To understand a major risk in the private equity market now, it is instructive to take a walk down memory lane. Or rather, a walk down a memory hall of horrors.

Do any of these names ring a bell? CTC Communications, Rhythms NetConnections, CAIS Internet, Danka Business, McLeod Communications. All were funded by large private equity firms in the months leading up to the middle of 2000. All were PIPEs (private investments in public entities) in the form of convertible preferred shares. And all went bankrupt, in the process destroying two of the firms involved – CTC was one of several bad Hicks Muse PIPEs; McLeod was one of two radioactive Forstmann Little deals.

While it is not clear whether or not PIPEs will again find their way into the portfolios of major private equity firms, it is worth noting that the conditions which pushed private equity into PIPEs are in place today. You can call it 'styledrift risk'.

In late 1998, the buyout market was reeling from a credit crunch that seriously crimped the style of the largest buyout GPs. Leveraged buyout deals were not getting done, or at least were not getting done in such a way that the projected returns seemed very attractive. The slowdown in deal activity presented another problem for many firms – the inability to put huge chunks of capital to work. Many GPs were planning significant new fundraisings, and their having an excess of dry powder would not support the case for a bigger follow-on fund.

PIPE deals offered several attractive qualities. They seemed to be a conservative (hold your chuckles) way to get involved in the explosive growth of telecom and internet stocks. Many of the convertible preferred shares paid dividends, after all. They had built-in exit strategies in that the private equity firms could convert to common equity above a conservatively set price. They were also a way to put hundreds of millions of dollars to work right away. The GPs who entered into these deals heralded them as examples of how private equity firms could be opportunistic and flexible, swooping in to provide capital where and when it was needed.

Before these PIPEs got jammed, so to speak, they did prove to be valuable justifications for upsized fundraisings. Although venture capital stole the show in 2000, raising more than buyouts for about the only time in history, US buyout fundraising enjoyed a record year, despite questions about the state of the traditional LBO market.

Although there are many indicators that most of the US private equity middle market has escaped relatively unscathed from the most recent credit crunch, the largest private equity firms are having unpleasant conversations with their bankers, who are warning that the cheap debt party has been halted, and the syndication hangover has just begun. In the meantime, the biggest private equity firms have raised enormous amounts of capital, and they want to raise more. Already Blackstone, KKR and TPG, to name a few, are speaking with limited partners about their next funds, as the most recent vehicles are halfway invested.

What happens if the second half of these funds cannot be deployed as quickly, and in such large doses? The message this sends is that deal sizes will be reduced, pacing will slow, and therefore fundraising should adjust downward, as well. But, say GPs, private equity firms are paid to be opportunistic and flexible. There are, in fact, opportunities to be had in the market now that require very large cheques and have the potential to produce “equity-like returns”.

Many of the largest private equity firms are planning to begin acquiring discounted corporate debt – much of it issued as a result of LBOs. Some firms are hoping to raise separate pools of capital for this debt-acquisition activity, but others hope to draw from their giant private equity funds. In the firm's first quarterly earnings conference call, Blackstone president Hamilton James noted that his firm had taken a keener interest in distressed debt. “I think we may be able to buy the debt in these companies and get a higher return than [we would have] on the underlying equity,” he said.

Will corporate debt be to the current credit crunch what PIPEs were in the run-up to the telecom meltdown? Let's hope not. But the minute private equity firms explain that they want to pursue a strategy that wasn't in the original flipbook, a degree of cynicism is highly appropriate.