Rise of the Zombies

I found this post by Bill Mauldin on “zombie companies” pretty interesting:

Debt can be useful when used wisely. And wisdom begins with being able to repay it.

So, if you have a debt-financed business, you should first have enough steady revenue to cover your other expenses and the interest on your debt. Then you should have a plan to reduce that debt.

If you can’t, something is wrong. And it turns out this is far more common than most of us think.

A new Bank for International Settlements study examined a database of 32,000 listed companies in 14 advanced economies to identify “zombie” businesses.

By their broad definition, a company is a zombie if it is…

at least 10 years old, and

  • its interest coverage ratio has been below 1.0 for three consecutive years.
  • That’s a low bar. Yet 12% of the public companies they checked couldn’t pass it.

Looking only at US listed companies, about 16% qualify as zombies. So, we are actually more zombie-friendly than our average global peers.

The percentage of zombie companies has risen sharply over the last 35 years. He never really addresses why there are so many more zombie companies than there used to be. My guess is that there are multiple reasons:

  • Debt is a lot more attractive than it used to be
  • Foreign competition
  • Dynamism in the economy, generally, has declined
  • Panicky governments are propping up an increasing number of companies
  • Banks have less incentive to get bad loans off their books than they used to

I’m open to other explanations. I think that zombie companies are probably a risk and they pose a risk that could land on us all at the same time. It’s probably better to address them now rather than when they actually become an issue.

Why are there so many zombie companies and what if anything should we do about them?

5 comments… add one
  • TastyBits Link

    It is primarily your third bullet point. The question is, why do people/financial institutions keep lending them money? Chicago, among many other cities, is a zombie squared – incurring debt to repay previous debt.

    As long as the debt is performing (being repaid), it can be counted as an asset. It may or may not be misallocated capital. For an investor who wants the steady income, a performing loan could make sense, but for a PE Investor, it could be a missed opportunity.

    For every borrower, there is a lender and vice-versa. For every crack head, there is a crack dealer and vice-versa. One cannot exist without the other.

  • PD Shaw Link

    It’s the circle of unlife.

  • Guarneri Link

    John Mauldin usually writes much better pieces than this one. A few observations:

    Banks will generally continue funding if fixed charge coverages are less than one while the firm organizes its affairs. The companies are in default and generally in workout and have restrictions on borrowing, and make modifications to their repayment schedules. Accelerating the loan is generally (as in rarely) not in the lenders interest. That’s why they fund.

    An interest coverage ratio less than one is a different animal totally. The loan is in workout, sustaining borrowing is supervised, and it is classified as non-performing, raising reserve requirements. It’s a big deal and never intended. Don’t draw any macroeconomic inferences. I’d like to see the list of companies in this situation, I doubt it’s the A list. Those that have arrived there are probably operationally impaired, those with only (leverage) incurrence test covenants, and deemed to have enterprise values exceeding the loan. The only other situations I can imagine are those where lenders expect governments to step in. Can you say GM? The debtors don’t just sit by like fools, or make loans for the sake of making loans and for Mauldin to imply that makes him look foolish.

    Governments always roll their debt. Corporations roll a portion as well, but the whole goal of workout is to slowly work down the lenders exposure, generally measured by absolute leverage (debt to cash flow) outstandings, or debt to enterprise value. Lenders are not happy with their asset position in default. Loans get marked down significantly depending on severity.

    As for PE investor opportunity, that’s really the vulture investor crowd. You buy the debt so you can call the shots. It’s usually very, very messy, and expensive. The cost to play can be millions just in legal fees. And if you do not prevail you lose your money. If you do prevail equity gets flushed, debt gets compromised and fresh capital plus residual debt converts to equity. Managers generally die. Good luck…..

    WRT why things have changed, I’d first like to see the list. But my bet would be on the notion of government intervention propping up losers, regulatory capture, and a general lowering of the stigma of failure to repay.

  • TastyBits Link

    @Drew

    … PE investor opportunity …

    I mean that you would probably take the loss and invest in something more profitable, but I doubt that you would make the investment in the first place.

    For anybody confused about vulture investors, they provide a necessary function. Like actual vultures, they consume what would otherwise rot, and environmentally or capitalistically, rotting carcases are not healthy to have around.

  • Guarneri Link

    Tasty

    The whole point of my comments were to point out the absurdity of Mauldin’s implied position that lenders were underwriting or benignly continuing to fund creditors who couldn’t service interest. I don’t know what he was thinking as its absurd on its face.

    I can imagine only rare cases in which would it happen AFTER a deterioration in expected company financial performance: 1) managed workout, 2) expected government subsidy or 3) large abundance of collateral in excess of loan – sort of “there is a long fuse before this firecracker blows up.” Its not some macro trend, and he knows it. He must have had some ax to grind and figured he could ply the uninformed.

    As for PE – they would be the guys who’s equity got flushed in workout, if the scenario was a private, not public equity setting.

    As for the vultures, yes, they provide an economic function. But its a very tiny specialty. They employ a half operating, half legal strategy and its a very high beta investment profile.

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