Hedge Fund Envy Comes to Buyout Shops

Distressed-debt investing is often a way to "engage in a corporate takeover when the company is insolvent, by buying the debt," Baird says. If an investor gets in at the right level, the bonds convert into equity after the company emerges from Chapter 11. The bondholders then own a controlling equity stake.

Another titan of the industry, Kohlberg Kravis Roberts & Co., is also launching a hedge fund. The operation will be managed by KKR FinancialKFN, the publicly traded real estate investment trust, and will be named KKR Strategic Capital Fund. The fund will begin operations after the second quarter this year. According to a company statement, the fund will "primarily focus on stressed and distressed opportunities and market dislocation investments."

None of the activity should suggest that private equity, as an industry, is in trouble. Funds raised by buyout groups are at all-time highs, reaching about $86 billion in 2005, according to Thomson Financial. This year, the Wall Street theme remains privatization, and strategists expect another record year of buyouts in many industries, from chemicals to broadcasting.

But with the pool of alternative investment managers growing, private equity firms can't rest on their laurels. Debt trading at private equity companies offers two new ways for the groups to boost revenue.

"They can buy distressed debt and place bets that they know more about what the company is worth than the market knows as a whole," says Baird. "Or they buy a lot of the company's debt so they end up with control of the company later."

On a call Wednesday that discussed earnings results in KFN, KKR executives said that the new fund is an answer to demands from some of its large institutional clients and will position the buyout heavyweight to better compete for capital.