The New Grave Dancers –

Few groups have benefited from the strong debt markets more so than the LBO community. Deal flow has climbed exponentially, thanks to the healthy high yield and leveraged loan markets, and nobody has proven as adept at manipulating capital structures in order generate returns. So now that buyout shops have encroached into the distressed debt space, some find it ironic that the same groups that push leveraged multiples to the breaking point are gearing up to profit from the subsequent dissolution.

Wright Capital is the latest to head into distressed debt, joining a cadre of firms that include HIG Capital, Sun Capital Partners, Blackstone Group, Onex Corp., Bain Capital and others.

While this tendency may leave some open to the “grave dancer” characterization, it can’t be denied that buyout shops have their finger on the pulse of the debt markets and are already well positioned to find success with a foot in both camps. Apollo Management is one group that has historically used both strategies to invest, and the distressed players, such as Cerberus Capital Management and Oaktree Capital Management, have profited by extending beyond distressed into buyouts. If the connection has yet to be made, this is the convergence everyone’s been talking about.

Buyout players typically enter the distressed market with a different mentality than the traditional players. The buy-and-sell mentality is still there, but most of the LBO participants don’t consider themselves traders, per se, as the buying and selling occurs over a stretch measured in years as opposed to months, and is designed to garner control stakes rather than non-control blocks.

HIG Capital’s John Bolduc, a managing director at the firm, says, “We tend to stay away from the hedge fund (or trading) mentality. They can make some complicated bets by looking at three sheets of paper on a research report.”

HIG, meanwhile, approaches distressed debt similar to as it would in a standard buyout, and makes its investments with designs of instituting a business plan that encourages a turnaround. Bolduc adds that while HIG won’t always get access to the management team, the firm’s distressed fund-being that it’s a middle market vehicle-typically works with the senior lenders, allowing for a more thorough due diligence process.

“We tend to have a bias toward the private equity and control strategies. There are more barriers to entry… At certain points in the cycle, trading strategies work, but right now the most attractive space is the smaller and mid-market deals where paper is much less liquid,” says Maria Boyazny, who heads Siguler Guff & Co.’s distressed fund-of-funds operations.

Why Bother?

A question many ask is: Why do buyout groups even need to get in at the distressed level?’ There are a number of factors that make this strategy more appealing than waiting for a 363 auction. For one, there’s less competition for control. Most creditors, including the hedge funds, are unnatural holders of equity, and would prefer to gain liquidity at a fair price than become a large equity holder counted on to make management decisions. The second factor, and perhaps more important, is that it inserts the buyout investors into the actual restructuring negotiations, giving them an active voice during a time when the critical decisions are made.

“It allows [buyout groups] to be influential in the restructuring process,” Chanin Capital Partners Managing Director Mark Rubin says. “When you’re on the outside, you can get information about the assets, but you’re not actually at the table discussing how the plan for the company will be established.”

Another important aspect is that while the LBO strategy is meant to gain control, if groups are outbid, they can often sell their accumulated holdings and walk away with something to show for the effort.

The Hazards

As “in tune” as buyout firms are with the debt markets, nobody said distressed investing was easy. For an asset class that has traditionally been very flexible in putting money to work, finding success in both good markets and bad, when it comes to distressed deals there is no switching hats from financial engineer to operations guy depending on market.

One distressed veteran asserts, “You can only eat one kind of food in this space. There’s no galloping around. It’s about being patient in a low default environment and inverting that to become impatient as soon as the default rate goes up.”

Moreover, finding the fulcrum tranche, or where the control stake actually lies, has become more of a guessing game with the advent of second lien and third lien debt positions. “There are more cats to herd,” Rubin says. “It’s always been difficult, but it’s even more difficult today. Sometimes it’s as easy as grabbing an $800 million bond issue, but in other instances the priorities are not always that clear, considering all the liens and subordination agreements… We’ll often find groups that aren’t sure will try to buy into every tranche of the debt structure.”

Still other naysayers believe some buyout groups could struggle outside of the structured deal flow found in LBO investing. Black Diamond Capital Management’s James Zenni, says that generally speaking, “It will be a challenge for some LBO firms to operate in the distressed space because the deal flowof opportunitiesis not necessarily an outgrowth of the traditional investment banking community. Distressed debt investing is more of nebulousmarket; it’s not as transparent where the opportunities lie.”

However, with the certainty of a slowdown in the LBO market, some buyout shops may view distressed debt as a way to keep active during the lull. Nobody is looking forward to a return to 2001, when the industry was unable to muster up $25 billion worth of deals; not even a quarter’s worth in today’s environment.

“Next year and 2007 should be an attractive buying cycle for distressed funds, and by 2008, we should be back to good times again [from the distressed perspective],” the source states.

And while nobody wants to embrace a “grave dancer” label, there likely won’t be a hint of compunction from new distressed debt players if their bets pay off. You won’t find Wilbur Ross apologizing for the profits he’s made in the steel industry. If today’s players can do the same for the airlines or auto parts that Ross did for steel, buyout groups will go a long way in shielding whatever “locust” typecast gets thrown their way.