The Return of the Zombies
The dark days of lockdown in March and April felt at times like the apocalypse, and it is perhaps appropriate that the phenomenon known as the “zombie company” continues to come to the fore. The concept of the zombie company is easily explained – imagine a company that is struggling to survive, is heavily indebted, able to just about cover the interest on its debts, but never any of the capital amount, reliant on pliant capital markets to continually roll their debt forward. It is the corporate equivalent of an individual who has accumulated too much credit card debt, and can make the minimum monthly payment but nothing more. The debt sits there, a huge weight around the neck of this company, restricting their ability to invest and grow.
Zombie companies become more prevalent during times of low interest rates, as the amount they need to pay in interest to stay afloat reduces. The concept was first seen in Japan in the 1990s, during the “lost decade”, but examples can be found across the world. In the UK, it came to the fore after the financial crisis when the Bank of England slashed the base rate to record lows. These low rates have persisted for the past decade, and have now been lowered even further following the Brexit referendum and the onset of the Coronavirus pandemic. A 2019 report from KPMG found that the proportion of UK companies in a zombie-like state could be as high as 14%. This proportion has only grown since then with many companies taking advantage of the Treasury-backed Coronavirus Business Interruption Loan Scheme (CBILS), which has enabled companies who are struggling to borrow up to £5m. We now have a perfect storm of readily available credit and low interest rates.
Many struggling companies will, when emerging from the pandemic, either default on these loans, or turn into zombies.
So why do zombie companies matter? The answer is all about the use of resources. Cheap borrowing keeps companies afloat who should otherwise fall into insolvency. Those companies tie up resources – labour, capital, and natural resources. An economist would argue that these resources would be better deployed in an efficient company. By letting the zombie company fail, those resources are re-invested in companies who can make better use of them. A growing number of zombie companies, who don’t have the funds available to invest, leads to an inefficient economy.
If and when central banks raise interest rates again, these zombie companies will find themselves unable to cover even the interest on this debt and will fall into insolvency. This leaves a potential tidal wave of corporate failures and job losses in the future. However, as the theoretical size of this tidal wave grows, the central bank becomes increasingly risk averse, trapped into maintaining low interest rates. This is the key policy dilemma currently facing central banks. Part of the rationale behind creating independent central banks was to free them from the political pressures of government, making it easier for central banks to take these hard decisions that drive long-term benefits, even if they can have devastating short term effects. However, it appears that central banks are increasingly reluctant to make such decisions.
What then is the path forward for businesses?
A number of companies, especially retailers and casual dining chains who were struggling with reduced footfall even before the pandemic, have turned to insolvency arrangements in attempts to save their businesses. Company Voluntary Arrangements (CVAs) have proven popular as a means to reduce rental costs, close unprofitable shops/restaurants, and agree a debt haircut with creditors. The business keeps trading, however unprofitable areas of the business can be closed en-masse, and a general reduction in the level of debt agreed. The Restaurant Group, owners of famous chains such as Frankie & Benny’s and Wagamamas, recently approved a CVA with their creditors.
Another insolvency tool that has been heavily used is the “pre-pack administration”. Pre-packs work by agreeing the purchase of the business and assets of a struggling business by another legal entity before the administration process starts. When the administrators are appointed, the business, assets, and often many of the employees are transferred to the other legal entity. The debt and any unprofitable areas are left behind in the old company, which is then wound down by the administrators. Debenhams, the department store chain which has been in financial distress for a number of years, completed a pre-pack in April 2019, whereby the stores and employees were transferred to a new company controlled by Debenham’s lenders. This of course wipes out the existing company’s shareholders which in the case of Debenhams included a c£150m loss to Mike Ashley’s Sports Direct who were trying to buy the company. Pre-packs are controversial because whilst the business survives, they leave behind a large pile of debt and out of pocket creditors, which will often include the public purse (especially the Pension Protection Fund). Any pre-pack sale to a connected party must go via the “Pre Pack Panel” which was introduced by the UK Government in 2015 to try and ensure trust and fairness in the process. However, it remains a controversial practice and one that I have no doubt will feature heavily in the business news over the next few months.
TheCityUK, the body representing the UK financial services, suggests the creation of a government-backed “UK Recovery Corporation” to help re-capitalise Britain’s companies during the recovery from the pandemic, replicating the founding of 3i following the Second World War. Business Growth Fund (BGF), currently the UK’s most active investment company, is also proposing a £15bn fund to invest in companies struggling with unsustainable levels of debt.
For investors looking at acquisitions in the short and medium term, accurate and comprehensive modelling of target companies, as part of a thorough due diligence process, will be imperative. Similarly, lenders will need to be diligent in monitoring their loan books in order to understand their exposure and downside risk. They must also be wary of their reporting requirements. For companies at risk of slipping into zombie status, understanding and optimising their business performance will provide the best chance of turnaround and long term success. Management should be able to know what product/service lines are unprofitable, where operational costs are excessive, and cash collection is poor. Being able to understand these key business drivers, through the use of well-built financial models, will allow directors/managers to implement decisions that will boost the chances of recovery.