* CVC, Partners Group, H.I.G. Capital invest more in debt
* Debt yields beat lacklustre private equity returns
* Investors watchful for conflicts of interest
By Simon Meads
LONDON, Oct 8 (Reuters) - How do private equity firms deal with banks' reluctance to stump up the money to back buyouts? They become lenders themselves.
When Swedish buyout firm EQT bought BSN Medical earlier this year, another private equity house, Switzerland's Partners Group , lent the bandage-making business it had previously co-owned a chunk of the 1.8 billion euros ($2.35 billion) needed to finance the deal.
Private equity firms ranging from CVC , one of Europe's largest, to the smaller H.I.G. Capital are filling the vacuum left by retreating European banks, which have slashed leveraged lending by 42 percent to $72 billion so far this year.
" have expanded into Europe to help with some of those financing situations," said H.I.G. Capital managing director Haseeb Aziz.
Before the financial crisis, private equity firms typically raised money from investors, such as pension funds and insurers, topped it up with bank loans and bought companies which they then shook up and sold for a profit.
Now, with banks pulling back, private equity houses are also raising debt funds which they use to lend money to companies to help finance buyout deals.
Investors in traditional equity funds are taking a bet on buyout firms' ability to make money by buying and selling companies. For debt funds, success depends on buyout firms lending money wisely - a very different proposition that has already caught regulators' attention.
Buyout firms are starting to look more like investment banks, said Graham Elton at Bain & Co, a management consultancy firm. "The difference between Blackstone and Goldman Sachs
is narrowing every week," he said.
Blackstone , a big U.S. private equity firm, has $4 billion to plough into riskier mezzanine debt globally, while the much smaller Partners Group has a 375 million euro fund for lower-risk senior lending.
By entering lending markets, private equity firms hope they could revive the flow of deals that was choked off when the financial crisis ended the debt-fuelled boom of the mid-2000s.
Buyout deals have slumped to $18.7 billion in Europe so far this year from $152.7 billion for the same period of 2007, according to Thomson Reuters data.
Debt funds have limited firepower as yet - about $3.5 billion according to one estimate - compared with the $52 billion of lending banks have cut this year.
But if the market in Europe follows the United States, up to 60 percent of debt for private equity deals could come from investors in the future, said Partners Group's head of private debt Rene Biner.
With $117 billion of unspent funds available for deals, that would imply debt funds of up to $84 billion based on current estimates.
If lending was to mushroom to that degree and deals became more risky, it could ring alarm bells for regulators w ary of any sign that an opaque shadow banking system was replacing traditional lending.
A recent European Union proposal by Bank of Finland governor Erkki Liikanen that banks separate private equity investments from less risky loan books showed the sector is already on regulators' radar.
Investors in debt funds are also wary of any signs of conflicts of interest which could occur if buyout groups lent money to companies they own.
If such a company were to get into trouble, the buyout group would likely want to keep it afloat to protect its own investment, while debt holders might just want to get their money back.
Investors seeking higher returns are also driving the move to debt funds. The cost of borrowing has soared, so the returns from the right debt deals can match what the industry once promised from its core activity of buying and selling companies.
Senior debt - the most secure level on the buyout capital structure, which gets repaid first in the event of a bankruptcy - prices 5 to 6 percent above the benchmark Libor lending rate, while riskier subordinated mezzanine debt is at a 11 to 11.5 percent spread.
Partners Group is targeting a 16 percent annual return from its mezzanine investment in BSN Medical supplemented with a small equity co-investment, at a time when private equity bosses
are telling investors to be happy with 15 percent from buyouts.
"In certain instances there are better returns at lower risk to be made out of debt instruments than out of equity ones, and in that instance why on earth wouldn't you do the debt play?" said Alex Fortescue at Electra Private Equity .
($1 = 0.7657 euros)
(Editing by Douwe Miedema and Erica Billingham)
Keywords: PRIVATE EQUITY/LENDING