Attack Of The Zombie Companies

Zombie companies have chronic, unresolved structural issues that render it to be a non-viable and unsustainable business with excessive debt burden for the levels of profitability and cash flow generated. Yet, the business continues to survive due to ongoing and typically irrational, inertia-driven support of their lenders or political systems, by virtue of extending or resetting debt terms, extending additional funding, or shielding from collections and liquidation. Zombie companies are unable to adequately service their debt obligations, with a material debt service coverage shortfall during any given period and in foreseeable future.

Last week, I was interviewed by Neil (Dima) Berdiev of DNB Advisory LLC, regarding my experience working with, and helping recover “Zombie Companies”. The interview originally appeared in Neil’s newsletter – “Tips for Commercial Credit Professionals”.

While not quite the antagonists of a horror film, Zombie Companies, are scary in their own right for company stakeholders. As the diagram above shows, Zombie Companies are companies that can barely afford to pay interest, and are unable to pay down debt. Their existence drags on far longer than the life of a business should, especially with the recent influx of Covid-19 related government loans being pushed into the economy. The article below explains why Zombie Companies will slow our country’s economic recovery, but also, how, with the right specialists, these companies can either minimize losses, or possibly be saved. 

Zombie companies have chronic, unresolved structural issues that render it to be a non-viable and unsustainable business with excessive debt burden for the levels of profitability and cash flow generated. Yet, the business continues to survive due to ongoing and typically irrational, inertia-driven support of their lenders or political systems, by virtue of extending or resetting debt terms, extending additional funding, or shielding from collections and liquidation. Zombie companies are unable to adequately service their debt obligations, with a material debt service coverage shortfall during any given period and in foreseeable future.

Can you think of your career when you may have had a Zombie company to work with?

Yes, I remember a number of situations. As a turnaround consultant many of the companies I am involved with are either Zombies or Zombie candidates. At one point one, you could even say I owned a Zombie company in the leather industry that experienced a fundamental supply-chain shift that crushed the company’s business model. As another example, I recently consulted for a company that has not fared well during the current downturn and management was unable to make proper adjustments to overhaul its cost structure to properly match to reduced levels of revenue. The company has received various stimulus loan financing, some of which probably should not have been provided given its condition (it did qualify by the program parameters though). Because management had no understanding of the underlying challenges and no plans to solve them, they did not put a debt repayment plan in place. Basically, they are getting money that as of right now they are not able to handle. It is concerning to me in this environment that some companies have been zombies or very close to it even before the downturn. Throwing lots of money at them is not a good strategy, because you are not addressing the reasons why these borrowers have been in this condition in the first place before Covid-19.

What were your key concerns and focus in dealing with Zombie companies?

My key approach has been to quickly diagnose what the real challenges are before even trying to fix them. Not all problems can be resolved and much of the solution depends on the amount of time and financial and non-financial resources a company is willing to expend to fix them. I typically dive into understanding the management dynamics and what or who could have caused those problems. For example, there could be management deficiencies – family members who are part of the business, but who are not producing and are driving the company into the ground. It is not something a turnaround professional can change unless they are empowered to make management decisions.

When working with any company, I develop a checklist that includes the following:

a) I conduct a management assessment. How motivated is the management team? Are they willing to commit their own money into the business to try to save it? When my father owned and operated a leather tannery, I saw firsthand that some products were in fashion and had considerable value one day, but could go out of fashion just as quickly and potentially lose a lot of money. My father was a consummate entrepreneur and was always thinking positively. He knew his business and believed in it. On occasion, he would take an IRA 60-day distribution and use it to buy inventory and then pay it back, despite the risks. Does your borrower/owner have the same trust and faith in their company? That is quite a telling sign. Naturally, business owners can make incorrect decisions but is your sponsor willing to put money in? Or have they already raised the white flag and given up the fight?

