Private equity to beat hedgies to distressed assets

LONDON (Reuters) - Cash-rich private equity firms such as Apollo, Blackstone and TPG are set to sprint ahead of more cautious hedge funds in the race to snap up cheap distressed assets -- at least for now.

With pockets still full after raising billions of dollars during the credit bonanza, but their traditional leveraged buy-out market practically dried up, private equity firms will be forced to look elsewhere, and can hang on to distressed assets for years to make big returns.

In contrast, hedge funds, who report performance data to investors every month and have to mark investments to market value, are not yet ready to take such an active approach.

"Private equity players are frankly in a better position to take on some of the risks, especially the larger positions," said Chris Goekjian, chief investment officer at Altedge Capital, which runs $700 million in fund of hedge fund assets.

"Private equity players have locked-in money. Distressed hedge funds can have quarterly or annual redemptions rights, so they definitely can get money pulled. If they take on larger deals and get redemptions, it hurts."

Private equity firms, once financed by banks, have now reversed the role and turned into financiers of large institutions such as Citigroup (C.N) or Merrill Lynch MER.N, which are under investor pressure to clear their decks of risky assets.

Private equity firms have bought about $25-$30 billion of leveraged loans from banks over the past 12 months, helping reduce banks' backlog of leveraged loan holdings to $45 billion from $237 billion a year earlier, according to Standard & Poor's data.

Last month Lone Star bought Merrill Lynch's portfolio of Collateralised Debt Obligations (CDOs) for only 22 cents on the dollar following a similar recent deal between UBS (UBSN.VX) and fund manager BlackRock (BLK.N).

More of these deals will follow, S&P said in a recent note.

Lehman Brothers LEH.N and Deutsche Bank (DBKGn.DE), as well as most Spanish banks, including Banco Popular (POP.MC) and savings bank Caja Madrid, are also planning loan sales, people familiar with the situations have told Reuters.

Such deals are "opportunistic attempts by larger, deep-pocketed private equity sponsors to maximise risk-adjusted returns in an environment where there are few outlets for traditional strategies, such as buy-outs," S&P said.

ROOTS

Private equity's forays into distressed investing won't surprise those with long memories.

Most private equity firms started in the mid 1980s investing in the junk bond market, whose eventual implosion eventually sank sector specialist Drexel Burnham Lambert. After its bankruptcy some former bankers moved into private equity and began buying high-yield bonds at deeply discounted prices again.

"A number of buyers have been in the distressed debt business since the 1990s and are now either coming back to their roots or are redoubling their focus in the sector to take advantage of fallout from the credit crunch," said Robert Young, Associate Partner at Deloitte in London.

The firms are now banking on this experience, said Mark Fennessy, restructuring partner at law firm Orrick in London.

"They have the analytical and restructuring talent combined to ensure they can get deals," Fennessy said. "Certain hedge funds lack real experience of having these deals."

HEDGE FUNDS HOLD FIRE

In contrast, hedge fund managers are reluctant to commit too much capital to distressed assets yet, having been burned buying some cheap assets only to see them become even cheaper.

"With mark-to-market, something that was offering a 20 percent annualised return could now be offering a 25 percent annualised return (meaning the price has fallen) ... which is why you've got to be careful," said Ken Kinsey-Quick, fund of hedge funds manager at Thames River Capital.

Distressed funds lost 3.92 percent from the start of the year to end-July, according to Credit Suisse/Tremont.

"The short-term environment is still very challenging," said Odi Lahav, head of Moody's European Alternative Investment Group. "With a typical holding period of about 18 months ... more recent investments have yet to hit the bottom line."

The longer-term picture into 2009 and 2010 looks better.

With some bankruptcies delayed because firms are still benefiting from "covenant-lite" deals struck in the first half of 2007, and structured credit assets simply not liquid enough yet, hedge funds are keeping their powder dry.

"Most hedge fund managers we speak to think it's a little early to go in (to structured finance), because if you buy paper now you may own it for a long time," said Altedge's Goekjian.

"Maybe later this year or early 2009 we'll start to see liquidity come back, and this could be a very interesting area."