UK Auditor's Report: Carillion Collapse Landed on Banks and Insurers
30-year design-build contracts for two hospital projects draw scrutiny
The collapse two years ago of one of the U.K.’s largest contractors stalled numerous projects, including two flagship National Health Service hospitals that were already in trouble. The failure of Carillion plc played havoc with the hospitals' construction schedule and budget. Because the projects had been procured under the Private Finance Initiative, banks and insurers took the biggest financial hit, according to a new report by the U.K. National Audit Office.
Carillion had design/build contracts with two separate companies. Each firm had roughly 30-year PFI deals to finance, design and build the two hospitals and then provide facility management services for their operational phase.
Carillion also held half of the nominal equity in the two project companies, which provided $74 million of debt financing and secured additional loans totaling $513 million. To make the projects more bankable, the hospitals and government contributed $279 million towards construction, which was “considerably more than was usual,” according to the auditors.
At the time of Carillion’s collapse in January 2018, the 646-bed Royal Liverpool hospital, owned by the Liverpool University Hospitals NHS Foundation Trust, was close to completion. Owned by the West Birmingham Hospitals NHS Trust, the 669-bed Midland Metropolitan Hospital in Sandwell was two-thirds complete.
Now, with both hospitals not expected to open until 2022, the Liverpool project is running five years late and while the Sandwell job is lagging by three years and nine months. But both jobs were in trouble when Carillion folded.
Design problems at Sandwell were delaying the work while the Liverpool project was hit early on by the discovery of asbestos and later by the emergence of structural cracking and other deficiencies in the work done to that point. The defects were later found to be serious, requiring 70 “structural interventions” involving some demolition and equipment removal, according to a review for the trust by Arup Group.
While NAO investigators did not look in detail into the causes of the engineering failures at the two hospitals, the auditors cite anecdotal evidence that Carillion had bid too low to achieve the required quality.
While there were contingency plans covering Carillion’s facilities management work on the projects, government and hospital officials had assumed that the PFI companies would complete the construction work. However, without recourse to Carillion’s balance sheet, the project companies lacked necessary funds and sought additional funding from the trusts.
But in May 2018 the government refused to bail out the companies. Auditors were fearful of setting a precedent that could potentially lead to “all the government’s PFI debts being reclassified as national debt.” The PFI contracts were terminated and the projects reverted to the public sector.
Because the Liverpool contract included provision for compensation to the lenders in case of termination, the government agreed to pay £55 million rather than embarking on lengthy negotiations to bring down the cost. The government could have avoided paying compensation had officials “better understood the cost to complete the Royal Liverpool,” the auditors noted.
With both trusts now directly running the projects, Laing O’Rourke is managing completion of the Liverpool project on a fee-based contract.
Since the original PFI deals were signed, the cost of both jobs has nearly doubled. In Liverpool’s case, the $487-million hike over the original $455 million includes $381 million to remedy the major structural and other faults.
Because the project companies’ investors and insurers for the most part have carried losses of around $784 million on the deals, the public sector is expected to pay only a 1% real cost increase for the two hospitals.
But since the public sector spending must take place during the construction period rather than over the whole 30 years of the PFI contract the net present value of the cost hike is officially put at 15%. Additionally, having initially contributed to the capital costs of the projects, the public sector bore some of the investor losses.
Meanwhile, as the Carillion fiasco put an unflattering spotlight on the U.K. construction industry, the accountancy business is also blushing. Just how the annual audits of Carillion’s books missed the huge hole in its finances is now the focus of another investigation — into the accounting firm KPMG by the Financial Reporting Council.