Zom­bie firms thrive in Europe

The con­ti­nent could be fol­low­ing the path of Ja­pan, where looser pol­icy and fail­ure of big banks to fore­close un­prof­itable ven­tures caused two decades of weak growth Liq­ui­date labour, liq­ui­date stocks, liq­ui­date farm­ers, liq­ui­date real es­tate... it will p

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When the con­struc­tion sec­tor slumped three years ago, Mike, the 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 pol­i­cy­mak­ers 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.

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 in 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.

Se­vere is­sue

And the is­sue looks far more se­vere than in pre­vi­ous re­ces­sions. In the eco­nomic slump of the 1990s, when EU gross domestic prod­uct shrank 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.

A clas­sic 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.”

Struc­tural rea­sons

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

“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 Ms 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- of­court 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. This is in sharp con­trast to the 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.”

Dead but alive

A build­ing site in San­tander, Spain. The low­est rates of in­sol­vency in 2011 were in Greece, Spain and Italy, the three coun­tries whose economies have strug­gled most.

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