Rise of the Zombies....Are they Creeping into Portfolios?

Zombie companies are companies that are no longer viable businesses but have been able to survive on the abundance of cheap credit. The decade long experiment with historic low interest rates has created a significant rise in zombie companies creating potential instability in the broader economy, increased capital allocation inefficiency and significant challenges for investors in passive or inexperienced credit managed products.  

While there is no formal definition of a zombie company firms that fail to book sufficient profits to cover their annual debt costs for three straight years are generally considered zombies.  Not all zombies are bad.  Amazon had historically built up years of losses before it became a profit powerhouse.  Other companies like JC Penny and AMC Theatres have not been as lucky with the prior filing for bankruptcy and the other on the brink.  In the latter cases the capital markets could be said to be working by allowing these firms to fail but behind the scenes there are many others continuing on, building up debt with limited prospects of being able to pay it off.  Nearly one in every five publicly traded U.S. companies is a zombie according to data compiled by Deutsche Bank Securities. That figure has doubled since 2013 and is up dramatically from the late 1990s. In the developed economies, approximately 12% of all non-financial companies are ‘zombies’ up from a mere 2 percent 30 years ago.

While the thought of letting businesses fail is unappealing, letting them survive, draining resources, resulting in a more severe fall out down the road may prove to be more scary.  In the industrial conglomerate sector in the US there are approximately 233,000 individuals employed by firms qualified as zombie companies.  Energy Equipment and services, hotel, restaurants and leisure along with hardware and storage are other vulnerable industries.  Some of the biggest names have actually found it easier to raise more debt during the present crisis as Federal Reserve intervention has breathed new life into the corporate bond and stock markets.

Branding current Zombie companies appropriately is difficult; regulatory incentives and the reliance on management transparency makes forecasting future zombie’s even harder. Leverage can be a guide but when is leverage sustainable and what triggers unsustainable leverage?  We don’t have an easy answer but there may be warning signs to look out for.  An example is the leverage buyout market where in the last 4 years there has been approximately $2 trillion worth of transactions. The EBITDA multiple at which these buy-outs took place has increased over those four years from 10 to 11.5 which is far beyond the 6X multiple they took place at 20 years ago. On average these deals were 58% debt financed, mainly through leveraged loans with the remaining 42% from equity, some of which were also partly financed through borrowed money. What happens if EBITDA declines?  Is the leverage sustainable and what are the credit covenants for investors? Although these questions are highly relevant and would justify an article all by themselves, let’s leave this aside. There could well be a scenario where private equity sponsors or private debt investors do not want to throw in the towel if the market doesn’t force them to do so. With a record $1.5 trillion of dry powder according to Preqin 2019 data private equity has a massive amount of money to keep things flowing and in the worst case keep appearances up while creating new zombies. This is how Japanese banks kept supporting the credit of failing firms in the late 90’s. In today’s world it is hard to see banks being the facilitators of new zombie companies, they are under too much regulatory scrutiny and at the time of writing were taking significant bad loan loss provisions. In contrast how many private equity and private debt managers have taken loss provisions over the last few months? Should we be convinced that this is all justified by superior judgement?

What are investors to do. Increasingly investors have sought the comfort of diversification through index funds and/or private debt funds that don’t appear to experience any price volatility.  Despite being a proponent of both vehicles for a portion of an investors portfolio the recent 25% rise in the SPDR Bloomberg Barclays High Yield Bond ETF since late-March and lack of private debt volatility should attract investor attention.  With the large majority of private debt managers having emerged post the global financial crisis and the undiscerning impact central banks are having on capital markets globally, product and manager due diligence is more important than ever.