"Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate... it will purge the rottenness out of the system. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less enterprising people”
– Andrew Mellon, US Treasury secretary, 1929
When the construction sector slumped three years ago, Mike, the shaggy-haired owner of a British commercial landscaping company, was left struggling to meet his overbearing debt payments.
Salvation came in the form of a cheap bank loan backed by the UK government, which helped him refinance his old debt at much lower interest rates. His company was saved from bankruptcy. But the blessing, as it turned out, has been a mixed one.
"All our money goes to servicing this new loan, so while we are still here we are in a kind of financial limbo with slim hope of a turnround,” he says. "Our equipment gets more tattered every day and our employees are demoralised.”
Mike’s problems go to the heart of a growing debate about the number of "zombie” companies in Europe. They are alive – but barely – thanks to government help, ultra-loose monetary policy and, often, the reluctance of lenders to write down bad loans since the crisis.
The concern is that these companies – which spend so much of their cash servicing interest payments that they are unable to invest in new equipment or future growth areas – could be at least partly to blame for the weak recovery in Europe, hogging resources that could go to more productive areas.
In the US, where the philosophy of "creative destruction” holds more sway, there has been a swift increase in insolvency rates since the crisis. But this has been far less the case in Europe, where policy makers have been more focused on protecting jobs than on boosting efficiency.
The growing fear is that the continent could be following the path of Japan, where low interest rates, looser government policy and the failure of the big banks to foreclose on unprofitable and highly indebted companies is thought to have contributed to two decades of weak growth.
"The fundamental tenet of capitalism, which holds that some bad companies need to fail to make way for new and better ones, is being rewritten,” says Alan Bloom, global head of restructuring at Ernst & Young. "Many European companies are just declining slowly and have an urgent need for new management, a revised capital structure or at worst to be allowed to fail,” he adds.
Policy response: the stuff of central bank nightmares
Zombie companies are always filed on the "nightmare” shelf in public policy, as authorities struggle to calibrate the right level of corporate liquidation.
Set policy – particularly interest rates – too loose and you will keep alive companies that should go bust or be restructured to use resources more efficiently. But set policy too tight and you will kill companies that are temporarily in trouble, exacerbating a downturn and destroying valuable economic resources
Figures from R3, the insolvency industry trade body, shows that one in 10 companies in the UK is able to pay only the interest on their debts but not reduce the debt itself, a common characteristic of zombie companies. This is up 10 per cent in the past five months to 160,000 groups, with 70,000 groups struggling to pay their interest payments.
In some parts of the continent the problem appears even more severe. The lowest rates of insolvency in 2011 were from Greece, Spain and Italy, the three countries whose economies have struggled most. Fewer than 30 in every 10,000 companies fail in these countries – this at a time when nearly one in three groups is loss-making, according to Creditreform, a risk management group.
And the issue looks far more severe than in previous recessions. In the economic slump of the 1990s, when EU gross domestic product shrunk by less than 1 per cent, the default rate for debt rated subinvestment grade by Standard & Poor’s hit 67 per cent, albeit with a small sample size. Today, after a fall of 4 per cent in economic activity in 2009 alone, the default rate has not gone above 9 per cent and now stands at 2.3 per cent.
This has sparked concerns in the corridors of power, with the Bank of England raising the issue for the first time in October. In its monetary policy meeting minutes it said that "some companies may have been able to remain in operation during the recession [as a result of government and central bank action]”, and that this might have "hindered the reallocation of capital towards more productive sectors”.
On the continent there are similar worries. "Behind the scenes there is an emerging policy debate about how many zombie companies there are and how bad the problem really is,” says Sony Kapoor, head of Re-Define, a Brussels think-tank. "This is an issue both the European Central Bank and the [European] Commission are concerned about”.
Ultra-low interest rates across Europe since the crisis have set the scene for the zombie company phenomenon – allowing companies to exist that would have failed under ‘”normal” circumstances – but it is the banks, according to insolvency professionals, that should shoulder much of the responsibility for any problems.
This is because in the past few years, struggling lenders have been unwilling to force the restructuring or liquidation of companies they have loaned money, even for groups that look unlikely ever to be able to repay.
Many banks have taken the view that if they can just let loans sit there – and even give the company a few years longer to pay if the loan falls due – they will, allowing them to keep their loan books marked at par and delay taking a balance-sheet hit.
