Wagering on debt

History suggests that when the economy stagnates, the buyout market fizzles and leveraged loan and junk bond prices drop, many opportunistic leveraged buyout players' fancy turns from deploying equity to snapping up distressed corporate debt. Fortunes were made in distressed credits in the 1990-'91 and 2002 downturns -- most famously, the estimated $2 billion profit Leon Black gleaned from his $3.5 billion purchase 17 years ago of the junk bond portfolio of insolvent Executive Life Insurance Co.

Today, as then, a credit crunch and limp economy have given rise to some major debt purchases by LBO houses. In fact, the buyout industry's only megadeals this year have targeted LBO loans from banks that had been stuck holding them when the credit markets tanked. Most of the loans financed LBOs done last year.

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A recent Standard & Poor's report puts the total value of the offloaded LBO loans at nearly $30 billion. The sales, involving such deep-pocketed buyers as Leon Black's Apollo Management LP, Blackstone Group LP and TPG Capital, have helped banks scale back the LBO loans clogging their books from $237 billion in July 2007 to $45 billion in July 2008. On average, banks have sold the loans for 15% to 20% below face value.

A feast for vultures
Major debt sales by banks in 2008
Date	Buyers(s)	Seller(s)	Kind of debt	Purchase price ($bill.)	% Discount to face value
May	BlackRock Inc.	UBS	Mortgage	$15.0	32%
April	Apollo Management LP, Blackstone Group, TPG Capital	Citigroup Inc.	LBO	12.0	15-20
August	Apollo Management, Blackstone Group's GSO unit, TPG Capital	Royal Bank of Scotland plc	LBO	Up to 8.0	NA
May - June	Blackstone Group's GSO unit	Citigroup Inc., Deutsche Bank AG, Royal Bank of Scotland plc	LBO	7.8	15
July	Lone Star Funds	Merrill Lynch & Co.	Asset-backed	6.7	78
Sources: Standard & Poor's, The Deal

Also in 2008, financial buyers snapped up at least a further $21.7 billion of mortgage loans and asset-backed securities from banks.

But despite superficial similarities, private equity's recent forays into cheap debt are distinctly different from distressed plays of the past, experts say. That's because today's debt market is very unlike those of 1990-'91 and 2002. The main difference lies in a disconnect today between the quality of loans and their market values. Just because an LBO loan today trades at 15% below par -- a telltale sign of distress in ordinary times -- doesn't mean the company that issued it is in trouble, experts note.

Rather, the biggest reason LBO loan values have tumbled is that traditional leveraged loan buyers have fled the market, limiting demand. In fact, most of the LBO loans banks have dumped this year were reasonably solid credits.

Meanwhile, the debt of truly troubled companies by and large hasn't fallen enough to entice many sponsors. In today's market, many healthy credits trade at distressed levels, while a lot of genuinely distressed debt seems overpriced to many private equity buyers.

The latter, says Howard Marks, chairman of Oaktree Capital Management LLC of Los Angeles, one of the country's biggest alternative asset managers and distressed debt investors, explains why financial buyers haven't plunged eagerly into the distressed arena.

Outside of a handful of depressed sectors, such as housing and retail, "there's not a lot of [debt] selling at giveaway prices," he says. Marks also remarked upon the proliferation from 2005 to 2007 of "covenant-lite" loans, used to finance many large-cap LBOs. Such loans, he says, help explain the lack of recent deals in which financial buyers scoop up distressed debt with an eye to taking over troubled companies by swapping debt for equity in a subsequent restructuring.

Oaktree pulled off takeovers of this kind in the early 2000s, including those of appliance maker Sunbeam Corp., cable operator Classic Communications and apparel maker Maidenform Brands Inc. But because covenant-lite deals are designed to forestall defaults and make it harder for creditors to force ailing companies to restructure, they've discouraged debt-driven takeovers.

"Defaults are still the No. 1 element that gives us our opportunities," Marks says. "And right now, default rates are very, very low."

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