Fed tightens noose on zombie companies

Investment Analysis Clubs Macro Economic Trends and Risks
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Many zombie companies were bought by private equity firms that loaded them with debt.

Zombie companies can barely pay interest expenses on their debt and can’t pay down principal. When their bonds and loans mature they are forced to borrow to pay off their creditors. (“Roll over” the debt.) The Federal Reserve has estimated that about one in ten listed companies are zombies.

Bond rating companies rate zombie debt as “high risk” or “junk” because they may default if their sales fall during a recession…or if interest rates are rising so they can’t roll over their debt at the previous low interest rate. These are rated at CCC or below.

A CCC-rated zombie that could borrow at 6.65% in 2021, when the Fed was doing ZIRP and investors were stretching for yield, will now have to pay 15.9%. The spreads between CCC debt and Treasuries has risen from 6% in 2021 to about 12% today.

https://www.wsj.com/articles/junk-rated-companies-face-greater-downgrade-risks-as-economy-slows-11669263665?mod=markets_lead_pos6

Junk-Rated Companies Face Greater Downgrade Risks as Economy Slows

Default rates are expected to go up if inflation and debt-servicing costs remain high, ratings firms say

By

Mark Maurer, The Wall Street Journal, Nov. 25, 2022

High-yield companies in the consumer goods, healthcare and entertainment industries are increasingly at risk of credit downgrades and even defaults as they battle rising interest rates and falling revenue, forcing some finance chiefs to consider alternative financing options.

Default rates for low-rated U.S. companies will likely reach 3.75% for the 12 months ending in September 2023, up from 1.6% in September 2022, but lower than the long-term average of 4.1% and the 6.3% default rate in September 2020, ratings firm S&P Global Ratings said in a report earlier this week…[end quote]

Companies may issue new stock and use the proceeds to pay off maturing debt.

Before investing in a high-yield bond fund, consider the impact of rising defaults in a coming recession. Before investing in any stock, read the financial statements and make sure the company can pay interest on its debts out of cash flow.

Wendy

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There was a bit of a hint to watch Kohl’s last week. Yeah just a small Yahoo story that Kohls was badly outdated and had too many stores. Things were beginning not to add up.

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I’ve never understood the concept of “I am buying this company by borrowing money to buy the company that becomes the responsibility of the company to repay, not me”.

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The Greater Fool (i.e. the debt buyer) documented in real life.

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The book, “The Lords of Easy Money,” describes this. Once the company has borrowed the money the managers can pay themselves more. They don’t care that the company is burdened with debt. Alternate uses for the company’s free cash flow would be expanding the productive plant, raising employee wages and/or increasing dividends to shareholders. But their strategy is to find ways to sell the company and pocket the money themselves.

Wendy

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Here’s the general process.

  1. Raise a bunch of money to take over the target company. There might be some borrowing, but a lot of it will be from private investors. The target should be a company with little debt and good cash flow.

  2. Once the company is purchased, have the company borrow a boatload of money. Borrow from multiple lenders, and make sure you are one of the biggest clients of the lenders. Use some of that money to pay big bonuses to the new management for their excellent ability to pillage a successful company for their personal benefit. Use most of the rest to pay a special dividend to the investors. Ideally, you can repay most or all of their initial investment, leaving them with the same ownership percentage, but little or no money left on the table.

  3. Operate the company for a couple of years, paying management handsomely, and then pay as much dividends as possible to the owners. Make sure investors get back more than they put in. Cut employee head count to reduce wages and benefits. Cut employee benefits to reduce costs further.

  4. Start paying accounts payable slower and slower. Switch suppliers so you can stiff old suppliers. Repeat until you run out of suppliers.

  5. Begin to make debt payments late. String them out as long as possible. (This is why you want to be among the biggest clients of the lenders - they will be forced to work with you for a while.) Blame suppliers for delayed shipments of necessary items. Blame employees for being no good layabouts. Cut headcount again. Eliminate some more benefits. Encourage unpaid overtime, and force middle management to work longer and longer hours.

  6. Never forget to pay top management big bonuses for their hard work during these difficult times.

  7. Once the creditors can’t take it any more, make a big show of being forced to declare bankruptcy by lenders who can’t see your “wonderful vision for the future.” Negotiate a big salary for top management for the hard work they will need to do shepherding the company through bankruptcy, preferably with a retention bonus for staying on the job.

  8. Abandon the husk of a once great company, now pillaged and with a destroyed reputation.

  9. For bonus money, write a book about the experience.

–Peter

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LBO is a simple game. Years ago I met a 40 year old guy who had done many deals. Early in his career he worked for UPS in logistics. Makes sense after what I will repeat of his words.

He simply said if a company has a very good top line and a skimpy bottom line, he can improve upon the bottom line. Company profits rising change the value of the company.

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If the company has size, #7 becomes: wail about “jobs”, cry for a government bailout, say the loss of “jobs” will be all the pol’s fault if they don’t throw billions into the company to replace what management already looted or squandered.

Steve

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I understand not wanting to invest in zombie companies, but from a macro point of view the Fed says that “zombie firms are not a prominent feature of the U.S. economy. Among both private and publicly listed firms, zombie firms are few in number and generally small; they are mostly concentrated in the manufacturing and retail sectors and account for a small share of total credit to nonfinancial firms.”

In addition, the WSJ article notes that while default rates are likely to increase next year to 3.8% that is still below the long-term average of 4.1%

DB2

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Wendy, you’ve been posting about zombie companies since early 2022. Is there any news or significant changes about them this year?

DB2

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Those higher costs of debt have recently exposed cracks in the commercial real estate sector.

Wendy

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After reading a little about CRE, it appears that most of the time, they try to separate out the properties into individual companies. That way if something goes wrong, let’s say too high debt service, with one building/project, nobody will go after the others to pay the bills. So, I suspect that they will be cascading bankruptcies of individual buildings/projects starting late this year, next year, and especially in 2026 when a lot more loans have to be renegotiated. For now, everyone was expecting a few rate cuts this year, and a few more next year, so they were hoping to push off the problem and then refinance later at lower rates. But now it’s looking like maybe one rate cut this year, and perhaps a few more over the next two years. They may not be able to push it off for that long because banks have all sorts of regulations that they have to abide by (pushing for a few months might work, but pushing for two years might not). And many areas of business and government are agitating for more RTO (“Return To Office”), not so much to improve productivity (it went up with WFH), but perhaps to help with a CRE recovery. Of course, the workers are strongly resisting RTO because it wastes many of their personal hours each week for commuting, and because it’s a huge PITA to have to go to the office just to sit there and do computer work, zoom calls, etc. Much easier and more comfortable to do it as home.

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