Although the store closures of big names like Bed Bath & Beyond make headlines, the rising number of "zombie companies" is more common among fast-growing, small businesses—but it doesn't necessarily mean that there are more bankruptcies ahead, according to experts.
A recent AP analysis found that there are 2,000 publicly traded companies in the U.S. that can be considered "zombies"—meaning that they are so heavy with debt, and short on money, that they cannot even afford to pay the interest on their loans.
This phenomenon is most common among fast-growing technology and healthcare companies—including biotech firms—and stems as far back as the late aughts, when corporations like Apple and Amazon were ascending, said BOK Financial® Chief Investment Officer Brian Henderson.
Companies pile on debt amid low rates
"There was a deflationary, low interest rate, low inflation environment from June 2009 to end of 2021, which lent itself very well to the rise of tech and biotech firms, many of which were going public," he explained. "Even if they weren't profitable then, venture capitalists took interest in these companies with the hope they might become profitable."
And it wasn't just new companies that took on more debt and greater risks during this period. Existing companies, too, tended to overleverage themselves, experts agreed.
"The availability of cheap debt drove many companies to change their capital structure and take on more debt than they would in a normalized rate environment. In fact, some of these zombie companies went so far as to take on debt for the sole purpose of repurchasing shares or paying a dividend."- Aaron Capps, director of commercial banking for Bank of Texas
While rates and inflation stayed low, even companies that were unprofitable managed to stay afloat—and keep growing—through tactics such as going public, and investors were willing to bet on these companies' success, Henderson said. In fact, in 2021, when the Federal Funds rate was near zero, there were a record number of initial public offerings (IPOs)—more than 1,000 in a single year.
"Going public fills the coffers of companies, at least for a time," Henderson explained. "They can use some of the cash to make interest payments, but the majority of it needs to be invested into growing the company. Otherwise, if they stay unprofitable and have to borrow more money, it just keeps getting burned up with interest payments."
Meanwhile, some companies were trying to increase the money in shareholders' pockets through stock buybacks, which can cause problems in the long run, Capps said. In fact, corporations spent $6.3 trillion on stock buybacks from 2010 to 2019, according to the Securities and Exchange Commission.
"That's a staggering number," Capps said. "Mathematically when a company buys back its own stock, their leverage increases. Buybacks are a form of returning capital and thus the valuation of the company tends to increase, favoring shareholders in the short term. The $6 trillion dollars that did not go into reducing debt, technology investment or R&D just went to buying shares. I think time will prove that to be the wrong decision."
Borrowing more difficult—and now more expensive
And now, with the Federal Funds rate the highest it has been in 22 years, companies that piled on debt when rates were low may be struggling to even pay the interest on these loans, and it also has become more challenging for them to borrow more money to try to get by, experts agreed.
"It was a different environment then. Today, if you are not profitable, you have to pay more for the weaker credit profile that you have."- Brian Henderson, chief investment officer at BOK Financial
Moreover, when businesses do borrow money, it's important to have a long-term outlook to managing debt, Capps noted. That includes:
- Defining a capital structure: This is the amount of debt relative to your business's assets and it should "allow you to have strength through the business and rate cycles as well as leaving room to fund growth," he said.
- Remaining disciplined to this capital structure: You should tie management or executive compensation to this structure, as well as long-term measures such as solvency and operating leverage, Capps noted.
- Prioritizing longer-term objectives over short-term gains: "Don't fall victim to mechanisms used to boost shareholder gains in the short-term, such as stock buybacks or reaching for yield," he cautioned.
What to do if your company is buried in debt
Although the moniker "zombie company" sounds scary, if your business is struggling to even make interest payments, it isn't necessarily time to sound its death knell, experts agreed.
Capps outlined three possible options for companies in this position:
- Increase profitability. Deeply understand your margins and sell off or close low returning assets, products lines or services your business offers. Eliminate unnecessary expenses and use the cash generated to reduce your debt.
- Stop shareholder distributions, dividends and buybacks. Instead, use the cash to pay down debt.
- Raise equity. However, this option has the downside of diluting existing shareholders' ownership, and it can also be challenging with a poor credit rating resulting from excess leverage, Capps noted. "It will increase the cost of capital for the business, but in the long run, it will ensure solvency and put the business in a better position to weather a business cycle."
The best option is still to avoid being so overleveraged, the two agreed. Otherwise, as Capps said, "The options are not great; there is no silver bullet."
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