Vulture Funds: How Hedge Funds Gamble on Distressed Debt

A Look at Hedge Funds that Buy Up Distressed Assets

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Paul Singer is a hedge fund billionaire that has delivered billions in value to his investors – but those billions came at a price. As a pioneer of so-called vulture funds, Mr. Singer has become famous for identifying countries in economic distress, buying up their debt for pennies on the dollar, and then demanding full repayment of the debt at all costs. Proponents argue that these actions hold countries accountable, while critics point to the high social costs of collection.

In this article, we’ll take a look at both side of the argument, a couple examples of these practices occurring, and potential changes to the way vulture funds operate.

Corruption & Accountability

Vulture fund proponents argue that they enhance accountability and reduce corruption by enforcing debt contracts. By reducing moral hazard, these funds may promote financial prudence over the long-term if countries learn from their past mistakes. Countries that are never responsible for their debt repayments, argue proponents, will simply continue to abuse the system by taking on more debt that they never intend to repay.

For example, creditors involved with Puerto Rico’s default pointed to a bloated public education system as a cause of their issues. The territory’s public education system has seen lower enrollments – as many have left for the U.S. – but spending on public education has increased substantially.

Without collecting on the debt, there would be no incentive for the public systems to be reformed and a subsequent default would likely follow.

High Social Costs

Those opposed to the idea of vulture funds argue that they often have enormous social costs, since capital is extracted out of the country and into hedge fund pockets.

While a country’s leadership may be responsible for financial mismanagement, these dynamics penalize citizens by taking away funds that could have been redistributed toward social good. Repayment also tends to hurt a country’s ability to ever emerge from debt – creating a viscous cycle.

For example, the Democratic Republic of Congo defaulted on its debt following a five-year war that ended in severe disease and malnutrition. Vulture fund pioneer Peter Grossman bought up the country’s debt and successfully sued it for $100 million – most of that being profit. The UNICEF argued that the $100 million could have been spent on clean water to save the lives of some 200,000 children instead of enriching a single hedge fund.

Changing Tide

Vulture funds have come under increased scrutiny from both domestic and international organizations for their practices. For instance, the UN Human Rights Council condemned the activities of vulture funds “for the direct negative effect that the debt repayment to those funds, under predatory conditions, has on the capacity of governments to fulfill their human rights obligations, particularly economic, social and cultural rights.”

In 2009, Congress introduced a bill aimed to prevent vulture funds from profiting on sovereign debt by capping the amount of profit that a secondary creditor can win through litigation based on those debts.

The measure did not successfully pass, but similar legislation did pass in countries like the United Kingdom, Belgium, Jersey, the Isle of Man, Australia, and other countries around the world with the help of non-profit organizations.

The future of vulture funds depends largely on these regulations, as well as whether or not countries learn from their past mistakes. In the meantime, hedge fund managers will continue to seek out these opportunities to deliver returns to their investors.

Key Takeaway Points

  • Vulture funds are hedge funds that specialize in buying up the debt of distressed countries or securities with the intent to collect all that it owed.
  • Proponents of vulture funds argue that they reduce moral hazard and improve accountability, but critics argue that they have a high social cost in some cases.
  • Many governments have taken action against vulture funds, but many countries like the U.S. still permit them to exist.