Financial Engineering

Ever since the Carillion story broke, I've been meaning to have a look back at another high profile company collapse, that of care home provider Southern Cross in 2011. It cropped up on the blog:- 

It's All in the Timing

The timing was exquisite. Just as prime minister David Cameron was on his feet and extolling the virtues of privatising further swathes of public services, the nation was absorbing the news that the largest private provider of care homes in the UK was packing up. Southern Cross serves as an absolutely perfect example of what can happen if public services end up being treated as businesses or 'investment' opportunities.

I absolutely loved it when a spokesperson for the private care home sector had the audacity to say on the radio that "the problem was that fees paid by Local Authorities for looking after the elderly had not gone up." Err no, the problem is that 751 care homes that used to be owned by Southern Cross were sold off to asset strippers who pocketed the £1billion pounds and saddled the management with rent bills instead! According to him, the public sector should be paying the inflated rents due to property speculators.

We all know that publication of the Public Services White Paper has been delayed for months due to spirited opposition from Lib Dems inside the coalition government. It's a really confusing mix of trying to encourage 'localism', which many feel is no bad thing, with doctrinaire insistence on breaking up public services such as probation. This, despite Cameron saying that public services "are the backbone of the nation."

Well I think the public are going to take some persuading that the Southern Cross debacle is anything other than a stark warning of further disasters to come and that would be inherent in this sort of public service 'reform' plan. Pictures of the elderly and frail being moved out of their care homes as they inevitably close over the next few weeks will quite rightly further embarrass the government and should serve to nicely highlight the differences between public and private service.

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Sorry, Jim, but that's an overreaction and scaremongering. Patients are highly unlikely to actually be turfed out of their beds. Nor is the 'problem' as simplistic as you would like it to be. I'm sure the "asset strippers" have their part to play, but if the business model relies upon increasing numbers of clients at increasing fees (basic costs of employing staff and other supplies are certainly going up), and these aren't happening, then you can't dismiss these - they are, too, part of the problem.

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It's interesting to note that our old friend Blackstone played a significant role in the demise of Southern Cross as well as Carillion. This from the Guardian in 2011:- 

The rise and fall of Southern Cross

Southern Cross, the troubled care home operator, stands on the brink of collapse this week just fifteen years after it was created. The company was set up in 1996 by a businessman named John Moreton, who had made his first fortune in his twenties during the North Sea gas boom. Moreton developed his new venture during the last major shake-up in the care industry, around the turn of the millennium, when government funding cutbacks and tougher care standards forced many homes to close or be sold off cheaply.

New operators such as Southern Cross Healthcare benefited, and the company had become a significant operator by 2002, with 140 sites. At that point, venture capital firm WestLB stepped in and bought Southern Cross for £80m as part of a management buyout. At that time, the City was confident that the care home sector needed to consolidate.

Two years later, US private equity firm Blackstone swooped, paying £162m for the company, which by that stage had 162 care homes. Blackstone made its ambitions clear from the start, pledging to turn Southern Cross into "the leading company in the elderly care market". Blackstone went on to buy NHP, one of Southern Cross's largest landlords, in a £1.1bn deal which also increased Southern Cross's size by another 192 leased homes. Further acquisitions followed, turning Southern Cross into the largest operator in the sector. NHP was sold off in March 2006, followed by a flotation of Southern Cross itself on the London stock market that summer.

Southern Cross performed well during its early days as a quoted company, nearly doubling its share price during the first year. That proved good news for Blackstone, which sold its final stake in the company in March 2007. It also continued to expand as demand for care home places kept rising, due to increased lifespans and falling capacity across the sector. Then, in the summer of 2008, the tale turned desperately sour when Southern Cross's expansion strategy was derailed by the financial crisis.

The company had been buying properties then selling them on again, while keeping a long-term lease. In the heady days before the collapse of Lehman Brothers, Southern Cross suddenly found itself unable to meet a £43m loan repayment deadline, because it could not find buyers for its property assets. In another blow, it warned the City that disappointing occupancy levels meant its earnings would not meet expectations.

The double whammy of profit warning and financing crisis sent its share price crashing from over £3 to just 130p in a single day. Chief executive Bill Colvin quit later that year, after Southern Cross began selling assets at a loss in an effort to repay its debts. Colvin was one of three senior directors who had received £36.6m after selling shares in Southern Cross in early 2008, when they were trading at 550p.

Southern Cross managed to renegotiate a new deal with its banks, and tried to ride out the storm. Then in May 2010, the crisis intensified again when Southern Cross revealed that local governments were sending fewer people into its homes, and pushing for lower fees.

In August, Southern Cross posted a profits warning, blaming the austerity cutbacks for a steady decline in occupation rates. These falling revenues rapidly left Southern Cross struggling to pay the leases on its properties. Hopes of a rescue takeover faded this year, prompting chief executive Jamie Buchan to warn that its rent bill was simply unsustainable. Many of its rents run for 25 years, and are subject to yearly upwards-only rent reviews.

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Of course there is another large care home operator in trouble as a result of 'financial engineering'. This from the Guardian last December:-

A shocking way to fund UK care homes

Why is Four Seasons Health Care, the country’s largest care homes operator, in financial difficulty? Why is the regulator, the Care Quality Commission, having to prod and cajole creditors to agree a standstill on debt repayments to prevent the business falling into administration? Why is this crisis happening only six years after the failure of Southern Cross, which at the time was the biggest company in the industry?

One could point to forces that are well-known. Fees are under pressure because local authorities’ social care budgets have been squeezed; overheads have been forced up by increases in the national minimum wage; and, at the margin, Brexit complicates staffing requirements.

