Zombie companies

As expectations of an economic recovery start to grow, so too does a concern that an army of businesses, so-called zombie companies, are holding back the recovery, tying up capital and resources.

To some, the collapse of these companies would be good for the long-term health of the economy, since it would free up resources for companies better placed to thrive and grow. For others, these companies have simply been unable to grow in turbulent times. Their failure – assuming interest rates are set to rise - according to this line of thought, would be something of an injustice since their owners are guilty of little more than trading circumspectly in difficult conditions.

The term ‘zombie companies’ has become something of a shorthand for businesses that are stagnant in that they are unable to invest or grow, but have survived the downturn propped up by very low interest rates and a banking sector concerned about adding too much bad debt to its balance sheets.

However, the jury is out on whether or not these companies exist in great number, or if they do, whether they represent a genuine threat to recovery.

The zombie population

Estimates on the zombie population range widely - from 100,000 to 400,000. According to insolvency and recovery body R3, nearly 100,000 can only afford to repay interest on their loans, while 200,000 are in acute distress, negotiating with creditors or struggling to meet debt repayments. However, Gareth Rumsey, research director at Experian, questions the validity of the argument that the recession has yet to clear out sufficient numbers of non-viable businesses.

'Zombie businesses are seen as a population threatening the overall economy. We’ve reached a point where that has become an accepted truth. Experian’s view is that it shouldn’t be accepted as fact,' he says.

Arguments that the insolvency rate is unusually low compared to the recession of the 1990s fail to take into account the many businesses that having simply wound up, he argues, rather than going through formal insolvency procedures.

What’s more, business dynamics have changed greatly, he argues. The business population of 2008 was 2.5 times that of the nineties and more focused on the service sector. And 1990 did see a considerable number of business closures, he argues, some 547,000 compared to 364,000 start-ups, the equivalent of a 6.4% fall in the business population.

Nature of the threat

Others are less sanguine. Mark Halstead, partner at Red Flag Alert, providers of proprietary business data, says that not only do zombie companies exist, but they act as a drag on other companies and the economy, preventing banks from lending to more viable businesses and tying up market share.

An atypical recession has protected businesses that would in other circumstances have failed, says Halstead. All regions of the UK have been afflicted and, while previously zombie companies were associated with financial services, now they straddle most business sectors.

There has also been a shift in business dynamics. Halstead points out that the UK business population is more service-driven that that of the previous recession with greater numbers of lifestyle businesses that are asset-light. Service and internet businesses with little debt or physical assets can underperform without failing or be wound up rather than go through formal insolvency procedures. According to this line of thought, there have indeed been businesses shaken out by the recession, but their demise is less visible.

So, who is to blame? 

Commentators point to the reluctance of banks to pull the plug on loans that they might in other circumstances have called in – in an act of collective forbearance. But as Julie Palmer, partner at Begbies Traynor, points out, for the first years of the recession that policy may not have been fully intentional. 'Banks themselves were reeling, rather than looking at the distressed businesses on their books,' she says.

What is more, a policy of forbearance could be seen as responsible behaviour during economic recovery. It is uncertain, however, whether that policy can still be regarded as sound in the context of the UK’s current uneven recovery, according to Ben Cairns, restructuring partner at EY. Cairns says Bank of England figures show that forbearance impacts only around 14% of banks’ SME loan portfolio by value, while in the commercial real estate sector, it affects some 35%.

The role of HMRC and its Time to Pay initiative whereby businesses could defer tax, is coming under increasing scrutiny. From one perspective, Time to Pay was a benign and necessary policy, one that gave struggling but not fatally flawed companies much needed breathing space. Increasingly however, questions are being asked about the companies that qualified for Time to Pay and whether it is time for the initiative to be phased out.

Mark Halstead believes it is time for forbearance, on the part of HMRC and more widely, to come to an end. 'Businesses that owe the nation – or the banks – a debt now need to repay to give the economy a chance to refresh and leave the bad news of the past few years behind,' he says.

There is an estimated £7bn tied up in Time to Pay. HMRC is, says Palmer, growing 'increasingly defensive' in the face of arguments that the scheme has reached the point where it is denying the economy considerable funds and making it more difficult for the businesses that are paying tax to hold their own. 'HMRC claims that it looks at the viability of businesses and that the policy is not a drain; it is keeping people in employment and therefore paying income tax,' says Palmer. 'It’s a laudable argument, but very early on they said yes to the wrong businesses, businesses that didn’t need the scheme, but exploited it as a source of low cost loans.'

So what will happen to these companies that exist on the margins?

In all likelihood, many will topple as recovery takes hold, as increased demand leads to over-trading, particularly for the SME sector. Recovery can be a dangerous time for businesses that are already over-extended.

There is little doubt that overly-geared companies will struggle, says Palmer. For every half-point rise in interest rates there will be an additional 4,000 company insolvencies, according to her firm’s estimates. With jobs on the line, it is a highly sensitive situation for politicians, the banks and the UK economy.

However, cause and effect is rarely a straightforward issue. Economist Frances Coppola, argues that a report by the Adam Smith Institute identifies four types of business that could be vulnerable to rising interest rates, only one of which matches the consensus definition of zombie companies. So collateral damage could be considerable.

Halstead believes there are signs that a policy of forbearance at HMRC is coming to an end. 'HMRC now petitions companies that haven’t made moves to pay. Where they were enforcing one or two petitions a week there are signs that this is increasing.'

While some commentators argue that artificially propping up ailing companies has extended the recession, others argue that forbearance on the part of the banks hasn’t been wholly negative. Indeed, it may have been a sensible strategy to wait for improved economic conditions rather than force a fire sale of companies’ assets at depleted values.

Nor are struggling companies themselves necessarily to blame. Julie Palmer believes zombie companies aren’t necessarily deserving of the criticism they have attracted. 'Is it right to keep lambasting them when they may be the reason that employment figures haven’t spiked the way they have in previous recessions?' she asks. Amongst these zombie companies there may still be viable businesses capable of recovery. 'Many of them should be applauded for the measures they’ve taken,' she says.

Meanwhile, many will still face a funding gap as we emerge from financial uncertainty. Invoice finance may help to meet that gap, Palmer argues, but banks are increasingly in better shape, if still smarting under public perception. If SMEs undertake to provide the management information that credit committees need and if politicians and the public give banks more room to manoeuvre, we may see a return to better economic health.

Liz Loxton, freelance journalist.