13 Dec The Walking Debt (Q3-22)

“Zombie companies”, a term we first coined at an investment conference in Toronto in October 2008, are companies unable to cover debt servicing costs from earnings and have assets with realizable values less than their debts outstanding but remain in the market rather than exiting through takeover or bankruptcy. In our Q3-2018 Investor Report, we said these companies were “ticking time-bombs in the current credit markets” and that “rising interest rates and higher wages” would risk “a major wave of defaults in the next recession.” We believe detonation is near.

Researchers at the Bank for International Settlements (BIS)¹ updated a previous study on the rise of zombie companies and found a significant increase in their number due to large-scale government support measures and massive easing of monetary conditions in the wake of the COVID-19 shock. The BIS examined a sample of almost 32,000 publicly listed firms from 14 OECD countries going as far back as 1980; however, private, unlisted companies, particularly SMEs², play an important role in the economy and their exclusion from the dataset may underestimate the zombie share. The BIS estimates that Canada registered the highest zombie share in 2017, at 20% (versus the 15% average), and that this is likely up by more than three percentage points since 2020. Among listed SMEs, the share of zombie companies is around 40%. Since zombie firms are more leveraged, they are the most susceptible to rising borrowing costs. These companies have stayed afloat in recent years by accessing easy money, selling assets, and through government support that encouraged (some might argue, imposed) banks’ forbearance. Banks have been blamed in the past for fostering the genesis and survival of zombie companies by delaying debt restructurings or liquidations. For example, the rise of zombie firms in Japan in the 1990s was linked to banks which “evergreened” loans to avoid charge-offs that would have pushed them against regulatory capital limits.³

Kearney, a global management consulting firm, recently published a study that corroborates the BIS’ research. Kearney examined approximately 4.5 million records of 70,000 publicly listed companies from 154 industries and 152 countries.⁴ It then filtered out the debt service burdens of these listed companies and stress tested them for higher interest rates to determine whether they match the definition of a zombie company. Kearney found that if interest rates were to rise by a factor of 1.5, the number of zombies would increase by 17 percent—assuming there is no change in the companies’ performance—and by as much as 38 percent if interest rates were to rise by a factor of 2. This would lead to an immediate risk of insolvency for many zombie companies and have negative spillover effects that would threaten a wave of insolvencies. This scenario appears totally realistic given today’s backdrop of falling share prices, rising interest rates, persistent inflation in many of the leading economies, and the threat of recession.

Private companies will not be spared. Data from Lincoln International (“Lincoln”), which analyzed the aggregate change in company earnings and market multiples for approximately 900 U.S. private companies with less than US$100 million in EBITDA, reveals the potential for a sharp decline in interest-coverage ratios for private equity-backed middle-market companies as yields increase. According to Lincoln, credit spreads have widened by 100 bps on average in 2022, with most of the move occurring in the second and third quarters. Lincoln said the average interest-coverage ratio on private companies it tracked was 2.2x in the third quarter of 2022, compared to 2.4x in the second quarter. However, these metrics were calculated using trailing interest expenses and earnings. If the effects of rate and spread increases in the third quarter are reflected (keeping earnings constant), the interest coverage ratio would drop to approximately 1.6x. A recessionary scenario would challenge the ability for these private companies to service their debt. Typically, private equity sponsors have been willing to inject capital to support their struggling portfolio companies, like they did in 2020-21, and keep debt obligations current. However, rising interest rates, declining valuation multiples, and persistent inflationary pressures may alter the investment thesis of some sponsors that will not be able to earn a sufficient return on the rescue capital.

We have argued that zombie companies crowd-out growth in more productive companies by locking resources, leading to a perpetual misallocation of capital that could be invested instead in businesses that are growing. Kearney estimates that the scale of this misallocation amounts to about US$500 Billion globally, not including the credit losses and other obligations (such as unfunded pension liabilities) which would not be satisfied in a bankruptcy. The real estate industry has the highest percentage of zombies today and the share is expected to increase in line with interest rates. According to Kearney, hotels and airlines are also among the most vulnerable industries globally, where the share of zombie companies doubles under both of its stress scenarios.

Banks and governments have prevented the normal functioning of the business life cycle by letting zombie companies persist. A firm’s viability should be an important criterion for its eligibility for government and central bank support; otherwise, there is risk of excessively dampening corporate dynamism by protecting already weak and unproductive companies. Canada has one of the most efficient insolvency regimes in the world and regulators and legislators should be encouraging zombie companies to use formal restructurings to resolve financial obligations and reset capital structures so that their businesses can start fresh. We stand ready to shore up companies that would be viable in less extreme circumstances.

[1] Banerjee, R and B Hofmann. “Corporate zombies: anatomy and life cycle”, BIS Working Papers, September 2020 (revised January 2022)
[2] Small and medium-sized enterprises with annual sales of less than US$50 Million, according to BIS data.
[3] Caballero, R, T Hoshi and A Kashyap (2008). “Zombie lending and depressed restructuring in Japan”, American Economic Review.
[4] “Zombie companies are on the increase worldwide.” A.T. Kearney, Inc., September 2022

Article excerpted from the Q3-22 investor letter