The origin causes of ‘zombie’ firms will maintain pressure on banks, and the government, to exercise a greater fiduciary duty in managing distressed SMEs and corporates. This will skew banks’ preferred strategy towards corporate turnarounds, rather than insolvencies, in the management of defaulted loans. This political reality may also diminish the prospect of a new UK ’bad bank’ to manage non-performing loans (NPLs).
Zombie firms are a stubborn problem to solve. As discussed in the previous article, in zombie status business owners can only generate enough revenues to repay debt and not build any enterprise value. The UK government’s pandemic response policies (e.g. coronavirus loan schemes and loosened insolvency laws), as well as ultra-low interest rates, have created the conditions for new zombie firms to develop in response to the artificial demand collapse caused by the pandemic. The consequences to the economy are stark – the survival chances of zombie status firms are low, and they act as a drag on the dynamism of the UK economy. All of which can reduce productivity, international competitiveness, economic growth and employment.
One indicator of the potential zombie firm universe can be inferred from the application approval rates of the government’s Covid loan schemes. In the ten months to late January, banks approved 43% (87,529) of total CBILS loan applications (201,343), for which banks were required to guarantee 20%
of credit risk. By comparison, 75% (1.47 million) of total BBLS loan applications (1.95 million) were approved. Of course, the BBLS was ‘light touch’ by design, with minimal due diligence and the government acting as 100% guarantor. To date, £45.4 billion has been extended under the BBLS. The prospect of zombie firms within this loan pool is high, and the proportion may grow over time.
Combatting the zombie threat
There are several ways to combat the threat that zombie firms pose to their survival, the recovery of the economy and long-term productivity. However, each has limitations and potential drawbacks. First, let’s consider the government’s policy response, the Pay As You Grow (PAYG) scheme, which provides flexible loan repayment plans.
Last week, the Treasury extended the scheme’s generosity to include an option to delay all repayments for a further six months, loan extension from six years to ten years, as well as options to make interest-only payments and pause payments. Business leaders and trade bodies immediately lobbied for the extension of the PAYG scheme to all government-backed loans. In the hospitality sector, trade body UK Hospitality called on the Chancellor to remove business rates to allow “businesses to repair shattered balance sheets” and tackle the rent mountain that has now hit £2 billion. It has also requested an extension to the furlough scheme, reduced VAT, further improved loan repayment terms, and the replacement of the job retention bonus (JRB) scheme. However, the government must exercise prudence in future direct stimulus to support vulnerable sectors as blanket policies may protect zombie companies that will never return to self-sustainability.
There are at least two more options open to the government. First, the debt issued under the coronavirus loan schemes could be converted into equity and managed in a government vehicle, akin to the post-Second World War 3i Group or a sovereign wealth fund. Debt-for-equity swaps would provide corporates with headroom in order to reinvest trading profits and boost long-term growth which could provide a way out of the zombie trap. But balancing fair value for taxpayer and corporates is complicated (e.g. how to price equity in the current environment?). Further, the scale of debt-for-equity swaps could be a significant administrative burden. Second, debt restructuring and forgiveness. TheCityUK Recapitalisation Group (RCG) proposed restructuring debts into more accommodating formats (e.g. a mixture of tax obligations, subordinated debt and preference shares). However, Onward, the Conservative think tank, raised moral hazard risks with this approach. For example, businesses may take on more debt if policies provide bailout insurance. More broadly, debt forgiveness can lead to interference with the economy’s dynamism by perceived rewards for failure. For example, if one company’s debts are forgiven, this provides a competitive advance over a rival business that survived without government support. But there may be some middle ground, such as in improvements to the restructuring regime.
The value of early decisions
One of the lessons corporates can learn from the last crisis is the value of making informed decisions early. In this environment, SMEs need to scrutinise financial health more forensically and more frequently than is necessary for less extreme conditions. For example, there is often a time lag between corporate distress and implementing a turnaround strategy. Simply put, longer delays will erode business value. As firms become more zombified, the ability to leverage business goodwill with creditors and suppliers deteriorates along with turnaround options and prospects. The lesson here is for corporates to not wait for banks to take action as by that point precious time will be already lost.
Remember, in the current environment banks and governments will heavily favour turnarounds over insolvencies. Therefore, early-acting corporates mindful of tough trading months ahead, even after lockdown restrictions ease, do have options. BTG Advisory provides diagnostic business reviews in which we scrutinise capital structures, evaluate corporate strategy, and create scenario forecasts. These insights help corporates to redefine strategy, whether survival or growth. If you would like to talk to us about your company’s strategy, please contact a member of our team.