The deleveraging of the economy in the wake of the economic crisis has dealt an especially crippling blow to private equity, an industry long as reliant on debt as candy makers are on sugar. For a blissful four-year span that lasted into 2007, leveraged buyout sponsors raked in vast profits fueled by oceans of cheap debt and by soaring asset valuations and a booming economy that were debt-propelled. Today that golden age seems as remote as the lost empire of the Incas.

"It's fair to say that the days of cheap debt in massive quantities as a major driver of private equity returns are not coming back soon," says John Eydenberg, who heads the financial sponsors group for the Americas at Deutsche Bank AG. "I think we may never again see the peak debt conditions we saw in 2006 and 2007." Says Steve Smith, UBS' global head of leveraged finance and restructuring: "I don't see them happening again for the rest of my career."

-- See related story: That worrying wall of debt --

Which raises the most critical issue private equity sponsors and their financial backers now face: Namely, what will life be like in a world where debt has all but dried up, such as now, or doesn't flow freely?

In one key area, it turns out, private equity is sitting pretty. Before the economy worsened drastically last fall, the industry replenished its coffers, drawing more than $550 billion in pledges from institutional investors in 2008, a near record. Two leading lights, Leon Black's Apollo Management LP and David Bonderman's TPG Capital, raised upward of $15 billion or more, their biggest funds ever.

Buyout firms now command some $470 billion in committed but uninvested capital, according to consulting firm McKinsey & Co. Moreover, sponsors usually only dream about this sort of investment environment, with countless companies begging for capital, banks and other capital suppliers on the sidelines, and deal values way down. Prices have tumbled so steeply, one sponsor remarks, that even debt-free investments done today could bring sterling returns after the economy turns back up.

"Returns in private equity have been highest in tight credit markets, when you're buying into a downturn," one industry executive says. "It's times like this that you find the most interesting deals."

But for now, that alluring prospect is vying for sponsors' attention with a worrisome, brewing development that could lay waste private equity returns and foster an industry shakeout. Though previous downturns have forced slews of poor performers, including some well-known names, from the business, the body count this time could be great. The problem lies in the staggering amounts of equity and debt capital that poured into LBOs from 2004 to 2007. From 2012 to 2014, about $430 billion of senior debt tied to that deal spree is set to come due. And unless the leveraged loan market roars back to life by then to accommodate a mass of refinancings -- something experts consider doubtful -- an avalanche of defaults could wipe out much of the equity the buyout industry wagered on scores of deals.

Most problematic are 55 megadeals that range in size from $5 billion to $45 billion. (The latter figure is what Kohlberg Kravis Roberts & Co. and TPG paid for TXU Corp., now Energy Future Holdings Corp., a Texas power outfit, in 2007, the largest LBO ever.) By McKinsey's reckoning, about $240 billion, or about 40%, of the equity capital that private equity firms put out from 2004 to 2007 went into megadeals. For the most part, the firms that backed these deals are an industry Who's Who.

Already some big deals have gone bankrupt, such as Chrysler LLC, whose biggest investor was Cerberus Capital Management LP, aluminum maker Aleris International Inc. (TPG), Tribune Co. (Sam Zell) and Linens 'n Things Inc. (Apollo). Those four obliterated over $8 billion of invested equity. Others are hanging on, some just barely. What's more, even relatively sound enterprises like Energy Future could find it hard to escape default in a stingy credit market.

"There will be a lot of RJRs," one buyout specialist predicts, alluding to KKR's $31.3 billion buyout of RJR Nabisco in 1989, which held the size record for an LBO for 16 years and which lost money for KKR. "Not bad companies necessarily, but companies with capital structures the sponsors can't extricate themselves from and that can't be refinanced."

This investor says he expects one-quarter of the megadeals to be total busts, another quarter to make a profit and half to post a partial loss. "But that's only if the economy recovers," he adds. "If it doesn't, those deals are all toast."

One top LBO banker calls even that scenario too bullish. "If we do have capital markets in, say, 2012, sponsors could have to refinance at grotesquely high interest rates, and that will permanently impair their equity," he says. "That's the good case." If, on the other hand, credit is scarce, sponsors may have to sell stock in their albatross deals to pay off debt, massively diluting their own stakes. Weak performers may end up being sold at a loss to deep-pocketed corporations or broken up and sold in pieces. Creditors would recover a fraction of what they lent, and sponsors would get zilch.

