Vultures are probably the most misunderstood creatures in the avian kingdom. They perform an invaluable role in the environment by cleaning up nature’s messes and removing toxic waste and the threat of disease.

Vulture investors carry out similar Darwinian functions in the financial ecosystem by getting rid of failing companies, digesting bad debt and mopping up after bankruptcies.

What separates the eponymous investment strategy from the vulture itself, however, is the dynamic way it can reward the scavenger mentality. And as financial professionals and their clients recognise the benefits of vulture investing - and disregard misconceptions about the strategy - more and more high net worth individuals and family offices are steering toward firms with expertise in distressed asset investing, especially for clients seeking strong returns and exposure to alternative assets.

Perhaps the most glaring misunderstanding of vulture investing is the notion that distressed asset firms prey on healthy companies, buy ownership stakes and become greedy activists - ripping solvent firms apart and leaving a non-functioning disaster behind.

This is simply a fallacy. In most instances, however, vulture investors actually rescue companies in crisis.

Distressed asset firms purchase companies’ most troubled assets, give desperate sellers, who are usually in need of liquidity for structural reasons, an opportunity to exit their holdings, and guide the at-risk entity through bankruptcy. Vulture investors in turn get a chance to profit - at considerable risk - from other people's mistakes.

In fact, just as the vulture itself converts nature’s waste into sustenance, distressed asset firms help recycle capital back into the economy following bankruptcy, allowing new owners to provide the capital and leadership to help reorganised businesses thrive.

So how does it work? Through fundamental research and analysis, vulture investors identify compelling opportunities in companies entering or emerging from distress, usually due to an inability to meet financial obligations. 

Distressed asset firms then invest in a firm’s distressed securities with the expectation that one or more catalyst event, such as emergence from bankruptcy, will eventually drive prices towards fair value. 

Bankruptcy is a powerful tool that allows failing companies to adjust their debts and get a fresh start with new owners. It also causes confusion and misunderstanding in the marketplace, creating inefficiently-priced distressed securities in the process.

Vulture investors, therefore, can capitalise on mispriced assets, taking an ownership position at a significant discount to fair value and invest in any part of the capital structure and at any point during the restructuring process. Some firms also have the flexibility to invest long and short in companies, regardless of market cap, both in fixed income and equity securities. While traditional distressed securities firms are content to merely subsist off of the roadkill left by the markets, the most seasoned and savvied vultures identify, anticipate, and capitalise on distressed opportunities before they arise and strike pre-emptively – by selling-short.

Though vulture investing is complex and requires active management, it can offer returns that justify the effort. In fact, vulture investing can generate strong risk-adjusted returns that may exceed the market performance of relevant equity indices through a full cycle. Moreover, the returns from vulture investing usually exhibit uncorrelated performance, tied to specific fundamental events occurring in the underlying companies that do not necessarily correlate with broad markets. As such, they can serve investors who are seeking to diversify their portfolios as an important diversification tool. In fact, some sectors of the US economy appear ripe for vulture investing entry now.

The energy industry, particularly exploration and production, is in trouble. Coupled with the lower commodity prices that energy companies have endured is the record amount of junk debt issued by the industry, in excess of $280 billion, over the past five years. Many companies simply don’t have the capacity to service their debt in such a downward commodity pricing cycle.

Additionally, as the US Federal Reserve moves closer to raising its benchmark interest rate later this year, there is a return to normalisation in the fixed income market – and as yields rise, the riskiest borrowers will experience an increasingly more difficult debt new-issuance market. As lenders lose their appetite to refinance excessively-risky capital structures in a rising interest rate environment, many companies in the energy space will clearly face higher default risk. In fact, numerous energy companies have already filed for bankruptcy.

The dry bulk shipping and the coal industries are others where we are currently seeing an increasing amount of distress. Dry bulk shipping rates are down substantially due to overcapacity and slowing global demand from Asian economies. Meanwhile, steam coal prices are down due to lower prices for substitute fuel – natural gas – while metallurgical coal prices are down due to softening demand for steel production. These fundamental trends in the coal and shipping industries are causing significant distress for those operators who don’t have sufficient flexibility to ride out the cycle as a result of excessive borrowings.  

Just as the vulture itself is always on the lookout for its next meal, financial professionals too should be on the prowl. Distressed investing is sure to satisfy the appetites of high net worth individuals and family offices seeking strong returns from alternative asset classes.