The Buyout Boys Reload

Periodic shakeouts are "what keeps the industry healthy," says Tony James of Blackstone Group. (By Chip East -- Bloomberg News)

Doing a swap rather than a sale avoids various complex financial and legal problems. It also means that the buyout firms are on the hook for only the cash they've put up, unless they choose to put up more. So if the loans prove to be truly disastrous, they will be Citi's problem all over again.

This kind of transaction isn't as sexy (or lucrative) as lining up the first $100 billion buyout. But hey, it helps cover the overhead. Double-cropping leveraged loans isn't likely to produce the 25 percent or so (before fees) returns to which buyout-fund investors have become accustomed (or would like to become accustomed). But it beats a sharp stick in the eye. Firms can realize returns in the high teens or low 20s (before fees) from buying this paper, which is a far less risky investment than putting up the equity in an LBO.

One reason banks are so eager to do these deals is that the takeover loans made late in the cycle tend to be really messed up. That's because banks were competing so hard for buyout business that they took leave of their senses. At a gathering of business journalists last month, Carlyle's Rubenstein riffed on the way banks were competing to finance buyouts on increasingly ridiculous (for the lenders) terms. After playing the banks off against one another, Rubenstein said -- a big smile on his face as he milked laughs from the crowd -- the firm ended up with a deal that worked like this: "I don't have to pay the debt on time, I don't have to write covenants, I don't have to worry about nuclear bombs, I don't have to have any equity. I'll do that deal."

In a more serious vein, consider a study of post-2003 buyout debt by Marty Fridson's Distressed Debt Investor. Fridson, who has been around high-yield debt since back when it was known as junk, said that before the lending excesses started in 2004, buyout debt followed a familiar pattern: The longer the debt had been outstanding, the more likely it was to be distressed (which he defines as yielding 10 percentage points or more above equivalent Treasury securities). The reason: The longer a buyout has been around, the more chance it has had to run into economic problems.

But the trend has reversed -- the more recently a loan was made, the more likely it is to be distressed. As of early May, 42 percent (62 of 146) of post-2003 LBOs were distressed, more than double the rate in the rest of the high-yield universe. This includes three of the four issues from this year, 49 percent (18 of 37) from 2007, and 34 percent (14 of 41) from 2004. The good news is that now is better than in mid-March, when Fridson found a full 50 percent of these issues to be distressed.

None of this means that huge private-equity deals -- formerly management buyouts, formerly leveraged buyouts, formerly bootstraps, soon perhaps to be "transformational equity" (a term that you hear bandied about on the buyout circuit) -- are dead. They're just in hibernation.

Buyout firms, which are always in full sales mode, are telling potential investors that this is a great time to commit money to their funds, because investments made in meltdown years and the two following years tend to do exceptionally well. History backs up the idea that investing in a burst-bubble climate is a great way to make money. A Cambridge Associates study shows that investors in funds formed in the years when bubbles popped and the two subsequent years have made returns far superior to those from funds in other years. For example, funds raised in 2001, 2002 and 2003 (after the stock market bubble burst) returned 33 percent, 29 percent and 31 percent, respectively, after fees, the best three years in the 20-year survey.

However, just because post-bubble buyouts have been good in the past doesn't mean they'll be good in the future -- history, after all, isn't destiny. The fact that firms are double-cropping in the debt markets is a departure from the historical pattern. In the past, they kept their powder dry in post-meltdown years and waited for things to improve.

It's going to take a while -- possibly a long while -- to see how all this plays out. For now, you've got to work on the companies you have, do smallish deals and find really creative ways to keep the Gulfstream in fuel until the market turns.

The folks at Clayton, Dubilier & Rice, a low-profile buyout shop that's been around for 30 years, waxed philosophical about this in their year-end letter to investors. "If the wind will not serve," they said, citing an ancient proverb, "take to the oars." In short, get ready for some calluses, buyout boys.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@fortunemail.com. Katie Benner is a reporter for Fortune. Her e-mail iskbenner@fortunemail.com.