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.
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
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.
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.
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.
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.
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.
Start paying accounts payable slower and slower. Switch suppliers so you can stiff old suppliers. Repeat until you run out of suppliers.
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.
Never forget to pay top management big bonuses for their hard work during these difficult times.
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.
Abandon the husk of a once great company, now pillaged and with a destroyed reputation.
For bonus money, write a book about the experience.
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.
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%