Leveraged Debt Funds Feel The Pinch

Funds affiliated with big-name buyout shops The Carlyle Group and Kohlberg Kravis Roberts & Co. that invested in mortgage-backed securities have taken a severe beating. Will the jitters extend to the numerous credit opportunity funds raised over the last year by such firms as Audax Group, The Blackstone Group, Oaktree Capital Management, Lehman Brothers, and TPG?

A month ago, Carlyle Capital Corp., a Euronext-traded investment company that targeted fixed income assets including AAA-rated mortgages and credit products, defaulted on $16.6 billion in debt after it failed to reach an agreement with its lenders to put up more collateral for its aggressively levered investments. The fund has entered liquidation, and investors will in all likelihood receive none of their capital. Meantime, KKR Financial Holdings LLC, a publicly traded specialty finance company, has had to assuage investors’ fears of a liquidity crisis after facing difficulties with its investments in debt backed by mortgage securities. It recently reached an agreement to turn over collateral to lenders—removing from its balance sheet about $3.5 billion in notes and mortgage-backed securities—and issued shares to fund new investments. The fund’s managers have shifted their focus to corporate debt, which now accounts for about 95 percent of its $8.5 billion in assets.

By contrast, the parade of credit opportunity funds raised by sponsors—Buyouts has identified at least eight such funds that raised $13.5 billion—don’t seem to be in danger of collapse. But some have hit rough patches. On Feb. 22, Oaktree Capital Management, the Los Angeles-based investment firm, injected about $200 million of mostly its investors’ money into its European Credit Opportunities Fund. Oaktree raised the $1 billion vehicle, which consisted of about $300 million in equity, in 2006 to invest in European first-lien senior bank loans, sources close to the firm told Buyouts. Over the course of January and February, the fund’s managers and its European lenders became concerned that some of its loans would trip covenants, though none ever did. Oaktree Capital declined to comment.

For the most part, these funds areconservatively structured, shying away from toxic residential mortgage-backed securities and using far less leverage than, say, Carlyle Capital Corp., which reportedly borrowed $30 for every $1 it invested in AAA-rated mortgage-backed securities.

Managers of Lehman Brothers’ Loan Opportunity Fund, which targets first-lien secured positions in LBOs in the new and secondary market, planned to leverage its investments 3.5x when it closed in October 2007, though it’s not using anywhere near that amount now. Similarly, Oaktree Capital’s European fund set out to use 3.5x to 4.0x leverage and is now typically employing 2.0x leverage; its Oaktree Loan Fund, a $4 billion vehicle it raised last summer to scoop up bridge loans, initially offered two tranches: one that was unlevered, and one that was 2.0x levered. But terms on the leverage available have been so unattractive Oaktree Capital hardly utilized it.

At least one limited partner, however, said leveraged loan investments in general are struggling. The New Jersey Division of Investment has committed about $1 billion to leveraged loan funds over the last three to six months. When the pension manager first got in, attractive loans were trading around 95 cents on the dollar; prices have since dipped into the mid-80s and have now settled into the high 80s, said William Clark, director of the pension fund, at a recent Buyouts conference. “We’re probably down a bit,” he said, when asked how the investments were faring.

Fund managers remain positive, however. Our sources close to Oaktree Capital, for example, said the firm’s $4 billion Oaktree Loan Fund is almost fully invested and anticipating returns of 8.5 percent to 9 percent; the firm is also still confident its European Credit Opportunities Fund can generate returns in excess of 20 percent.

Lehman Brothers expects falling prices will allow it to buy debt on the cheap with its Loan Opportunity Fund, for which it raised $670 million. Lehman has deployed about half the fund. “It’s a good market if you’re a buyer and you have capital and capacity,” said Michael Guarnieri, a managing director who oversees the fund. But there is a shortage of quality paper, he said. “Sometimes your inability to buy paper you like is a challenge, even when the overall market is volatile.”

Prices for mid-market senior secured loans have increased about 25 to 50 basis points, from about LIBOR plus 450 to LIBOR plus 500, since Audax Group in December began reviewing investments for its Credit Opportunities Fund, which targets mid-market senior secured loans in companies generating $10 million to $50 million of EBITDA. The fund has so far focused on new issues, though it has bought some secondary paper. Audax Group is also seeing better discounts on the debt its buying. It can get 1 percent to 2 percent original issue discounts, or 100 basis points to 200 basis points, when in last year’s more robust market the firm was more likely to encounter discounts of 25 basis points to 50 basis points. Loans also typically come with LIBOR floors of 3 percent to 4 percent, a new development since December, said Michael McGonigle, a managing director who oversees the fund.

Guarnieri of Lehman Brothers and our sources close to Oaktree Capital said creditors are not pressuring their funds to put up more collateral.

Perhaps some of these funds jumped in the market a little too early, as New Jersey’s Cark suggests. The mark-to-market value of leveraged loans continues to drop, forcing Wall Street banks to seek out novel ways of ridding their balance sheets of loans they agreed to underwrite for big buyouts but haven’t been able to sell since the debt markets seized up. As these loans depreciate in value, they drag on banks’ income. “That’s what’s driving them crazy,” said one attorney.

One way banks are trying to unload the debt is by offering financing to potential buyers. A hypothetical scenario works like this: A buyer agrees to purchase $1 billion of debt, but only puts up a third of the price in equity. The bank cuts a new loan to finance the rest. In the process, the bank eliminates its exposure to the hung debt by a third, and the new loan reflects more favorable market conditions and contains better interest rates.

Citigroup is nearing an agreement to do just that. The investment bank, as of press time, was finalizing a deal to sell off $12 billion of its leveraged-loan portfolio to a handful of buyout firms. To facilitate the sale, Citigroup was prepared to provide financing to the group of LBO firms and sell the securities at a steep discount to par—at about 90 cents on the dollar. The investment bank is trying to eliminate the leveraged-loan exposure it built up in 2007, estimated at nearly $43 billion.

Banks aren’t just pitching these deal to hedge funds and other typical debt investors, which are more likely to negotiate better terms. Instead banks are pitching the deals to pension funds, insurance companies and other entities that don’t usually invest in such securities.

The idea doesn’t sound good enough to Audax Group, which has stayed away from such offers. “There’s a lot of volatility in that area,” McGonigle said. “It’s hard to say what the right entry point is for those loans. Some thought it was in October or November of last year, and then the market still had some downside.”

Another idea banks are kicking around are special purpose vehicles that would hold a group of loans, from which the bank could syndicate debt or equity interests to hedge funds and other buyers. That set-up is less likely, however, without a robust collateralized debt obligation market.