Curse of the zombies rises in Europe amid an eerie calm

By Gillian Tett Published: April 3 2009 03:00 Last updated: April 3 2009 03:00 A decade ago, when I worked as a reporter in Tokyo, I worried about Asian zombies. For when the Japanese banks tipped into crisis in the late 1990s, scores of companies were cast into an "undead" state - in the sense of being too weak to flourish, but too complex and costly for their lenders to shut down. Hence they remained half-alive, poisoning the corporate world by silently spreading a sense of stagnation and fear. Now it seems that the zombie curse is threatening to appear in Europe too. In recent months, investors and policymakers alike have devoted attention to tackling the problem of toxic mortgage debt. But, so far, they have generally ignored the corporate debt world. On one level that is not surprising: to date, losses on corporate debt have been insignificant compared with the mortgage sphere. However, that eerie calm does not mean all is well. Far from it. Deep inside the corporate debt markets the climate is turning increasingly sour. And if this continues unchecked it will have poisonous implications for the wider economy - not least due to the terrible "zombie" curse. The issue revolves around Europe's vast, collateralised loan obligation market. A decade ago, when companies took out loans that were ranked below investment grade ("leveraged loans"), more than 90 per cent of that debt stayed in the hands of banks. But earlier this decade, asset managers started to create CLOs (or vehicles that invest in bundles of bank loans). By 2007, there were more than 50 such CLO managers in London, who were buying over half of all leveraged loans. Indeed, their appetite for corporate loans was so voracious that borrowing costs became absurdly cheap for buy-out funds - which in turn fuelled an LBO boom. Now, however, many of the LBOs arranged from 2005 onwards are quietly going wrong. No wonder. After all, Europe's economy is contracting and some of the LBOs arranged in 2006 and 2007 carry absurdly high debt burdens, sometimes eight times projected earnings. In a rational world, many of those over- leveraged, underperforming companies should now go bust, wiping out the equity and junior debt holders (at least). Some of those entities might sensibly then be restructured, others might die. There is a limit, for example, to how many yellow pages operators or estate agents an economy needs. But that shakeout is barely happening. Instead, a host of over-leveraged entities are staggering on, in a half-dead state. Just take a look at Foxtons, the British estate agent (in breach of covenants but still in business), or Klöckner Pentaplast, the German plastic film maker, (engulfed in debt, but still operating). In part, this situation reflects a dire shortage of funds to support restructuring. In the current, liquidity-starved climate, there are few hedge funds able to support a workout. Instead, the only groups that can support a restructuring tend to be the private equity groups themselves. But that means when companies run into problems, the equity holders are generally not being wiped out; instead, these LBO groups tend to keep sticking money in the companies to keep them staggering on. The other problem lies with the CLOs. As my colleagues Paul Davies and Anousha Sakoui have recently written, precious few CLO management groups in London have the skills - or funds - to oversee restructuring deals. Nor do they always have much incentive to push for rational workouts. After all, these managers only receive fees if they can keep their CLOs alive. If triggers are breached in a manner that forces an unwind (say, if the value of loans collapses, or loan ratings fall) the fee income dries up. Hence many CLO managers - like many private equity groups - have an incentive to keep propping the system up, for as long as they can. They also have incentives to protect the junior tranches of CLO debt, since that produces most fees. No wonder Mayfair is buzzing with rumours that a few small CLO managers are using unorthodox approaches for valuing their loans, or acting in a partisan manner in relation to the interests of junior debt. I have no idea whether such rumours are true (and unless you are a CLO investor it is almost impossible to check, and pretty hard even if you are). However, what is crystal clear is that the problem will not die away soon. After all, the pressure on the CLOs and corporate world alike is mounting, as Europe's economy worsens. Yet, as long as the incentive structure remains this perverse, the players have motives to keep propping things up. It all feels - dare I say it - terribly Japanese. And while that may not worry policymakers right now, because no politician ever wants to hasten corporate bankruptcies, the implications are alarming. Just look at Japan for evidence of that. For a world littered with corporate zombies is not a world where activity is likely to flourish again soon - particularly when those half-dead companies are linked to their new 21st century brethren, the zombie CLO. gillian.tett@ft.com