"Many continental banks are under pressure in terms of their own balance sheets, which is preventing them from moving into a more aggressive programme of restructuring and recycling some of the companies through the economy,” says Andrew Grimstone, senior restructuring partner at Deloitte.
Aclassic example of this has been in Spain, where the small savings banks in particular were badly hit by the collapse in the housing market in 2008. In 2011 it emerged that of the €323 billion worth of real estate loans on the books of Spanish banks, about €175 billion worth were "problematic”, according to the Ministry for Economy and Competitiveness. The government had to mandate the banks to take extra provisions.
Gilles Moec, European economist at Deutsche Bank, says that outside the UK, the zombie problem is chiefly focused in the peripheries of Europe rather than the core. "In Spain, Ireland, Portugal and Greece, banks have been reluctant to pull the plug on companies as it would have forced them to crystallise heavy losses.”
This phenomenon has been a huge frustration to distressed hedge funds, many of them from the US, which poured money and resources into Europe in the early years of the crisis in the expectation of an imminent wave of asset sales. But this has not materialised, with many banks still clinging to loans for dear life.
"A lot of the money raised for European distress in the past few years has not been put to work at the same rate as many expected,” says Galia Velimukhametova, who runs the European distressed fund at GLG, the hedge fund. "The banks have not been selling assets as fast as was envisaged.”
But the banks are not the only problem. Some companies are zombies for more long-term structural reasons, such as a burdensome pension liability amid an ageing population. One midsized UK shipping company, which did not want to be named, generated £6.1 million in profits in 2011 but was obliged to contribute £6.3 million to its connected pension fund in the same period, making it a "pension zombie”.
The company’s chairman told the Financial Times: "We are a zombie working for the benefit of current pensioners but to the detriment of future pensioners as we are unable to invest in new growth areas.” The cumulative exposure of the UK Pension Protection Fund, the safety net for the underfunded schemes, to defined benefit schemes stands at £227 billion, a 32 per cent increase on 2011, according to KPMG.
There are early indications that the situation for zombie companies might be starting to change. As banks edge their way back to health, some are becoming more willing to write down non-performing loans to market values and sell them. The Basel III banking regulations also make holding loans more expensive, which is likely to encourage further selling.
"Sooner or later these companies are going to have to be restructured,” said Velimukhametova.
PwC estimates that European lenders have €2.5 trillion worth of loans that need to be unwound in the coming decade, about €1 trillion of which are likely to be non-performing. A record €65 billion is estimated to have been sold in 2012, compared with €36 billion in 2011 and just €11 billion the year before.
But with politicians still focused on lowering the rate of corporate failures, any substantial trend is likely to be slow, economists say. The all-time high of €65 billion to be sold this year is still a drop in the €2.5 trillion ocean. Insolvency rates are set to rise only very slightly next year, according to S&P.
Many European jurisdictions are still ill-equipped to deal with restructurings in the courts. While Spain passed a new law in 2009 facilitating out-of-court debt restructuring, proceedings can still be slow and difficult, many in the industry say.
There is a cultural barrier, too. In much of Europe a corporate failure is looked upon as a stain against a businessman’s name. This is in sharp contrast to the more pioneering US attitude. "Failure is an expected part of being an entrepreneur in the US,” says Jon Moulton, founder of BetterCapital, the private equity house. "But in much of Europe it is not the same. Entrepreneurs can face years of stigma and court battles after a single failed venture.”
Today, the big debate in policy circles is about whether more companies going bankrupt in Europe would be a positive development in the long run. Some take a hard line.
"Europe is like a forest floor that is being clogged with weeds, choking off nutrients and light to saplings with a chance of becoming trees,” says John Alexander, head of CBW’s corporate recovery and insolvency department. "What Europe needs is a fire to clear out the undergrowth.”
But others in the restructuring and economics communities – along with most politicians aware that there are few votes in creative destruction – take the view that at this stage at least, stability and employment is more important than eking out every penny of efficiency.
"The main people who promote a tougher stance on struggling companies are the vulture funds and the advisers who think they will get more work,” says Derek Sach, head of restructuring at RBS. "My judgment is that the pain has been about as much as you can take without civil unrest.”
For Mike and his struggling company, the creative destruction approach does not seem attractive. Even if his equipment is growing more rickety and hopes of a recovery are dimming by the day, he says there is always a chance: "A run of good contracts could be just round the corner. We live in hope.”