Consider the not atypical plight of First Data Corp. When KKR bought the credit- and debit-card transaction processor for $29 billion in September 2007, it piled on $22 billion of debt, the equivalent of 11 times Ebitda the year before the LBO. The acquisition value was a stratospheric 16 times Ebitda. Even after adjusting for $300 million in annual operating cost cuts, the deal value was lofty, at 11 times Ebitda.

Like nearly every target of the buyout binge, First Data has gotten a big lift from one byproduct of the downturn: falling interest costs. LIBOR, the benchmark interest rate for First Data's $12.9 billion bank loan, has gone from 5.5% to under 1% since the LBO, and as a result, in the quarter ended March 31, First Data's interest expense fell to $448 million, from $518 million a year earlier. But adjusted Ebitda fell still more steeply, from $577 million to $491 million. That narrowed the gap between cash flow and nominal interest expense from $59 million to just $43 million. For now, First Data isn't producing enough free cash flow to pay down debt.

Even if a rising economy buoys First Data, the company could be forced into a painful restructuring when its bank loan falls due in 2014. In a liquid leveraged loan market, lenders might not think twice about rolling over their debt. But if the market remains thin and insolvency looms in 2014 for some of First Data's own lenders, which include highly leveraged collateralized loan obligation vehicles, the creditors may drive a very tough bargain with KKR and the company.

"If a company can't pay back creditors, there are limits to what you can do," says Richard Epling, a corporate bankruptcy lawyer at Pillsbury Winthrop Shaw Pittman LLP, speaking in general about solvent companies that cannot refinance. "Just maybe you'll find a [bankruptcy] judge who will stretch out maturities at a market rate of interest. But I'm thinking that's going to be little hard," says Epling, who has represented creditors and borrowers alike.

He says it wouldn't surprise him if creditors, including vulture private equity firms that have snapped up loans and bonds, wrest control of largely healthy but debt-freighted businesses if markets are anemic when their debt matures.

Well in advance of the 2012-'14 maturity bubble, sponsors are working frantically to forestall calamity by downsizing LBO debt and extending maturities bit by bit.

In recent weeks, hospital operator HCA Inc., which KKR bought in 2006 for $33 billion, sold secured senior bonds to retire $1.5 billion of its $12 billion term loan. While the bonds' coupon, 8.5%, topped the interest rate of the loan, the deal enabled HCA to reschedule the due date of that sliver of debt from 2012 to 2019.

Other private equity-controlled companies, such as Blackstone Group LP's Graham Packaging Co. LP, have persuaded lenders to push out loan maturities a couple of years in exchange for slightly higher interest. Deutsche Bank's Eydenberg says he expects activity in HCA-style secured bonds-for-loan swaps and in renegotiated maturities to exceed $100 billion a year for the next few years.

More rickety companies, meanwhile, have turned to distressed-debt exchanges to slash debt. The exchanges are ways to erase loads of unsecured, high-coupon bonds trading at pennies on the dollar by offering smaller quantities of secured, not-so-risky notes in exchange. A small army of companies have employed the move, including four companies in Apollo's stable. One of them, casino owner Harrah's Entertainment Inc., whose revenue has nosedived since Apollo and TPG bought it for $29 billion, has employed a combination of techniques to chip away at its debt and stretch maturities.

The least-used maneuver is the most obvious: raising equity to retire debt. The reason sponsors have avoided it is because it would severely corrode their returns. Nevertheless, one banker predicts "a raft" of equity deals. "If we stay in a market where equities are static and credit is static," he says, costly and dilutive equity cures are sure to proliferate.

Will the private equity industry's all-out campaign to delever reduce defaults and avert disaster? Some experts are optimistic, though much will turn on the economy's health.

"Many of the mega-LBOs were of best-in-class companies whose earnings power coming off the [economic] bottom will be pretty high," observes Eydenberg, who says maneuvers such as debt swaps could buy precious time. "Many have cut costs dramatically to insulate their Ebitda, and they have very flexible debt structures. I don't expect to see the healthy ones going down, and I think the 2006-'07 class of LBOs will have a much lower default rate than many think."

