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Carillion’s collapse – Blame it on the Schuldschein?

Strange new terms cropping up in a company’s annual report can say a lot about the financial position it has managed to get itself into and the unusual lengths it may be having to go to in order to find new funding

17/11/2017

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

Should you ever feel tempted to think you have seen it all as an investor, just dig out the latest set of accounts from one of the UK’s multi-faceted band of support services companies. Reverse factoring, anyone? What about Schuldschein bonds? Each year, here on The Value Perspective, we work through hundreds of balance sheets and we had come across neither term until we saw the most recent accounts from Carillion.

Read any article on the Wolverhampton-based facilities management and construction services business these days and, chances are, you will see it described as “beleaguered” – and with good reason. Its market capitalisation has shrunk by roughly three-quarters since announcing one profits warning in July, a second in September and a third, postponing the testing of banking covenants in November.

We are not going to risk accusations of being wise after the event by suggesting these novel financial terms guaranteed Carillion was heading for such a tough time. But – and you knew that word was coming – experience does teach you the presence of such strange beasts in an annual report or a conversation with management, say, could reasonably be taken as a warning there may be trouble ahead.

The concept of 'reverse factoring'

Take this idea of ‘reverse factoring’, which is perhaps most easily explained by initially referring to, well, factoring. That is when a business is owed money and, rather than chasing the debt itself, signs it over to a bank, which pays the money – minus an appropriate fee – and then goes after the debt. This is a reasonably common business practice that, when used sensibly, can help companies temporarily boost cashflow while avoiding the hassles of debt collection.

A few years ago, the government decided it wanted to encourage large companies to be more considerate to smaller businesses in their supply chain. One consequence of this was that, if big construction groups – such as, say, Carillion – wanted to remain in with a good chance of winning government contracts, they needed to ensure they started being more prompt about settling their invoices.

Rather than being more prompt about settling their invoices themselves, however, many chose to reverse factor what they owed. For a fee, a bank would pay what was owed to the supplier within the new shorter timeframe and allow Carillion to settle up further down the line. To be clear, there is nothing wrong with this practice and it can be a useful financial tool but, equally, there is no avoiding the fact it is a slightly different form of borrowing – in effect, a bank is providing money today, so you do not have to.

And, if you want to unwind the arrangement at some point, all the extra cashflow you have been enjoying will need to be put back into the system. Carillion has more than £400m of this kind of financing – more than twice its current market capitalisation – in addition to all its other debt, so this is just one more thing it will eventually have to find money for if it wants to return to something approaching a more normal financial footing.

Carillion's use of a Schuldschein bond

Though perhaps not by way of another Schuldschein bond – which is how Carillion raised £112m last January. As we say, whenever you see something in a company’s debt structure you have not come across before – and this type of bond was certainly new to The Value Perspective – it can be a sign a business’s existing debt is sizable enough to put off more traditional sources of debt capital to UK businesses, such as banks and standard bonds.

When that happens, a company will have to think a bit more laterally about where to find any extra financing it needs if it wants to avoid the embarrassment of raising new equity – hence the rise in the use of curious-sounding instruments such as ‘hybrid bonds’ or ‘PIK-toggle bonds’, that blur the lines between equity and debt as we have discussed in articles, such as Pik-ing holes and Flashing lite.

While the Schuldschein bond is not so exotic – indeed, in many ways, it is deeply traditional – it is highly unusual for a UK business to turn to this market to raise funds. Originating, as you may have guessed, from Germany, the Schuldschein is a form of private placement debt.

This has the advantage of removing the need for some of the awkward little details required by a public debt issuance, such as an audited prospectus and a credit rating. A company will meet investment houses and other potential lenders in Germany and then they will take a view on whether or not they want to give you any money.

And you would at least have to entertain the possibility that, having scrapped around for any sort of yield in the historically low-interest-rate environment that has persisted since the financial crisis bit in 2008, some people may have begun to let their due-diligence standards slip of late – to the extent they ended up lending £112m to a now financially … beleaguered UK contractor.

At the very least, these two examples say a lot about the position Carillion had managed to get itself into and the unusual lengths it was then having to go to in order to find the extra financing it needed.

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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