Street Support for the DB's LBO View

From Dow Jones:

=DJ STREET SAVVY: LBO Funds Get Warning Shot From Bear's Fund

Thursday, June 21, 2007 7:37:15 AM (GMT-04:00)
Provided by: Dow JonesDJ
By Spencer Jakab
A Dow Jones Newswires Column
(This article was originally published Wednesday)
NEW YORK (Dow Jones)--Consider the similarities and linkages between the housing and the private equity booms. Now let's extrapolate from that the possible implications for the equity markets from Bear Stearns Cos.'s (BSC) distressed mortgage hedge funds, whose assets were being auctioned off Wednesday by creditor Merrill Lynch (MER).

One doesn't need to know the minutiae of collateralized debt obligations to grasp that losses in one category of lending vehicle could affect confidence in others that have been eager buyers of loans used to fund leveraged buyouts. In fact, an analyst who sits on the trading floor of a New York brokerage said there are rumblings in the credit markets Wednesday afternoon that the liquidation in mortgage bonds are sparking a sell-off in other assets outside mortgages.
Could the liquidation of the Bear Stearns fund force other mortgage funds to realize losses on opaque securities that they must now mark-to-market? More importantly, could this ripple through the larger financial sphere and ultimately impact the private equity industry's borrowing ability?

The analyst noted that "the Bear Stearns news is resulting in selling in all credit markets, particularly loans and corporate bonds."
While he didn't say it was likely, seemingly small problems in loan markets could turn into large ones for equities.
"Because of the size and leverage, a contagion/blow-up is always possible, and because many structured products recently introduced have never been stress-tested in real life, fireworks could occur if they unwind," said the analyst.
The two funds run by Bear Stearns held about $21.2 billion in long and $8.5 billion in short bets on mortgages as of March 31 on $638 million in equity capital, according to The Wall Street Journal. Unlike earlier asset sales by the fund, Wednesday's auction of opaque, illiquid securities may force other players in the mortgage arena such as collateralized debt obligation funds to reprice their securities and possibly realize paper losses. Collateralized loan obligations, big buyers of LBO debt, are a subset of CDOs that might be affected if losses were to cascade.
CDOs contain significant leverage but are able to attract copious funding by bringing in investors who can only buy high-quality paper. They achieve this by finding investors willing to take on the first losses in what are called equity tranches and derisively referred to as "toxic waste."
Other buyers of loans are hedge funds or proprietary trading desks using huge leverage. They depend on the cheapness of credit default swaps, or CDS, to hedge against repayment risk and can arbitrage the slight difference between the cost of protection and yields to make money. If the cost of protection rises, they would be unwilling to buy more loans, and liquidity could suffer in the private-equity arena.
At the moment, the implied cost of protecting against defaults in the leveraged loan market is almost as low as it has ever been, in sharp contrast to riskier parts of the mortgage market. A hedge fund manager involved in merger arbitrage says that the cost of CDS remains extremely cheap, allowing funds to snap up such loans at record-low yield spreads and still eke out healthy, low-risk returns with 1000% or more leverage.
"Implied default rates have never been so low," he said.
Unlike subprime borrowers, companies taken private in recent years have proven to be excellent credit risks so far, so this makes sense, and extrapolating this into the future might even be sensible. But this could be a moot point if investors throw the proverbial baby out with the bathwater, choking off funding to hedge funds and newly planned CDOs that are an integral part of the future funding plans of private equity. Unlike earlier LBO booms, commercial banks are on the hook for relatively little of this debt, selling it off to these institutions.
"Now banks have incredible ability to syndicate loans," said the hedge fund manager, who noted that the debt for the $10.3 billion purchase of Home Depot Inc.'s (HD) wholesale business will be several times oversubscribed by CLO and other leveraged funds. "What these banks do is write a check for $10 billion and sell the loan in a few days to CLOs," he said, noting that he isn't overly worried about future deal flow.
The collateral liquidation may be a blip that has no impact on LBO financing, or it may be a sign of things to come for the private equity juggernaut that has been boosting stock prices. A drop in confidence or new funding would hit stock prices if an aggressive buyout firm like KKR or Blackstone begins to face the same sort of scrutiny as a potential subprime mortgage borrower does today.