Slimmer Pickings for Vultures

Double-digit returns sound pretty attractive when the economy is slumping. So it's no surprise that cash ploughed into distressed-debt funds now tops $200 billion. These so-called vulture funds can return 30% or more annually during economic meltdowns. But credit-boom innovations will make it harder for them to wring such rewards out of the current rising level of defaults. The best-performing vulture funds typically take an active role in a borrower's bankruptcy. They may snap up deeply discounted debt and hope it pops after a company restructures. Or they may seek to get the debt exchanged for equity, giving them a big stake in -- if not outright ownership of -- the restructured firm. This now may be more complicated. First, the loan-market boom caused borrowers to pile on senior secured debt. Senior debtholders are first in line for company assets or equity. With more senior lenders to deal with, vulture investors may find it more expensive to acquire a controlling position. Then there are second-lien loans. These credit-boom innovations are wedged between a company's senior-secured and senior-unsecured debt. But their rights in bankruptcy aren't well-established. Legal spats between senior secured and second-lien lenders over the division of spoils could gum up bankruptcy negotiations. Meanwhile, so-called covenant-lite loans can allow troubled companies to stagger on for longer, burning through cash and leaving vulture investors with less meat to chew off their carcasses. The news isn't all bad. The fact that collateralized debt obligations now hold lots of leveraged loans could be helpful. Some of these have to sell when the value of those loans drops. That is beginning to happen, and it means there should be a steady stream of cheap loans for vultures to swoop on.