Private matters

Since the leveraged finance market tumbled last summer, banks have struggled to sell billions in debt that is stuck on their balance sheets. With the traditional buyers nowhere to be seen, the private equity shops are up to the challenge.

“The bank market grew five-fold over the past five years. But the demand component, consisting mainly of CLOs, really didn’t change,” said a senior banker. “Private equity firms have now become a large replacement.”

Last week, for example, the Carlyle Group‘s leveraged finance arm closed a US$450m CLO fund, Carlyle Credit Partners Financing (CCPF). The vehicle seeks to buy loans at discounts.

To increase buying power, the vehicle will use 12-year debt to leverage the equity. Unlike other CLOs, there are no mark-to-market pricing triggers, allowing the purchase of illiquid securities. JPMorgan structured and placed the fund.

The deal includes AAA, AA and BBB rated liabilities. It is Carlyle’s 10th CLO.

The Blackstone Group is also looking to purchase leveraged loans at discounts. The firm is raising Riverside Park, a US$510m CLO through GSO Capital Partners, the hedge fund manager it acquired last month. The fund is also employing leverage to enhance buying power.

Citi is arranging the Riverside Park CLO. It consists of AAA liabilities but also includes A, BBB and BB securities. The collateral package will comprise US dollar-denominated obligations, at least 85% of which will be senior secured loans, S&P said. The vehicle priced in March and was expected to settle on April 15.

Investment manager Ares is prepping as well. The firm is issuing Ares Enhanced Loan Investment Strategy III, a US$800m CLO made up mainly of senior secured loans, a banker said. JPMorgan was the underwriter.

Structured at the money management division of the private equity shops, these CLOs allow the firms to put in more equity and use less leverage than they would through traditional funding vehicles. While lower leverage could also mean lower returns, they are seeking to boost income by purchasing debt at pervasive discounts.

The idea behind the funds is obvious, especially as buyout shops know the credits intimately. “Everybody is trying to create liquidity in what has been an illiquid market. That’s the goal,” a private equity professional said.

CLOs are just another vehicle that private equity firms will use to exploit current opportunities. In the past few weeks, Citi and Deutsche Bank sold mammoth portfolios of loans and bonds to private equity shops. Texas Pacific Group, Blackstone and Apollo Management were involved in these transactions.

Citi sold US$8bn of loans to private equity shops, Citi CFO Gary Crittenden said on the firm’s quarterly earnings conference call on April 18.

These large sales have helped reduce the backlog of buyout debt from US$400bn last summer to roughly US$175bn today, say market sources. Reducing that supply further is paramount to the revival of the leveraged finance market.

“We hate selling at a discount,” a banker said. “But banks need to sell those loans to keep their front-end business alive and generate the capacity to create new loans.”

The sales have helped private equity shops acquire large chunks of debt instead of buying small pieces in the secondary. Meanwhile, there is the opportunity for large returns. “Blackstone and Apollo, for example, are going to make a lot of money doing this, more than the equity returns in many cases,” a second banker said.

The move can make a lot of sense, particularly for those that were in the running to buy a company and lost the auction.

“Given the deep discounts offered at present, private equity firms can get a return that matched the IRR that they were looking at when bidding for a company in the first place,” the banker added. “They may be buying the riskier parts of the capital structure, but that is still better than they would have gotten with an equity investment.”

Less volume, more deals

The volume and number of LBOs has indeed dropped. In the year to date, the volume of LBOs has declined 91.5% to US$10.6bn from US$125.2bn in the same period last year. The number of deals also reduced to 141 from 233, a 39.5% drop, according to data from Thomson Reuters.

“It makes sense that with the absence of LBO opportunities they would be looking for openings to deploy their cash. They’ve raised large funds and they have considerable amounts of money sitting around,” one banker said.

Indeed, in the absence of traditional buyers, bankers are relieved to see private equity firms raise funds to invest in the supply overhang. “These credit opportunity funds are filling in nicely and getting our supply overhang down,” said the first banker.

Private equity firms have evolved from a traditional model to a diversified asset manager model. Blackstone, TPG, Carlyle and Apollo all employ multiple strategies.

Indeed, private equity shops are also finding opportunities elsewhere. They have started to deploy some of their cash reserves by investing unleveraged equity into struggling banks. Last week, National City raised US$7bn of equity ahead of a first-quarter loss of US$171m. The bank also slashed its dividend to US$0.01 per share from US$0.21.

Part of the capital raise included a US$985m investment by Corsair Capital, which gets a seat on the board of directors. The move follows that of TPG, which along with an investor group infused US$7bn in Washington Mutual earlier in the month.