Susan’s recent post on Argentina is worth a read. So are the comments, if only because they seem to illustrate an oft-made mistake in discussions about international debt: people accusing the sovereign-debt investor of being “stupid” for investing in the first place.
Trouble is, investors like NML Capital aren’t stupid. In fact, they’re some of the most sophisticated investors out there. NML Capital, you see, is a “vulture fund.”
Vulture funds are investors that knowingly jump into messes. They might, for instance, buy debt that seems sure to default for pennies on the dollar, and then use their resources to extract a few more pennies than they paid from the corporation or the sovereign. They often prove to be lucrative enterprises. One source claims they average returns of 3 to 20 times their initial investment–for an incredible return of 300% to 2,000%.
These investors aren’t just smart, they’re beneficial in a few ways. When a country defaults on its sovereign debt, it has significant leverage over the investors: it can tell them to take a pittance or face a long, expensive battle to get just a little bit back. Because of vulture funds, skittish investors can escape from that battle and get some immediate cash, while the vulture funds take on the complex, expensive, and lengthy battle of recovering against the sovereign. So here we see two critical benefits: the funds provide liquidity to risk-averse investors, and they also make sovereigns understand that someone out there still plans to enforce the original debt. That understanding might discourage default in the first place, or help investors get better “workout” terms from the sovereign in the event of default.
But I’m not suggesting that these funds are all rainbows and butterflies. The funds complicate the debt resolution process for sovereigns that default on their debt. That complication might then keep the defaulting country weak for an unnecessary length of time–something the international community probably doesn’t want to see. The funds also might manipulate international law to get the most money back (for instance, by setting up entities around the world to take advantage of favorable jurisdictional situations). And they can complicate international relations, as we saw in Argentina.
Whatever their merits, one thing is for sure: vulture funds like NML Capital are certainly not stupid.
-Michael
I stand corrected.
Partially, anyway. I still think it’s an ill-advisable market to voluntarily involve oneself in, and, as a matter of equity, vulture funds are about the least sympathetic litigant imaginable.
But I had no idea vulture funds were that lucrative — I wouldn’t have guessed sovereign debt collection could be so much more lucrative than regular debt collection. … Then again, I guess countries can’t file for Chapter 7.
I’d like to see the data behind that ADBG article, though. Is the “annualized returns average 50 to 333 percent” an average return for the bonds that the vultures succeed in collecting on, or an average return for all bonds purchased by vultures? And exactly what percentage of the recovery is eaten up by the (undoubtedly huge) legal fees?
I would be equally interested in seeing the data. But I can think of at least one reason why the margins are so crazy in “sovereign debt collection” compared to “regular debt collection.” (I found one source suggesting U.S. debt collectors make about 5 to 6 percent net profit.) Sovereign debt collection seems to require lots of capital, patience, and expertise. I imagine that there aren’t many out there with all three. So sovereign debt holders probably can’t shop around for great offers when it comes time to ditch their debt and get out of a bad situation. And if the vulture funds are able to snatch up the debt for a small sum, it might not be that hard to turn a profit.
I also wonder if sovereign bond holders are unable to afford the political costs of collecting on defaulted debts. If they are seen engaging in debt collection shakedowns against a state, maybe it’ll make the bond markets of other sovereigns less willing to deal with them? Or possibly they have other investments that the feds can use as a pressure point to get them to back down from causing diplomatic strife?
So you need someone who has a lot of spare capital lying around, is diversified enough to have the ability to sit on a hundred million dollar investment for a decade while waiting to collect, and is also relatively immune to political pressures. Yeah, I guess that does tend to weed out a lot of the competition.