In a recent book, “Capitalism without Capital: The Rise of the Intangible Economy” Jonathan Haskel and Stian Westlake note the tendency of modern companies to operate almost without any tangible assets.
Apple may be the world’s most valuable company, but it owns little physical property. It is the group’s intangible assets — such as its software and design — that underpin its value.
Many of the attributes of intangibles are positive, note the authors: for instance, they can be scaled up and can generate synergies. But one is more troubling, and that is their “sunkenness”.
This refers to the fact that intangible assets have little or no ready market value, unlike property or plant and equipment. They may have scant worth to any other business, meaning that in a crisis their value may suddenly and terminally collapse.
Carillion’s failure is an object lesson in the perils of sunkenness. The British outsourcing group imploded this month in spectacular fashion, leaving next to no value for creditors, including its many pensioners, who now face seeing their retirement incomes hacked back by the financially hard-pressed Pension Protection Fund.
Much of the criticism so far has been aimed at the practice of outsourcing, and whether it is right that private companies should in effect take in the public sector’s washing. But Carillion’s failure points to other worries. It shows the bank-like dangers of levering up companies with balance sheets stuffed with hard-to-value and illiquid intangibles. And also the risk of executives making things worse by striving to avoid admitting their mistakes.
Carillion’s balance sheet shows the extent of its dependence on these ethereal assets. At the end of 2016, things that could be sold in a crisis (ie fixed assets and stocks) accounted for just 5 per cent of the total. Its solvency thus depended on the valuation of intangibles accounting for nearly 40 per cent of the balance sheet. Almost all of those were goodwill — acquired with the many companies Carillion acquired over the 18 years of its existence.
Goodwill is supposed to reflect the present value of future cash flows coming from a company’s underlying assets — or in Carillion’s case those businesses it purchased. Companies awash with intangibles are often tempted to borrow against this asset base, especially — as with Carillion — when they have government-backed revenues.
But, as Professor Adam Leaver of the University of Sheffield points out, this carries dangers. It requires the borrowing company to ensure “that the present costs of its future liabilities can be met from the income generated by its underlying assets”. And here lay the ticking bomb in the group’s case.
What Carillion should have done when it realised it had overestimated the future value of its contracts was to write down some of the goodwill on its balance sheet. The snag of course was that this would have twitched it towards insolvency, likely costing the top executives their employment and escalating bonuses. So instead it pursued other less responsible expedients to keep the spinning plates aloft.
These included piling up yet more short-term liabilities; not only to tide over cash shortages on underwater contracts, but also to pay out big dividends to keep shareholders onside.
Carillion also attempted to double down by taking in more contracts, hoping to use the money to pay back short-term creditors. This not only risked robbing Peter to pay Paul, but also led to a slump in margins as the group slashed prices to secure business. The operating margin fell from 5.3 per cent to just 4 per cent between 2012 and 2016, according to Prof Leaver. This contributed to the group’s collapse.
Two things follow from these observations. The first is that in a less tangible business world, clearer rules are needed on valuing intangibles. In Carillion’s case, everyone seems to have taken their cue from what others were doing. So lenders continued lending because the government was still mystifyingly issuing contracts — almost to the end. Presumably the auditors will claim they took comfort from the fact that Carillion was still able to raise finance.
This, of course, should not excuse KPMG a serious grilling about its conduct. The accountants must explain why they failed to impair goodwill by even a shilling in spite of the group’s increasingly desperate manoeuvres.
In Britain, like the US, investment in intangible assets now exceeds that in tangibles. Rules are not the only thing that need to evolve in this environment. Shareholders and creditors must think harder about governance in more intangible ventures. That might mean controlling leverage more tightly, and forcibly switching off dividends when companies contract high borrowings. Carillion’s pension scheme members might now be better off had the trustees followed this muscular, but legal, approach.
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