Let the Free Money Zombies Die
Bankruptcies across Canada and the U.S. have started to tick up this year. As we approach the latter innings of this business cycle and credit conditions continue to tighten, things will likely get worse. This is bad news for Zombie corporations which are defined as firms that can pay the interest on their debt to stay in operation but are unable to pay off any principal. This may have been viable over the past 15 years as central banks flooded the market with cash and held interest rates near zero, but this is no longer the case. Interest rates have risen swiftly over the past 18 months and as the debt of these companies comes due, they will have to refinance at much higher rates. This should lead to an increase in bankruptcy filings and a redistribution of assets over the next several years.
Most bankruptcies are voluntary, as a company files for bankruptcy to protect themselves from creditors and seek a more orderly sale and investment solicitation process or liquidation. Bankruptcy can also lead to creditor-approved restructuring where private credit is used to replace tired lenders and or match free cash flow more accurately to debt service with payment-in-kind (PIK) interest. Involuntary bankruptcies are rare and occur when a company’s creditors file for bankruptcy on their behalf. In Canada, business insolvencies, which include bankruptcies and proposals (restructurings), have been increasing since 2021. The trailing 12-month value as of June 2023 is approaching 4,000 and has surpassed 2019 levels of 3680. The last time levels were this high was in 2015 when they were at 4107. The current number is trending in the wrong direction.
Source: Government of Canada
We see similar trends in the U.S. According to S&P Global, U.S. corporate bankruptcies for only the first 5 months of 2023 are higher than any other comparable 12-month period since 2010.
On a positive note, while higher rates have been painful for many businesses that engaged in aggressive financial engineering, they may be leading to a golden age for private credit and asset redistribution. As traditional sources of funding such as banks and private equity pull back in the current economic environment, more businesses are turning to private credit to buy time and or acquire assets. This has allowed the industry to invest at or near the top of the capital structure and maintain robust credit standards while borrowing costs increase. Interest rates are projected to remain higher for longer, which will continue to be a strong tailwind for the asset class. As we can see below, the past 15 years of near-zero interest rates were an anomaly, not the norm. Historically, rates have been much higher. The average prime rate in Canada from 1955 to 2023 was 7.02% compared to 7.2% today.
Source: Canada Prime Rate History (1935 – October 2023) | WOWA.ca
Although it may be painful for some, we think this is a healthy part of capitalism that should be allowed to play out. Not only are zombies inefficient, but they are often bad, low-margin competitors who lower the growth and productivity opportunities of healthy firms. As weak companies are taken over or consolidated, stronger more innovative firms will emerge that are managed more efficiently and therefore better able to adapt for survival in a normalized rate environment. Private credit will benefit from this higher rate environment due to its floating rate structure, and will be ready to support these firms where the opportunity is suitable. For the greater good, it’s time to let the free money zombies die and kiss the unintended consequences of ZIRP goodbye.
About Bond Capital
Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital secured structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for over 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.