms is responsible for the services they supply and consequently needs to ensure that its contractors are able to deliver those services sustainably. As Ministers are accountable for the resilience of services, they cannot be blind to the risks that the companies delivering those services hold.

87.The Government should improve its due diligence processes to understand the resilience of the cashflow and financial position of its partners. In 2017, the Government still awarded contracts to Carillion despite the weakness of the company’s balance sheet on the basis of “quite detailed tests on the financial capability of Carillion”. The Government should urgently review its due diligence procedures on the contracts awarded to Carillion. The Government should commit to announcing its findings from this review in its response to this report.

Competition and contestability

88.In conjunction with this trend towards more aggressive strategies which led to companies facing difficulties, there has been more and more concentration in some public service markets. The Minister told us that in some markets, for what he described as “the provision of complex public services” there was significant concentration, as the top five suppliers have nearly “60% of the market by value”.203 However, he also argued that there were markets for facilities management, construction and business processes (such as accounts or pensions administration) where the market is less concentrated.204 Phil Bentley, CEO of Mitie, agreed with the Minister: he said that the government’s facilities management contracts had the “least concentration” he had ever seen in a market.205

89.Other witnesses to our inquiry agreed with the Minister that some markets for government contracts were too concentrated. Paul Davies said that “concentration is an issue” in the market.206 Reform, a think tank, said that the “supply side is concentrated and becoming increasingly concentrated”.207 Sir Amyas Morse, the Comptroller and Auditor General, argued that “there has been an unhappy tendency for market concentration to happen and I do not think that the Government have done very much to prevent it”.208 Matt Dykes from the TUC said “we have seen market concentration reducing choice and contestability”.209 While Rupert Soames of Serco disagreed that there was concentration in the entire government services market, he acknowledged that “if you get particular specialisms like prisons … you can get narrow individual markets”.210

90.The Minister agreed with these concerns about the concentration of some public sector markets. However, he cautioned that “getting in new big contenders for that particular market in complex public services is not straightforward because you need companies that have the administrative financial capacity to provide services of that character”.211

91.However, this point was challenged in our evidence. Professor Sturgess argued that it was not competition but contestability (“the credible threat of competition”) which “seems to make the difference”.212 He argued that “as long as the barriers to entry are low and there is a credible threat of competition, the monopolists will act in a competitive manner.”213 As Chris Ham stated “the stimulus to improve performance… exists when providers know that purchasers have alternative options” even if they do not immediately exercise them.214 The Australian Productivity Commission argued that in situations where you have long or medium term contracts the real impetus to reform comes from what they described as “periodic contestation”.215 Domberger and Jensen (University of Sydney) argue that contestability should ensure that even natural monopolies “need not result in losses of economic efficiency”.216 Therefore Professor Sturgess argued the Government should be less concerned about the number of participants in each market, than about the barriers of entry to new entrants.

92.Barriers to entry however do appear to exist in public sector markets. Small and medium sized enterprises (SMEs) have difficulties in gaining in government contracts. The Government “reckon that about a quarter of all Government expenditure with third parties goes to SMEs either directly or indirectly”, this includes spending which goes through large companies who buy from SMEs.217 Reform told us that “government does not have the expertise to procure and manage contracts with SMEs” and describe onerous bidding processes involving hundreds of meetings and documents.218 Competitions exist in which bidding processes take over 18 months and require the equivalent of 12 A4 boxes of information.219 89 per cent of firms working with the public sector, according to the Federation of Small Businesses, received late payments of bills.220 The Federation also argues that small businesses struggle to get accepted onto Government framework contracts.221 The British Institute for Facilities Management linked concerns about price and risk transfer had both “deterred businesses, both large and small, from bidding”.222

93.The Government are committed to “lively, innovative and dynamic markets”.223 The Minister argues that the Government will “maximise the number of alternative suppliers” through “requiring” Departments to follow a “playbook of guidelines, rules and principles that will encourage new entrants to the market.”224 In particular, the Minister committed the Government to remove barriers to entry for small businesses.225

94.There is widespread agreement that contestability (the credible threat of competition) is important in order to support an efficient market for public sector services. Contestability motivates firms to improve services and cut costs and motivates the public sector itself in the same way. The combination of limited competition and high barriers to entry generates worse outcomes however for the Government.

