As the UK economy double dips there is a still more sinister spectre stalking UK investors: zombie companies that have little hope of repaying their debts, kept alive by banks unwilling to crystallise losses.
Debt - £100m or so of it - was a key factor in pushing Clinton Cards into administration last week. It wasn't alone; the Insolvency Service, a government body, revealed there were 4,303 company liquidations in the first quarter of 2012, a 4.3 per cent increase on the same period a year ago and a 0.2 per cent increase on the previous quarter. "There are still thousands of 'zombie' companies that are stumbling on, as banks are reluctant to push all but the basket cases into insolvency," warns David Birne, insolvency partner with accountant HW Fisher & Company.
In normal conditions, debt is a vital tool for a thriving, growing company. When recession bites, wages still need to be paid and stock still needs to be bought, so if cash is tight credit allows companies to ride out these bad times. "Used wisely and in moderation, borrowing clearly improves welfare," says Stephen Ceccheti, head of economics at the Bank of International Settlements (BIS). "But when it is used imprudently and in excess the result can be disaster."
So when does debt become bad? The trouble often starts when loans are called in by the banks and other refinancing options have been closed off. If you are a UK-listed company, you have to elbow your way past Italy, Spain, RBS, Barclays, and a whole host of former AAA rated entities for access to credit.
Significant numbers of companies could find themselves in trouble. Corporate recovery specialist Begbies Traynor recently released its quarterly Red Flag Alert, which showed there had been a 55 per cent increase in UK companies facing ‘critical’ levels of financial distress compared with the final quarter of 2011. Those sectors that saw the most rapid rise in difficulty were property services and construction. Admittedly, the year-on-year trend showed a 17 per cent fall in distress, but the year ahead is still likely to be difficult.
"Those companies in, or facing distress, will need to have understanding lenders to survive," said Ric Traynor, chairman of Begbies Traynor. A report last week from ratings agency Standard & Poor's said UK companies will need to raise at least £220bn to refinance debt and fund growth programmes.
It's no different outside the UK. Experts from KPMG’s restructuring division estimate that worldwide over $4 trillion of corporate debt matures in the next three years. Companies that expanded through debt-fuelled acquisitions between 2004 and 2008 will find their debts are now coming due, as the typical maturity on corporate loans is between five and seven years. If they haven't repaid, they'll have to refinance - and they are likely to find it an expensive exercise. The eurozone crisis has pushed Spanish and Italian borrowing costs in particular to record highs. If the cost of supposedly 'risk-free' government debt is rising, it has a knock-on effect across credit markets.
They'll be competing with sovereigns, too. European governments have to raise €798bn (£641bn) of debt in 2012, according to estimates from Credit Suisse fixed-income research.
Banks: 2008 again
The very entities that could provide a lifeline to struggling companies have problems of their own. Estimates from Nomura put this year's European banking industry refinancing needs at about €650bn. The banks also have the headache of trying to meet tough new regulatory requirements under Basel III, which requires them to hold bigger capital cushions, and pressure from shareholders for better returns. These conflicting factors will force them into either more fundraising, or shrinking balance sheets, which would mean fewer loans.
In December, the European Central Bank flooded the credit markets with €489bn of cheap, three-year bank funding, which reduced the Ted spread (see below) and resulted in a rush of issuance from both banks and corporates, taking advantage of this brief window of liquidity. But the problem hasn't gone away. Neill Thomas, head of KPMG debt advisory, said: "With the potential impact on bank liquidity, we could see a second credit crunch." And, this time, governments won't be able to step into the breach - they've got financial problems of their own.
Spotting the weaklings
The good news is that many UK companies are in much better shape than in 2008-09, having cut costs, debt - and in some cases, dividends - aggressively. Selina Scales, credit analyst for the GLG European Distressed Debt Fund, said there are a number of companies that are now much better-placed to cope with a downturn. But she warns that others will struggle if the downturn is sharp. "We are forecasting into our models a severe recession in Europe," she says. The bond market seems to agree; research from GLG shows that pricing in the high-yield market (bonds from the weakest issuers) implies a default level of over 40 per cent, compared with around 29 per cent at the end of 2010. In other words, two in every five non-investment-grade issuers could go under. And the iTraxx crossover index, a measure of the cost of insuring sub-investment-grade debt against default, is above levels seen just before Lehman collapsed.
How do you go about deciding whether a company's debt levels pose a potential threat to its survival, and where do you find that information? There are a whole range of other signs to watch for (see below).
The economy: under pressure
The dearth of bank finance coincides with a darkening of the economic outlook. Richard Plackett, manager of the £1.3bn BlackRock UK Special Situations fund, warned earlier in the year that he expects company profits to come under severe pressure over the next six months. "The environment is uncertain. There will be a lot more profit warnings and downgrades over the next six months than over the past two years." That's a view supported by the latest Ernst & Young analysis of profit warnings, which said that despite analysts taking a red pen to their growth forecasts, things could still take a turn for the worse as consumer confidence rests on a knife-edge.
Banks are becoming increasingly reluctant to lend to each other, just as they were in 2008. An important indicator of this is the 'Ted spread', which measures the difference between the interest rates on US government bonds and interbank lending rates. A widening spread, caused by lower yields on Treasuries and higher interbank rates, is a sign of mounting distress - and, worryingly, it has been on the march upwards since the end of last July, hitting 58 basis points at the end of December, more than double the 20-25 basis point normal range. It rose to levels of 100 basis points just before Lehman Brothers went into bankruptcy and hit around 300 on Black Monday in 1987.
