Rise of the private equity debt fund

Not satisfied with earning huge private equity management fees, plus carried interest, two of the world’s largest buyout firms are casting their net wider than private equity, with debt proving particularly attractive. Carlyle and Blackstone have both established CLO managers and launched a number of funds, but only recently have they entered the European debt market.

In the US, Carlyle is something of a veteran in the area. It started investing in corporate debt in 1999 when it launched the US$900m Carlyle High Yield Partners. Now it manages seven high-yield funds, a distressed debt fund and a mezzanine fund, both established in 2004. It launched its European attempt in the same year. Lead by Mike Ramsay, formerly head of leveraged finance at Prudential M&G, the European leveraged finance business works alongside Bank of Scotland Corporate, investing in senior secured bank loans, as well as mezzanine loans and high-yield bonds. The 10-strong team manages two collateralised loan obligations under management in Europe: CELF Loan Partners BV, a €450m CLO, which closed in April 2005; and CELF Loan Partners II PLC, a €475m CLO, which closed in November 2005. The funds are invested predominantly in euro-denominated senior secured and mezzanine leveraged loans.

Fellow big gun Blackstone has also taken a stroll down debt avenue. It started its Corporate Debt Investments group in 1999 and it is made up of two businesses: Blackstone Mezzanine Advisors, launched in 1999, and Blackstone Debt Advisors (BDA), formed in 2002. BDA has closed on seven vehicles, including Hyde Park CDO, the firm’s first foray into the European debt market. The European team was set up in September 2005, led by Debra Anderson, formerly of Intermediate Capital Group. The €500m CDO is funded through a combination of fixed and floating rate notes, with the portfolio collateral including a minimum bucket of 75% for senior secured and unsecured loans. Mezzanine is subject to a 25% maximum bucket, high-yield bonds 5%, and fixed rate obligations 5%. A quarter of the portfolio can be made up of non-Euro denominated loans. The fund was 90% ramped up at closing (February 23, 2006), with a 12-month ramp-up period. Of the opening portfolio 28% was UK-based, with a further 20% in Germany.


The official line from Carlyle and Blackstone is they are establishing CLO funds because they want to offer a variety of investment products to their investors and opening up a debt business is a natural extension for the mega-firms. There is increased demand from their investors for yield, and as most private equity money comes from big endowments, insurance companies and pension funds, all of which will put more money into debt than private equity, it makes business sense to satisfy that demand. It’s a step on the path to becoming more than just a private equity firm; to becoming an alternative investment management business.

What setting up a debt fund offers senior partners at Carlyle and Blackstone is diversification. For example, mezzanine returns tend to increase as private equity returns fall, because leveraged private equity is more difficult as interest rates increase whereas mezzanine interest obviously rises. By having their fingers in different pies, GPs are able to spread risk better; they are able to limit their exposure to one particular asset class. Blackstone, for example, has a number of businesses aside from private equity and corporate debt, including private real estate, a fund-of-hedge funds, as well as its corporate and restructuring advisory arms. In April it announced another addition to its investment armoury, a new long/short equity investment business.

All these extra products add to the amount of assets a firm has under management, which means the likes of David Rubenstein and Stephen Schwarzman will be able to sell their stakes in their respective firms at a higher price. There is a limit to how big a firm can be if it only focuses on private equity. James Stewart, director at ECI Partners, says: “A lot of the larger, branded private equity funds are seeking to expand their offering in alternative investment and it’s quite natural to expand into a related area such as debt. It’s no surprise that these guys are considering these types of funds and want to exploit the opportunities that arise in debt trading. They have an understanding of leveraged debt, giving them a degree of sophistication and access to the market, differentiating themselves from other traders.”

Being such big names in the private equity game, Blackstone and Carlyle have been able to capitalise on their brand. Having had such a presence in the industry means investors know who they are and trust them. Carlyle has also been able to get first mover advantage, setting up its European business and launching its first European CLO in April last year.

The branding issue is an important one. Over the last 12 months there has been a significant increase in the number of CLO managers entering the market place. Having the name of one of the most famous private equity firms behind you undoubtedly makes it easier to stand out from the crowd.

