A Beginner's Guide to the Vulture Fund
As economies approach a severe downturn, many face a time of extreme financial insecurity. In these harshest of cycles, assets depreciate, sovereign debt racks up and the prospect of bankruptcy looms. With corporations and nations alike in desperate need of urgent financing solutions in the depressed market, ‘vulture funds’ often can provide this injection of liquidity. Important to note here though is how these funds don’t invest despite market conditions; rather, they invest because of the market conditions.
Strikingly labeled ‘vulture funds,’ these investment groups identify, research, and pounce on securities- generally fixed income instruments that pay handsome interest rates- whose prices they deem severely undervalued due to a particularly harsh economic climate. Simply put, when everyone panic sells their shares of a given company due to unfavourable market/consumer sentiment, the price of shares tends to plummet to irrationally low values. This rash selling of securities and their subsequent mispricing galvanises the notorious vulture funds into action; the portfolio managers will look to capitalise on the market conditions through acquiring a significant portion of these underpriced securities. As expected, the purchase of these near-bankrupt equities or near-default high-yield bonds is a very high risk, for many of these funds lend to companies with little chance of substantial financial recovery. Accordingly, the riskiness of the investment warrants particularly high reward as the liquidity provided may prove crucial to postponing or averting the company’s distress [1].
However, the work of vulture funds doesn’t stop there. In fact, some of their most prominent practice occurs on a national level too. In this case, the vulture funds target the sovereign debt of countries that suffer from particularly difficult social and economic hardship. Though sovereign debt is typically issued by the national government to finance growth and national prosperity [2], these vulture funds look to obtain significant portions of this debt at highly discounted prices. Similar to their activity on a corporate level, the vulture funds will seek high rates of return on their investment due to the pronounced risk of the country defaulting. In the event that the country does indeed default, the funds will then engage in a fierce legal dispute in order to claim both the principal investment plus the significant interest against the debtors [3].
In practice, vulture funds employ three main tactics to execute their investments:
First comes the infamous ‘forced takeover.’ Under this approach, vulture funds swoop up substantial portions of equity in a distressed company in order to establish their presence as the controlling shareholder. In turn, this has the knock-on effect of encouraging the remaining shareholders to swiftly exit the company, selling their shares at similarly discounted prices and thus guaranteeing control for the incoming fund.
Moreover, vulture funds engage in the restructuring of debt as one of their quintessential tactics. When providing liquidity to companies and nations in dire need, the vulture fund will meticulously draw up legal contracts that impose punitive measures on the said borrower in the case of a default, thereby guaranteeing the vulture fund’s ‘high return’ is amongst the first debt to be paid. One such example of this could be in the form of a debt/equity swap, which is often used to prevent insolvency and keep a struggling company alive by writing off existing debts and issuing similarly-valued equity.
One further strategy employed by vulture funds is known as ‘overseas asset takeover.’ Under this approach, vulture funds attach significant assets as collateral when negotiating contracts with foreign governments to buy up their sovereign debt. By including overseas assets/property in the contract, vulture funds are guaranteed possession of these properties (which they can then sell to recover their capital and make further gains) in the case of an overseas default [4].
Amalgamating these different tactics ensures the ability of vulture funds to ‘feed on’ the distressed companies and nations, whilst ensuring their own compensation for taking on the risk. And so, with the theoretical knowledge of how these funds operate, it’s worth examining a case study of vulture funds in action.
One of the most infamous examples of vulture fund activity pertains to the 2001 Argentinian debt crisis. That year, Argentina found itself in a particularly turbulent time, both politically and economically; deep into a four-year recession, the country was plagued by a hugely overvalued currency, unsustainable foreign currency borrowing and misguided fiscal policy- all of which accentuated fears of the country defaulting on its $93 billion USD of external debt. And so, with GDP dropping by a huge 28% and 57.5% of all Argentinians living in poverty, the country unsurprisingly defaulted on its enormous foreign debt. Subsequently, the vulture funds who had bought up much of this debt at enormous discounts- including NML Capital (a subsidiary of Elliott Management), Aurelius Capital Management and Dart Management- engaged in 15 arduous years of negotiations in order to squeeze out as much capital as they could from the weakened Argentina. Coming to a close in February 2016, the negotiations ended with a ruling in the United States District Court, which ruled heavily in the vulture funds’ favour; Argentina was instructed to pay every single bond back to the vulture funds at full value- accumulating to $4.65 billion USD and a staggering 1180% return for NML capital alone. Argentina was also made to cover all legal expenses for the 15-year case [5].
Figure 1 highlights Argentina’s staggering unemployment and inflation rates during the 2001 recession.
The nuances of this case study simply aren’t easy to stomach. On an ethical level, one may have trouble with the idea that a hedge fund can be rewarded over a 1000% return by a country in the midst of its biggest economic and political crisis in its entire history. With unemployment in Argentina soaring, foreign debt rising, and austerity soon to hit, the notion that a vulture fund can make such incredible returns on a small investment may appear morally wrong. However, it is worth noting that there used to be laws championing the rights of countries that find themselves in a situation like that of Argentina in 2001. The Champerty Defense prohibited vulture funds from buying up debt with the sole intent of bringing a lawsuit against the issuer. Under this law, Argentina may have actually succeeded in its aforementioned 15-year case. Unfortunately for them though, Senator John Marchi (who interestingly held alleged connections with said Elliott Management) introduced a bill that forbade any reference to the Champerty Defense in a court of law, which in turn has enabled the continued aggressive practices of vulture funds today [6].
Regarding the moral dimensions of how vulture funds operate, one ought to consider the arguments supporting their practice. After all, one may claim that the funds are ‘merely providing a service.’ Without their lending, the near-defaulted entities would simply have no chance of any meaningful financial recovery. As asserted by Uruguayan economist Arturo Porzecanski, he points to how- in the case of Argentina- Elliott Management ensured that 50,000 Italian pensioners got paid. Without the work of hedge funds like Elliott, these pensioners may not have received a single penny simply due to Argentina’s irresponsible economic policy. Likewise, Mark Brodky of Aurelius Capital Management proudly asserted after the case against Argentina: “We at Aurelius believe in the rule of law. We believe wrongdoers should be held accountable rather than rewarded; and we have decided to make a stand.” As such, it may be argued that vulture funds’ ability to pinpoint illegitimate and unsustainable financial practices makes their work worthwhile and perhaps even praiseworthy [7].
No matter how one views the work of vulture funds ethically, they’re ultimately here to stay. As the world’s economies continue to grapple with the detrimental impacts of COVID-19, it seems inevitable that vulture funds will continue to prey on struggling investments as they look to prosper in these harshest of economic climates.
References
[1] https://www.investopedia.com/terms/v/vulturefund.asp
[2] https://www.investopedia.com/terms/s/sovereign-debt.asp
[3] https://www.managementstudyguide.com/vulture-funds.htm
[4] https://www.managementstudyguide.com/vulture-funds.htm
[5] https://www.nytimes.com/2016/04/01/opinion/how-hedge-funds-held-argentina-for-ransom.html
[7] https://ftalphaville.ft.com/2019/04/16/1555399578000/The-utility-of-vulture-funds/