Are Buyout Firms Making The Same Mistake As Goldman Sachs?

You may remember Goldman Sachs Liquidity Partners III LP. The group, part of Goldman’s hedge fund group, raised $1.8 billion in late 2007, including $100 million from Goldman itself. Levering it 3x, the fund invested in distressed debt, including leveraged loans, mortgages and asset-backed securities. Well, they were juuuust a bit early. The fund was down more than 55% as of last fall.

In fact, the effort proved so disastrous that Goldman decided last November to waive the fund’s lock-up period, allowing investors to recoup their money. The fund has a 1/20 fee structure, but with the redemptions it has received, its managers are basically working for free.

Reading through yesterday’s Bloomberg article on the problems of Apollo Management, I have to wonder when that firm is going to do the same for its Apollo Credit Opportunities Fund, considering at least $2 billion worth of loans it bought have lost half their value. According to Bloomberg:

Apollo called $751 million of that last April, according to Calpers disclosures. That same month Apollo was among the private-equity firms that purchased more than $10 billion in loans used to finance leveraged buyouts from banks including Citigroup Inc.

Much of that debt, including $2 billion in loans to now- bankrupt Lyondell Chemical Co., based in Houston, has lost more than half of its value, forcing Apollo to put up more cash to meet a margin call in the second half of last year as bank loan prices plummeted to record lows, according to people familiar with the matter.

With this in mind, I asked a lender source what Goldman did wrong. He said “They made the amateur credit investor’s error that low price can make up for bad structures. It doesn’t work.” The fund’s money went toward leveraged loans of companies with flawed capital structures that were too complex and included too many layers of junior securities, he said.

The other big mistake Goldman’s fund made was buying seven-year assets with two to three year financing. “They borrowed short to lend long, and that combination is toxic,” the source said. Sure, Goldman had bad timing (too early), but with a high default rate, that doesn’t matter, he added.

What this likely means for Apollo is that its debt fund’s success will rely on the capital structure and performance of the underlying companies. Let’s just hope they aren’t companies Apollo owns (but that’s a whole other story)…