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Does an improving economy mean a zombie cull?

As our economy is on the rise and set to outperform most of Europe in the year ahead, you may think we will see a corresponding fall in the number of business failures in Scotland and the rest of the UK.

It is however, highly possible that we will see the opposite occur.

The latest statistics, released earlier this month by UK Government agency the Insolvency Service (IS), show that there were 922 Scottish companies that entered a formal insolvency process during 2013, down 36.3 per cent from 2012, when there were over 1,400. While on the surface it may appear that this drop in businesses failures is a result of improved trading conditions, it is likely that other forces are at work and it is quite possible that there will be more pain to come for many struggling companies.

The peak of business insolvencies tend to occur as the economy is in recovery mode rather than when it is at the lowest point. While the old maxim that a recession is an effective means of clearing out weak businesses may be true, the impact is normally felt 12 to 18 months after the economy has picked itself up.

I know of many struggling companies that are, at the moment, being supported by their creditors, particularly banks, which are allowing them to continue in the hope they can eventually emerge from their current difficulties. Many more of these businesses would be failing if creditors were not prepared to agree to extended, delayed or deferred repayment terms. As the economy continues to improve, confidence in the market for business assets will also rise. This includes the distressed assets found in ailing businesses, as they are deemed to carry more value in good times than during the lows of recession.

The recession from which we finally appear to be emerging is, of course, not like any we've ever experienced. As a result I think we will see a bit of a deviation from the usual pattern with a gradual rise, rather than a spike, in corporate insolvencies spread out over the next few years as the economy continues to grow.

The mis-selling of interest rate swap products by banks is also a key factor here. Any bank involved in dispute about one of these products with a business client is unlikely to call in the insolvency practitioners until that legal claim is resolved. Another reason for this protracted period of post-recession business failures is the fall in property values, and especially in commercial property values. The slow recovery of this market means that overexposed lending will more than likely continue for quite a while yet.

However, once these issues resolve themselves the UK could witness a macro-economic version of the Night of the Living Dead with the eventual cull of so-called zombie businesses over the forthcoming years. Zombie companies are ones which carry heavy debts, generating just enough revenue to pay down interest but usually with no realistic hope of getting themselves into the black let alone making a profit.

They only exist because their lenders support them through bad times in the hope that they will still be of value when the outlook improves. When recovery begins to take shape, those lenders might seize on the opportunity for an exit.

Even those rare zombies with growth potential during an up-turn will perish as they are likely to be denied the lender support and additional capital they need to do grow. As a result they are likely to fail under the competitive pressure from those companies who are able to fund their new activity in the improved marketplace.

On a more positive note for some struggling firms, it is also possible that some of these businesses could be rescued through the form of a Company Voluntary Arrangements (CVA). CVAs are important formal insolvency mechanisms that can help companies to resolve their financial problems whilst retaining existing management and ownership structures. They are effectively a way to bind creditors into accepting a repayment proposal, which is usually impossible without such a statutory mechanism, and help sort out some companies which are facing insolvency. They have a key role to play as we continue to navigate unchartered waters, albeit within an apparently improving outlook.

In contrast with the latest IS statistics I suspect more pain will follow for those companies, especially those which are currently operating as zombie companies.

While it does mean more pain for some of these struggling businesses, we must not lose sight of the fact that there is a positive economic outlook for the UK going forward. Although we will see a likely rise in the number of business failures in the next few years, we should also celebrate that the improved climate should provide a platform to help new businesses to thrive.

Matt Henderson is the Head of Business Recovery and Insolvency at Johnston Carmichael.

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