European High Yield : Zombies

They Walk Among Us: Zombies, High Yield and The Market

thegr8destructo

July 1, 2020

Zombies – This is part one of two on Zombie Companies. I was surprised at just how prevalent “Zombification” is and how it presents itself in High Yield, the Markets and  Economy. Bad news is they walk among us. Good news there seems to be a consensus as to how to root them out. Not So Good News – I don’t think they get dealt with.

“You Have to Wash these People Out”

 

This video is a must watch. For me it encapsulates what capitalism should be about, why Zombification is likely to rise with Central Bank Intervention. It hints at what needs to happen – bankruptcies- a cleaning out of the system. It also highlights the potential for casualties in the form of employees and the tough decisions faced by Central banks.

 

What *is* a Zombie Company?

Zombie companies come in a variety of flavours – this 2018 BIS paper  “The rise of zombie firms: causes and consequences”  by Banerjee and Hoffman sets out the most know definition: “as firms that are unable to cover debt servicing costs from current profits over an extended period”.

In the paper they break this down further:

  • “Broad” – Persistant Lack of Profitability in Mature Firms
    • Interest Coverage Ratio less than one for 3 years
    • More than 10 Years old
  • Narrow – same as “Broad” but additional constraint of how future profitability inferred from the firm’s market valuations
    • Ratio of Assets Market Value to Replacement Cost (Tobins Q)is below the median within the sector.

 

Now, the original paper that started the whole zombie debate “Zombie Lending and Depressed Restructuring in Japan” was published in ’06 by Caballero, Hoshi and Kashyap.

Their paper looked at Japan’s experience – the collapse in the banking sector, asset price declines and support of the central bank and how this resulted in supporting firms that would otherwise been removed from the economy under normal competitive forces. Their definition of Zombie Firms is based around companies having access to subsidized capital provided by banks unwilling to take losses on their loan books.

Generally though the BIS paper definition is the one you will likely come across the most. Others have broadened the definition to include additional metrics or even exposure to disruptive technologies.

 

Why are Zombies a bad thing?

Zombie companies are bad because they:

  1. Crowd out Investment – Capital is mis-allocated – firms that are growing and having a positive effect for the economy have less access to funding. Banks who have lent to zombies are more constrained as to additional lending
  2. Employment – Human capital is tied up in companies that are barely growing – at the same time making it harder for healthy firms to access the talent pool making it more expensive for the sector
  3. Margins – Zombie firms tend to have lower margins compared to peers as such they impact the sectors ability to price their products as a whole – there is a constant risk of downward price pressure
  4. Inflation – Zombies exert a downward pressure on inflation (see later) making the escape from Central bank largesse even harder

Creative Destruction

Chamath Palihapitya hits the nail on the head in the video – a wholesale clearing out of Zombies, should in theory, be best for the economy.

At the heart of why Zombies are bad is that they stop “Creative Destruction* this is an idea developed by Schumpter in the 1950s: “process of industrial mutation that continuously revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one”.

So old less productive activities give way to more productive ones. Think online retail, electrification of cars, streaming services, data centers. these are all very real and tangible examples – despite the ability to argue Tesla and Netflix could be classifies as Zombies using the broadest term. Here, it is worth pointing out that growing companies find it harder to turn a profit , but the sign of their success can be found in rapid growth and acceptance of their product if they are. Additionally when looking at the broadest sense of the zombie definition low interest coverage may be the norm for a given sector.

In terms of Zombie sectors, these tend to be capital intensive and you need only look at where most of the defaults, consent solicitations and restructurings have occurred to see who is most exposed – Retail, Tourism and Leisure, Hotels, Airlines, Autos etc.

KPMG published an analysis of the prevalence of zombies in the UK’s Public and Private markets by Sector in 2019. Looking in the rear view mirror at end H1 2020 you can see how predictive this was for defaults/ restructurings when the system was put under stress:

 

Getting Rid of Zombies – Short Term Pain, Long Term Gain?

 

In order to facilitate “out with old, in with the new” involves:

  • minimizing the costs of bankruptcy/ insolvency.
  • reducing the personal costs of failure associated with start ups
  • ensuring human capital can easily be reemployed in the same sector or elsewhere is also important.

This one of the most interesting features of the Zombie Problem for someone involved in High Yield Debt in Europe.

