From the desk of Jeroen Bakker,
Benelux Consulting Lead, Pierpoint Financial Consulting
In the fourth episode on (In)Famous Securities Lending Transactions, we focus on one of the most significant default situations in the United Kingdom: Carillion Plc. What happened? Who was to blame? And more important did anyone profit?
The year is 2018 and on January 15 Carillion Plc. went into compulsory liquidation with liabilities close to £7bn, by far the largest ever trading liquidation in the UK.
Carillion Plc was founded in 1999 as a demerger from Tarmac and throughout the 2000's and ' 2010's a string of takeovers was done including Citex Management Services, Mowlem, Alfred McAlpine and John Laing. Outside the UK Carillion grew steadily with takeovers mainly in Canada and in August 2014 Carillion made an unsuccessful bid on Balfour Beatty valuing the company at £2.1bn.
Initial concerns about 'Carillion's financial situation were raised by analysts back in 2015 when Carillion was deemed to be more leveraged than reported due to reverse factoring and extended supplier payment terms. Reverse factoring is a financing solution whereby the ordering party (in this case Carillion) asks a third party to finance their supplier's receivables, often at a lower interest rate. This combined with an expected profit shortfall made Carillion a favourite for hedge funds to short by the end of 2015.
During 2016 and 2017 Carillion reported many difficulties in ongoing projects. A £845mn impairment charge in its construction division led to the stock being demoted from the FTSE 250 and a profit warning led to the stock price movements as per the chart below. A drop from 300p to 200p (or 33%) over 1,5 year is not that substantial; however, the FTSE 100 rose more than 30% in the same period.
With the securities lending data provided by FIS Astec Analytics, we can now have a look how the pending financial difficulties of Carillion played out in the financial markets and if short sellers were able to structure any profitable transactions.
To start, we will look at the securities lending utilisation levels as this is often, even before securities lending fees, an indicator that short interest in a particular stock is rising.
The graph shows an increase in utilisation towards the end of 2015, a slight drop at the beginning of 2016 followed by an ever-increasing utilisation up until August 2018 which was the end of the trading phase of the liquidation.
In general, non-main index stocks have a utilisation of around 10-20% once it gets to that range there is substantial interest from institutions to short the stock. When a stock goes beyond that utilisation level there should be a direct impact on the fee involved.
The securities lending fee graph, which is indexed using January 2015 fee as a baseline shows a rather stable 2015 and 2016, only halfway through 2017 the fee increases exponentially to close to 300% of the GC fee back in early 2015. The sharp drop in January 2018 is, of course, the announcement of the liquidation which kept utilisation levels high but caused a drop in fee to around 5%.
If we then view the utilisation and the fee in one graph you can really see the trend which will happen when stock become special. First the utilisation levels creep up slowly while fees remain GC and only when utilisation levels reach the 60%-80% bandwidth does the fee start to increase as well. At first slowly but as more parties get involved, the stock fee becomes rapidly very special.
Now that we have looked at the utilisation and fees, we can make a hypothetical trade and see if there was any revenue is shorting Carillion. Let's assume an investment manager is shorting £10mn of Carillion stock at the beginning of 2017 and keeps the short on until the announcement of the default on January 15 2018.
The transaction would look as follows:
The SBL fee is calculated based on the number of shares multiplied by the stock price times the SBL fee of the day divided by 365 or:
Value * Fee 365
This fee is then accrued daily and paid on a monthly basis.
This calculation example, which would net the investment manager more than £9.2mn in little over a year, is, of course, looking at the situation in hindsight. The actual investment decision and the timing of shorting a stock require a lot of analytics and risk control, including stop-loss orders. Although it was not the case here, as we saw in my Wirecard article, shorting a “bad” company can often result in significant unrealised/realised losses before becoming profitable.
So, one manufacturing company bust, 2.000 people out of a job, 27.000 people with reduced pension payouts and hedge funds that made a killing; end of the story? Not quite. The fall out from the Carillion default was quite severe, including politically.
In May 2018 the report of a parliamentary inquiry stated that the Carillion's collapse was "a story of recklessness, hubris and greed, its business model was a relentless dash for cash". It accused the directors of Carillion of misrepresenting the financial realities of the business. A separate report blamed the UK government of outsourcing contracts based on the lowest price instead of the quality of service as well as rewarding contracts to Carillion after the company had already issued profit warnings.
In multiple parliamentary select committees, many parties were questioned and Carillion directors were put on the stand to justify their actions as well the big four accountancy firms who benefitted greatly from the situation. In the end, a call for criminal investigations into the collapse never really came to fruition.
The Carillion collapse; a fraud, mismanagement, lack of governmental oversight or all of the above?
Please get in contact with us if you would like me to write about a particular securities finance transaction in which you want to know more.