Carillion: who is protecting the Trade and other Unsecured Creditors?

The collapse of Carillion poses an urgent question for participants in Supply Chains who have no payment security, and have made deliveries of goods and services with a credit period. That means almost every business.

The question is whether the shareholders will really experience “moral hazard”: do they only make a recovery from the liquidation once all creditors higher up the “creditor ladder” have had their claims satisfied in full?

Unfortunately the Trade and other Unsecured Creditors are likely to fall victim to the structuring of the financing behind Carillon and end up, once the creditor ladder has been strung, on the bottom-most rung.

Otherwise why are they being led to expect only 1p-in-the-£1 of their claims, when Carillion has contracts through which it can convert Stocks to Work-in-Progress to Finished Goods to Trade Receivables to Cash?

We believe 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 bank debt on the books of Carillion, but we believe that what will in due course become clear is that VCs have been able to put themselves at the top of the creditor ladder and not the bottom, to the detriment of all unsecured creditors.

This type of financing structure means that most of the “capital” of the target company (Carillion in this case) was not equity but debt, and the key differences are:

• 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.

The assets of the target company will be 100% charged to either the banks or the VCs, and so the Trade Creditors are selling in without payment security.

This type of 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: https://www.ft.com/content/a4c3d9a2-d1d3-11e7-8c9a-d9c0a5c8d5c9

QUOTE

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.

UNQUOTE

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 lenders' priority claims. That is not surprising for Fixed Assets.

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 this is common practice for VCs:

1. to legitimise their injecting debt rather than equity;
2. so that they act as the Working Capital lender towards the company;
3. 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 funding the Fixed Assets.

Then we can infer that the financing structure is like this:

1. 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);
2. the VC holds its equity in the target company itself - the equity being a smallish amount;
3. the spv borrows from banks;
4. it on-lends to the target company at an interest margin of 4-5% over its own cost-of-borrowing;
5. this interest is tax-deductible for the target company, eliminating its taxable profits and corporation tax liability;
6. the spv receives a security charge over the Current Assets of the target company as security for its loan;
7. 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:

1. Banks lending directly and secured on Fixed Assets;
2. The spv – meaning the VCs – secured on Current Assets;
3. Unsecured creditors
4. The shareholders – the VCs, albeit that this equity slice is very small.

The banks have provided almost all the debt financing - to the target company directly in respect of and secured on Fixed Assets, and indirectly through the spv in respect of and indirectly secured on Current Assets.

The VC will soon earn back the equity in the form of its 4-5% margin on the Current Assets financing such that, in a liquidation, it 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? The liquidator liquidates the assets and applies the resulting cash in accordance with the creditor ladder, the financing contracts in place and applicable law. The answer is no-one.

If that is the answer in Carillion's case, and in Monarch's and Comet's, how many other situations like this are there?