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Funds News

New debt funds get off to a tough start

NEW YORK (Reuters) - Vulture funds aiming to sink their claws into unwanted leveraged buyout debt are having a hard time getting off the ground.

The funds being raised by private equity firms and hedge funds to take advantage of the credit squeeze are not finding the bargain prices they hoped for.

Instead, loans are selling for around 96 cents on the dollar -- hardly the 90-cent-or-below fire sale prices the funds are banking on.

While there is still more than $300 billion of leveraged buyout (LBO) debt hung up on Wall Street, credit markets are holding up fairly well. Banks have taken heavy write-downs but the damage has not been as bad as some analysts predicted.

So with the credit markets chugging along, some are questioning the wisdom behind the LBO debt funds that firms such as Citigroup Inc C.N, Goldman Sachs GS.N, Kohlberg Kravis Roberts & Co KKR.UL and TPG Capital TPG.UL reportedly are pursuing.

“I personally believe that too much money is being raised to do this,” said Scott Malpass, vice president and chief investment officer at the University of Notre Dame.

“And now that the volatility has gone away, and spreads have started to tighten again, banks will want to be more patient and tougher at what they want to sell the loans at,” said Malpass, who invests part of the school’s $5.7 billion endowment into private equity firms.

Private equity firms buy companies by borrowing most of the money. Frothy credit markets allowed buyout firms to do more than $1 trillion of deals in the last two years.

Food chain Dunkin' Donuts, broadcaster Univision, hospital group HCA and Hilton Hotels Corp HLT.N -- whose deal is expected to close this month -- all agreed to be bought by private equity firms.

The credit crunch this summer cut off borrowing from banks and spooked debt investors, leaving banks stuck with more than $300 billion of loans on their balance sheets, the so-called hung debt.

That scenario prompted the new crop of vulture funds.

DISCUSSIONS

Citigroup and KKR are in discussions about a type of fund that would invest in banks’ hung debt, according to sources familiar with the matter. Citi and KKR declined to comment about the arrangement.

Citigroup may allow KKR to borrow as much as $8 billion for the fund, with KKR providing $2 billion through its Strategic Capital Fund, Financial News reported on Wednesday.

The Citi-KKR arrangement has stunned some on Wall Street.

After all, a big chunk of Citigroup’s hung loans come from deals orchestrated by none other than KKR. Citigroup took a huge write-down in its quarterly earnings, in part from hung loans. KKR’s $26 billion buyout of payment processor First Data Corp was among the deals that Citigroup got stuck with.

Therefore, Citigroup is apparently agreeing to a fund that lets KKR grab loans from the bank on the cheap -- even though KKR was responsible for many of the hung loans in the first place.

The math of the vulture funds goes as follows: A private equity firm raises $1 billion and gets another $3 billion from banks for a debt vulture fund. The fund looks to buy debt around 90 cents on the dollar, hoping to get a roughly 20 percent return on its investment.

It hopes that banks would look to get rid of all the loans stuck on their balance sheets at a bargain price. Doing so would allow them to start lending again, and keep them from taking a loss on the loans.

The vulture funds, meanwhile, would sell the loans later for a premium when the markets recover.

But that scenario hasn’t played out. Not yet at least.

First Data’s loans, for example, priced at between 96 cents and 98 cents on the dollar. Loans for the $5.6 billion private equity buyout of Allison Transmission sold for 96 cents. At that price, it’s a 4 cent haircut for the banks, but that’s not as bad as some predicted.

Debt investors with lower return thresholds than private equity or hedge funds have shown that they’re willing to step in to buy the hung loans.

Of course, should a recession hit and credit markets worsen, the current climate would change, allowing the vulture funds to see plenty of opportunities.

“It’s a long game and we’re in early innings,” said Erik Hirsch, chief executive officer at Hamilton Lane, a firm that oversees commitments of more than $50 billion from institutional investors.

“The loans aren’t being bought at big discount prices, and the funds may not end up finding those prices,” Hirsch said. “We’ll have to wait and see.”

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