UPDATE 1-Lone Star-Merrill deal marks power shift to funds

(Adds background in eighth paragraph, bond prices)

NEW YORK, July 29 (Reuters) - Lone Star's deal to buy bad loans from Merrill Lynch & Co MER.N signals a growing power shift as private equity firms mop up after the year-long credit crisis.

Merrill Lynch said on Monday it will take a $5.7 billion third-quarter write-down as it unloads large holdings of risky debt. More than $400 billion of write-downs and losses at major banks since last year characterized the first phase of the financial crisis.

“The second part of the story is the distressed funds that have been raising funds to take advantage of motivated sellers,” said Frank Morgan, president of the UK-based Coller Capital’s U.S. unit in New York, where it has $8.5 billion in assets under management.

The Merrill deal included the sale of $30.6 billion of repackaged debt known as collateralized debt obligations, or CDOs, to buyout firm Lone Star Funds, for just $6.7 billion, or about 22 cents on the dollar.

Dallas-based Lone Star has some $23 billion under management, making it one of the larger buyout funds, but it has a reputation for secrecy. It was founded in 1995 by financier John Grayken, who formerly worked for billionaire Robert Bass.

Funds specializing in distressed assets swelled to $129 billion, their highest ever, from $118 billion at the end of 2007, according to industry tracker Hedge Fund Research.

Other funds, including Marathon Asset Management and Avenue Capital Group, recently have raised billions of dollars for distressed opportunities, according to sources familiar with the two funds. The companies declined to comment on their fund-raising activities.

Lone Star, which recently raised $10 billion in two funds, declined to comment. The Lone Star deal will result in a $4.4 billion write-down for Merrill and it will finance about 75 percent of the purchase price, Merrill said.

“It’s a great deal for Lone Star and I think they are going to make a lot of money,” said Tom Benninger, founder of Global Leveraged Capital Management, a $1 billion fund that buys distressed debt and other assets.

The market views CDO assets as “toxic” and has driven down the prices well into distressed territory, but many CDOs continue to generate substantial cash flows from non-defaulted mortgage holders, said Benninger.

“Everyone thinks they are toxic, but they have underlying cash flow,” Benninger said. Still, public investment banks like Merrill are under pressure to clean up their balance sheets.

“When you sell them, you lock in the losses,” he said. “If this was a private company, you would reconsider a sale at those prices.”

Merrill Lynch’s 6.875 bond due in 2018 gained on Tuesday as its spread narrowed 19 basis points to 383 basis points over U.S. Treasuries, according to MarketAxess data.

The Merrill deal is the latest distressed purchase for Lone Star. CIT Group Inc CIT.N said on Tuesday that it had agreed to sell a $9.3 billion subprime mortgage portfolio to them for $1.5 billion in cash, with Lone Star assuming $4.4 billion of outstanding debt and other liabilities.

The ability for Lone Star to take down these assets also shows that the current market is very dynamic and private buyers may be a source for unlocking frozen credit markets.

“This particular crisis is different from previous crises in that there are very well-heeled investors in the market,” said David Snow, executive editor of Private Equity International, a trade magazine based in New York. “This may be a hopeful sign of a certain amount of liquidity from these private investors that will allow the gridlock to be broken.”

Merrill also benefits by being able to clean up its balance sheet and get rid of the securities.

Private investors and sovereign wealth funds “can take risks that large corporations can’t take,” Snow said. “This is another changing of the guard in the investment world with a new and different sort of financial institution exercising a lot of influence and flexing a lot of muscle.” (Editing by Jonathan Oatis)