Can private equity hack it against the vulture funds?

Just how far are private equity houses prepared to go to unload their funds? If recent estimates that there is currently E45bn (£30.95bn) of uninvested private equity money sloshing around Europe are to be believed, then it must be pretty damn far.

With ever-present moans of concern that there is simply too much competition for too few attractive companies, then surely private equity firms are looking into other areas of investment?

According to a number of lawyers in this field, it seems that equity houses may be prepared to go as far as the distressed debt market to unburden themselves.

At first, this seems to be an incongruous mix. In much the same way as junk bonds were viewed in the early 1980s - a high-risk slightly sullied instrument - distressed debt has long been seen as the stamping ground for opportunistic vulture funds. It has certainly not been a playground for the loftier ambitions of a well-heeled private equity firm. But these stereotypes may soon be seen as seriously outmoded, at least if US private equity firm Apollo has its way.

The house, founded in 1990 by Leon Black, who, as the former head of M&A at junk bond juggernaut Drexel Burnham Lambert was involved in the legendary takeover of RJR Nabisco, is currently stalking Vantico, which is being advised by Allen & Overy.

According to a number of sources, Apollo has gained a 35 per cent share of the senior debt in Vantico, a distressed company if ever there was one.

The Swiss speciality chemicals business, the result of a buyout financed by the then Deutsche Bank-owned Morgan Grenfell Private Equity in 2000, defaulted on a loan repayment in January this year, effectively speeding up a financial restructuring that had already begun to creak into action last September.

Just last month, the details of a debt for equity swap spearheaded by New York-based distressed investment fund MatlinPatterson Global Opportunities, represented by Bingham McCutcheon, were released.

MatlinPatterson, the largest holder of $250m (£159.7m) worth of high-yield debt in Vantico, had already laid out plans to roll the company into chemicals giant Huntsman, in which the distressed debt investor holds a 49.9 per cent stake. Considering that the lead bank in the syndicate is Credit Suisse First Boston, where David Matlin and Mark Patterson (who set up MatlinPatterson) were both executives, it seemed like pretty much a done deal. But not so. With its 35 per cent share in the senior debt, Apollo, advised by Latham & Watkins, has gained a blocking stake based on the majority bank concept, where decisions taken by a syndicate must be backed by 66 and two thirds of members.

This is a powerful position to be in. Not only does this give Apollo incredible sway within the syndicate, but, as bondholders in Vantico are structurally, rather than contractually, subordinated, the equity house will potentially be able to usurp the ambitions of the likes of MatlinPatterson.

While there were already plans to restructure Vantico's finances, no doubt there were smaller banks, scarred by the recent financial history of the chemicals group, who preferred to get out now. Cleverly, Apollo offered that incentive.

Of course, it's unusual, if not extremely rare, to see a private equity house take this course of action. In fairness, Apollo is a slightly different animal from your archetypal private equity outfit. It is understood that as well as private equity, the firm invests in real estate and distressed debt.

But there are signs that other US houses are dipping their toes into the ever-increasing pool of debt. Apparently, the Blackstone Group has shown interest in this area, while the Carlyle Group last year set up a $500m (£318.5m) fund to invest in distressed assets.

Whether this trend will stretch as far as Europe is yet to be seen. Certainly, private equity lawyers admit that in the past 12 months, their clients have been looking into this area, albeit tentatively.

Any reservations may be based on a number of extremely complex issues that acquiring debt, rather than, say, the usual private equity funded management buyout, can uncover.

Working out the inter-creditor agreements - for instance finding out whether bondholders are structurally or contractually subordinated to the senior debt - is a complex but necessary task in gaining the best position to control the direction of a restructure and the subsequent acquisition of the equity. An understanding of where the value lies within the often maze-like structure of a company is also imperative. However, this should not be a barrier to private equity houses, as due diligence is their bread and butter and, as one lawyer points out, because firms often employ ex-investment bankers, they are more than capable of trawling through complex company structures.

One potential problem area is the investors in the funds. There is a question of whether pension fund investors who have put up money for private equity would be happy to see their money sunk into distressed debt.

Underlying any fund is a memorandum or partnership agreement where rules are set out about what a private equity house can or cannot invest in. While these rules vary from fund to fund, this is nevertheless an area where an opportunistic house could be constrained from straying into other fields of investment.

Finally, lawyers question whether private equity houses are capable of being as tough as vulture funds. As one lawyer says: "You really have to be able to play hardball with other parties, specifically the bondholders. This is a very aggressive area."

However, if this implies that executives in private equity houses are a bunch of namby-pamby yellow bellies, that is patently not the case. As most lawyers will know, private equity houses are more than capable of getting down and dirty with the best of them. Whether they chose to use these skills in a relatively untested environment remains to be seen.