In this paper, Jorge Padilla, Joe Perkins, Salvatore Piccolo, and Paul Reynolds focus on industries that require intensive investment to compete and innovate well before demand materializes (or fails to do so). In these industries, the existence of exit barriers may cause firms to become “zombies” ex-post and result in significant underinvestment ex-ante. They first discuss the link between the investment decisions of firms and the existence and significance of exit barriers. Then, they consider the role of mergers as an exit mechanism that promotes efficient investment and fosters competition. They conclude with a discussion about optimal merger policy.
Zombie companies are firms burdened by large amounts of debt, which are just able to manage their existing liabilities with the help of weak banks afraid of acknowledging that theirs are non-performing loans.
Zombie firms are a serious problem for future growth. They tie up scarce resources and trap industries and economies in cycles of low productivity, as they neither have the incentive to innovate nor leave the market through voluntary liquidation. Most worryingly, the proliferation of zombie firms deters the entry of new and more productive businesses. Start-ups are either deterred because of the aggressive pricing policies of firms gambling for resurrection, crowded out from access to credit, or both.
Europe was populated by zombie firms before the COVID-19 pandemic went on the rampage through our economies. This was one of the reasons for its poor productivity growth. The COVID-19 crisis and the policy response aimed at maintaining economic activity and protecting employment during lockdowns have increased the number of walking dead corporations in our economies. For the reasons stated above, they pose a clear threat for business dynamism and, more generally, economic recovery post-pandemic.
It is not easy to get rid of zombies; they are very resilient. This is for two mutually reinforcing reasons. First, they are sustained by poorly capitalized banks fearing the intervention of the prudential regulators and myopic governments concerned about the impact of a wave of bankruptcies on their electoral prospects. Second, they are protected by inefficient bankruptcy laws and poor banking supervision.
Mergers are one of the ways in which zombie firms can and, sometimes, do exit the market. Healthy firms have an incentive to purchase their zombie rivals to force their exit since they would not leave the market otherwise and their presence has a negative impact on the healthy firms’ return on investment. Of course, such acquisitions give rise to a welfare trade-off. On the one hand, they are likely to inflate the prices consumers pay, since zombies may set prices low; often unsustainably so. On the other hand, such mergers reallocate business assets to more productive firms. As the OECD states, “reallocation of resources across firms, entry of new businesses and efficient exit mechanisms are key to boosting aggregate productivity growth.” Moreover, the option to exit via merger can help encourage investment ex-ante for all market participants, as it reduces the risk of investments that prove unsuccessful and the risk that failed firms undermine the profitability of otherwise successful investments.
It is this last dynamic effect that the authors discuss in greater detail in this paper because it is the one that may tip the balance in favor of more permissive merger control in industries where investment is key but costly and the return on investment is subject to considerable uncertainty since investment takes place before demand materializes, or not.
Most firms, possibly all, become zombies unwillingly. They are the result of investment and financing decisions proven wrong in time, weak banks unwilling to acknowledge non-performing loans, and a bad policy mix: lenient monetary policy, insufficient prudential supervision, and strict bankruptcy laws. The authors show that adding to this policy mix a strict merger control cannot constitute appropriate public policy.
The authors first discuss the link between the investment decisions of firms and the existence and significance of exit barriers. Then, they consider the role of mergers as an exit mechanism that promotes efficient investment. They conclude with a discussion about optimal merger policy in industries that require intensive investment to compete and innovate and where the existence of exit barriers may result in the proliferation of zombie companies.
 Jorge Padilla, Joe Perkins, Salvatore Piccolo and Paul Reynolds are economists at Compass Lexecon. The authors’
views do not necessarily represent the views of Compass Lexecon or its clients. The opinions in this article are the
authors’ sole responsibility.
 See Andrews, D. & Petroulakis, F. (2019). “Zombie Firms, weak Banks, and Depressed Restructuring in
Europe,” VOX EU, CEPR. Available at https://voxeu.org/article/zombie-firms-weak-banks-andrestructuring.
 See Zingales, L. (2021). Attack of the COVID Zombies.