‘Zombie’ reckoning: goodnight to the walking debt?

February 2023  |  COVER STORY | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

February 2023 Issue

‘Zombies’, ‘zombie stocks’, ‘insolvent borrowers’, ‘the corporate undead’ and the ‘walking debt’. These are just some of the numerous terminologies for companies in a state of zombification, perpetually teetering on the brink of extinction.

Exactly how a company earns ‘zombie’ status is difficult to define, but a loose definition is those businesses that cannot cover the interest on their borrowing from operating profit for three consecutive years and have no money or capacity to invest or grow. They are also unable to employ extra members of staff.

Defining them further is the Adam Smith Institute, which lists the following features as being common in zombie companies: (i) they are heavily indebted; (ii) they generate enough income to pay the interest on their debts but cannot reduce the principal; (iii) their ability to meet loan interest payments depends on continuing low interest rates; and (iv) they are unable to restructure and become more profitable because of the high costs in servicing their debts.

“In turn, these features vitiate the need for the zombified company to go into receivership, thus preventing the redeployment of capital and labour to more productive sectors,” adds the Institute.

“Zombie firms are smaller, less productive, more leveraged, invest less in physical and intangible capital and shrink their assets, debt and employment,” adds the 2022 Bank for International Settlements (BIS)’ report ‘Corporate zombies: Anatomy and life cycle’. “Their performance deteriorates several years before zombification and remains significantly poorer than that of non-zombie firms in subsequent years.

“Over time, some zombie companies exited the market, while others exited from zombie status,” continues the report. “However, recovered zombies underperform compared to firms that have never been zombies and they face a high probability of relapsing into zombie status.”

To coin a phrase

In no way a recent phenomenon, the term ‘zombie company’ was coined in 1987 when Edward Kane, currently professor of finance in the Carroll School of Management at Boston College, referred to American savings and loans institutions that had effectively been wiped out by commercial-mortgage losses, but were allowed to continue operating, because regulators had hoped there would be a market rebound. “These institutions have very distorted incentives, just as the zombies do in horror movies,” stated Mr Kane.

Twenty years later, the label was being widely used, particularly by the media, following the 2007/08 global financial crisis, when several companies in North America and Europe received multibillion-dollar bailouts, and hundreds of thousands of others found themselves trapped in a seemingly bottomless pit of high debt – a scenario that many economists felt was holding back the economic recovery of many industrialised countries.

Fast forward another 15 years and little appears to have changed. “Zombies have caused a meaningful reduction in growth and prosperity,” says David Trainer, founder and chief executive of New Constructs. “Because effectively, what a zombie stock is, is a waste of capital. To the extent that the capital is wastefully employed in these businesses that have never actually produced any real economic value, we are losing the opportunity to invest that in more productive areas.”

Zombie proliferation

Today, zombie companies still typically rely on refinancing debt to maintain their existence. These entities have a high chance of going bust if they suddenly cannot pay their minimum debt obligations. Moreover, they are proliferating.

According to ‘The Walking Debt: Zombie companies are on the increase worldwide’ – a September 2022 study by Kearney that draws upon approximately 4.5 million data records from around 70,000 listed companies from 154 industries and 152 countries – zombie companies account for 4.7 percent of all listed companies globally, with their number having risen by 10 percent since 2021, to more than 3000 today.

Drilling down, across the globe, the share of zombie companies averages between 4 and 6 percent, but with significant differences in growth rates. While North America saw its share of zombie firms rise from 3.5 to 5.7 percent between 2010 and 2021, Europe saw a much larger increase from 1.2 to 5.5 percent.

In addition, stress tests undertaken as part of the Kearney study show that the proportion of ‘zombie companies’ is set to rise even higher in the months and years ahead. Thus, barring any changes to the economic environment, according to Kearney, the number of zombies would rise by 17 percent if 2021 average net-interest rates (then at 1.5 percent) rose by 1.5 percent in 2022, or increase by 38 percent if these interest rates doubled.

The Kearney study also found that, worldwide, zombie companies already account for $108bn in inefficiently deployed equity and together carry a total debt of nearly $400bn. Globally, most of these companies are found in the mid-market, although this is likely to represent only the tip of the iceberg: a larger number of mid-market companies are not listed on the stock exchange and are therefore not included in these figures but could also fit the definition of a zombie company.

“The issue of zombie companies – insolvent borrowers that receive financial help from their creditors to remain alive – is global,” says Angela De Martiis, policy researcher and adviser at the Organisation for Economic Co-operation and Development (OECD). “The share of zombies across Europe and the rest of the world has trended up over time, with spikes around downturns. Mapping the zombie share, we observe a widespread but heterogeneous prevalence across countries.

“This suggests the existence of different factors at play, from firm to institutional and financial market characteristics,” she continues. “Countries with advanced markets and institutions are likely to have fewer zombies. This could in part explain the lower prevalence of zombies in the US with respect to Europe.”

That said, it should be noted that drawing definitive conclusions as to the prevalence of zombie companies can never be an exact science. “The data on zombie companies is notoriously noisy,” says Karl Schmedders, professor of finance at the Institute for Management Development (IMD) Business School. “Different analysts use different measures, and so estimates range from less than 5 percent to more than 20 percent.

