Vulture fund

A vulture fund is a hedge fund or private-equity fund that invests in debt considered to be very weak or in default, known as distressed debt. Investors in the fund profit by buying debt at a discounted price on a secondary market and then using numerous methods to sell the debt for more than the purchasing price. Debtors include companies, countries, and individuals.

Vulture funds have had success in bringing attachment and recovery actions against sovereign debtor governments, usually settling with them before realizing the attachments in forced sales. Settlements typically are made at a discount in hard or local currency or in the form of new debt issuance. In some instances, such as those involving Peru and Argentina, such a seizure blocked payments to other creditors of the sovereign obligor.

Sovereign debt collection was rare until the 1950s when sovereign immunity of government issuers started to become restricted by contract terms. This trend developed from the long history of sovereign defaulting on commercial creditors with impunity. Accordingly, sovereign debt collection actions began in the 1950s. One example was the freezing of Brazil's gold reserves held by the Federal Reserve.

Investment in sovereign debt with the intent to recover was also restricted due to the laws of champerty and maintenance and by the fact that most sovereign debt was syndicated. Under the doctrine of champerty, it was illegal in England and the United States to purchase a debt with the sole intent of litigating it. The distinction was made that if the debt was purchased to effect a recovery or facilitate investment, the doctrine was not a bar. Most jurisdictions have now eliminated the doctrine as archaic.

Similarly, sovereign debt owed to commercial creditors in the late 1980s was principally held by bank syndicates. This was the result of the petrodollar crisis of the 1970s when oil earnings were recycled into bank loans. The syndication of debt among banks made recovery impractical, as a fund intending to litigate had to buy out the entire syndicate of holders or risk having the proceeds of litigation attached pursuant to sharing clauses in the loan agreements.

As the 1980s progressed, debt rescheduling efforts in Latin America created many new and easily traded instruments such as Brady bonds that brought new players into the market, including banks and hedge funds. The original creditors then wrote down their positions and sold the debt into the secondary market, which is a market consisting of banks and investment funds focused on buying at discounts to achieve above market returns on their investment.

In this process, much debt was repurchased and converted into local currency by the sovereign country issuers in official debt conversion programs designed to attract investment, and in severely indebted countries through World Bank funded buy-backs. The result is that the old syndicates were broken up and many unreconstructed syndicate "tails" were available for purchase at discounts exceeding 80% of the principal face value. That pricing encouraged funds to invest in recovery actions, which would not otherwise make financial sense due to their length and cost.

Businesses that need more capital than their founders can raise by personal contacts are enabled by this legal method of attracting investors to buy a portion of the business. Owners would invest capital and obtain common stock or equity in exchange for invested cash or other property like machines, factories, warehouses, patents or other interests. Then the owners would raise additional capital by borrowing from lenders in capital markets by selling bonds. In corporation law, the owners of these bonds come first in line for repayment so that if there is not sufficient funds to repay the bondholders, the stockholders get wiped out. The bondholders step into the shoes of the former shareholders. The shareholders own nothing because they, the owners, could not fully repay all the contractual promises, or loans. So like a bank (the mortgagee) that has lent money to a home buyer (the mortgagor) takes possession of the security (the home) when mortgage payments are not made (i.e. foreclosure), the bondholders of a corporation take possession of the business from the former owners (the shareholders) when the corporation falls into bankruptcy. Thus, when shareholders cannot repay bondholders, in principle, bondholders become the new shareholders. In practice, however, it is more complicated.