Those factors are real but let’s not lose sight of the ingredient at the centre of the Four Seasons affair. It’s debt – too much of it. Terra Firma, Guy Hands’ private equity firm, over-paid for the business in 2012 and loaded up with leverage. At heart, this is an old-fashioned tale of financial engineering gone wrong. Southern Cross came from the same unlovely stable – in that case, the financial error was addiction to fancy sale-and-leaseback property deals.

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Four Seasons has arrived at a point where it is struggling to meet a £26m debt interest payment due on Friday. H/2 Capital Partners, the US hedge fund that has bought up majority positions in both classes of debt, holds the aces. It will probably clean up at the expense of Terra Firma since, with a gentler debt structure, Four Seasons is a good business. H/2 should still do the decent thing and get the financial restructuring underway as soon as possible. There is no need for an administration that could cause problems for the regulator and local authorities. Get on with it.

The rest of us, though, can only look at the current standoff and shake our heads. The UK is awash with long-term pension fund money that would happily build and own care homes for modest real returns. Instead, we have a high-stakes financial game in which players aim for fatter rewards. The result, in this case, is that control of the biggest care homes operator in the land will probably pass from a private equity outfit that made a rotten bet on financial leverage to an opportunistic US hedge fund that hunts for junk bonds to buy at a discount. It’s a shocking way to fund provision of care homes for the elderly.

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All of which brings us back to Carillion, the theme of 'financial engineering' and on-going revelations. In addition to a vast hole being revealed in the pension fund, it's good to see attention at last moving to the role of accountants and exactly what they do for their large fees. 

This from the FT draws some other startling historical comparisons that pre-date the financial crisis of 2008 and in the process, admirably demonstrates our seeming inability to learn by earlier mistakes:-   

The ‘true and fair’ questions that dog Carillion

In the early 1990s, two American economists, George Akerlof and Paul Romer, wrote an academic paper with the eye-catching title: “Looting”. Its subject was the Savings & Loan crisis of the 1980s, which ended up costing the US taxpayer some $132bn in a string of bailouts. What intrigued the authors was the way some S&L owners ran their failing real estate lenders into the ground, wholly focused on value extraction and without a thought for the losses that they would leave behind. 

They displayed a “total disregard for even the most basic principles of lending”, failing to verify the most basic information about their borrowers or, in some cases, not even bothering even to ask for it. Why, the economists asked, had they behaved in so cavalier a way? One reason, they concluded, was the existence of a government backstop. The state stood behind deposits that the S&Ls had taken. 

But that was not the only thing encouraging the owners to loot their own operations. There was another big factor: poorly framed regulation. Easy-to-arbitrage rules and sloppy accounting standards kept S&Ls nominally afloat when in reality they were not viable. That created the circumstances in which owners could plunder dividends out of capital, as they either prayed for a miracle, or prepared to cast the depleted creditors into the taxpayers’ lap. 

Echoes of this unsavoury situation can be found in the case of Carillion, the British outsourcing and construction group that has just collapsed owing more than £2bn to its banks. Once again, the government bobs up on the periphery, in this case chucking out state-funded contracts like confetti that appeared to underwrite the group’s viability. Carillion’s board may not have looted, but it does seem to have practised what one might call “reckless abstraction”. It sucked out cash to placate stock market investors even as executives wrote the mountain of under-priced contracts that ultimately buried the business, triggering a £1.2bn writedown in the second half of last year.

In the five years to 2016, the directors recommended paying £357m of dividends to shareholders, despite generating just £159m of cash from operations. Over the same period, the bonuses for the two top executives climbed from nothing to more than £1m a year in 2016. 

Carillion is hardly the first listed business to base today’s juicy payouts on (inaccurate) estimates of tomorrow’s outcomes. One of the more notable features of pre-2008 banks was their enthusiasm for using mark-to-market accounting to write up unrealised profits on assets, thus conjuring large and imaginary surpluses out of complex securities. The swag was then packaged up and paid out largely in the form of debt-funded bankers’ bonuses. As for the later losses; well, of course, the taxpayer paid. 

Clearly, it is unhealthy for the state to backstop private corporations — although in Carillion’s case, the government’s involvement fell short of a fully-fledged bailout. But no less worrying are the signals sent by modern accounting standards, which continue to give great leeway to recognise unrealised gains. 

Under company law, it is a cardinal principle that limited companies should only make distributions out of distributable reserves, not capital, to protect investors’ cash. Yet in a world where anticipated revenues count towards today’s profits, it is hard to know precisely where that crucial line lies. The investor’s main defence is the auditor being required to call out imprudently recognised sums. 

In Carillion’s case, it is reasonable to ask whether this happened. We do not know yet how KPMG came to rubber stamp accounts supporting the payment of a £79m dividend last year, leaving distributable reserves of just £93m on the group’s balance sheet. What we do know is that Carillion wrote off £1.2bn just a few months later; a move that not only obliterated its reserves many times over, but also all of its profits over the previous eight years. 

If the rules permit excessive latitude, that raises questions not only about standards, but also about the auditor’s watchdog, the Financial Reporting Council. Other past scandals exhibit similar features, including the overstatement of supplier rebates by supermarket owner Tesco, and the implosion at Quindell, an insurance software group. 

Accounts are supposed to show a “true and fair” view of a company’s affairs. If they do not, it is pretty concerning. The S&L crisis highlights the peril of allowing directors to write their own figures. Faulty standards run the risk of meaning accounts cannot be relied upon. As a group of investors, activists and academics put it this week in a letter to the FT: that poses “devastating consequences for all stakeholders who depend on businesses remaining going concerns”.