A Tsunami of Insolvencies or the March of the Zombies?

Making sense of the outlook for business distress and potential insolvencies is particularly difficult as we start to emerge from more than sixteen months of business turmoil. Conflicting data abounds.

On the one hand, the amount of debt taken on under government backed loan schemes is huge. UK government statistics show the Bounce Back Loan Scheme for small businesses has lent over ￡47bn to 1.56m businesses. Further significant amounts have been lent through other schemes with the total over ￡80bn. How will this be repaid? Several surveys show that many businesses think they will struggle to survive the next six months. Many think the low rates of insolvency filings during the pandemic are just insolvencies postponed. The insolvency profession has been hiring and gearing up for a tsunami of insolvencies.

On the other hand, Andy Haldane, the Bank of England Chief Economist said recently that?The Bank of England does not expect to see a wave of bankruptcies among British firms when the government ends its coronavirus emergency support for the economy. He said that the loans are spread over long durations, “which increases the chances of them being able to be paid back and therefore bankruptcy is not picking up very much from current relatively subdued levels”. A survey by Lloyds Commercial Banking showed?companies were increasingly upbeat about their trading prospects as sentiment improved to its highest level since November 2018.

It does seem hard to see how both points of view can be reconciled. Will we get a Tsunami of insolvencies? Looking back to the 2008 financial crisis I recall high expectations that there would be a massive increase in insolvencies. As we all know that didn’t happen. Low interest rates, bank forbearance, HMRC forbearance etc, all contributed to a very benign environment with no great increase in the number of insolvencies. Ever since, insolvencies have been bumping along at historically low rates. This led to the rise of so-called Zombie companies. Just making enough profit to pay the interest on loans but not enough to repay the loan or to invest, they are the corporate “undead”. It is hard to know how many there are, but various estimates suggest hundreds of thousands.

By contrast, the USA was much more willing to allow businesses to close and suffered less of a problem with Zombies. It is interesting to look at what the US did with Covid. Their loan support process was different. Firstly, there were at least some basic checks and balances to prevent obvious fraud. Companies could borrow regularly and were then allowed to submit regular claims (with proof) for certain allowable expenses such as payroll costs, rent or mortgage interest, utilities, and a few others. The amount of such eligible expenses was then forgiven from the loan. This meant that most businesses didn’t end up with loans they will never be able to repay, and it had the effect of keeping money circulating.

There are calls in the UK for various business support measures to be extended. The government has already extended the period during which landlords cannot repossess premises and is legislating to make rent arrears the subject of binding arbitration rather than the usual legal remedies. Exactly how that will work remains to be seen. Politicians are fearful of insolvencies and job losses making the headlines and there is a real risk they will act to prevent it. If they do, they will create another swathe of zombie companies. We need to stop running away from the creative destruction of capitalism whereby the weak fail and capital is allocated to more successful and productive businesses.

Two recent proposals caught my eye. The Federation of Small Businesses (FSB) have proposed that loans to small businesses under the Bounce Back scheme should be allowed to be swapped for employee equity, with the lender claiming the loan forgiveness amount back from the government under the state guarantee. The full proposal can be found on the FSB website.?I have reservations. Valuation would be an issue and I’m not sure a lot of business owners would want to see their equity diluted to any great extent. The premise is that employees with equity are more motivated, and productivity is improved. But would that be enough to compensate for a poor business model and competitive disadvantage? Would it be enough to provide investment? I fear not. There is no inbuilt mechanism to target better companies with good growth prospects and it could just create more zombies.

The second proposal was by the Institute of Chartered Accountants in England & Wales’ (ICAEW) Manufacturing Community. The document detailing this proposal is available here: Introduction of a Coronavirus Business Recovery Offset Scheme | ICAEW and essentially?proposes enhanced tax allowances for investment in capex, R&D, skills development, and export activity, along the lines of the existing scheme for R&D expenditure but at an enhanced rate with the resulting allowance then offset against government guaranteed loans.?I think this idea has potential. It would help mainly manufacturing businesses, would encourage investment and could help the UK’s chronic underperformance in productivity. A bit like the US schemes mentioned earlier, it gets money circulating and would benefit suppliers and employees of participating companies as well as reducing the debt in successful businesses. As it is based on existing arrangements it should be easy to implement and could make an impact quickly.

The coming months will see whether we do get a tsunami of insolvencies and large increases in unemployment or whether it is perhaps just a return to historic levels. What we really shouldn’t do is to kick the can down the road and create an ever-larger number of zombie companies. Measures to mitigate the worst effects of insolvencies and unemployment should be targeted at helping viable businesses with a future and ideas like the ICAEW’s are the type of thing that merit consideration. Viable businesses that are over-indebted and struggling from the effects of the pandemic should seek help as early as possible, not wait until they run into difficulty. Experienced turnaround professionals can help such businesses and often save unnecessary insolvencies.