What is a Vulture Fund?
A vulture fund is made up of investors who profit from distressed securities. The group may be formed as a hedge fund or private equity group.
Nicknamed for the bird that feeds on carcasses, vulture funds thrive and profit on debt that is extremely weak or already in default. Vulture funds often target government bond securities, but they may also target corporations and individuals.
While highly risky, these types of funds can also return extensive rewards.
How does a vulture fund profit?
Vulture funds buy extremely risky debt at extensive discounts, then take legal steps to collect the debt.
When governments, corporations, or individuals cannot pay debts they owe, eventually they will enter default. The closer an entity is to default — and particularly once it reaches that stage — the more worthless their debt is.
Worthless debt can be purchased on the secondary market for a mere fraction of its value. Hedge funds that purchase this debt are referred to as vulture funds. They buy the debt for an extreme discount.
Once the debt is owned, the fund then takes legal measures against the original debtor. They sue the country, corporation, or individual that owes the debt. The goal is to recover as much of the original debt as possible, thus making a substantial profit against what the fund paid for it.
If, for instance, a vulture fund acquires $10M in debt for a mere $1M and then sues for the full $10M to be repaid, the fund stands to earn 1000% in profit.
Are vulture funds legal?
While these types of funds are completely legal, there has been growing concern in recent decades about the propensity for vulture funds to target government debt. Critics believe that vulture funds cause distressed countries to fall even further into financial distress because of the legal actions taken against them.
Due to these concerns, many countries have attempted to pass legislation limiting or forbidding them.
The US was the first to take legal steps in 2009 with the Stop VULTURE Funds Act. The intention was to limit how much profit a creditor could make from secondary purchases. This legislation failed, however. Other countries have since succeeded with various limitations including Australia, Belgium, and the UK.
In 2014, the United Nations voted to exclude vulture funds from the bankruptcy restructuring process of sovereign nations.
Are vulture funds ethical?
Arguments about the ethics of buying debt in the secondary market abound. Many criticize funds for making profits on countries, companies, or individuals who are already struggling with massive financial burdens.
Critics are particularly vocal about the effect these debt collection actions have against poorer countries, claiming that the actions of the investors exacerbate the countries’ problems.
Investors and fund managers defend their actions and positions. They hold firm in the statement that they did not cause the financial problems to begin with. They are simply collecting on debt that is legally owed to them.
Some even point out that vulture funds help keep nations more honest, and make them potentially inclined to think more carefully about how much debt they take on.
In the case of sovereign nations, laws can potentially be passed that effectively excuse the nation from whatever level of debt it wants. For now, these types of funds are quite popular in some investment circles, because they have such a high potential of return.