Zombie firms: corporate carrion

August 2015  |  COVER STORY  |  BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

Like the unfortunate creatures often seen shuffling around on celluloid, zombie companies are considered a plague, corporate carrion, little more than a collective drain on the economies of the countries they pervade.

Also known as ‘zombie stocks’ or ‘the living dead’, zombie companies are unproductive corporate entities that continue to operate due to ultra-low interest rates and the forbearance of creditors. They stagger on, year after year, stifling growth and their numbers are steadily rising.

In the US and across Europe, these companies are growing and multiplying. Indeed, in some Central and Eastern European jurisdictions, where zombie companies are referred to as ‘empty’ companies, there are startling examples of how such entities have stifled growth, many of which lend weight to the notion that the less developed the economy, the greater the concentration of zombie companies.

In the UK, figures compiled by John Ashcroft and Company, which feature in the 2014 analysis ‘Zombie Companies: Myth or Reality’, portray zombie companies as a being a scourge on the UK economy – an expanding threat that is impeding recovery and hampering growth.

Intriguingly, despite zombie companies often being characterised as one homogenous group of businesses all suffering similar problems requiring similar solutions, the Institute for Turnaround, a European body representing turnaround and transformation professionals, has actually identified three distinct types of zombie: (i) pension zombies – those businesses that may otherwise be trading successfully but whose pension liabilities are of such a scale that they cannot be met; (ii) property zombies – property businesses weighed down by debt that cannot raise capital, however, low interest rates enable them to use rental income to service the interest on their debt; and (iii) industry zombies – companies (often manufacturers or producers) that cannot generate sufficient growth to do anything other than service (or partially service) their debt.  

Further afield, zombie companies are also a major problem in the Far East, with Japan in particular having had its economy, the world’s third largest, held back by stagnating companies for decades.

In a global economy seeking to increase productivity and sustain growth, zombie companies are like businesses on life support that need to be switched off if long-term recovery is to be achieved.

Zombies and the threat to the global economy

Currently, the perceived wisdom is that zombie companies delay bankruptcies, hold back healthier companies and prevent capital being recycled and reinvested. Certainly, in the years since the financial crisis and the ensuing weak economic recovery, this has undoubtedly been the case. However, as the recovery continues (albeit it in fits and starts), it remains largely unclear as to what extent zombie companies still infect global economic growth. “The real danger of zombie companies is that they are unable to contribute to growth in the global economy as they cannot invest,” suggests Mark Thomas, a business strategy expert at PA Consulting Group.

This lack of investment, according to Company Watch, is impacting a range of industries, with the retail, media, construction, and business services sectors in particular suffering from a proliferation of zombie companies. “The scale of the global zombie problem is well illustrated by our research for the UK, which shows that at the end of 2013 there were 227,000 zombie companies with liabilities at least £5000 higher than their assets,” says Nick Hood, business risk adviser at Company Watch. “The combined deficits in their balance sheets totalled £70bn. This is equivalent to three times the government’s defence budget, almost as much as the education budget and two-thirds of the entire cost of running the National Health Service.”

Cheap debt and reluctant lenders

Large-scale financial bailouts, access to cheap debt and the reluctance of lenders to write-off bad loans all exacerbate the zombie company scenario. “These factors have been the core drivers contributing to a startling growth in UK’s corporate zombie army,” notes Mr Hood. “Between 2008 and the end of 2013, there has been a steady decline in corporate insolvencies. They have dropped 24 percent from 26,443 in 2009 to 20,070 in 2013. They fell again to only 18,425 in 2014.”

According to Andrew Tate, vice-president of insolvency trade body R3, the sluggish recovery of the economy in the UK after the recession was a key factor in the creation of zombie companies. “Normally, rapid economic expansion after a recession puts pressure on businesses weakened by the difficulties of the downturn,” he says. “After the last recession, a slower return to growth, combined with low interest rates and creditor forbearance kept the pressure off struggling businesses. However, some of these businesses are yet to transition from struggling to growing, even as the economy has picked up the pace.”

In the US, corporate bankruptcy activity has also declined, to an unprecedented and record-breaking low according to BankruptcyData.com. In 2013, corporate bankruptcies plunged to an historic 24 percent (their lowest level since 2006) and, as of late 2014, this downward trend has held, confirm the US Bankruptcy Courts.

Japanese zombies

In Japan, the volume of unprofitable firms is a persistent phenomenon, an issue that has, for a long time, had a detrimental impact on the country’s competiveness on the international stage. Much of the blame for this unenviable state of affairs is routinely dumped on the doorstep of the Japanese banking community. In their white paper ‘Zombie firms and economic stagnation in Japan’ , Alan Ahearne and Naoki Shinada claim that one contributing factor to Japan’s weak economic performance over the past decade is that Japanese banks continue to provide financial support to highly inefficient, debt-ridden companies.

“Such poor banking practices in turn prevent more productive companies from gaining market share, strangling a potentially important source of productivity gains for the overall economy”, state Ahearne and Shinada. “Productivity growth is low in industries reputed to have heavy concentrations of zombie firms (such as construction and retail). The reallocation of market share is going in the wrong direction in these industries, adding to already weak productivity performance. In addition, there is evidence that financial support from Japanese banks may have played a role in sustaining this perverse reallocation of market share.”

Further demonstrating the corrosive economic impact that zombie companies are having, a high-ranking member of the Japanese finance ministry, director general Masatsugu Asakawa, recently warned that the economic growth of his country is being held back due to the many thousands of zombie companies that continue to operate – an issue that has afflicted the Japanese economy for a good many years.

