Vulture capitalism refers to the practice of buying up struggling firms, stripping them off their assets and enabling a few venture capitalists to make a high profit at the expense of genuine business and ordinary workers. The term originates from the Vulture bird which looks for distressed animals and then finishes them off.
Vulture capitalism is closely linked to the practice of aggressive take-overs – financed by a leveraged buyout – Vulture capitalists buy the existing firm and then lend it money and sell off its assets. This makes the firm struggle in the long-term and even if the firm fails, the vulture capitalists have profited from the sale of assets, and lending the company money at profitable rates. Vulture capitalism is also related to financial engineering, where the accounts of firms are managed to benefit certain individuals like debt holders.
Vulture capitalists might be contrasted with venture capitalists. Venture capitalists are interested in investing in firms to maximise their long-term potential. For example, financing innovates new firms to enable them to compete against bigger rivals. But, venture capitalists do not invest to secure the firm’s long-term development but focus on selling off valuable assets and liquidating the rest of the business – leading to the loss of a potentially viable business. The decline of many bricks and mortar American retailers such as Sears, Toy R Us has partly been blamed on ‘vulture’ capitalists.
Example of vulture capitalism
In a recession, a car firm may make substantial losses and be at risk of going out of business. In the long-term, the business may have the capacity to rebound and during a period of strong growth become profitable again. However, rather than look to the long-term, a vulture capitalist may see the prospect of making a quick profit. If the business is facing insolvency, then may be able to offer a very low price for the business – say $4 billion. But, then rather than help the firm recover, they immediately sell all main assets – prime land, factories and then make workforce redundant. Selling all assets may net $7 billion, so it is an easy $3 billion profit. However, this is a wastage of economic resources. If investors had enabled the firm to ride out the recession, then the long-term value of the business could have been much higher – $20 or $30 billion.
Also, the process of asset stripping and making people redundant has high economic and social costs. The unemployed lose income and are unproductive. It represents a loss of economic welfare as there is no effort to make use of trained labour and the years of investment in research and development.
Example of vulture capitalism – Sears and Kmart
Private equity firms have often bought firms. To finance the purchase of big retail firms, the private equity firms themselves borrow money. Once they have bought the new company, they can run it in the interests of the private equity firm who bought it.
For example, in 2005, a hedge fund manager Eddie Lampert arranged the merge of Sears and Kmart. (Source) He then used revenue from the company in a stock buyback to reward shareholders and push up the share price. He then increased corporate debt of Sears and Kmart – personally lending billions to the firm. The new owners of the firm also:
- Sold off major assets. Rather than own stores, Sears/Kmart sold them to the private equity firms (Sears holdings paid to a separate company called Seritage) and then they have to pay rent on a property they used to own.
- With sales lagging, the same private equity investors can lend Sears/Kmart money – increasing their corporate debt.
- The firm Sears was losing assets – such as land and property but increasing its cash liabilities – debt repayments and rental payment.
- The owners of the new retail company have a conflict of interest. They can potentially profit from making poor long-term decisions from the ownership of the firm.
- In other words, the vulture capitalists can potentially make a profit from undermining the real economic value of the firm but concentrate on stripping assets, lending money at high profit and rewarding shareholders.
Toys “R” Us filed for bankruptcy in September 2017. After being bought out by Bain Capital and Kohlberg Kravis Robers.
In 2004, Toys R Us had $2.2 billion in cash or cash equivalents. In 2005, it was bought in a leveraged buyout. A leveraged buy out involves buying a company by increasing its debt. By, 2017, this had fallen to $310 million, but debt had more than doubled to $5.2 billion.
During this time sales revenues remained steady at just over $11 billion. (Source)
Venture capitalism vs Vulture capitalists
Not everyone agrees with this perspective. They argue that the firms fail – not because of the intervention of hedge fund managers but because of underlying market conditions. For example, traditional bricks and mortar retailers have been struggling to compete with the online power of Amazon and Walmart. The problem is not hedge funds, but underlying weaknesses in the firm.
Also, economists suggest that if failing firms close down – it is not a loss of economic efficiency, because it allows labour and capital to switch to more profitable and efficient elements of the economy. Joseph Schumpeter used the phrase ‘Creative destruction‘ – the idea that business failures were essential to allowing capitalism to reinvent itself.
Last updated: 12 May 2020, Tejvan Pettinger, www.economicshelp.org, Oxford, UK