The Trade and other Unsecured Creditors of Carillion are being led to expect only 1p-in-the-£1 of their claims. This is curious when Carillion has contracts through which it can convert Stocks to Work-in-Progress to Finished Goods to Trade Receivables to Cash.
The creditors have supplied on Open Account terms, with no payment security, and with a credit period of 30 to 180 days i.e. where the invoice has not been paid late if the creditor receives their money at the very end of the agreed credit period.
These would be considered completely normal Terms of Trade where a supplier sells to a domestic customer, even if – for the same supply made cross-border – the creditor might think of requesting Advance Payment, a Documentary Collection or a Documentary Letter of Credit.
Supplying to a large domestic company creates an illusion of security, in Carillion’s case based on who Carillion was supplying to in turn (public projects, high-profile projects) and on Carillion’s acting in consortia with other major companies to carry out the projects.
In the event the comfort drawn by creditors from the context in which Carillion was acting was illusory. Creditors should have taken a hard and detailed look at how Carillion was financing itself, and the implications of that knowledge for themselves. The unsecured creditors did not do this, and they look set for a 100% write-off. But Carillion is far from a one-off in this regard, and the situation will repeat itself unless the underlying issues enjoy a much larger degree of profile than they have had so far.
The problem for the unsecured creditors is that, while in law their claims rank as Senior Unsecured Liabilities and should rank near the top of the "Creditor Ladder” in the liquidation, the financing of Carillion has been arranged by its owners and its banks so that Carillion’s assets have been encumbered, creating Preferred Creditors and causing the Trade and other Unsecured Creditors, once the creditor ladder has been strung, to be standing on the bottom-most rung.
It will be interesting to see whether the shareholders really experience "moral hazard": do they only make a recovery from the liquidation once all creditors have had their claims satisfied in full?
One expects this not to be the case, and that it will come out into the open that Carillion was financed by Venture Capitalists ("VCs") who have loaded up Carillion with debt, mostly on-lent by themselves.
Certainly, there will be some direct bank debt on the books of Carillion, but there is precedent for VCs injecting the larger part of their "capital investment" in a target company (Carillion in this case) not as equity but as debt, exploiting the key differences:
- The debt can be secured on assets, whereas it is unlawful to allow equity to be secured on a company's assets;
- Interest on the debt is deductible as an expense, reduces the taxable profit and the liability to corporation tax;
- Equity yields a dividend, which must be taken out of post-tax profits, meaning (i) a profit must have been made in the first place; and (ii) tax must already have been paid on it;
- Loading a company up with debt should be controlled by Thin Capitalisation rules and by HMRC – oh yes, dream on...
So, a "profit warning" by such a company entails something of a charade as the owners will have been taking most of their remuneration out as a pre-tax expense of the target company, and as interest income – not dividend income – for themselves.
The assets of the company will be 100% charged to either the banks or the VCs, and so the Trade Creditors are selling in without specific payment security (like a claim on an escrow account, or a Letter of Credit) or general payment security (the certainty that there is a large pool of unencumbered assets to meet the claims of unsecured creditors in a liquidation).
Since the amount stated for Trade Creditors in the target company's accounts will be both large and self-refreshing, Trade Creditors actually represents a form of Medium-Term Debt, with two enormous advantages to the target company:
- The risk profile for the creditor is that of Subordinated Debt, because all the assets of the target company are encumbered in favour of other parties;
- It is interest-free, when Senior Unsecured Debt should cost LIBOR plus 2% for a company with unencumbered assets, and Subordinated Unsecured Debt to the same company might cost LIBOR plus 10%.
Neither Senior Unsecured Bank Debt nor Subordinated Unsecured Bank Debt would be available at any price to a company like Carillion that had encumbered all its assets, so Carillion's creditors have unknowingly been doing what no bank would do: provide unsecured finance to a company which had encumbered all its assets. Furthermore, they have been providing off-market finance in the security dimension (no security at all) at a radically off-market price (interest-free).
