The debt markets for buyouts have snapped back to a reality from which they're not likely to stray soon. While a killjoy for private equity, it may be a good thing for debtholders.

"We've corrected to a place where you feel better about ultimately owning the credit risk," says a banker involved in arranging sponsor deals.

While it didn't coincide with an economic tsunami of any sort, the reality check took hold the week of June 20, with both a key austerity vote looming in Greece and nasty negotiations on the U.S. debt ceiling extension. Suddenly, major buyouts that had locked down financing commitments earlier in the year lost money for banks, opportunistic refinancings stalled, debt rates jumped about 100 basis points, and lenders began to recall the original purpose of covenants.

Some $17.6 billion in institutional debt "flexed up" in the second quarter, versus just $11.6 billion that "flexed down" in that period, according to Thomson Reuters Loan Pricing Corp. The "flex" is the room banks have to tweak debt they're arranging after they've committed but before they've syndicated it; flexing up usually entails increasing the interest rate or cost of the loan to the borrower in some way -- often to the chagrin of sponsors. Tellingly, that's the highest-volume flexing up, both in absolute terms and as an up-versus-down ratio, since the third quarter of 2007, when banks began choking on hundreds of billions in bank debt from megadeals.

The financing that most clearly delineated the pullback was for the $2 billion buyout of Lawson Software Inc. by Golden Gate Capital and Infor Global Solutions, announced April 26. Banks committed to a $1.04 billion term loan and a bridge to be taken out by bonds. Lenders on the deal were Credit Suisse Group, Bank of America Merrill Lynch, Deutsche Bank AG, Morgan Stanley and Royal Bank of Canada, according to regulatory filings. By June 6 the pricing on the term loan was shaping up to be LIBOR plus 450 basis points with a 1.5% LIBOR floor and a 98.5-99 original issue discount.

But over the next three weeks, fears over Greece mounted while battling over the debt ceiling intensified. On June 21 the price for Lawson's loan leaped 50 basis points and increased the discount by a cent on the dollar, only to notch the loan up a further 25 basis points while deepening the discount to 96 less than a week later. Still, that wasn't enough for lead arranger Credit Suisse to syndicate out the entire amount -- this is where Wall Street likely took some hits -- as the banks unloaded only $600 million to hesitant buyers and had to hold the other $440 million, agreeing not to sell below a 96 original issue discount for 120 days.

On June 29, the Greek Parliament approved new austerity measures, and debt buyers noticed there wasn't much supply available. Lawson's bonds were performing well, and Credit Suisse didn't appear to be caving any further after maxing out nearly all its flex options. Investors began buying Lawson at 96 or above on July 1, allowing Credit Suisse to unload everything by July 6. Other financings where banks have lost or will lose money, according to sources familiar with the deals, include the buyouts of CKx Inc. and SRA International Inc., and Cumulus Media Inc.'s acquisition of Citadel Broadcasting Corp. -- adding Goldman, Sachs & Co., Citigroup Inc., J.P. Morgan Chase & Co., UBS and Macquarie Capital to the banks arranging corrected deals.

Bankers point to high levels of froth up to that point. The availability of credit had spawned a feeding frenzy, with yield seekers pouring money into bond funds, only to see that used to refinance loans, the capital from which would need to be redeployed. Covenant-lite and payment-in-kind -- not to say unlimited restricted-payment -- deals had become uncomfortably common. And a relative dearth of M&A meant banks were competing ferociously for business, pricing loans as tightly as possible where any shift could have canceled out fees and caused losses, which is what happened.

But that low volume also means there's just $11.5 billion of leveraged buyout debt coming to market as of July 14 this year, according to LPC, versus $189.7 billion in July 2007. So the amount of money lost will be small -- a few million dollars per deal. Overall, deals that need financing now can get it, bankers say, whereas opportunistic deals will wait for better terms in the fall -- after the early-August deadline to extend the debt ceiling.