Zombie companies only promise short-term gains, despite long-term risks

Research from leading global consultancy Kearney reveals that M&A deals with zombie companies mostly produce short-term gains, despite significant long-term risks.

Zombie companies refer to those that have been active in the market with revenue greater than zero for over 10 consecutive years, but have not been able to meet interest obligations through operating profits for three consecutive years.*

Although the business value of zombie companies is often lower than their accumulated debt, Kearney’s ‘Zombie buyers beware’ report found that the financially distressed firms are surprisingly attractive to strategic investors.

These investors account for 81% of all zombie-related mergers and acquisitions, with financial investors responsible for the remainder. According to Kearney’s analysis, the majority of acquired zombie companies are biotech or software companies.

For companies that are acquired in this segment, for example due to a superior R&D pipeline, it is often part of the business model evolution, so being a zombie company is an anticipated phase in their development.

Short-term gains don’t translate in long-term rewards

 While buyers initially enjoy an attractive return on their investment, these gains are fleeting.

Kearney’s study highlights that zombie M&As generate a 15% increase in total shareholder return (TSR) one year post-acquisition, but this trend reverses over time. After three years, TSR declines by 14% – compared to a 13% average decline observed in the overall M&A market.

Of all the M&As studied in the research, those involving zombie companies have a higher-than-average transaction value to revenue (4.0 vs. 2.5). Zombies’ price to book equity is also higher than the market average at 2.9, compared to 2.2.

The initial allure of higher returns make these zombie companies a tempting target for strategic investors. However, Kearney’s report has indicated that the sustainability of these investments is not guaranteed, with the long-term performance significantly lagging behind other deals.

Nils Kuhlwein, Partner at Kearney, comments: “Our report has shown that strategic investors have clearly recognized the potential of zombie companies to generate returns, that other investors may often overlook. That said, it’s crucial for investors to dig deeper before entering M&A deals with these distressed firms, as long-term rewards are far from guaranteed.

“While initial returns may be enticing, the longer-term risks cannot be ignored. Potential buyers should be thoroughly investigating and identifying the R&D, new products, or other valuable assets that make a zombie company attractive before deciding to invest.

“Focusing on these key factors will allow investors to better assess the true potential and sustainability of their investments, ensuring that they can make informed decision beyond mere short-term gains.”

Christian Feldmann, partner at Kearney, adds: “Interestingly, in the first year after a deal, the value that zombies create for buyers is more than double the market average. Our research has shown that strategic investors perceive these zombies as having a higher value potential than financially stable firms, and are willing to pay more as a result. It’s clear that these companies have huge investment potential, but investors must ensure that new deals are aligned with long-term corporate objectives, with a post-deal plan in place to manage expectations later down the line.”

Kearney’s ‘Zombie buyers beware’ report is available in full, here.

*Economic Cooperation and Development’s internationally recognized definition of a zombie company.