This type of financing structure was shown to be in place in the cases of both Comet and Monarch, who went down. Here is an extract from an FT article about Monarch on 25 November 2017, in which Greybull Capital - the owners - are also described as its secured creditors:
Monarch Airlines' former owners could yet make a profit on their investment despite administrator warnings that secured creditors are unlikely to be repaid in full. In its first creditors report since Monarch’s collapse, KPMG said the airline's secured creditors would probably "suffer a shortfall," even once two of Monarch’s main assets — its take-off and landing slots and the airline's engineering business — were sold.
Though it remains unclear how much money will be recovered for Monarch's secured creditors, Greybull Capital, which has first call on the airline's assets, could still walk away with money. The creditors report does not detail how much money is likely to be recovered for Monarch's secured creditors, which after Greybull includes PPF, Monarch's pension scheme. In total, Monarch has a secured debt of about £167m, with Greybull owed about £160m and PPF £7.5m.
We can assume that Comet's land&buildings were mortgaged, and we know that Monarch's aircraft were leased, such that the Fixed Assets of both companies were subject to the financiers' priority claims. It is not surprising that the Fixed Assets were financed on a secured basis.
What is more perplexing is that Greybull, in Monarch’s case, appears to have been the main supplier of the financing of Working Capital. Comet's owners likewise had a floating charge on the company's current assets.
From these facts we can infer that VCs do this all the time:
- to legitimise their injecting debt rather than equity into their target companies;
- so that they act as the Working Capital lender towards the company;
- to thereby structure their main income flow out of the transaction as interest, which is tax-deductible for the target company, rather than as dividends which come out of post-tax profits.
Since VCs tend to have little money of their own, we can surmise that they in turn borrow the money they inject into the target company as debt, and that they borrow it from the same set of banks that are directly funding the Fixed Assets of the target company.
a. the VC establishes a "special purpose vehicle" company (an "spv") for this purpose in respect of each investment it makes (i.e. in respect of each target company), and injects a very small amount of equity into the spv;
b. the VC holds the equity it owns in the target company itself - the equity being a smallish amount that the VC may have itself;
c. the spv borrows from banks – in a large multiple of the spv’s own equity and of the equity the VC owns directly in the target company;
d. the spv on-lends to the target company at an interest margin of 4-5% over its own cost-of-borrowing;
e. this interest is tax-deductible for the target company, eliminating its taxable profits and corporation tax liability;
f. the spv receives a security charge over the Current Assets of the target company as security for its loan;
g. the spv grants a back-to-back security charge on all the spv's assets in favour of the banks, from whom it has borrowed as per (c) above.
The target company's financing is from four sources, satisfied in this order in a liquidation:
||The spv – meaning the VCs – secured on Current Assets
||Banks lending directly and secured on Fixed Assets
||The shareholders – the VCs, albeit that this equity slice is very small
The banks have provided almost all the financing - to the target company directly in respect of and secured on Fixed Assets, and indirectly through the spv in respect and indirectly secured on Current Assets.
The VC will soon earn back the whole equity amount it has invested, because this equity is thin, and because it is earning a 4-5% interest margin on the substantial Current Assets financing through the spv. In a liquidation, the VC will not be too concerned if it loses the equity entirely.
The VC will be at the top of the creditor ladder with regard to the Current Assets of the target company, reducing its risk. Its risk is further reduced by the low equity it puts into the spv and by the spv's debt funding being without recourse to the VC itself.
The VC has very limited value-at-risk, it enjoys a high return, and is at the top of the creditor ladder. The banks meanwhile have security – directly and indirectly – on the entire assets of the target company.
The unsecured creditors of all types are left to whistle in the wind. Who is looking out for them? The liquidator? No, the liquidator liquidates the assets and applies the resulting cash in accordance with the creditor ladder, the financing contracts in place and applicable law.
No-one is looking out for the Trade Creditors except themselves. Trade Creditors thus need to be extremely wary of supplying on a domestic basis to companies financed in the way Carillion, Comet and Monarch were financed.
But it is easier to issue such a warning than for the Trade Creditors to act on them:
- How are Trade Creditors to know how their client is financed?
- What do they do about it once they have found out?
- How many of their potential clients are not financed like this such that, if they decide not to sell to such clients on Open Account, do they have no market left?