With the financial meltdown, cheap debt has taken on new meaning for private equity investors that dabble in distressed securities. New Mountain Capital LLC of New York and at least two others, JLL Partners Inc., also of New York, and Leonard Green & Partners LP of Los Angeles, are turning their sights on debt trading, at least as an interim fix to the dealmaking hiatus. Others seek approval from limited partners, institutional investors say.

"Since traditional PE isn't working right now, this is a way to capitalize on market dislocations and earn returns for our LPs," says one buyout executive who requested anonymity. "Let's say we liked a company two years ago, but someone else offered to buy it at 12 times Ebitda, and its debt is now trading at 2 times Ebitda," another source says. "We can make a great return."

To those schooled in traditional equity investing and company building, debt trading may not come intuitively. Distressed debt, as distinguished from distressed control investing, has been the specialty of a select few -- Apollo Management LP, Oaktree Capital Management LP, Cerberus Capital Management LP and Oak Hill Advisors LP.

Many private equity firms have considerable capital at their disposal in pools raised in 2007-'08, though that doesn't mean LPs aren't worried about whether the shift from equity to debt will be seamless. Some worry that general partners may not have the temperament or training for buying and selling debt if their orientation and philosophy have been attuned to growth equity. "Some firms like Apollo and a few others that really have debt and equity expertise may be perfectly suited to make the transition, but other personalities might not be," says one adviser to LPs.

The fear: that a GP may try to buy the distressed debt of a portfolio company that it acquired at inflated multiples. "I'd be uncomfortable with buying debt to support a company where the sponsor overpaid," says another adviser. "You're not likely to see those peak valuations and peak earnings that the company had for some time, so unless you believe it will add significant value, you're just throwing good money after bad."

New Mountain has received approval to carve out $300 million from its current $5.1 billion fund to invest in distressed debt, sources confirm. Its LPs, including new ones, have the option of additional co-investments.

Last year the firm hired Robert Hamlee, who managed distressed debt funds at New York-based GSC Group, and John Kline, also from GSC. New Mountain founder Steven Klinsky oversaw equity and debt deals as a Forstmann Little & Co. partner and is a co-founder of Goldman, Sachs & Co.'s leveraged buyout group. Douglas Londal, managing director and former Goldman executive, also handled debt and equity deals.

The firm isn't interested in buying debt in existing portfolio companies, a source says, largely to avoid the potential for conflict of interest. Twelve of the 16 companies in its active portfolio were acquired with no debt, and the rest are not distressed, he adds.

JLL has a provision in partnership agreements allowing it to invest up to 15% of capital in debt securities and has done so over the years, sources say. JLL is investing out of a $1.5 billion Fund V and a sixth fund, hoping to raise $2 billion. Sources say the firm has not historically bought debt in its holdings.

Likewise, Leonard Green, with LP consent, acquired debt positions within its current fund, a $5.3 billion pool completed in early 2007, before the the credit crunch, sources say. The firm avoids investing in its own companies' debt.

Both firms trace their lineage to junk bond pioneer Drexel Burnham Lambert. JLL managing director and co-founder Paul Levy previously managed restructurings and exchange offers at Drexel. All three managing partners at Leonard Green, John Danhakl, Peter Nolan and Jonathan Sokoloff, worked at Drexel.

Executives at all three firms declined to comment.

LPs who would rather not get more exposure to debt aren't pleased at a shift in strategy, which threatens to spill over to other midmarket GPs while LBOs are frozen. As one LP says, "As tough economic conditions threaten portfolios, I'm not so sure they should be taking their eyes off the ball."