20th November 2020
In the first of a two-part series Leonard Curtis Director Phil Deyes looks at the ‘zombie’ firm phenomenon, what key economic ingredients are needed to create them and how to spot one.
A ‘zombie company’ is the description applied to a business that is only generating enough liquidity to meet operational costs and debt interest payments. This chronic liquidity pattern has usually been going on for some time, with the business burning through cash for nothing other than survival.
The term was first applied to Japanese firms supported by their banks during the period known as the ‘lost decade’ in around 1990. It then returned to the mainstream after the financial crash in 2008 and then again during the China crash in 2016. The spectre of the ‘zombie company’ now seems to be back again as economies around the world feel the shockwaves of the current Covid-19 pandemic.
So, let’s take a look at the zombie phenomenon in more detail and how such companies may impact upon the economy as we move further into the depths of this pandemic.
What are the key economic ingredients for the creation of zombie companies?
Particular to the UK, there were five key ingredients that provided the fertile ground for the creation and continuation of zombie companies.
- A low interest environment. Zombie companies thrive in an environment where money is cheap and stays there. The last financial crash saw a liquidity programme like no other, utilised to bail out the banks in 2008. The aim of the programme was to unlock what was becoming a moribund financial market, which saw many institutions fail. The end result was that cheap money flooded into the market and interest rates hit an all-time low which is where they have stayed. A low interest environment also tends to push investors into more risky investments with the aim of getting a better return, but taking a bigger risk.
- Access to capital & increased financial regulation. To ensure banks ‘were never again too big to fail’ increased regulation then followed, making banks retain more liquidity to cover poor performing loans. This resulted in banks selling swathes of their loans to de-leverage their balance sheets. Many institutions decided that retaining low interest impaired debt was locking up too much good capital, so it was cheaper to sell it en masse, at a discount, rather than retain it on their balance sheet. The buyers of this debt wanted the loans they had purchased to be repaid as opposed to granting new facilities. A huge number of businesses were therefore looking for ‘new homes’ for their loans, most likely via the refinance markets. Coupled with this was the exiting banks, tightening up their credit policies and causing the availability of lending to shrink. This would ordinarily have slayed the zombie (rising demand and falling supply pushing up interest rates), but the huge funding vacuum created was filled with a new breed of lender, colloquially known as the Alternative Funding Market.
- The new kids on the block. Crowd funding, peer to peer and all other forms of secured lending, largely unregulated, boomed, allowing the availability of cheap debt to continue. The refinance and loan origination market exploded, with these new funders raising capital from less familiar markets. The internet facilitated the joining up of those with money, with those needing money, the peer to peer market flourished and, initially, was largely unregulated. FCA oversight then followed. A light touch regime, an abundance of demand and large numbers of both individuals and corporations looking for new ways to invest and get a better return, both allowed zombie companies to both persist and thrive.
- Consumer spending to create growth. The UK was probably more susceptible to the credit explosion, being an economy largely driven by consumer spending. Cheap and readily available consumer debt, coupled with cheap and quick-to-access corporate debt, in a low interest rate environment, was an ideal place for businesses to be able to recycle debt.
- The leveraged buy-out. This has become commonplace. As a result of private equity (again, people with money looking for new ways to invest), the acquired company itself borrows the money to pay for its own acquisition. This enables debt to be recycled and new debt created, leveraging against existing assets. Cash did not necessarily form part, or if it did, only a small part, of the overall transaction. Zombie territory, to an extent.
As we now move to the current pandemic, we not only have continued inexpensive credit that is widely available (although the market is now recoiling to a certain extent), but a series of unprecedented financial support and business protection measures to ring-fence businesses still further.
Certain sectors of the economy have been so badly affected by the pandemic, they cannot even service operational costs from available cash, let alone interest-only debt servicing. Ordinarily, these businesses would fold, but the intervention and support measures have protected these companies from the most severe consequences of this crisis, and rightly so for certain businesses.
But problems are indeed emerging, as the levels of financial support and business protection measures diminish at the same time businesses return to a semblance of trading. They are also starting to recommence operations with an increased debt burden that requires servicing, as compared to pre-pandemic. The uncertainty around how long these measures will last is also creating unpredictability in the market and anxiety amongst business owners.
Businesses were prepared to borrow cheap money to survive and fund, in many instances, losses in the hope of a V-shaped recovery. Even with a potential vaccine on the horizon, restrictions remain and the recovery is likely to take much longer than perhaps first predicted, leading to the rise and development of the zombie company.
How to spot a zombie company – what are the tell-tale signs?
In technical terms a zombie company will have an Interest Coverage Ratio (the relationship between the EBIT and interest expense) below one. Once the ratio falls below 1.5, the ability of a company to service debt effectively becomes questionable.
This lack of liquidity has usually persisted for an extended period, with little or no prospect of achieving earnings sufficient to start making capital repayments. In its most chronic form, the position never gets any better.
A toxic balance sheet
There are few signs of growth, no dividends are available to stimulate further investment and long-term prospects are poor. Assets are regularly refinanced and the majority are secured by way of mortgage, asset finance (HP, leasing) or sales ledger finance.
Funds raised are commonly used to replenish lost liquidity within the business rather than to help purchase a capital asset or stimulate growth. There are rarely further free assets, owned outright by the company.
Stagnation and creditor support
Zombie firms tend to muddle through rather than restructure or expand. They will usually wait for someone else to make the first move as regards insolvency and be pushed into it rather than take the plunge themselves. They thrive on persistent creditor acquiescence, as neither financial institutions, HMRC nor trade creditors want to crystallise a loss or suffer a slow and painful exit, waiting for the insolvency practitioner to determine whether a recovery is possible.
As well as the balance sheet and cash generation being poor, they tend to seek extended credit terms or frequently breach existing ones. It’s easier to kick the can down the road. They ask for funds in advance where the contract does not provide for it, as they need to front-load their cash requirements and once they have the cash, often sit back and use the money for other purposes.
They may request early drawdowns from stage payments if it’s a function of their contract, but again may divert the cash onto other projects or expenses. Product quality and quality control tends to slip with increased returns and credit notes. The driver is to generate cash rather than focus on the performance or output of the business.
Haemorrhaging of talent
Staff turnover tends to increase, as talented people usually see the writing on the wall, or are sometimes not getting paid themselves and have no choice but to move on. Employees tend to bear the brunt of the difficult calls with creditors and customers and eventually get fed up, stressed and decide to call it a day.
Credit insurance usually falls away as their performance dips and creditworthiness is shattered. Existing lines of credit get squeezed further and they burn through even more cash as they move to pro-forma or cash on delivery.
They tend to look to extend year ends and file returns late as they don’t want to disclose to the outside world their pitiful financial state or can’t afford to pay for the accounts to be prepared. These are classic signs of a distressed or zombie company.