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Buy'em, Bleed'em, Buy'em Again Cheap: Could Debt-for-Equity Swaps Secure Continued PE-Ownership of Bankrupt Portfolio Companies?

Private Equity funds may have found a new use for the uninvested funds (known in industry jargon as "dry powder") they're currently sitting on, which are estimated to total from USD 500 billion to as much as a trillion.

Surveying their failing portfolio companies from atop this mountain of cash, the funds are writing down the value of their investments - in some cases to zero - while simultaneously raising the threshold for providing financial support to portfolio companies whose collapse will throw hundreds of thousands of workers out of a job. According to a March 9 report from Reuters UK, "Private equity companies will only support those companies with a good chance of survival, where their fresh equity injections will earn high returns of 40 percent, far in excess of the industry's standard return of 25 percent." However, any commitment to renewed funding for firms which have had the last drop of cash leveraged out of them by the funds puts them on a collision course with the banks, who are not in a lending mood. As Reuters puts it, "Those private equity firms with money are trying to claw back their losses by charging high rates for new funds…their aggressive attempts to wring the best deal for new money commitments is sparking a battle for control as cash-strapped banks demand better proposals to avoid putting the cash up themselves…" The article goes on to quote a 'senior investor': "It's a question of who has the cash to keep companies going. Previously, senior banks would have had cash available but banks have no cash, this is handing opportunities to private equity firms with cash."

Investment funds that specialized in high-risk debt during the boom years - including the riskiest bits of LBO debt spliced into collatoralized loan obligations, or CLOs - are currently in freefall, contributing substantially to the trillions of dollars in losses for the global financial institutions. These losses have also hit buyout houses with dedicated operations speculating in junk-rated debt - like the massive losses at Blackstone resulting from their purchase of loans they bought in 2008 from Deutsche Bank. KKR's publicly listed KKR Financial Holdings LLC has seen its shares fall by 97%. KKR Financial was set up in 2004 to buy high-yield debt to finance buyouts.

In the first half of 2007, at the height of the buyout boom, CLOs bought close to two-thirds of the debt which financed the deals. The private equity houses set up these funds, earning additional money through fees they collected from investors who bought the paper which kept the buyout business moving. But CLO sales fell to USD 17 billion in 2008 from 100 billion in 2006, as investors ran away from securitized debt. According to JP Morgan, CLO bonds rated AA are trading at one quarter of face value. Standard & Poors says the riskiest bonds are trading at 10 cents on the dollar, and the number of borrowers with the lowest credit rating has doubled over the past year. Unsurprisingly, Bloomberg quotes Moody's senior credit officer as saying "The absence of new CLOs magnifies the chance companies won't be able to refinance debt."

So the buyout funds which turned their attention to buying back debt at the earlier stages of the crisis - and who've gotten badly burned because the market for debt continued to plunge - may have discovered a new tactic: buying back second-lien debt to position themselves for a major equity stake in their own bankrupt companies. According to another Bloomberg article of March 13, Apollo Management and TPG, having failed to refinance the massive debt falling due for their highly leveraged USD 30 billion 2008 buyout of casino complex Harrah's Entertainment, "Are buying debt to protect themselves should the world's biggest casino company fail. By amassing Harrah's debt, Apollo and TPG may be able to retain control of the company in a bankruptcy."

In a remarkable comment on the debt purchase, Bloomberg quotes a Harrah's spokesperson as saying "We're pleased that they continue to show confidence in our company."

Apollo and TPG know the game is probably up for Harrah's, and they're not indiscriminately buying just any bonds: they're loading up on second-lien debt, which, should the company fold, would give them a claim on equity, and thus continued control of the company they've leveraged to death (first-lien debt holders have the first shot at any cash).

Bloomberg: "Harrah's, which Moody's Investors Service included this week on a list of 283 U.S. companies considered the likeliest to default, is looking to swap 2.8 billion in bonds for new second-lien notes. As part of the exchange, Harrah's is also offering to buy back its old and new second-lien notes for 37 cents on the dollar in cash, which would allow Apollo and TPG to build a larger position in the securities."

Investors, including pension funds, who helped finance the Harrah's buyout, will of course continue to lose massively - as will Harrah's employees. As US bondholders lobby for a potential piece of government toxic asset relief, it is urgent that unions and public interest groups use this opportunity to highlight the financial pillage and massive conflicts of interest at the heart of the buyout business and its collapsing wall of paper.