Recognising that it is important for Japan to increase its competitiveness by rewarding profitable companies through tax cuts, Mr Asakawa also stated his belief that “policies that prevented loss-making firms from surviving on cheap money to service their debts would also help to lift productivity and pave the way for the expansion of healthier companies.”

When pressed on what should happen to the zombie companies that continue to proliferate, Mr Asakawa is unequivocal. “Any company that’s been around for ten years and is still not making a profit should not be doing business,” was his considered response when he spoke about the issue to the Telegraph earlier this year.

“The situation is not easy, given Japanese culture and Abenomics,” says Jon Moulton, chairman and founder of the Better Capital fund vehicles. “These companies need to be changed or closed and there is no way that this happens without pain that Japan does not want to suffer. Interest rates would solve the zombie problem but the politics would be intolerable. Their best hope is that new attractive businesses can be grown quickly enough to hasten the demise of the hopeless zombies as employees and suppliers desert the hopeless cases.”

Taking the fight to the zombies

Part of assessing stagnating economies and insipid growth involves looking at the steps being taken in the US, across Europe, and in the rest of the world to curb the number of zombie companies still in operation. For many, the belief is that zombie companies are beyond redemption.

“While interest rates remain at historic lows and growth continues to be anaemic at best, the zombie army of the walking corporate dead will not just stumble on but will grow still further,” believes Mr Hood. “It has become remarkably difficult for a business to fail if its owners are determined to carry on. But politicians fear the reputational damage from the impact of higher rates on over-indebted consumers, whilst central bankers are endemically over-cautious after the global financial crisis. Unfortunately, in this scenario low growth is a self-perpetuating inevitability.”

One solution is for banks to take close look at their loan books and think of ways to reorganise them. “The important thing is that when underperforming loans are sold on, they are done so at realistic valuations,” points out Mr Tate. “This is a topic which some central governments appear to be addressing with banks so that the banks themselves are encouraged to avoid significant ‘zombie loans’.”

Others favour dealing with zombie companies through restructuring or dissolution – methods which involve significant cost, time and legislative issues. “Neither the financial will nor the skills and resources are available to restructure most zombie companies,” says Mr Hood. “They will have to be dissolved through the appropriate insolvency procedures. But the process of eliminating these zombies will take many years to complete and there are serious issues around the world with the cost of formal insolvencies. In the US, some experts believe that escalating professional costs are significantly inhibiting bankruptcy filings, especially among mid-market and smaller enterprises. This key issue needs resolving urgently, so it’s encouraging to see the UK government taking measures to curb the wilder excesses of insolvency practitioners’ fees.”

A ‘prove your worth’ strategy is another option. “If a company has a business capable of making an economic return but is not because of a bad strategy or management of financial structure, it should normally be rescued or restructured. If not, it should be kindly put out of its misery,” says Mr Moulton.

A somewhat ineffective way of dealing with the zombie issue is a phenomenon identified by the Institute for Turnaround – the 'pass the zombie' phenomenon – which involves zombie companies being moved between banks, private equity and others. This dubious practice often compounds zombie symptoms and the rapid churn of external investor/debt provider results in inconsistent and low quality support.

A troublesome trio: zombie banks, zombie consumers and zombie governments

As great as the threat of zombie companies may be, for some, including Mr Thomas, there are greater dangers to be faced within the zombie fold, principally those posed by a further three categories of zombie: zombie banks, zombie consumers and zombie governments. It is these three types of zombie that are holding back the global economy.

“At a time when there is a shortage of high quality jobs, businesses struggle to find demand for their products, and investors struggle to find high return opportunities to invest in, an aggressive approach to liquidation would result in not ‘creative destruction’ but destructive destruction. Once healthy demand returns to product, capital and labour markets, ‘creative destruction’ will again be a valid concept. Until then, the focus needs to be on these other categories of zombie,” says Mr Thomas.

Death of a zombie

With the global economy slowly moving away from the financial crisis, to what extent might the continued presence of zombie companies prolong the years of stagnation? The answer here will depend largely on the country in question. “Each country’s zombie companies might have been created by different factors,” explains Mr Tate. “In the UK, there are a number of factors to be aware of that might change soon. Firstly, interest rates will rise from their record low at some point, which could mean zombie companies having to make a decision about their future. Secondly, banks are also looking at their loan books and selling some impaired loans at a discount.”

Others, including Mr Hood, are resigned to the likelihood of a prolonged economic recovery, at least as far as the UK is concerned. “The existence of commercial dead wood distorts competition, encourages lowball bidding just to generate income and cash to keep servicing debt and puts healthier, financially viable companies at a serious disadvantage. The inevitable outcome is low productivity and a stagnant economy, with no end in sight and no credible policy initiatives to deliver a solution,” he says.

Many observers are not overly optimistic about a quick resolution to the zombie problem. “As insolvencies remain at a record low and there has been no economic change significant enough to prompt resolution of zombie situations, all that has happened is that banks have largely divested their zombie portfolios to large funds and traded out of ownership,” says Christine Elliott, CEO of the Institute for Turnaround. “These less transparent funds have put in place strategies to deal with the zombies but until a wave of substantive refinancing – predicted for 2016-17 – happens, there is unlikely to be a seismic shift in the situation.”

For the moment at least, zombie companies continue to exist and operate under the radar. They are an infection which pervades the global economy, an affliction without an obvious cure.

© Financier Worldwide

BY

Fraser Tennant