One key lesson from Carillion’s demise is that risk mitigation tools may not provide the level of protection that contractors may need but the answer may be found in surety bonds
When the UK’s second largest construction company declared insolvency on 15 January 2018 it sent shockwaves throughout the industry, with an estimated 25,000 to 30,000 subcontractors and other suppliers owed approximately £1 billion ($1.4 billion). It is understood the company started losing money on some of its more prestigious contracts and ran up significant debt in order to offset these losses.
Analysts argue the company overreached and took on too many risky contracts as it fought to stay afloat. And eventually the losses, payment delays and debts caught up with Carillion. In 2017 it issued three profit warnings within a span of five months and wrote off over £1 billion on its contracts, making it even more difficult to manage and service its debts.
Even the announcement the firm had been awarded the £1.4 billion HS2 contract was not enough to halt its demise. “It was a big hit to the sector but with hindsight it didn’t necessarily come as a huge surprise,” says Tomas Zapletal, head of UK surety at Swiss Re Corporate Solutions. “When you’re extending payment terms to your suppliers and your creditors for no valid reason that’s a warning sign that this company is perhaps under pressure.”
As the fallout continues, the insolvency has highlighted the many pressures that main contractors are under. While insolvency within the largest UK contractors was not as big an issue during the financial crisis as some had predicted, Carillion shows many of the inherent difficulties remain. According to analysis by Construction News, conditions have deteriorated over the past 12 months “lending weight to fears that Carillion’s collapse is unlikely to be the last among the UK’s biggest firms”.
“It’s not easy to be a main contractor working for demanding customers, and at the same time managing the supply chain and the subcontractors,” thinks Zapletal. “In a market that’s quite competitive the margins gets squeezed to such an extent that there isn’t much headroom for companies like that to manoeuvre.”
Carillion has also drawn attention to the importance of surety bonds when it comes to protecting governments, private owners and lenders from contractor defaults. “If you’re looking to build a new prison, hospital or motorway you want to make sure that the contractor that you appoint will be there to complete the project, be that next year or five years down the line,” says Zapletal. “It’s a risk governments face when they appoint private sector companies and it’s important for them to be prepared for defaults.”
“Surety bonds give them extra protection they need,” he adds. “The bonds are there to compensate the government for losses or damages suffered under those contracts as a result of the contractor defaulting. For sureties, the contractor is the risk and the government is looking for a third-party guarantee that if the contractor defaults the government will be able to call on that guarantee and look for compensation.”
Surety bonds have a number of benefits in comparison to other risk mitigation tools, such as irrevocable letters of credit (LOCs) for instance, helping to bridge the gap between contractors and the banks and injecting liquidity into the system. And unlike LOCs, completion of the construction project remains a key goal of a surety bond, which remain in force for the duration of the contract, in addition to the provision of financial protection.