Jeremy Corbyn’s Labour party likes to describe outsourcing companies as “rip off” organisations that are out to “fleece” the public. It’s a nice line, but is there any real substance to these claims?
You certainly wouldn’t think so, looking at the state of some of the outsourcing companies. Or, at least, if they are fleecing, they are making a very poor fist of it. Last week, shares in Interserve — one of the larger UK operators — more than halved in a single day after the company told investors it was in talks with its banks about a rescue plan.
It is just one of a number that are wrestling with cratered finances. Kier, Capita and Mitie are also seeking to rebuild their balance sheets. Kier, another construction and support services company, launched a £264m rescue rights issue last month.
And it’s hard to see much positive coming from Interserve’s restructuring talks — at least from the shareholders’ perspective. The company badly needs new loss-absorbing equity if it is to continue as a viable entity. Yet following the share price slump, Interserve’s market capitalisation is £19m. That is just 3 per cent of its net borrowings, which stand at a towering £553m.
The Corbynite critique rests on the idea that these “crony” organisations are gouging the public. Some may be, but there’s plenty of evidence in the opposite direction. Indeed many of the sector’s problems appear to stem precisely from companies’ willingness to take on jobs on impossibly tight terms — a practice known as “suicide bidding”. Take Carillion, the construction and outsourcing company that collapsed this year. When the Ministry of Justice took back some prison contracts the company had entered into, it found the prices completely unsustainable. The recovered operation raised the government’s costs on those services by some 15 per cent.
This may seem puzzling. The industry has been consolidating, partly encouraged by the public sector which sought increasingly to negotiate big contracts rather than lots of little ones. Normally such a process might allow companies to restore margins.
But that ignores the skewed priorities of these companies. Outsourcing business models were always less about making money from the humdrum game of providing excellent products and strong customer service. No, the idea here was to pursue new business at all cost.
Fresh contracts were vital not simply because of investor focus on the size of the order book. They also offered interesting accounting possibilities. Accounting rules allowed companies to write up substantial profits in the early years — a process that in turn encouraged reckless bidding. (Concerns about long-term losses could always be assuaged by the belief that the contractor — once entrenched — would renegotiate more favourable terms — a process known as “land and expand”.)
As with essential utilities such as energy and water, the comforting presence of state-backed cash flows encouraged financial institutions to bankroll this party, providing the finance for a wave of cash takeovers.
Substituting debt for equity might have been imprudent, given the largely intangible assets against which the bankers were lending. But it helped to push up earnings per share, synthesising growth and subsidising bosses’ healthy bonuses.
Where the utility parallel breaks down is that outsourcers are not regulated businesses, with watchdogs whose duties include the responsibility of ensuring they can finance their activities. Worse, when Carillion failed in January, the government not only dashed hopes that the possibility of disruption would induce it to make a bailout; it also put the company directly into liquidation, a process that helped it to pass on or reabsorb the contracts with minimal compensation. The banks involved found themselves exposed to a thumping loss.
The penny has now dropped, which explains the frantic efforts of bankers to replace debt with more equity. But with investors disinclined to chuck good money after bad, the banks may — as with Interserve — have to supply much of that new equity themselves.
It’s a mess perhaps, but very far from the picture painted by Mr Corbyn. Bankers and executives are being forced to take some of the consequences of their own actions (although past, unearned bonuses have not been disgorged). The state has little incentive to take steps that would raise its own costs while it has private contractors’ equity to call on.
The financial restructuring under way may ultimately result in less favourable financial terms for outsourcers’ customers. But that is reality and will force companies to innovate or shrink. What emerges should be stronger.
This is hardly crony capitalism; it is how markets ought to work.
Get alerts on UK outsourcing when a new story is published