95.The Government needs to ensure that the market for Government contracts remains contestable from within the public sector, from existing companies and new entrants. We welcome the Minister’s commitments in this area and we await to see in the Government’s response details on its new measures to increase small and medium sized enterprises’ participation in the market.

96.The Government should test the thesis that less competition (as opposed to contestability) also undermines outcomes for the public sector. This reflects a widely held consensus but it would be useful for the Government to commit in its response to commission further research. The Government should outline in its response to our report the detail behind the Minister’s commitment to a new playbook of guidelines, rules and principles.

Instability in Large Contractors and the case of Carillion

97.The capital structure of many of the large companies involved in public sector services means that it was increasingly likely a company would fail. The increased concentration in the market meant that when a company did fail, it was more likely that it would have a major impact. Companies in this case may become too big to fail. There have been recent cases in the public sector where this has been a reality: in 2016, Learndirect received an adverse Ofsted report; whereas the Department for Education would normally have cancelled the company’s contract, in this case it did not. PAC speculated after these events as to whether this suggested that Learndirect Ltd was “too big, and too important to government to be allowed to fail”.226

98.The NAO in 2015 published guidance to Departments about the failure of providers of public services. They suggested that Departments should develop contingency plans for failure.227 Our predecessor Committee made similar points after the collapse of the charity, Kid’s Company, when we argued that contingency plans should be prepared to protect vulnerable users in the event of a failure.228

99.The Government has argued that Carillion’s collapse was not entirely due to their UK government contracts. The Minister told us that Carillion’s difficulties “arose out of some construction contracts” and involved “overseas clients”.229 Overall Carillion’s margin on public sector work was 1.4 per cent in 2017.230 The Minister is correct that Carillion’s business spanned the private and public sector: according to its accounts, the UK public sector accounted for 33 per cent of its global income and 46 per cent of its UK income in 2016.231 However, as we noted above, Carillion’s business model made it very vulnerable to a few contracts becoming unprofitable and undermining the entire business (Paragraphs 79 to 81).

100.The Government was initially surprised by the profits warning made by Carillion in July 2017.232 PAC published papers which suggest that the Government “was not aware of Carillion’s financial distress” until its July profits warning.233 This is despite the fact that some investors were cautious about Carillion from 2015. Euan Stirling, Global Head of Stewardship and ESG Investing, Aberdeen Standard Investments, told the BEIS and DWP joint committee that Carillion’s “debt levels that were growing every year and every half-year as the company failed to convert its profitability into cash flow”.234 Other investors however found Carillion’s profit warning in July 2017 “surprising”.235

101.From July 2017, the Cabinet Office began preparing contingency plans for the Government. This process was complete for central government in January 2018, though the Cabinet Office was “still seeking information on schools and local authorities” at the point that Carillion went into liquidation.236 These difficulties were apparent to the company. Keith Cochrane, the former Chief Executive of Carillion, said that the Cabinet Office “expressed their frustration to us on occasion” about their communication with other parts of the Government and found “it quite challenging” to pull together a single public sector contingency plan.237

102.In January 2018, the Government took the decision not to supply Carillion with emergency liquidity. Sir Philip Green, the Chair of Carillion at the time, said that he was “deeply disappointed” and “surprised” by the Government’s decision as, in his view, “this was a business capable of making cashback profits in the medium term.”238 Carillion asked for a total of £223 million support for a period from January to April 2018, including £160 million of direct support from the Government and the deferral of £63 million of Carillion’s tax liabilities.239

103.The Government decided not to provide this support. The Cabinet Office were pessimistic about Carillion’s plans for the future and believed the company might ask for further funding in the future.240 They performed an options analysis exercise which “concluded that a trading liquidation was the preferred option” as it “met the Government’s objectives” to maintain services, minimise disruption, maintain job security, minimise cost and avoid setting a precedent.241 The Government argued that it was “right not to reward failure” and that Carillion’s “directors, shareholders and lenders… should bear the brunt of the losses”.242