There is no standard insolvency regime in Europe. Neither is there a standard response to unemployment – CoVID has highlighted the different responses governments have had, their ability and willingness to sustain support for individual employees. Anyone looking at the European Union, especially today, understands that there is considerable complexity at play whenever establishing consensus around Fiscal and Monetary policy,

In order to really tackle Zombies there needs to be a coordinated response within Europe as well as a willingness/ determination at a national level to strengthen banks, realize losses and restructure companies. This is complicated by politics, core vs. periphery in Europe. Recent announcements by Monti dei Pashi to hive off its NPLs to a bad bank suggests that progress is being made at the national level.

Arbor Research estimate that US Zombie companies in the US employ nearly 2.2mm out of a total work force of 158mm (May-20) or c 1.4%, A clear out of Zombies in a “normal” year would have a significant impact relative to “normal” unemployment. A decision to kill off zombies altogether is politically charged, without providing new jobs for those displaced.

Playing Devil’s advocate you could argue in using the current crisis as a catalyst to deal with Zombies given the magnitude of financial aid being thrown at the problem makes sense.

However, focus so far has been on keeping companies running providing liquidity. Germany has certainly been strict in terms of which companies have received aid, and the UK’s Chancellor has commented the bar to receive state aid is high. The question is should the bar be universally higher to weed out the Zombies?

Insolvency Regimes, Barriers to Exit, Focus on the Employees

 

The 2017 OECD paper “Zombie firms and weak productivity: what role for policy?”  looked at how productivity growth is linked to weak banks, insolvency regimes and how this impacted productivity.

Within Europe the periphery (Italy, Spain),Portugal they estimated that “solvency reforms that reduce barriers to corporate restructuring and the personal cost associated with entrepreneurial failure could translate into a decline in the zombie capital share of at least 9 percentage points in Spain, Italy or Portugal – countries where the zombie capital share stood at 28%, 19% and 16% in 2013, respectively”.

This suggests that there is significant room to reduce the productivity drag associated with zombies through reducing the barriers to exit in a restructuring process. The positive take-away is that over the 2010-2016 period there had been an improvement in Insolvency Regimes and Banking Sectors. Peripheral countries still exhibited higher share of zombies compared to their “core” brothers and sisters.

Insolvency regimes continue to be revised – for those interested you can look at recent changes in the UK and Netherlands (click through). Additionally if you want a useful guide to the different regimes across Europe then there is this from 2017 by Deloitte. Ultimately,one day, Europe may harmonize all the different regimes.

Weak Banks and Evergreen Lending

Weak banks are at the heart of the Zombie proliferation. In the 2006 Japanese study zombies were subsidized by banks hoping to avoid losses by “ever greening” their loans to troubled companies. This then ties up capital that could be allocated more productively. There appears to be a reasonably string link between bank health and the prevalence of Zombies:

Generally the relationship between weak banks and Zombies is high.

The ECB working paper “​Do we want these two to tango? On Zombie firms and stressed banks in Europe”  concludes sustainable economic recovery requires both banks and firms to de-lever.

Given the Increase in Corporate Debt to GDP has been increasing (albeit non uniformly) across Europe and the US, and the “solution” to the current crisis appears to be unlimited liquidity it is hard to imagine the status quo reversing near term despite the benefits of dealing with NPLs.

This article from the Chicago Booth School studied 110 Italian banks from 1990 when the country was in recession and non performing loans were 9% and defaults 4%.

The take away is that retaining risky debt in the hope borrowers recover with the economy is not a  winning strategy. The problem is that as humans we tend to choose the least “painful” choice when making decisions about losses.

They found that the banks that restructured their loan books and reduced their exposure to risky clients enjoyed a significant improvement in their return on assets.

 

Loss Aversion

I admit it, this is a bit of a detour, but an important one in my mind. Loss aversion is a huge component of Zombification IMHO. It happens at the Bank level with banks not taking losses on their loan books in the belief that leverage borrowers will eventually rebound. It also happens in the high yield and loan markets as investors choose to provide covenant amendments, extensions, debt payment holidays etc in order to avoid a default or a loss on their books.

Loss aversion refers to people’s preference to avoid loss over making a gain:  it is better not to lose £5 than to find £5. Phrased another way faced with an equal chance of winning 1200 or receiving 0, or receiving £500 immediately people generally choose the latter. The Former offers a probability weighted gain of £600.

Humans are hard wired to make the less painful / higher certainty choice. This makes Zombification a product of human make up and, for me at least, makes it easy to understand why banks sit on risky lends.

Similarly it explains why investors will agree to a restructuring if it avoids a default. The issue here is that once a name has restructured and ends up in trouble a second time the recovery tends to be materially lower than if there had been a full restructuring the first time around.

