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Locusts into Vultures: Buyout Firms Turn to Speculating in…LBO Debt

Always in the forefront of financial innovation, the buyout houses are rushing to speculate in the massive debt their activities have generated. Private equity firms are lining up for the heavily-discounted debt – some USD 350 billion of it - the banks are anxious to unload following the collapse of the high-yield debt market

Apollo Management, Blackstone, TPG, Carlyle Group, and Oaktree, among others, are all raising funds from investors to specifically target "distressed" LBO debt.

According to a Reuters report of August 15, Blackstone is particularly keen on debt generated by the sale of companies they studied for a possible buyout. Reuters quoted CEO Hamilton James as stating "For companies that we worked on and were overbid, we're starting to look at those as being very attractive investments where, frankly, I think we may be able to buy the debt ... and get a higher return than the underlying equity…" The report went on to note that "Some LBO and hedge fund managers are discussing the possibility of buying the entire portfolio of LBO debt off the books of investment banks, according to one private equity professional who did not want to be named."

While the first tranche of unsold buyout debt was unloaded by the banks at 97 cents on the dollar, TPG's TPG-Axon was recently able to pick up a chunk of the debt from KKR's buyout of retailer Dollar General for 87 cents on the dollar – with an expected return of 18%.

The Financial Times, commenting on the proliferation of "recovery" funds on September 5,, wrote: "Managers are pitching double-digit returns to investors and claiming relatively low risk. Lehman is looking for about $2bn…and Oaktree of California is looking for up to $5bn. GLG of London is seeking $250m, investors said, but it could be geared up to three times. [our emphasis]" All of which is reminiscent of the pitch to investors at the height of the buyout boom. Carlyle Group's David Rubenstein, speaking at a recent Dow Jones Private Equity Analyst conference, has even suggested that pension funds should buy the debt from the banks! Carlyle hasn't failed to notice that pension funds continue to substantially increase their investments in private equity funds even as the credit meltdown continues.

The emergence of massive funds specializing in LBO debt (one hedge fund has already raised USD 7 billion) raises fundamental regulatory issues. The investment banks who have been collecting the fees and securitizing and peddling the debt to fund buyouts now find themselves unable to offload it, except at a heavy discount, to the very funds whose buyouts created the debt in the first place. Picking up heavily discounted buyout debt could bring massive rewards to funds who lost out in bidding wars which drove purchase prices to ludicrous earnings multiples – and leave them in possession of the company in the event of a default. All the classic conflict of interest issues raised by the buyout process are magnified and intensified here. It only remains to be seen how the rating agencies, which played a fundamental role in stoking the LBO boom, will rate the offerings…