Distressed debt funds on the march

Distressed-debt funds, which swoop to take control of companies when they hit the rocks, are surging towards an all-time fund-raising record.

These funds thrive in down markets and, with the FTSE 100 just having experienced one of its worst weeks of losses in three years, the frenetic pace at which they are raising money will fan fears that an economic downturn is imminent.

Unlike in past cycles, private equity giants - including Texas Pacific Group, Carlyle Group and Blackstone Partners - are at the forefront of the movement.

Edward Eyerman of Fitch, the credit rating agency, said: "[These funds] are all raising money now because we are at a point in the cycle where a lot of people are anticipating that default rates have only one way to go - and that's up."

Distressed debt investors wait until companies run into trouble, buy their debt for pence in the pound to gain control, and can then force break-ups or restructurings. Increased money-raising in the sector is seen as a harbinger of hard times.

No fewer than 18 firms are now in the market to raise $10.3bn (£5.5bn) in distressed debt investment pools - nearly twice what was raised last year, according to research firm Private Equity Intelligence.

Only once in the past 15 years have funds breached the $10bn barrier, in 2003, when distressed debt funds attracted $11.1bn worldwide to take advantage of the wave of companies the stumbled after the last market downturn.

Mark O'Hare of Private Equity Intelligence said this year's total "could easily exceed" that peak.

The prominence of private equity firms in the latest fund-raising wave has resulted in cynicism. This is because no other single sector has arguably done more to bring about the precarious levels of debt hanging over companies than the buyout firms themselves. Now some of them are raising money to cash in on their inevitable fall.

In recent years, buyout funds have used larger and larger amounts of debt to fund their takeovers, which they value based on detailed projections. In a market where interest rates have remained low and stable, and general market conditions have been benign, such financial engineering has worked, prompting buyout firms to get more aggressive with the levels of debt they hang on their companies. "Buyout firms have been testing the limits for the last 18 months," said Mr Eyerman. Much of the corporate mergers and acquisitions activity has also been heavily funded by debt.

A rise in interest rates, or a major shock to the economic system that affects the underlying businesses' ability to generate the cash to repay such heaving loans, can tip companies into trouble. "You think people would learn, but it never seems to happen that way," said a fund executive. "It's going to be ugly for a lot of companies, but it will be good for us."

Private equity-owned companies are particularly vulnerable to higher interest rates because the junk-rated debt that they generally rely on carries floating rates.