104.At this point, the Government’s contingency plans came into operation. The Minister argued that the Cabinet Office at this point faced “one of the biggest challenges that it has probably ever confronted”.243 The collapse of Carillion, according to him, represented “a huge risk to some of our core public services”.244

105.The Minister said that “the contingency planning for the most part did work effectively” and “there was no interruption in the provision of key Government services”.245 The Local Government Association told us in their experience that services had continued on the ground.246 Sir Amyas Morse pointed out that in many cases the partnership structures the Government had designed “worked rather well”.247 The NAO believe that the net costs of the liquidation of Carillion to the Cabinet Office will be £148 million (the cost to the public sector as a whole will be “slightly higher”).248

106.As some failure of suppliers is inevitable, we have heard suggestions about how the Government’s approach to failure might be improved after Carillion. Sir Amyas Morse said that the Government should “have more open discussions with bidding contractors about scenario planning and what would happen in certain scenarios”.249 Rupert Soames, CEO of Serco, and Matt Dykes from the Trade Union Congress both supported “living wills” (meaning a document setting out clearly what would happen in the event of a company failing).250

107.Contractors can and have withdrawn in the past from contracts in situations where they themselves did not go bankrupt. For example, on the Department for Work and Pensions troubled providers threatened to pull out in December 2012.251

108.John Manzoni told us that the Government also could see the point of ensuring that suppliers had contingency plans to ensure services would continue.252 The Minister told us that the Government was pursuing its own review of its work with Carillion during its collapse to identify lessons for the future.253 In a speech in June 2018 the Minister said that the Government would “require all key suppliers to develop what are known as ‘living wills’”.254

109.The Government made the right decision to let Carillion fail. The Government lacked confidence in the plans put forward by the company’s management. The cost of funding the company would have been higher than the costs of the liquidation. It is notable that the shareholders and financers of Carillion have lost money through the failure of the company. We agree with the Minister that this is appropriate as it sends a signal that ultimate responsibility for Carillion rested with its management, shareholders and financers.

110.The failure of Carillion could have resulted in the collapse of public services. It did not. The Cabinet Office and the Government ensured through contingency plans worked on between July and January that they could cope with the liquidation. The Government deserves credit for ensuring that, in January 2018, services mostly continued. The Government were right to prioritise the interests of the public who use those public services.

111.The Minister for the Cabinet Office has announced a review of how the Cabinet Office responded to the Carillion crisis. That review should take note of the weaknesses in the Government’s approach. These include the Government’s surprise that Carillion issued a profits warning in July 2017, when some investors had been warning about the state of the company for years.

112.The Cabinet Office should ensure that it holds appropriate information about the contracts held by each of its strategic suppliers and aggregate the risk exposure from across the whole of Government to large contractors like Capita and Serco. We understand that the Public Accounts Committee will be reporting on this issue shortly and we await their recommendations with interest. The Cabinet Office should also ensure that it learns lessons from this crisis about how to quickly collaborate with local government to deal with the issues raised by a collapse such as Carillion.

113.We welcome the Minister’s commitment to bring forward proposals for living wills with each key strategic supplier. The Government should lay out in their response to this report what these living wills will contain. The Government should clarify whether these wills would only apply when a contractor goes bankrupt, or whether they would also apply when a contractor withdraws effectively from a contract. The Government should set out measures to ensure that the public knows that these living wills are agreed: so that users of services can have confidence in their resilience despite what may or may not happen to particular companies.

