By Cyrus Church, Co-Head of Execution – Neu Capital
Zombie companies are those that need bailouts in order to operate; carrying debt that outweighs their value. These companies are propped up by government subsidies and lender forbearance that if removed, would result in serious financial damage.
While this term has gained traction over the past three months as the global economy attempts to grapple with the Covid Financial Crisis, it isn’t a new term. In fact, zombie companies were prevalent in the GFC particularly in Europe, when unsustainable businesses with negative equity were able to continue trading due to the forbearance from lenders. By 2013, almost 6 years after the start of the GFC the OECD estimated that the share of capital sunk in Zombie firms in Greece, Italy and Spain was 28%, 19% and 16%, respectively.
Global push to support businesses
Governments are currently providing financial support to businesses on an unprecedented scale. In Australia, federal, state and local governments are providing employment assistance for more than 72 per cent of the nation’s 13.2 million-strong labour force.
And we are seeing the same approach happen around the world as governments look to ensure the survival of economies on the brink. While in the UK, more than a quarter of workers are now furloughed, New Zealand provided a 12 week lump-sum wage support paid to affected employers, and within Australia, we have seen a number of schemes with measures totaling $213.6bn from the commonwealth, $11.8bn from the states and $105bn in RBA-government lending by the end of March alone.
This government support was vital in order to bring temporary relief from this widespread and hard-hitting pandemic. Yet unfortunately, it means many companies are not yet to see the aftermath of Covid-19.
And while it may seem like an easier option to look back to financial performance pre-Covid-19 as a rationale for further forbearance, this approach won’t help them survive as debt mounts up. In fact, over the coming months, we will see governments start to pull back financial support, and this will reveal the large-scale balance sheet damage.
Critical long-term decisions
For those companies currently receiving government aid and lender forbearance a short term cashflow focus can take over management decisions in a bid to ‘make it through’. This is the mindset of the zombie company and it can damage both the company and the economy in the long term.
Reducing capital expenditure
As companies focus on short-term cash flow, they put long-term investments on hold. For example, a manufacturing company that was planning on purchasing a modern piece of machinery to improve efficiencies and guarantee a profit in the long-term may be retracted.
Tourism, on the other hand, would be deferring capital expenditure and investments into refurbishments of sites and upgrading of facilities. That important investment into refurbishing hotel facilities every few years may be delayed. While pushing back the upgrade of beds, painting of walls and replacement of lobby furniture will save significant cash over the short term, over the medium to long term it will damage the customer experience and brand value, resulting in a far less valuable business.
Restructuring is completed slowly
Company costs can be very rigid. Businesses can be locked into long term leases on premises, employment contracts can have redundancy provisions, and supplier agreements can have pricing that is linked to minimum volumes.
If the company has formed the view that demand will be reduced for a long period of time, then changing the cost structure is critical to ensure profitability. However, lease termination costs, supplier re-negotiation and employee redundancies all cost money to implement.
For those that are managing cash flow, they will likely look for ways to avoid hefty one-off implementation costs associated with the above changes. Consequently, changes are made in a piecemeal fashion.
Eroding employee confidence
Australia’s JobKeeper payments, which are a subsidy for businesses significantly affected by coronavirus, have enabled Australian companies to put off restructures while they figure out the delayed, long term financial impacts of Covid-19. This will lead to drawn-out restructuring processes, which has a significantly negative impact on employee wellbeing, with continuous change adding to the uncertainty of their role and future.
Sadly, larger restructures are set to come to the forefront as government support programmes start to unwind and boards form a new, realistic view of what the sustainable level of demand for their goods and services will be.
We will also likely see a lot more ‘Deed of Company Arrangements’ for insolvent companies, and ‘Schemes of Arrangements’ for solvent companies that will be used to share the financial burden among stakeholders.
Forbearance and zombie companies
For the businesses that have been given leniency by the banks, debt reduction will occur through a combination of operational performance improvements and equity raises. As we witnessed post the GFC, the wave of equity raises to repair balance sheets took 18 months.
Whilst forbearance will be in line with the friendly bank image the Big Four have tried so desperately to foster, it may end up amplifying the problem facing Australia, with company performance continuing to erode and causing negative impacts to the broader economy.
In fact, for companies where operational improvement or future equity raises are not realistic, providing forbearance will simply create a wave of zombie companies that eventually become insolvent once support is withdrawn. The financial impact of this will be severe.
In order to ensure that Australia can gain future business and economic stability, Australian lenders should learn the lessons of how Europe managed and mismanaged the GFC. By taking such lessons on board and making brave decisions today, businesses will be dealt with fairly and efficiently as we navigate our way out of Covid-19.