UPDATE 2-Schaeffler warns Continental not to raise capital

(Adds paper, source on potential other bidders)

HANOVER, Germany Aug 5 (Reuters) - German automotive supplier Schaeffler Group warned takeover target Continental AG (CONG.DE) on Tuesday not to resort to a big capital increase as a way to fend off Schaeffler's hostile $17.5 billion bid.

The family-owned ball bearing specialist amended its takeover offer by dropping a condition that would call off the bid if Continental prepared during the offer period -- which still runs until Aug. 27 -- to raise its share capital.

"The Schaeffler group thus counters market speculation that its offer to Continental shareholders could be prevented by such preparatory measures," it said in a statement.

It stressed, however, that it was sticking to the condition that Continental could not carry out a capital increase during the bid period, thus making a takeover much more expensive.

It insisted Continental was legally prevented from taking any capital measures that would serve only to torpedo the 11.3 billion-euro ($17.48 billion) bid.

"The Schaeffler group, which now is Continental's biggest shareholder with more than 8 percent of the shares, considers the adoption of capital measures unjustifiable because they would harm the interests of Continental shareholders," it said.

Continental had no comment on the statement.

If the takeover happened, it would be the biggest so far this year in Europe and would put the combined group third behind Robert Bosch GmbH [ROBG.UL] and Japan's Denso Corp (6902.T) among the world's top suppliers to the automotive industry.

LOAN TALKS

The German fencing match came as Schaeffler lines up ranks of banks to help finance the deal.

The loan backing the bid totals 16.1 billion euros, a banking source told Reuters Loan Pricing Corp in London.

The loan was launched to Schaeffler's key relationship banks last week and a bank meeting has been scheduled for Aug. 8 in Frankfurt. Those banks have been invited to commit 700 million euros to the fully underwritten deal, the source said.

Advisers for Continental and Schaeffler continue to hold unofficial talks as the two sides seek a solution that would save face for both, sources familiar with the situation said, but few bankers thought a friendly deal was possible.

Schaeffler is not considering a substantial increase in its offer or limiting its targeted stake to less than 30 percent, as Continental has demanded, according to several bankers advising the family-owned company.

Continental will make its official recommendation to shareholders next week regarding the takeover bid, which it has so far rejected.

A source close to Continental told Reuters the company was in talks with a five strategic and financial investors that it hopes might outbid Schaeffler.

The search for a white knight could be difficult, however, because of antitrust issues and a difficult market environment that makes it tough to finance large takeovers.

German daily Handelsblatt reported in a preview of a story to be published on Wednesday, citing financial sources, that Continental was in talks with private equity firms Apollo and KKR about a friendly bid.

A financial source told Reuters KKR had no interest.

Continental declined to comment.

Continental shares closed up 0.4 percent at 72.21 euros, above the 70.12 euro per share cash offer that Schaeffler has proposed, which represents the legal minimum. ($1=.6466 Euro) (Reporting by Arno Schuetze in Hanover, with additional reporting by Philipp Halstrick in Frankfurt and Alisdair Reilly in London; editing by Tony Austin and Gerald E. McCormick)