Nevertheless, the returns that LBOs done at the market's peak ultimately deliver, many say, are apt to be skimpy at best, and not solely because of the colossal debt. Another drag on returns will be the bloated LBO valuations of that era. With money now tight, sponsors have little chance of selling their holdings for close to the valuations they paid. "My prediction is that many private equity funds of that vintage won't return capital, won't break even. Those that do will be top-quartile [performers]," says an executive at a major buyout house. "The industry will be challenged and tested in a way it never has before."

One major test will be how adeptly the industry wields its $470 billion purse. Investment houses built on debt must be able to reap decent gains from lightly leveraged acquisitions and debt-free financial bailouts. For buyout firms reeling from LBO losses, that money may be a path to redemption.

Over the past quarter century, private equity has realized some of its richest gains investing when values are beaten down. Two buyout titans, in fact, Leon Black of Apollo and TPG's David Bonderman, first gained fame as distressed-asset players, and even now Black is perhaps best known for the fortune he made years ago buying and selling junk bonds he'd grabbed from a defunct insurer, Executive Life Insurance Co.

After a flurry of bank-bailout deals early last year that mostly backfired because the firms bought in too early, private equity has started once again to plow serious money into downtrodden financial institutions. Two weeks ago, Wilbur Ross' WL Ross & Co. LLC, Blackstone, Carlyle Group and Centerbridge Partners LP teamed on a $900 million, government-assisted equity bailout of Coral Gables, Fla.-based BankUnited Financial Corp. Earlier this year, JC Flowers & Co. LLC led a group that acquired assets from failed mortgage lender IndyMac Bancorp, and in December, MatlinPatterson Global Advisers LLC agreed to prop up Flagstar Bancorp Inc. As happened in the late-1980s S&L crisis, regulators see the private equity industry's vast store of capital as a partial remedy for the banking system's ills.

In the industrial sector, vulture firms are starting to pounce on rivals' misfortunes. In March, for instance, Apollo and Oaktree Capital Management LP parlayed their debt positions in Aleris, the bankrupt aluminum maker TPG had owned, into a controlling stake, and buyout houses are amassing struggling companies' bonds and loans on the cheap for speculative aims or with an eye to taking them over.

Still, deal activity will likely stay tepid until the economy has definitively touched bottom. "It's still really, really early in this whole process," one industry executive says. "The problem is that buyers' expectations and sellers' expectations are in a different place. But once expectations come into line -- and they are starting to -- deal volume will pick up dramatically."

Even then, the legacy of their mid-decade excesses will dog private equity firms for years. The fallout, say many, will be ugly. Boston Consulting Group Inc. says that as many as 20% to 40% of all PE houses will close down as LPs redirect capital pledges to the strongest.

What's more, there will likely be a drastic overhaul of how private equity operates, some sponsors say. Many expect the hefty transaction fees firms have collected, which in some megadeals topped $200 million, to be reined in. Megadeals themselves will be a casualty, and buyout funds will be scaled back to reflect the downshift in debt financing.

"A lot of people now are talking about a new alignment of financial incentives for private equity and hedge funds," a buyout sponsor observes. "The incentives to do deals were skewed by the [huge] fees that sponsors and bankers were pocketing." Likening the deal binge to a hamster running furiously on a wheel, he says: "People will look back and ask, 'Why did the hamster run like that?' It was because of the food it saw in front of it.

"That kind of incentive makes sense for a hamster. But it led to the insanity" that gripped the buyout market, he says.

He and others argue that when LBO activity eventually revives, banks and sponsors alike, chastened by the pain they caused themselves in the mid-2000s, will keep a lid on leverage and structure deals prudently. "It will be like what happened to venture capital" after the bursting of the tech and telecom bubble in 2001, he argues. "People didn't dispose of the VC model," but overhauled it.

Others aren't so sanguine about private equity's ability to learn. "At some point the competition for deals will heat back up," says UBS' Smith. "People's memories fade. I'm highly confident that we will overcook the market again. It happens every 20 or 30 years.

"The next time it does," he says with a laugh, "I hope I'm around to participate."