* 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 dealwith banks' reluctance to stump up the money to back buyouts?They become lenders themselves.
When Swedish buyout firm EQT bought BSN Medical earlier thisyear, another private equity house, Switzerland's Partners Group, lent the bandage-making business it had previouslyco-owned a chunk of the 1.8 billion euros ($2.35 billion) neededto finance the deal.
Private equity firms ranging from CVC , one ofEurope's largest, to the smaller H.I.G. Capital are filling thevacuum left by retreating European banks, which have slashedleveraged lending by 42 percent to $72 billion so far this year.
" have expanded into Europe to help with some of thosefinancing situations," said H.I.G. Capital managing directorHaseeb Aziz.
Before the financial crisis, private equity firms typicallyraised money from investors, such as pension funds and insurers,topped it up with bank loans and bought companies which theythen shook up and sold for a profit.
Now, with banks pulling back, private equity houses are alsoraising debt funds which they use to lend money to companies tohelp finance buyout deals.
Investors in traditional equity funds are taking a bet onbuyout firms' ability to make money by buying and sellingcompanies. For debt funds, success depends on buyout firmslending money wisely - a very different proposition that hasalready caught regulators' attention.
Buyout firms are starting to look more like investmentbanks, said Graham Elton at Bain & Co, a management consultancyfirm. "The difference between Blackstone and Goldman Sachs
is narrowing every week," he said.
Blackstone , a big U.S. private equity firm, has $4billion to plough into riskier mezzanine debt globally, whilethe much smaller Partners Group has a 375 million euro fund forlower-risk senior lending.
By entering lending markets, private equity firms hope theycould revive the flow of deals that was choked off when thefinancial crisis ended the debt-fuelled boom of the mid-2000s.
Buyout deals have slumped to $18.7 billion in Europe so farthis year from $152.7 billion for the same period of 2007,according to Thomson Reuters data.
Debt funds have limited firepower as yet - about $3.5billion according to one estimate - compared with the $52billion of lending banks have cut this year.
But if the market in Europe follows the United States, up to60 percent of debt for private equity deals could come frominvestors in the future, said Partners Group's head of privatedebt Rene Biner.
With $117 billion of unspent funds available for deals, thatwould imply debt funds of up to $84 billion based on currentestimates.
If lending was to mushroom to that degree and deals becamemore risky, it could ring alarm bells for regulators w ary of anysign that an opaque shadow banking system was replacingtraditional lending.
A recent European Union proposal by Bank of Finland governorErkki Liikanen that banks separate private equity investmentsfrom less risky loan books showed the sector is already onregulators' radar.
Investors in debt funds are also wary of any signs ofconflicts of interest which could occur if buyout groups lentmoney to companies they own.
If such a company were to get into trouble, the buyout groupwould likely want to keep it afloat to protect its owninvestment, while debt holders might just want to get theirmoney back.
Investors seeking higher returns are also driving the moveto debt funds. The cost of borrowing has soared, so the returnsfrom the right debt deals can match what the industry oncepromised from its core activity of buying and selling companies.
Senior debt - the most secure level on the buyout capitalstructure, 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 11.5percent spread.
Partners Group is targeting a 16 percent annual return fromits mezzanine investment in BSN Medical supplemented with asmall 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 riskto be made out of debt instruments than out of equity ones, andin 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