“Naturally, we would expect problems in those jurisdictions that saw very low interest rates in recent years and drastic interest rate increases in 2022,” he continues. “So, the US particularly comes to mind. Concurrently, the European Central Bank (ECB) is struggling to increase rates to necessary heights because of concerns of sovereign debt problems across the European Union (EU).”

Zombie sectors

As well as zombie companies’ characteristics in terms of their capital and financial structure, the industry in which they operate is also an important factor when evaluating the severity of this phenomenon.

“Zombie companies feast on cheap credit, so the low interest environment we have experienced for over a decade has resulted in zombies across all industries, albeit more in traditional sectors that have been less impacted by technology or other disruptive changes,” says Ben Hughes, senior managing director of corporate finance and restructuring at FTI Consulting. “The sectors that are likely to have zombie companies already facing distress will be those that are most exposed to current market challenges – industries that rely heavily on energy, are consumer facing or have revenues in sterling with costs in other currencies.”

According to the Kearney study, out of all the industries it examined, the real estate sector had the highest percentage of zombie firms globally, with real estate developers and diversified real estate companies particularly affected. Effectively, if interest rates continue to rise relative to 2021, up to 15 percent of companies in the real estate sector will be zombified – one in seven listed companies in the sector – meaning that, as in the years prior to the global financial crash, the real estate sector once again poses a considerable risk to the global economy.

“A fundamental shock to a large sector with significant leverage, such as real estate, could put real pressure on the international credit system,” adds Mr Hughes. “As we witnessed in the aftermath of the global financial crisis of 2007/08, the collapse of one or more major banks would be felt far and wide given the interconnectivity of the global economy.”

In addition to real estate, there are, of course, other sectors where zombies are more likely to lurk. “In Europe and the US, zombie companies operate predominantly in manufacturing, contrarily to, for example, Japan,” asserts Ms De Martiis. “At the same time, the existence of disparities within manufacturing point at the necessity to include industry characteristics when predicting future zombie companies, as the presence of zombies in a sector can put non-zombie companies in that same sector at risk.”

Interest rates rising

With central banks raising interest rates in a bid to cool off their economies, time may be running out for zombie companies, with many believing a prolonged stretch of bankruptcies is a likely scenario in the months ahead.

Indeed, in the US, the Federal Reserve has increased interest rates by 75 basis points, while in Europe, the ECB’s Governing Council has increased rates by the same margin to combat inflation, with central banks likely to make more rate rises in the months to come. Thus, with economic conditions changing so rapidly, zombie companies may be starting to die off, given that they exist on cheap credit that is now in shorter supply.

“Most zombie companies should go bust,” opines Mr Hughes. “By definition, zombie companies are only just managing to service debt and are not able to invest for growth nor improvement. If zombies presented an attractive investment option, they should have already secured new money. For those surviving on the life support of cheap debt, perhaps a higher interest rate environment is the catalyst we need to focus time and capital on the healthy.

“Given how challenging the trading environment is becoming, we may also see more healthy firms move toward zombie status,” he continues. “Companies that could previously cover their interest payments may no longer be able to if they have to borrow at higher rates.”

As an interesting aside, prior to the threat interest rate rises now pose to zombie companies, the consequences of the coronavirus (COVID-19) pandemic were once thought to have the potential to cull zombie numbers.

“Many expected an uptick in bankruptcies in the wake of the pandemic,” notes Mr Schmedders. “But that did not materialise due to central banks’ quantitative easing initiatives flooding global markets with money. As a result, many companies were able to refinance at very low rates.

“So, the pandemic may have actually saved some zombies that suddenly could borrow at very low interest rates,” he continues. “However, those times are now over. Therefore, we would expect the number of bankruptcies to strongly increase in 2023 and 2024 compared to 2020-22.”

On the brink

As interest rates rise and cash buffers built up during the pandemic erode, we are likely to see a sharp rise in default rates, with zombie companies facing a reckoning that will affect both investors and the economy alike as the risk of a global recession in 2023 mounts.

“As lower interest rates are a breeding ground for zombie firms, we can imagine the opposite effect with rising interest rates,” suggests Ms De Martiis. “The main challenge will be to continue to support productive but high debt enterprises due to the pandemic shock and at the same time distribute credit more efficiently, avoiding an adverse selection process. Hence the need to separate the zombie companies from those that instead have potential for recovery.”

Others anticipate an uptick in the number of zombies entering some form of restructuring in the coming years. “I believe it will be a steady flow over a longer period rather than a tsunami of activity over a shorter period,” observes Mr Hughes. “While this may result in the crystallisation of losses for shareholders and lenders, it will create new opportunities for businesses and investors with the appetite and financial capability to acquire the business and assets of zombie companies.”

Thus, with the double whammy of a deep recession and higher interest rates, as well as reduced revenues and higher borrowing costs, investors and banks are now far less inclined to lend to zombie companies. This may ultimately push many to the brink but, at the same, time remove the burden they place on global economic growth and productivity.

© Financier Worldwide

BY

Fraser Tennant