Buyout firms add trading unitsfor distressed market

Angus C. Littlejohn Jr. got tired of losing out to swifter hedge funds on some fine deals, and so his $1.3 billion middle-market private equity firm added hedge fund-like trading capabilities.

Mr. Littlejohn and his firm, Littlejohn & Co. LLC, are not alone. A number of buyout firms that focus on distressed companies have added trading groups, hoping that the ability to buy and sell debt securities would make them more nimble. Sun Capital Partners Inc., Boca Raton, Fla.; and Centerbridge Partners LP, New York, a firm formed in 2006 by Mark Gallogly, former head of private equity at Blackstone Group, and Jeffrey Aronson, former head of distressed investing at Angelo Gordon & Co., both straddle traditional private equity and hedge fund investment worlds.

These firms are not restricted to taking majority interests in private companies but, like Littlejohn, can buy non-control stakes in distressed firms as well as take control and non-control stakes in troubled companies' publicly traded debt. Later, the debt can sometimes be converted into control equity ownership of companies. Executives at Littlejohn expect the flexibility might give them an edge during a market downturn.

“We expanded the organization to include trading and distressed securities on the theory that it was an important defensive move,” said Mr. Littlejohn, chairman and chief executive officer of the eponymous Greenwich, Conn.-based firm.

In the past, Littlejohn and other distressed buyout firms could buy large chunks of debt directly from banks. That strategy became extinct when the banks started turning that debt into securities and distressed buyout managers could buy debt only in tiny slices at a time. Having a hedge fund capability gives Littlejohn and other distressed managers the ability to make money on the tiny pieces of debt when they can't aggregate them into a majority stake.

“In the last few years, less-than-stellar companies had no problem refinancing their debt and could get a better deal than they had before. That's gone,” Mr. Littlejohn said. “Now when companies bust their covenants, they will have to do something. They can't refinance. They will become underperforming debt.”

This is where trading comes in. Having a trading capability gives private equity firms that once could buy controlling interests only in companies with the ability to take minority debt positions in companies — that's important, he said, because the recent credit crunch has created more non-performing debt situations.

“If anything the market is going in our direction,” he said.

But Littlejohn & Co. couldn't have made the move without the acceptance and support of the firm's investors. Instead of raising a separate fund, Littlejohn & Co. reopened the firm's $650 million Littlejohn Fund III LP, added $200 million in capital commitments from all of the fund's limited partners and obtained permission from all of the fund's investors to include the new non-control distressed debt strategy.

“Eventually, we will end up with two funds,” Mr. Littlejohn said, referring to a private equity fund and a distressed debt hedge fund.

Similarly, Sun Capital Partners added trading capabilities in 2004 when it closed the first part of a distressed debt securities fund, said Anthony Polazzi, vice president of the Los Angeles office of Sun Capital.

The firm raised the $1.3 billion fund in two tranches, one part closed in September 2004 and the second closed in April 2006, said Richard A. Hurwitz, Sun Capital's vice president, corporate communications.

The securities trading capability inherent in the fund gives Sun Capital executives access to more deals because they become familiar with the distressed companies in which they buy the debt. If they like the company, they can buy more of the debt, hold it until the company reaches bottom and then convert the debt into a majority stake in the firm.

“It's an advantage because it allows us to see deals in which companies are not in a position to give up control,” Mr. Polazzi said.

Since it isn't restricted to taking majority interests, Sun Capital can take positions in more companies.

Still, the trading capability does not insulate buyout firms from the debt squeeze that is making life more difficult for buyout firms, Mr. Polazzi said.

“Buyouts are dependent on financing. Ultimately, you have to refinance your capital,” he said.

But it does give buyout firms another option. Distressed buyout firms are loath to buy a majority interest in a troubled company that's still on its way down.

“It's like catching the proverbial falling knife,” Mr. Littlejohn said. “I prefer buying debt securities when in falling markets where you don't know the bottom.”

There are also more distressed debt securities opportunities because the distressed company deals have not been coming up for sale en masse just yet.

“There's a little distress, but it's not to the extent we expect to happen in the later part of this year or next year,” Mr. Polazzi said.

In the meantime, distressed debt securities, which were too highly priced last year, are now selling at greater discounts, Mr. Littlejohn said.

Contact Arleen Jacobius at [email protected]