Pandemic policy responses by the UK government and the Bank of England (BoE) and the reaction from corporates have created the right conditions to breed a new generation of ‘zombie’ companies that could drag on the UK economy if left unchecked. When the government unwinds its loan schemes and protections and companies must become self-sustainable again, a permanent mark will remain on the balance sheets of many SMEs – that of excessive debt. The consequences are yet to play out, but a new wave of zombie firms may be part of what comes next. Zombie firms are companies that continue to trade through recessions with trading profits lower than debt interest payments. A broader definition explains this as a ratio where trading profits are below 2.5 times annual interest payments.
Almost one year ago, when the pandemic first forced the closure of the UK economy, corporate revenues collapsed virtually overnight, which severely reduced the working capital reserves required to meet operational liabilities. When these capital buffers fall below liabilities, it creates a cash flow crisis; one solution is to take on more debt. In the ten months to the end of January, the UK government extended £71.44 billion in coronavirus loans to corporates, supported by ultra-low interest rates by the Bank of England. Along with this generous monetary and fiscal support, businesses were also buffered by loose insolvency laws and creditor protections, such as the moratorium on creditor enforcement rights, postponements to VAT and PAYE filing and payments, and the temporary suspension of director liabilities. All this stimulus and protection has helped keep firms from failure, but the cost increased debt to absorb the collapse in cash flows and balance trading losses.
Below the surface, heightened risks to corporate survival remain. UK productivity and corporate profitability have fallen dramatically. While the number of underlying company insolvencies was higher in the latest quarter compared to the previous quarter, the total number of registered underlying company insolvencies in 2020 decreased to the lowest annual level since 1989, according to the Insolvency Service. Underlying annual company insolvencies decreased by 27% to 12,557, compared to 2019.
The government’s loan schemes are akin to cash flow lending to corporates that are now operating in an environment where demand has collapsed for many sectors, and the outlook is highly uncertain. The effect of this additional debt is twofold. First, the extra debt risks corporate liabilities outstripping total assets, which would trigger technical insolvency. A recessionary environment could exacerbate this, which could cause the downward repricing of company assets. Also, when firms are technically insolvent, options to secure new financing narrow. Second, the burden of overleverage can lead to corporates only able to make interest payments and forced to suspend investment and restrict (or reduce) employment. This is where corporates only exist in the protective bubble of central bank generosity and loosened insolvency laws. These companies are afloat, somewhere between normalcy and death, and characterised as the corporate living dead, or ‘zombie firms’.
Zombie firms tend to be characterised by negative cash flows and interest cover ratios (ICRs), an inability to deliver a return to shareholders and capital locked in a bottleneck. Compared to non-zombie firms, zombies are smaller, less productive, more indebted, with a more than twofold increase in the probability of bankruptcy or takeover, according to a study by the Bank for International Settlements (BIS). At the macro level, where zombification becomes systemic across the broader economy, employment, investment and productivity suffers. It can reduce economic dynamism and performance and create “congestion effects” for productive firms and stifle vibrant new entrants. Often firms recover from zombie status, but then relapse.
There is also the problem of protecting unproductive companies. In response to the pandemic, central bank and government – UK and worldwide – took immediate measures to mitigate the impact of the coronavirus-induced recession on corporates. This rapid solution has become more targeted over time, with increased support for vulnerable sectors such as hospitality and leisure. As the economic impacts of the pandemic continue, this balance becomes more delicate. On the one hand, to support companies that would be self-sustainable in less extreme circumstances. One the other hand to protect the overarching dynamism of the UK economy, but not shield weak and unproductive companies through blanket financial and solvency support. To shield vulnerable corporates, even if inadvertently, represents a tacit reward for underperformance, which is the antithesis of a dynamic economy. Over the longer term, the deleterious effects could plunge the UK economy into a negative productivity spiral and affect the decision-making of healthy corporates if they perceive ‘reward for failure’ in government policies.
A couple of comparisons with the GFC are noteworthy. Last time, overleverage created the financial crisis; this time, an artificial demand collapse created the crisis which prompted governments and central banks to encourage corporates to take on more debt. Both environments created zombie firms, but firms that have or will become zombies this time will be blameless of corporate mismanagement which characterised the GFC. All of which will influence the attitude of government and banks in favour of turnaround strategies over insolvencies to recoup losses. There are solutions to this economic malaise, which will be considered in the next article.
We will explore solutions to the zombie trap, what the UK government has so far proposed, and other options the government may be considering ahead of the Budget next month. If you would like to talk to BTG Advisory about your company’s financial health and options, please contact us and we will identify how best to improve your corporate resilience.