So I would like to add being human to the list of causes of Zombification.

 

Interest Rates – Lower, Longer, Wronger?

 

Interest rates are a key driver for Zombification. They act in 2 ways. The first is that they reduce the overall cost of borrowing, allowing Zombies to grow their debt piles via refinancing and lower coupons. Secondly they encourage risk taking “reach for yield” is a much cited phenomena when looking at how credit spreads tighten as investors look to lock in marginal increases in yield for a step down in credit quality Zombie firms tend to be riskier than there normal counterparts as such risk seeking behavior buoys Zombie market values and reduces the pressure when they look to refinance their debt.

Charles Schwab in their Half Year outlook point to the performance of small cap stocks as a sign of irrational exuberance in the markets driven by liquidity.

 

The Corona crisis has resulted in a frenzy of debt issuance and increased corporate borrowing all at low interest rates – although it is important to note Zombies have opted to pay up to get financing done. on the heels of the previous crisis corporates issued debt to buy back shares fueled by the Liquidity from the previous crisis. Such companies may find themselves “zombie-lite”. Rather than banks mis-allocating capital to inefficient companies, it has been the companies own treasuries buying back equity as the “smart trade”. They will come out of the crisis having increased indebtedness and reduced productivity. If you need a poster child for the share buyback disaster look no further than airlines.

Inflation – Symptom or Cause?

Inflation – is like silver to Zombie companies – it is what will (possibly) kill them. Zombie companies tend to be low margin businesses and cost inflation will erode those margins further making bankruptcy more likely., With higher inflation comes higher rates and higher refinancing costs. That debt pile amassed at low interest rates becomes even more of a burden on cash flow.

Whether you see inflation is another matter.

Zombies are by and large  dis -inflationary. They create over supply – cutting prices is necessary to win market share, Not only that, because of the mis-allocation of productivity they exert a downward force on sector growth rates.

A study by Eisert et Al found that Zombies had an incredible effect on the level of inflation:

“As a result of the zombie companies, each year, inflation was 0.45 percentage points lower than it would have been if those cheap loans for companies in need did not become available. This is a bitter pill to swallow for the ECB, which had set the target of increasing inflation by 2% a year for the past ten years. In practice, this increase was only 1.3% per year” – Eisert et al Zombie Companies temper desired inflation Jun-2020

That is huge – the low interest rates allow zombies to increase their indebtedness at the same time reducing their profitability and impede central banks attempts stimulate it.

High Yield – Stockholm Syndrome?

In Part 2 we will have a look at some of the names in the Zombie hall of fame, their prevalence and growth.

High Yield appears to be suffering from Stockholm Syndrome. It has been held hostage / so de-sensitized to Zombie companies that it does not appear to be discriminating with extreme prejudice between the good and bad. I say extreme prejudice as there is little reward for being partly right or a little bit wrong at the moment.

This morning I read the headline  “TKE underlines the toxicity of the covenant wars” – essentially a highly levered large LBO deal with weak covenants. The article says weak covenants are a free option for the borrower, but there is no reciprocal option for the lenders.

The terms of the deals were pushed back on, re-drafted and the deal priced. The Second TKE headline I read was “Investors Pile into $9 Billion Debt Sale for Elevator LBO”. Move on, next stop, nothing to see here.

So what I hear you say?

Well it’s this – we are operating in a market with bankruptcies, restructurings, frauds and zombies. The balance of power should be with those lending to high yield companies. The margin for error is stacked against them – the financial fall out of Q2 has yet to be reported and in the mean time preemptive  restructurings, amendments and extensions will help give issuers the space to breathe – but of those I would love to know how many saw the lender extract value for themselves. The likelihood you own a bond that could drop 10 points in your portfolio has increased massively. And if there is a second wave – good luck to issuers who did not access enough liquidity through emergency schemes the first time.

Moodys published a report today “Current vintage bonds are ill-equipped to preserve value in a downturn” essentially stating High yield issuers have “unprecedented flexibility” when it comes to covenants – particularly those bonds with PE Sponsors. Additionally I came across “High Yield Light Bonds” as a phrase more than once in the last 24hrs – High Yield Lite is not High Yield. It is not even Junk. It sounds like the Robin Hood Traders debt vehicle of choice on the road to nowhere.

All considered it doesn’t sound like high yield Investors are in the driving seat. If anything they seem to be offering up their arms for Zombies to have a nibble on. I am not sure how investors take control back and clean out the Zombies or even if they want to.

 

 

 

 

 

 

 

 

 

 

 

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