Since the 2008 recession, we have witnessed the infiltration of seemingly benign economic creatures with a dark side...They limit domestic productivity and threaten to exacerbate a future economic downturn. They are the zombie firms.
Zombie firms can be defined as companies where turnover is static or falling, profitability is persistently low, margins are being squeezed, cash and working capital reserves are limited, leverage levels are high, and where there's a limited ability to invest in new equipment, products or processes.
The sharp rise in zombie firms in Europe over the past decade could be explained by the loose monetary policy environment, greater creditor forbearance by lenders, and government policies that fueled lending. Rather than cease trading, businesses have staggered on creating a notable drag on European productivity.
Using the 'wide' (where interest coverage ratio is less than one in the last three years and the company older than 10 years) or 'narrow' (where the company's Tobin's Q is lower than the median for the sector) definition for a zombie firm, the health care, energy, IT and real estate sectors in the EU have been impacted the most.
And, if rising interest rates (the biggest universal threat looming for zombie firms) continue, highly leveraged businesses may soon find that once-affordable borrowing will become difficult to repay.
It's not all black and white though in terms of definitions. Take Tesla and Netflix, for instance. They are both established businesses, each turning over billions of dollars and generating very little in the way of cash or profits. So, under the global definition, they are both considered zombie firms!
Why Luxembourg AIFMs & GPs must stay vigilant
The effect of zombie firms on investment institutions here in Luxembourg cannot be underestimated. As the world's second largest investment fund center, Luxembourg is a prime candidate for potential economic impacts given its high number of private equity/debt houses. Private debt funds are particularly interested in zombie firms as they represent a more attractive alternative to traditional lenders.
Luxembourg AIFMs and GPs must tread carefully and be savvy to the inherent risks of zombie firms, ensuring they implement robust and appropriate frameworks for their activities. After all, they will be under the scrutinous eye of the CSSF.
Private equity and private debt players must focus on ex-ante analysis to avoid seemingly attractive investment opportunities which may embed hidden risks.
And what about portfolio managers? Well, they certainly have their work cut out and should start by asking themselves some burning questions: Are the targeted corporations properly valued? Is there a robust cost structure? What are the key risk indicators?
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