But the notion of private equity firms getting involved with debt is making some private equity fund managers uncomfortable. They don’t like the idea of mandating an investment bank to sort out the financing only for it to be bought by the likes of Carlyle or Blackstone, giving them access to the due diligence and supporting information. Some sponsors have become careful about who invests in their deals. This has been an issue ever since hedge funds started buying debt as well, but firms have no right to say who owns its debt, unless they are prepared to pay extra to have covenants built into the paper that allow them to track who owns what. As a result this has created a certain amount of sensitivity between sponsors and has made it more difficult for sponsor-backed CLOs to ramp up.

One unintended consequence of private equity-backed CLOs is improved transparency. As these private equity firms build out their platform through debt structured vehicles, the reporting requirements for those CLO platforms would be the same as any other, meaning the assets in the pool need to be rated. This is pushing private equity firms to accept that more transparency is required around their portfolio companies.


According to Tim Harrison, a senior partner in 3i’s buyouts team: “It is another example of the convergence between the private equity market and hedge funds, and is being driven by the banks’ need for liquidity, particularly in the higher-rated debt markets. Private equity sees this as a route to controlling businesses in a different way.” Stewart argues it is the growth in debt funds trading in secondary debt that has added momentum to this kind of market development. However, he doesn’t expect it to catch on with any but the largest firms. “There are tremendous opportunities but I think it will be confined to the larger end of the market. Mid-market debt will still continue to be dominated by the investment banks.”

Harrison acknowledges the fears some private equity firms may have over the likes of Carlyle and Blackstone getting involved in their deals. “We are being more vigilant about who is buying our debt, but we do not finance our deals as aggressively as some others have, we have sensible EBITDA multiples. We don’t want a bank just dissipating our debt to anyone in the market, but 65% to 70% of our deals are done by banks that are invested in our buyout funds. We work pretty hard to build these relationships with the banks. We can’t force them not to sell when they see a set of circumstance to sell, but we would expect some sort of dialogue.”


The issue of ring-fencing also needs to be addressed. Carlyle insists its private equity and debt businesses are kept separate, but the two do help each other out from time to time. The buyout team may only do one deal every six months, perhaps less. When they are looking at a deal they can talk to the high-yield team and ask what’s going on in the market and what pricing terms they should be looking at. Similarly, for the debt fund managers it is useful to be part of a firm as large as Carlyle’s. The high-yield fund looks at the whole spectrum, but the team cannot know everything, so it can get some specific expertise from one of the 10 sector teams Carlyle employs.

Whether this help will ever include investing in each other’s deals is yet to be discovered. Duke Street Capital used to have a CLO business, Duke Street Capital Debt Management, which was acquired by David L Babson & Company, a subsidiary of the Massachusetts Mutual Life Insurance Company, and renamed itself Babson Capital. Under Duke Street’s umbrella the CLO side was prevented from investing in Duke Street deals, the argument resting on conflict of interest. This situation is replicated in Carlyle and Blackstone’s CLOs. However, the question remains whether the debt side would sit idly by if the equity business were struggling. It is unlikely Carlyle or Blackstone will ever have to answer such a question, but should smaller firms ever attempt to establish a debt fund, it’s something worth bearing in mind.

This could be a moot point as most private equity insiders argue the establishment of CLOs will be the preserve of only the largest private equity firms in the future, and argue that Carlyle and Blackstone could soon be joined on the CLO stage by some of its peers very soon. A leading candidate for such a move is CVC, which, in April hired David Wood, formerly head of European leverage finance for six years at Deutsche Bank following a spell as a senior banker at JPMorgan in its acquisition finance team. A 30+ year veteran of the leveraged finance and banking market, Wood is, according to a company press release, working alongside partner Marc Boughton on further developing CVC’s financing initiatives. CVC refused to comment for this article.

CVC’s move into debt should

not be surprising, it is one of the largest private equity firms in Europe, although whether it will invest in its own deals – CVC has been notoriously touchy over who buys up its debt – is at present unknown. What can be assumed is not only CVC is thinking about it. Harrison said 3i is looking to increase its coverage of the distressed debt, and there is no doubt that others, both US, UK and European-based firms, are keeping

a close eye on how Carlyle and Blackstone perform.