LBO Shops Drove Debt Boom; Now, They Profit From Its Fall

By HENNY SENDER
August 15, 2007; Page C1

Private-equity firms helped create billions of dollars in debt during the leveraged-buyout boom. Now some of those funds are eyeing and buying that very same debt at discounts as its value plunges.

Borrowed money has been the fuel of the deal boom in recent years. Private-equity firms loaded up the companies they purchased with huge debts -- bank loans and bonds -- to finance their purchases. Those loans, arranged by Wall Street, were then sold to hedge funds and other investors in a deal machine that chugged along energetically for years.

But the recent credit crunch has thrown a wrench in the gears by frightening off many buyers of those loans. That has left the banks that arranged the financing holding some of the debt while other debt issued before the current turmoil in the debt market rapidly drops in value.

Three weeks ago, with investors increasingly spooked, the banks that arranged financing for private-equity giant Kohlberg Kravis Roberts & Co.'s buyout of Goodlettsville, Tenn.-based retailer Dollar General agreed to sell some of that debt for as little as 87 cents on each dollar owed. Hedge funds led by TPG-Axon, an affiliate of TPG, swooped in, attracted by returns of close to 18%.

Indeed, that could turn out to be a better return than what KKR earns as Dollar General's new owner, with far less risk, given how much KKR paid to buy the dollar-store chain.

The Dollar General deals show just how quickly calculations around deals has changed. Until recently, the buyout game has focused on buying the stock, or equity, of companies whatever the price, as private-equity firms bet they could quickly take their money off the table. That's because a number of deals clinched by buyout firms took place at lofty prices and after heated auctions. Now, investors in the bonds of these companies are nervous, sending down their prices -- and presenting an opportunity for some firms who see buying the debt as a way to make a potentially rich return.

Meanwhile, the kind of 20% returns that buyout firms had become used to aiming for in many buyout deals look increasingly unlikely. Tony James, president of private-equity firm the Blackstone Group this week noted how only recently it was being routinely outbid by 10% to 15% by rivals in auctions for companies.

Now, he noted, that reluctance to bid higher has left Blackstone with plenty of capital to turn its sights to the debt market looking for similar bargains, Mr. James said.

TPG, the former Texas Pacific Group, and the Carlyle Group also have funds aimed at investing in debt, a large part of which was raised to finance buyouts. Executives at many private-equity firms say that could even include investing in the debt of their own deals.

Today, the underwriters who agreed to provide and arrange financing for those deals are often stuck holding debt they haven't been willing to sell to investors. For now, those banks are holding most of the debt on their own books. But because they are obligated to provide financing for a huge pipeline of $400 billion in deal financing globally still to be done, many expect they'll eventually have to resort to selling the loans at a discount.

Some underwriters, especially the Wall Street firms, can't afford to hold all that debt, especially as their own stock prices sag. For now, though, fire sales on debt have been limited while all the arrangers of the debt, who need to agree on the pricing of all this debt, argue about what to do based on their own financial interests and the size of their own balance sheets.

Still, potential buyers insist the sheer size and number of deals in the pipeline will eventually force discounting of the loans and bonds. These deals include BCE Inc. , Alltel Corp., First Data Corp. and TXU Corp.

Meanwhile, prominent debt investors like Marc Lasry of Avenue Capital are raising new money to boost the size of their latest funds. Mr. Lasry's has expanded the latest fund to $7 billion from $5 billion.

"Our debt fund is fishing," says Steve Rattner, founding partner of Quadrangle Group. "The opportunities are interesting but not yet compelling. There is not yet sufficient fear in the market."

One reason many expect increasingly better deals in the debt market on new loans and bonds is the prices on the debt that is already being traded. The debt of recent deals trades far below the levels of just a few weeks ago.

Take, Realogy Corp., a firm offering real-estate brokerage and other services Apollo Management bought months ago for $6.7 billion. That price was nine times its earnings before interest, tax, depreciation and amortization.

Today the bank debt trades at 93 cents on the dollar while the bonds trade at around 75 cents on the dollar, investors say. Still, many potential buyers add that they are holding off because Realogy is sensitive to the housing downturn. That means the debt isn't likely to return to better levels any time soon and could trade down a lot more.

But even at today's level, the return on the debt is likely to surpass the return on the equity from the deal, with far less potential risk. Moreover, if the company encounters even stronger head winds and one day defaults, the debt holders would wind up owning the firm.

The private-equity firms say that even if their companies have a lot of debt, these companies are far larger and stronger than in the past and have such flexible capital that they can withstand any storm. If they are wrong, of course, debt today that trades at 87 cents on the dollar will obviously fall much further.

But with current yields above 15% and the possible upside of debt turning to equity, private-equity firms are increasingly embracing these trades.

Write to Henny Sender at henny.sender@wsj.com