Accelerated decay: zombies at risk after rate rise

June 2018 | FEATURE | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

June 2018 Issue

Existing in a world of cheap debt and low interest rates, zombie companies – defined by the Bank for International Settlements (BIS) as “a listed firm, with ten years or more of existence, where the ratio of earnings before interest, taxes, depreciation and amortisation (EBITDA) relative to interest expense is lower than one” – generally are at little risk of being extinguished.

That is, until recently.

In March 2018, an alarm bell sounded for zombie companies when the US Federal Reserve announced a rise in interest rates – a quarter-point hike that puts the new benchmark funds rate at a target of 1.5 percent to 1.75 percent. This rise is expected to impact three groups in particular. Of these, US corporations (the other two comprise retirees and US workers) have been singled out as the entities that will be hardest hit.

According to the BIS, the number of zombie companies doubled in the US between 2007 and 2015, to account for around 10 percent of all public companies. The interest rate rise threatens to send these companies to oblivion. What is more, this perilous scenario has not come without warning.

In May 2017, the International Monetary Fund’s (IMF) annual ‘Global Financial Stability’ report included a stark warning about the health of the US economy: that 22 percent of US corporations are at risk of default if interest rates were to rise. As its primary evidence for this contention, the IMF report cites the rapid decline in the average coverage ratio – the ability of current earnings to cover interest payments – over the past two years.

“An unproductive fiscal expansion could lead to a sharp rise in borrowing costs,” states the IMF report. “Such a sharp rise in interest rates amid tepid earnings growth could further compromise the ability of firms to service their debt”. As a consequence, according to the 2018 Deutsche Bank study, ‘The persistence of zombie firms in a low yield world’, the number of zombie companies would be reduced and productivity would receive a boost.

Zombie impact

“Zombie companies, like all companies, will feel the Federal Reserve interest rate increases, yet the movement in interest rates alone will not have a precipitous effect on their future,” says David Barnitt, founder and president of Attract Capital. “The hike in rates has been relatively tame in a historical context, with an absolute increase of 175 basis points over the last seven years and 125 basis points over the last 16 months.” In his view, the change in the US tax law limiting business interest deductibility to 30 percent of EBITDA is likely to have a larger and more material effect.

“Given they do little more than fulfil their loan repayment obligations and generally have no real long-term business model, the options for zombie companies would appear limited.”

“Zombie companies use interest expense as a tax shield to mitigate their debt service ratio shortcomings,” explains Mr Barnitt. “Without full deductibility of interest and restrictions on net operating loss (NOL) carryforward levels, zombie companies will be forced to restructure their debt if they are to stay afloat. It makes little sense for companies that have a runway of growth opportunity not to reliquefy their balance sheets through equity infusions. Through exiting the zombie twilight, these companies will grow faster and be able to invest in building viable long-term business models.”

Zombie resuscitation

Given they do little more than fulfil their loan repayment obligations and generally have no real long-term business model, the options for zombie companies would appear limited. As it happens, oblivion is not the only option for highly leveraged companies. How, then, does one resuscitate a zombie?

“Unless zombie companies engage in widespread re-equitising of their balance sheets and restructure their debts, they will have little chance of a future,” suggests Mr Barnitt. “Such companies, despite their headline appeal, have a minimal effect on US economic activity due to their lack of dynamism in the high growth, tech-driven US economy. However, they hold appeal for a strategic acquirer that can absorb valuable assets such as customer accounts or intellectual property.”

Furthermore, to resuscitate a zombie company requires a refocusing of growth strategies and major reinvestment in systems and processes. “Valuation creation is always generated from the left side of the balance sheet, rather than the right side,” he says. “The sooner zombie companies undergo fundamental business model transformation, the better.”

Zombie future

“The US economy is not materially affected by the number of zombie companies, yet the increase in rates and tax changes will likely accelerate the need for these companies to reinvent themselves,” adds Mr Barnitt. “Equity capital will need to come and strong business plans will have to be developed. A large wave of restructuring-induced asset sales will likely cleanse the market, with valuable pieces being acquired by strategic acquirers.”

Whether the outcome proves to be reinvention or release, the takeaway is this: if zombie companies are not exactly dying, they are certainly headed for a period of accelerated decay.

Fraser Tennant