The larger buyout market is currently experiencing a phenomenon private equity professionals sometimes refer to as a “hiatus”. Put more bluntly, financing has dried up.
At the heart of the problem is a $300 billion (€212 million) mountain of bridge loans and debt underwriting commitments that helped to fuel the buyout boom, but which now, following the summer's liquidity crisis, can only be sold at a loss. Wary of making new underwriting commitments until the backlog has been cleared, the banks have pulled in their horns – and cut off GPs' supply lines in the process.
So, how to relieve the blockage and get the supply lines humming again? Cue the “hung bridge” fund, so-called because its purpose is to buy up the product “hung” on banks' trading desks. The $3 billion Oaktree Fund recently launched by Oaktree Capital Management is just one example. Just prior to going to press, New York-based Centerbridge Partners announced it was seeking $1.5 billion to $2 billion for investment in out-of-favour credit including leveraged loans.
The phenomenon is spreading fast. Appetite from investors to access hung bridge funds is reported to be substantial and some estimates suggest that they could raise sufficient firepower to consume as much as $170 billion of the LBO debt overhang.
Moreover, in addition to dedicated funds, some LBO firms are said to be exploring whether they can invest in debt from existing funds. While it may be possible, it's an option best exercised with caution, sources say. Quite aside from possible accusations of style drift there is the practical issue of whether pre-specified investment parameters are being breached.
Says Michael Halford, partner in the corporate finance department at law firm SJ Berwin in London: “If you want to make debt investments from a fund that was raised for mainstream private equity, you need to look very carefully at whether the documentation is sufficiently flexible to allow you to do it.” He suggests that fund advisory committees offer a useful sounding board in situations like these.
Nonetheless, there's no lack of firms looking at LBO debt as a serious investment proposition. “People in the alternative investment market are thinking that maybe there's a real opportunity for them here,” says Marco Massotti, partner and co-head of the private equity group at law firm Paul, Weiss, Rifkind, Wharton & Garrison in New York.
In certain quarters, however, scepticism reigns. Do these funds not represent supreme chutzpah on the part of LBO funds? They helped create the problem, for which they now offer a solution – at a price.
Less cynical market sources point to a strong mutual advantage in these transactions. GPs, they say, may be willing to pay a highly competitive price for the debt and, in the process, assume modest returns – typically in the high teens. For the banks, the advantage is obvious: reducing the size of the hit they might otherwise have expected to take. For GPs, the resumption of more normal market conditions once the old inventory has been shifted should mean the banks reopen for business.
In the words of Steven Costabile, global head of the private equity funds group at AIG Investments in New York: “There is a commercial benefit for the banks, and for the GPs it means the banks can get back to funding new deals quicker.” Noone mentions the hackneyed phrase “win-win situation” – but you do get the sense it's on a few people's lips
In an interesting twist, some of the hung bridge funds are sponsored by the banks themselves. For example, the Financial Times recently reported that KKR and Citigroup were launching a joint venture worth between $5 billion and $10 billion to invest in impaired loans, including LBO debt. Some may see in this an irony given that these organisations helped fuel the boom. At least they appear to be undertaking the clean-up with equal enthusiasm.