No protection

From the ashes of torched markets, great fortunes are born. That hoary Wall Street truism (or words to that effect) has been voiced often of late by buyout industry moguls trying to put a sunny spin on these bleak times, even as they aim to show the maxim still holds true. History offers them cause for optimism.

Indeed, one of private equity's most celebrated investment coups was Leon Black's scarfing up Executive Life Insurance Co.'s distressed $8 billion junk bond portfolio for less than 50 cents on the dollar in 1991, when the economy was on its back. Black and his then-young firm, Apollo Advisors LP, wound up with a $2 billion profit. A decade later, the post-9/11 recession led to another steep drop in asset values -- a correction that set the stage for an era of unparalleled, debt-fueled profit taking.

But while in the past the buyout business has exhibited remarkable resilience, always picking itself up after every bad fall and then powering back to profitability, things may be different this cyclical go-round. Painfully different. Not even the profusion of bargain-priced deals and distressed securities plays available in today's battered markets have enough upside potential to blunt the damage much of the industry will suffer.

The hurt begins with the drying up of leveraged finance, the mother's milk of leveraged buyouts. Among its many effects, the dearth of debt has becalmed the once-feverish market in large-cap LBOs and slowed profit-taking to a trickle, particularly exits via sponsor-to-sponsor sales. As a consequence, the tidal wave of deal fees and carried-interest lucre that washed through buyout houses from 2004 to 2007 -- and that top U.S. firms like Kohlberg Kravis Roberts & Co. and Carlyle Group used in part to rev up global expansion and launch new investment vehicles -- has largely evaporated. Moreover, sponsors have been forced to fund deals they have gotten done predominantly with equity. According to Dealogic, the total dollar value of buyouts announced worldwide in 2008 through November ran 73% below last year's record-setting level: $182.9 billion, versus $670 billion during the first 11 months of 2007. The drop-off has been especially steep lately, with LBO volume down nearly 90% in October and November. Exits through sponsor-to-sponsor company sales were off 82%, Dealogic says.

The buyout industry, meanwhile, faces a far worse problem than a moribund LBO market and dwindling revenue. To their horror, sponsors have watched market values of their existing equity holdings nosedive, with some holdings pitching into the abyss. Because most of the holdings are private, the extent of the losses isn't as readily apparent as for public stocks, which have dropped an average of 37% this year. But one clear sign of the deteriorating worth of buyout-linked equities is where the bank loans of LBO'd companies currently are trading: at an average 76 cents on the dollar, according to a Standard & Poor's loan index. When senior loans trade that low, it implies a market value for the underlying equity of zilch.

Now contrary to what prices suggest, the odds are slim that most buyouts done from 2005 to 2007 will go down in flames. When loans of even a steady cash producer like First Data Corp., a credit-card transaction-processing company KKR acquired in 2007 for $29 billion, whose chance of default is fairly low, trade as much as 33% off par, it's a sign that fear and illiquidity are skewing prices.

Even so, not every expert dismisses the market's dreary message out of hand. Michael Zupon, who runs Carlyle's U.S. leveraged finance funds, says that if the recession is protracted and unusually acute, recovery rates on defaulted leveraged loans could be "significantly lower" than in previous downturns. "You cannot rely on past cycles as your guide in this market," he says. He also predicts a possible "fundamental shift in the way that certain businesses are valued," with the Ebitda multiples that investors apply to LBO'd businesses descending and staying down.

If that occurs, many of the raft of jumbo LBOs executed at the peak of the buyout boom in 2006 and 2007 -- some priced at stratospherically high Ebitda multiples -- may wind up losing money even if the target companies themselves perform well. Meanwhile, the economy's woes are starting to take down weaker performers, particularly retailers and other businesses that live and die on consumer spending. A half dozen or more private equity-backed retailers have gone bankrupt so far this year, and Standard & Poor's foresees the default rate for speculative-grade credits, currently 3.2%, possibly climbing as high as 9.6% by October. Among the bigger LBO'd companies now threatening to go bust are Sam Zell's Tribune Co.; Apollo Management LP's Realogy Corp., a residential real estate broker; the casino operator Harrah's Entertainment Inc., which Apollo co-owns with TPG Capital; Blackstone Group LP and Bain Capital LLC's Michaels Stores Inc.; and, needless to say, Cerberus Capital Management LP's Chrysler LLC.

Sponsors aren't sitting around bemoaning their fate. Virtually all the top firms now have distressed-debt investment funds, and they're angling to capitalize on the bloodied credit markets, à la Leon Black in 1991. Carlyle's Zupon says he sees "extraordinary opportunities" now that LBO loans trade in the 70s. Unfortunately, moves by several elite sponsors earlier this year to buy huge bundles of such loans at cut-rate prices -- 85 to 95 cents on the dollar -- have fared poorly so far. Having leveraged up to buy the loans, typically 4-to-1, they're showing hefty mark-to-market losses on the equity they sank into their purchases, and some firms have been hit with margin calls. Black himself, whose firm amassed more than $20 billion in face value of loans, is said to be sitting on a substantial loss. Buyout firms also have gotten scalded investing in ailing commercial banks.

But even if such down-cycle plays eventually turn a profit, they won't suffice to offset a weak showing in the bread-and-butter business of buyouts, because that's where the bulk of the industry's capital resides. And if the 2006-'07 crop of deals is generally a bust, that would drag down the industry's dollar-weighted returns for years -- an eventuality that would have unpleasant repercussions.

"If you add up all the capital risked in 2006 and 2007, it probably approached half of all the capital risked in the history of private equity," notes one industry executive. "It's going to take a while for LPs to digest" the results, he says. And if the results are as dismal as debt prices suggest? "I think that would have a strong effect in terms of LPs saying, 'I don't want private equity at all, or I want a lot less of it.' "

He and others are predicting a backlash from LPs, resulting in stingier capital pledges and shrinking fund sizes; a throttling back of expansion efforts by major players and a spate of layoffs; perhaps even cases where LPs renege on their commitments by refusing to fund certain deals. "I think we could see a wave of defaults" by disaffected LPs, the executive says.

If you thought 2008 was a rocky year for private equity, then brace yourself, because 2009 should be rougher yet.