The fall of American giants such as Sears and Toys R Us has brought the focus back on vulture capitalists. People react negatively when they hear about private equity firms who have profited off the misery of other weaker firms. This is the reason why they have coined a derogatory term for the companies. This term is called vulture capitalism.

Vulture capitalism sounds a lot like venture capitalism. However, they are very different indeed.

Venture capital is about nursing nascent firms and building large companies out of them. On the other hand, vulture capital is about taking down other companies and profiting from their demise.

This description of vulture capitalism makes it sound like a questionable economic activity which should be illegal.

However, the reality is that vulture capitalism also serves an important economic function. In this article, we will have a look at what vulture capitalism is why it may be necessary for the economy as a whole.

What is Vulture Capitalism?

Simply put, Vulture capitalism is the process of making money off dying firms. Vulture capitalists typically buy a stake in a firm at rock bottom prices. They are able to do so because they invest in firms which other financiers typically avoid.

They provide finance to businesses which are considered to be unviable by traditional means.

For example, Toys R Us and Sears were considered to be outdated brick and mortar stores working in the age of Amazon.

Traditional lenders like banks were wary of lending money to these businesses.

Once, they have identified the target, vulture funds set aggressive financial goals for the revival of the firm. There are two possibilities, one is that the firm is able to perform.

In this case, both the firm and the vulture fund win and everyone is happy.

Alternatively, vulture funds structure the firm in such a way that they can gain even if the firm as a whole fails.

Hence, vulture funds always seem to gain money even if the underlying firm in which they have invested money goes bankrupt and ceases to exist.

Criticisms against Vulture Capitalism

• Vulture capitalists often make money because they invest against some kind of intangible brand.

  For instance, if a firm has proprietary technology, banks wouldn’t lend against it. This is because proprietary technologies are intangible assets and arriving at a valuation for them can be difficult.

  However, vulture capitalists are aware of the valuation of these intangible assets. Hence, if the firm doesn’t perform as expected, they sell such assets and recover their cash

• Vulture capitalists are known for aggressively reducing the headcount of companies that they invest in. The number of people employed by companies tends to reduce drastically when vulture capitalists take control. This increases the unemployment and other welfare payments for the areas in which these firms operate.

  However, the irony is that vulture capitalists pay a very low tax rate. Hence, they reap the profits by firing people whereas the government and taxpayer are left holding the bag in the end

• Vulture capitalists first lend money at very high-interest rates to these dying firms. Once these firms are not able to pay back the loan, they take control of an important asset such as the company’s real estate. They then lease back the same real estate to the company at very high rates. Hence, vulture capitalists firms end up milking money while the rest of the firm is driven to the ground.

Is Vulture Capitalism Necessary?

• Vulture capital firms are instrumental in reallocating resources in the economy. These firms take people and resources out of companies where they are not being optimally utilized. Then those same resources are used in other sectors of the economy where they are able to achieve a more productive outcome.

  Politicians and media seem to focus too much on the part where people lose jobs. However, not enough attention is paid to the fact that resources are freed so that they can be utilized better.

• Vulture capital firms are able to revive a lot of firms and even governments. When organizations borrow from vulture capital firms, they know that this is their last hope. This is the reason why they seem to give it their best shot which works many times.

  Consider the case of Greece as well as Argentina. Both of these countries were facing a financial crisis.

  However, Greece had the support of other Eurozone countries. Since it had the support of helpful countries, it did not take the situation seriously. Greece continued to spend borrowed money recklessly and hence has reached the verge of bankruptcy.

The same situation was faced by Argentina. Here, also finally the government ended up becoming bankrupt, and the vulture firms were blamed heavily for it.

However, thanks to the constant pressure that these funds exerted, Argentina ended up in much better financial shape, and the crisis was smaller than it would otherwise have been.

The bottom line is that vulture capital firms don’t throw good money after bad. If they realize that a firm is not going to turn around, they cut their losses and move out. Many times they end up strangling the company which is why they end up with a bad name.