Vulture funds are a subset of hedge funds that invest in distressed securities that have a high chance of default. The fund buys risky debt instruments at highly discounted prices in the secondary market and benefits by taking legal action against the issuers for debt recovery. Vulture fund portfolio managers seek investments offering very high potential returns due to their high risk of default.
Vulture funds mainly target fixed income instruments such as high yield bonds, or equities that are in or nearing bankruptcy. These instruments are frequently in the form of sovereign debt of distressed countries.
How do vulture funds work?
“Vulture” is a metaphor that compares vulture funds to the behavior of vultures, birds that prey on carcasses to extract whatever they can from their defenseless victims. Vulture funds deal with distressed securities, which have a high level of default and are in or near bankruptcy. The funds purchase securities from struggling debtors with the aim of making substantial monetary gains by bringing recovery actions against the owners. In the past, vulture funds have had success in bringing recovery actions against sovereign governments and making profits from an already struggling economy.
The willingness and ability to sue for recovery is the central strategy of vulture funds. They exert pressure on the debtors to honor their debts, even when the debtors are in financial distress. Sometimes, the funds attempt to obtain attachment on the country’s overseas assets as a way of recovering their investment. For example, the US-based investment management firm, FG Hemisphere, attempted to obtain an attachment of DRC Congo’s Washington Embassy for a $100 million debt that the government owed them. Such actions burden the debtor and complicate their financial management processes as they try to restructure their debts.
Legacy cases involving vulture funds
In the recent past, there have been a few cases involving venture funds and sovereign debts. These cases include:
Argentina defaulted on its $82 billion in sovereign debts during its economic crisis in 2001. Some of these debts were purchased in the secondary market by vulture funds. The country agreed to pay six vulture funds, negotiating for a total payout of $6.4 billion in 2016.
Puerto Rico recently filed for bankruptcy due to its inability to service its debts. Media reports show that the country’s agencies owe approximately $120 billion to its creditors. Some of these creditors included Oppenheimer Funds and Aurelius Capital. These creditors have formed an ad hoc bankruptcy negotiating group to try to reach a settlement.
The Democratic Republic of the Congo has been in a debt crisis for a long period of time. Many creditors have threatened to sue the country to recover their debts. FG Hemisphere recently filed legal action against the country in a bid to recover debts after a Jersey court awarded the company $100 million against the DRC-owned mining company, Gecamines. The vulture fund had purchased the debt for $3 million from Yugoslavia, and the debt has grown to over $100 million, inclusive of interest. In 2012, the Privy Council in London blocked the award after a successful appeal by Gecamines.
What is wrong with vulture funds?
Vulture funds have been criticized for profiting from countries that are in financial distress. The former UK Chancellor of the Exchequer, Gordon Brown, described vulture funds’ actions as “morally outrageous” for trying to benefit from debt relief programs for impoverished countries that are aimed at educating children and tackling the increasing poverty levels. For example, in countries like Zambia and Argentina, the education budget was slashed to facilitate court awards for vulture funds. In a 2007 IMF report on vulture funds, it was reported that 11 out of 24 developing countries were involved in legal tussles with vulture funds.
Vulture funds have also been criticized for their debt recovery mechanisms. These funds purchase debts at deep discounts with the intention of suing debtors for recovery of amounts exceeding the original debt amounts (because of interest and penalties on the debt). The funds have average recovery rates of 5 to 20 times their initial investment, and this puts their rates of return at 300% to 2,000%, which is considered punitive to debtors. The funds also regularly turn down invitations to participate in debt restructuring, instead choosing to pursue legal action for the debt’s face value plus any additional interest, penalties, arrears, and legal fees.
However, vulture funds counter that:
1 – They are merely trying to collect a debt that is legally owed to them
2 – They did not create the financial problems of the issuer
Legislation against vulture funds
The United States was the first country to introduce legislation to prevent vulture funds from benefiting on defaulted sovereign debt. (With nearly $20 trillion in outstanding debt, it may have been looking ahead a bit.) The bill’s supporters wanted to put a limitation on the amount of money that a court could award creditors. The bill was, however, voted down by the US Congress. Other countries that introduced and passed similar legislation against secondary creditors include the United Kingdom, Belgium, Jersey, Australia, and the Isle of Man. 2010 legislation in the UK Parliament removed the ability of vulture funds to file recovery actions in the UK courts.
The United Nations General Assembly introduced a bankruptcy law for sovereign nations in 2014, which would require vulture funds to be excluded from the restructuring process. The members voted 124-11 in favor of the new bankruptcy process. However, it’s worth noting that those who voted in favor of this measure are those who are likely to be sovereign debtors rather than vulture fund investors.
Distressed securities are financial instruments that are near or already going through bankruptcy. Due to their high risk and the issuer’s inability to service the debt, these instruments have declined in value. Investors who purchase these securities in the secondary market have the potential to earn high returns. These securities carry a credit rating of CCC or below from top rating agencies such as Moody’s, S&P, and Fitch Group, and have anticipated returns of more than 1000 basis points above risk-free securities such as UK Treasury bills.
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