Post-global financial crisis the phrase “zombie companies” was coined. What is a zombie company?
A zombie company is an operation that looks and acts like a normal company because it is able to continue to operate based on government subsidies, rent relief and reduced costs of doing business, left without support the business is unsustainable.
Lulled into a false operating model and permitted to trade without the financial pressure to change some businesses will simple continue on unaware they are operating in a zombie capacity.
In Australia we seemed to skate round the edges of the GFC with businesses here not requiring large scale government financial help. Therefore we haven’t yet experience the impact as zombie companies reach the end of their sustainability. Even if your business has reacted, changed operating and business model to become sustainable, what do all the businesses around you look like?
The common problem with zombies is because they appear to be trading as per normal you don’t know which businesses are affected. As we march towards the September government support cut of date are you checking your networks, those business you rely on for supplies and distribution. Are they sustainability?
The natural approach is to demand the government support is extended, however this will ultimately put of and possible increasing the zombie impact.
So businesses have 2 options.
Option A continue to use the government support without assessing and developing a sustainable business or Option B take the time the government support is giving business to create optimal sustainability.
Diving deeper to understand the various impacts and facts driving the need for businesses to act sooner rather than later.
Government-backed businesses
Businesses are currently being propped up by governments that are providing cash subsidies on an unprecedented scale. In fact, more than 72 per cent of the nation’s 13.2 million-strong labour force is now employed by federal, state or local governments.
The Australian government has even put a moratorium on insolvent trading to provide directors, who were wavering, with the additional comfort that they should trade on regardless of the current climate. Banks, on the other hand, are being asked to provide forbearance and amendments to facility agreements across the majority of their clients.
In the short-term, this is the right approach to take and the government, lenders and corporate sector have behaved admirably. However, as the economy begins to pull the government welfare, bandaid off and we stagger out of our isolation, we will start to see how bad the wound is.
Long-term damage
For many companies, the COVID-19 financial impact will be terminal. Whilst it will be very tempting for boards and banks to ignore poor performance and over-leveraged balance sheets and instead focus on December 2019 financials to justify “normal” valuations, this is a dangerous approach. It justifies doing nothing, even in situations where a company is crippled with too much debt.
Additionally, this approach has no time limit, as credit paper submissions in 2023 will still be referring to pre-COVID earnings as a rationale for further forbearance. In such circumstances, lenders have two main options. They can enforce their security, sell the business and assets, and realise a loss. Or, they can provide continued forbearance and hope that the enterprise value of the business returns to levels where recovery is possible.
The future for organisations on life support
Insolvencies are bad. Nobody is arguing otherwise. However, the far more sinister outcome can be a protracted and drawn-out period where the company is on life support and spending the weekend at Bernie’s. Under this scenario, companies focus on harvesting short-term cash flow and making decisions that damage the business over the medium-term, including:
Lowering capital expenditure: That modern piece of equipment that will improve productivity and has a return profile that is justifiable over a 10-year period may be overlooked as the focus is on the next 12 months only.
Restructuring is completed slowly: Shifting premises, moving to new operating systems and making staff redundant all have implementation costs. With banks in charge the incentive is to simply harvest cash flow and make changes in a piecemeal fashion.
Uncertainty among staff: A drawn-out restructuring process can be toxic for staff, especially key employees. It is far better from an organisational psychological perspective to have one larger restructure and then emerge with a new, well-capitalised ownership structure and a growth mindset.
Banks determining future business stability
In the coming months and years, the banks will be faced with the challenge of determining the businesses that can simply be given forbearance and those that will require them to take more drastic action.
For the businesses that have been given leniency from the banks, deleveraging will occur through a combination of operational performance improvements and equity raises. Post-GFC, the wave of equity raises to repair balance sheets took 18 months to really kick off, with record volumes only occurring in late 2009.
For companies where operational improvement or future equity raises are not realistic, then providing forbearance will simply create a wave of zombie companies. The financial impact of this will be severe. In fact, by 2013, almost six 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 per cent, 19 per cent and 16 per cent, respectively.
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 causing negative impacts to the broader economy.
Learning from past experiences
In Australia, we are very fortunate that our banks are well capitalised and can absorb a one-off financial hit associated with the COVID financial crisis. In Europe during the GFC, this was not the case and in order to ensure capital ratios, strict impairment budgets were introduced that prevented banks from dealing with zombie positions promptly.
The fifth element we use the recognised global business transformation model to assess business capabilities define new business models and create 3 stage roadmaps to either rebuild or grow your business. Contact us to find out more.
Jacinta@thefifthelement.me
Support text written by Cyrus Church, co-founder, Neu Capital