Private equity boss Jon Moulton. Photograph: David Levene
The staff and owners of Manchester tea-bag maker JR Crompton thought a sympathetic bank manager would rescue them in times of trouble; after all, the company had been around since 1856. What they didn't know was their future was in the hands of young, aggressive traders in a well-known investment bank in London. The traders had bought parts of the company's debt, gaining enough control to block a proposed restructuring. The company was pushed into administration and the assets sold. Crompton ceased to exist.
Vulture funds are at the extreme end of a booming market in distressed debt - pushing companies into administration for profit even when other investors feel the company is worth saving.
The funds circle struggling firms and buy their debt at a discount to gain control of the business. Usually hedge funds or proprietary desks at large investment banks, the funds may turn their debt into equity in a restructuring, gaining a stake or full control of the firm, or sell the assets in a liquidation, receiving a higher price for the debt than they paid for it.
"When debt has been acquired at a substantial discount to par, the fund may still make a profit notwithstanding the liquidation of a company," says Mark Hyde, global head of restructuring at law firm Clifford Chance. "If you buy at 20 and recover at 30, you've made a good profit."
Administration will also relieve the company of its pension deficit, making a sale of the assets more attractive - which was the case at Crompton.
The deals are struck behind the scenes. The secondary market where loans trade is not public, with investors buying and selling large amounts of a company's debt in bilateral transactions.
Usually based in offices in upmarket areas, vulture funds also tend to act together. Last summer, debtholders of Martinsa Fadesa, Spain's largest construction company, imposed stringent conditions on a restructuring deal, which led to the company's failure. The funds, which bought the debt at a discount after Morgan Stanley sold some of its loans, negotiated favourable terms for themselves: as soon as the sale of assets started, they would receive payments within one year, whereas some Spanish savings banks will have to wait as much as seven years.
Other funds have become professionally noisy. By imposing conditions or threatening a restructuring, they encourage other creditors to buy them out just to see the deal through. Most restructurings need the agreement of all creditors.
Not all distressed funds are run by aggressive players who put companies into insolvency deliberately. "Debtholders are entitled to get as much as they can but you want to save jobs as well," says distressed-debt investor Jon Moulton. "But if somebody deliberately blocks a restructuring, or does nothing about a problem, that's being an asset stripper. All we're trying to do is to find value, help a company. More often than not we preserve jobs, but sometimes a hopeless business needs to close down."
Vulture funds are only one of many players to profit from a company's misfortune. Those at the top of the tree include private equity directors, who bought firms with as much debt as possible - sometimes putting in no equity or cash at all - and used the company's profits to repay debt instead of making operational improvements. Private equity firms also borrowed even more money to pay themselves substantial dividends, credit rating agencies such as Standard & Poor's warned.
"Undoubtedly people have benefited during the good years from financial engineering," says Buchan Scott, head of investor relations at Duke Street Capital, the private-equity firm behind Focus, the DIY chain which had to be restructured. "Ultimately, the debt was too high and the sector fell off the cliff. We didn't call the administrators, we ended selling it to Cerberus, but it still was one of our most successful investments [after growing it from seven to 450 stores]."
Primary lenders, such as Barclays, RBS or Deutsche Bank, sold billions of pounds worth of loans for leveraged buy-outs (LBOs) in the market, allowing hedge funds and other investors to take positions in a company's debt.
Young and financially savvy, distressed-debt players study companies - sometimes beyond the belief of bankers and company directors. A US hedge fund once produced an 800-page report on Drax, Britain's largest power station, whose failure turned into multimillion-pound profits for funds such as BlueBay when its debt was converted into equity. Through similar transactions, BlueBay holds - or has recently held - stakes in Polestar, a printing business, and Danoptra, a gaming company.
Vulture funds swoop after a company is about to or has breached its banking covenants - a move than can give them the right as creditors to call in the administrators. The creditors usually appoint banking advisers, such as Rothschild, Close Brothers or Houlihan, and specialist law firms, including Clifford Chance, Freshfields or Allen & Overy. The company appoints its advisers as well. Each stage of the process generates fees for all the professionals involved.
"Round-table meetings between all the stakeholders can get quite heated - you see people getting very angry, shouting," Hyde says. "This is not surprising given that somebody who has to accept that they're going to lose all their investment is likely to get emotional."
Alfred Schefenacker, a German industrialist, was absent from the meeting that had to decide the fate of the car parts maker he had devoted his life to. Company advisers Alix Partners moved the firm's headquarters to from Germany to Britain's more creditor-friendly administration and restructuring system. Schefenacker creditors turned some of their debt into equity, rescuing the company but leaving the founder and owner with a substantially reduced stake. It wasn't his company any more.
Some companies are trying to ring-fence their loan syndicate, closing the doors to vulture funds. "We don't tend to have vulture funds in our company portfolio - we like to have control of the banking syndicate to ensure a proper alignment of interest in case things go wrong," said Duke Street's Scott. Vulture funds "have other agendas - they are much more short-termist and less relationship driven".
Hedge fund managers have found their niche in the market. Wealthy and flexible, they will pick up the distressed assets of insolvent companies and recycle them, said Matthew Prest, head of European special situations group at Close Brothers.
Vulture funds may also help a business survive by assuming a level of risk that high-street banks would not tolerate - and charge accordingly for it.
"We don't see hedge funds as being difficult," says Alistair Dick, restructuring director at Rothschild in London. "They can often provide more flexible capital than the original lenders - typically banks and CLOs [collateralised loan obligations] - so they can help in the process."
The vultures risk becoming distressed themselves if their trades go wrong. "Buying distressed debt is always a gamble," says Hyde.
Some hedge funds are stuck in deals because buyers are hard to find. Others have bought debt at 60p to the pound only to see it fall further. They are under pressure as the $1.2tn (£860m) hedge-fund industry is expected to see an outflow of $450bn in assets this year through losses and withdrawals, on top of the $600bn lost last year, according to Bloomberg News.
"People are scared now to invest in turnaround opportunities - they don't think we've reached the bottom," Prest says. "Things will turn when people start believing they have some visibility about the future, some confidence about the forecast in the company, or when prices have gone to a certain level.
"We still have a very illiquid secondary-debt market. Buyers are looking at things from a very bearish point of view, while sellers think tomorrow will be brighter."
At this point, only the administrators have their fees guaranteed.