This article has been written together with Tristan Ramirez.
After a decade of steady expansion, the rise of zombie firms has accelerated with the Covid-19 crisis. Today, the phenomenon is threatening entire slices of our economy and straining public health resources. Reinforced by mass unemployment, forecasts for growth and debt ratios have been revised, dragging the global economy into an even more uncertain period.
A favorable environment for zombie firms
The main driver of corporate zombification is a decline in interest rates. Thousands of private equity players are navigating a storm of uncertainty due to large investments in zombie companies from distressed sectors, e.g. leisure, hospitality, tourism and travel.
Significant amounts of leverage are used to finance the acquisition of these businesses. Loans are at the core of the problem: according to the Financial Times, 80 percent of loans are so-called covenant lite – in other words, products with borrower-friendly terms and poorly covenanted clauses.
These instruments are sometimes contained in off-balance collateralized loan obligations (CLO), reinforcing the opacity of debt figures and increasing the difficulty of risk assessment.
In order to tackle this challenge, ESMA published a report on 13 May 2020 to deal with CLO rating issues and highlight supervisory concerns. The report provides an overview of CLO rating practices and medium-term risks in this asset class. It includes internal organization in terms of credit rating, interactions with CLO issuers, operational risks, commercial influence on the rating process and the need for proper analysis of CLOs.
Entire slices of the economy affected by Covid-19
Recently, the cruise sector was hit full force by Covid-19.
Perhaps the most striking example comes from one of the largest cruise operators: After the virus exploded, thousands of people were quarantined on board for multiple days. Several hundred were infected and six died.
In order to stay out of deep water, this operator planned to raise $3 billion in bonds. Multiple investors indicated that the firm, while it still has an investment-grade rating, intended to pay a coupon of above 12 percent on senior secured bonds.
After this episode, projected earnings in the cruise sector remain under scrutiny. All upcoming cruises leaving the US have been cancelled and future bookings for other cruises have sharply decreased.
The situation was further exacerbated by guidelines from health officials and governments regarding sea travel, recommending avoiding exposure to such crowds.
The US government has allocated $2 trillion in financial support to boost its economy, including $500 billion for companies in difficulty. Unfortunately, most US operators are based abroad and are not eligible for this financial assistance.
On the other side of the Atlantic, companies that were not eligible for public financial support had to get creative in order to avoid bankruptcy. Sir Richard Branson, for example, has pledged his private island in the Caribbean as collateral to raise £500 million and save the Virgin Group.
On the old continent, the European Commission has allocated €540 billion: €100 billion to maintain jobs and reduce unemployment risk, €200 billion to support European SMEs and €240 billion to sponsor member states in the form of credit lines.
PE players on alert: a credit bubble that continues to grow
Private equity firms that are invested in areas most at risk from the pandemic face an uncertain future.
The inflow of liquidity from central banks or government lending programs makes it possible to supply funds with liquidity in the form of refinancing. The knock-on effect is a deterioration in the interest coverage ratio.
These firms’ responses tend to normalize the presence of zombie companies, artificially maintained through liquidity infusions while avoiding corporate restructuring. The concept of creative destruction has given way to an ecosystem made up of a myriad of zombie firms.
Funds need to regularly test their covenants (every quarter) and update their information base while keeping an eye on the financial risk within a loan portfolio.
Firms have an interest in bending the interest rate ratio curve. An assessment of restructuring options can be carried out in order to identify viable schemes and improve corporate performance.
More generally, private equity firms need to address the debt-related vulnerabilities that impact lending banks in the event of a default. According to the European Central Bank, zombie firms congest markets and constrain the growth of more productive firms, to the detriment of aggregate productivity growth.
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