Are the owners/managers more worried about their next paycheck or are they able to look long-term? Of course everyone is worried about their companies in this economy, but do the owners have a plan how to return to profitability? If they are primarily focused on the short-term, how can they develop a plan for overcoming this period, yet alone fixing a zombie company? I try to assess the motivation and dedication of the management team.

b) Market conditions and customers is another area of focus. Are they churning customers which are large important ones or gaining new customers? Are the margins consistent from year to year? Have costs as a percentage of sales increased. For example, are the increases in the cost of warehousing and distribution, IT, advertising, and marketing accounted for within their sales prices?

c) Does the business model make sense in the current climate? How does it make sense, if they are losing money or perhaps not producing enough cash flow and have been doing it for some time? What is going to change now? What would it take to change the business model? If I can’t answer these questions to my satisfaction, then I know there is a problem that likely won’t be fixed.

d) Then I work to understand if the owners, especially if separate from management, have additional liquidity and equity. This is where the money is likely to come from, after the company burns through its liquidity. In some instances this additional liquidity may be that secondary line of defense in this recession, unless the business is bleeding cash today and needs more money now. If the turnaround process is going to take time, and it typically does, these additional resources can be critical and may give a lender additional confidence to support the company, knowing that it is working with a turnaround consultant to “unzombie” itself.

e) Fraud is my red light and fire alarm, even if it is a suspicion of fraud. A situation involving fraud may push a company into the Zombie territory, unless it is a sham already. If fraud, then you need to bring in your legal counsel, involve law enforcement as appropriate, and follow your fraud process checklist right away. There is no time to waste.

Do Zombie companies have hope?

While not often, these situations do occur, especially if the market changes in a company’s favor. For example, a company has been in the area of manufacturing rubber gloves and has faced significant challenges over the past several years. As a result of the Covid-19 pandemic, the business’s backlog filled up for 2-3 years and all of a sudden there is a viable business model and strength of cash flow to improve and even thrive. In the short-term, the company may require additional funding and the bank or ownership should be willing to make a capital infusion. On the other hand, you may have a company that has struggled for 2-3 years before Covid-19 and nothing has improved structurally. It does not have operational strength, management quality, or financial condition to take advantage of the current climate. It is very likely the company will not survive.

What would you tackle immediately in dealing with Zombie companies?

A quick yet effective assessment is the first part of my work in adding value to the company or for the commercial lenders, depending on which party I represent.

In addition, I try to determine if someone may be interested in buying the company, which could be a way to save a zombie company. Can it be rolled up to a customer, supplier, or perhaps a competitor? Another option would be a controlled liquidation where lenders and creditors are paid and hopefully leave something for ownership. I also evaluate the management team. Are they are unwilling to make changes and adamant in doing things the way they’ve always done it? They may not be motivation to adapt. Should new management be brought in? Is their particular service skill or technology applicable to a different industry? Could their expertise be transitioned into a new environment? For example, can an old school metal shop move to the aerospace industry?

What have you seen lenders getting right and wrong in lending to Zombie companies?

Trying to influence the management team to address problems proactively and quickly is one way a commercial lender can add value to its borrowers. This may include a recommendation to bring in a turnaround specialist to develop and implement operational, strategic and organizational changes. Those lenders that know when and who to get involved are often able offer that high-end service business owners appreciate. Denying additional financing requests or cutting a company off can also serve as a much-needed signal for the management team to begin addressing problems.

On the negative side, I have seen commercial lenders that helped create and perpetuate zombie companies for many years. How did the lender allow for this to happen? How do you get out of this situation? It is always interesting to see how quickly a bank or another lending institution is ready to acknowledge the problem and want to fix it. That is a difficult, but important decision. Some may be scared of what can happen. In the event a company does start to make progress in paying down debt, a bank may still strangle the business by controlling its access to cash for fear of the demise of the business. Another challenge that commercial lenders are likely to run into is that the more seasoned lenders may still be compensated to bring in new deals and work on the most profitable accounts. As a result, unprofitable zombie companies are left to less experienced relationship managers who have a limited understanding as to how a business is run and won’t know how to work well with business owners. Much can go wrong when an inexperienced relationship manager is left to deal with a complex situation with which even the most experienced peers may struggle.