177 Serco LCC0022

178 Mitie Trading Update (September 2016), Mitie Trading Update (January 2017), Mitie Trading Update (May 2017)

179 Glyn Barker Chairman’s statement (April 2018)

181 Q704

182 Q465 (Nick Davies)

183 Q7 Liaison Committee 7 February 2018

184 Q7 Liaison Committee 7 February 2018

185 Q7 Liaison Committee 7 February 2018

186 Professor Haslam and Dr Nick Tsitsianis LCC0029

187 House of Commons Library Briefing Paper Number 8206, The Collapse of Carillion, March 2018, p. 18

188 Ibid. p. 19

189 Professor Haslam and Dr Nick Tsitsianis LCC0029, (Professor Leaver) LCC0043

190 Goodwill is an accounting estimate on the value acquired by a firm when purchasing another firm over and above the value of the assets acquired. Professor Haslam and Dr Nick Tsitsianis LCC0029

191 Business, Energy and Industrial Strategy and Work and Pensions Committees Second Joint report of Session 2017–19, Tenth Report of the Business, Energy and Industrial Strategy Committee of Session 2017–19 and Twelfth Report of the Work and Pensions Committee of Session 2017–19, Carillion, HC 679, p. 13. J. Ford ‘Carillion’s troubles were shrouded in a fog of goodwill’ Financial Times, 18 June 2018

200 LCC0043 (Professor Leaver)

209 Q684 (Matt Dykes)

214 Chris Ham, Contestability: a middle path for healthcare, British Medical Journal, Vol. 312 (January 1996)

215 Australian Productivity Commission, Introducing Competition and Informed User Choice into Human services: reforms to human services, No. 85, October 2017, p. 24

216 S. Domberger and P. Jensen, Contracting out by the public sector: theory evidence and prospects, Oxford Review of Economic Policy, Vol. 13, Issue 4, December 1997, p. 69

218 Reform LCC0006

219 Public Accounts Committee, Contracting out public services to the private sector Forty seventh report of the Session, Forty-seventh Report of Session 2013–14, HC 777, p. 9

220 Federation of Small Businesses, Nine out of ten public sector suppliers hit by late payments, April 2018

221 A framework agreement is an arrangement made with providers that sets out terms and conditions for specific purchases, which can be made through the term of the agreement Federation of Small Businesses, UNSTACKING THE DECK: BALANCING THE PUBLIC PROCUREMENT ODDS p. 5

224 Ibid

225 Ibid

226 Public Accounts Committee, The monitoring, inspection and funding of Learndirect Ltd, Twenty-Second Report of Session 2017–19, HC 646, p. 3

227 Report by the Comptroller and Auditor General, Principles Paper: Managing provider failure, Session 2015–16, HC 89, p. 15

228 Public Administration and Constitutional Affairs Committee, The collapse of Kids Company: lessons for charity trustees, professional firms, the Charity Commission, and Whitehall, Fourth Report of Session 2015–16, HC 433, p. 43

230 Report by the Comptroller and Auditor General, Investigation into the government’s handling of the collapse of Carillion, Session 2017–9, HC 1002, p. 7

231 Ibid. p 16

232 Ibid. p. 7

233 Public Accounts Committee, Forty-first Report of Session 2017–19, Government risk assessments relating to Carillion, HC 1045

234 DWP BEIS Joint Inquiry Q998

235 DWP BEIS Joint Inquiry Q1026

236 Report by the Comptroller and Auditor General, Investigation into the government’s handling of the collapse of Carillion, Session 2017–9, HC 1002, p. 31

239 Report by the Comptroller and Auditor General, Investigation into the government’s handling of the collapse of Carillion, Session 2017–9, HC 1002, p. 37

240 Ibid. p. 44

241 A trading liquidation involved insolvency proceedings starting but with the Insolvency Service funded to continue public services. Report by the Comptroller and Auditor General, Investigation into the government’s handling of the collapse of Carillion, Session 2017–9, HC 1002, pp. 41–3

243 Ibid

244 Ibid

248 Report by the Comptroller and Auditor General, Investigation into the government’s handling of the collapse of Carillion, Session 2017–9, HC 1002, p. 48

250 Q675 (Rupert Soames), Q726 (Matt Dykes)

251 Report by the Comptroller and Auditor General, Programmes to help families facing multiple challenges, Session 2013–14, HC 878, p. 8

Published: 9 July 2018