Done Deals in Distress

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And the biggest buyers of that debt last year, managers of collateralized debt obligations, are struggling to repair their portfolios filled with toxic mortgages and other investments gone sour.

Meanwhile, other buyers are being picky. Distressed debt funds—which raised a record $24 billion last year, up from $7 billion in 2006—are demanding higher returns or bulletproof guarantees like the "most-favored-nation clause," in which banks agree to buy back the debt if its value depreciates shortly after the sale. Some are even asking banks to help finance their debt purchases, debt traders say. "They know that if one of these buyouts goes bad, all the bonds in the market could drop," says one buyout veteran.

UNFAIR PUNISHMENT?

The deals getting whacked the hardest are in especially troubled industries such as real estate, retail, and newspapers. Take Apollo's $8.75 billion buyout of Realogy, a collection of real estate brokers such as Century 21, Coldwell Banker, and Corcoran Group. Nine months after the deal closed, debt investors have marked down the value of the company to $5 billion. If it had to sell Realogy today, Apollo would lose the entire $2 billion it ponied up for the purchase. Realogy officials declined to comment.

Some firms argue that the punishments being doled out in the debt markets are unfair. The beaten-down valuations, they say, ignore companies' underlying financials. "One of the keys in analyzing what is and what is not distressed is how an acquisition is performing—and especially how it was capitalized and structured," says Steven Anreder, a spokesman for Apollo, which has two other companies with discounted debt. Kathleen Waugh, a spokeswoman for Toys 'R' Us with bonds at 68 cents on the dollar, echoes: "We are pleased with our performance. We cannot control market conditions."

Maybe so. But it may take a while for the companies to justify the initial sky-high valuations. And if the economy slips into a recession, defaults are inevitable. All of which means firms may be forced to hold on to these companies far longer than many imagined. "The argument that the recent funds will result in great returns is almost fanciful at this point," says one investor in buyout funds.

It's not unlike the situation venture capitalists faced after the dot-com bubble burst. Such players raised record amounts from investors lured by the dazzling returns of previous, smaller funds. But later funds flamed out when the companies failed to live up to their high price tags. Burned investors are only now beginning to regain interest in VC funds.

The road to recovery could be equally long in the buyout world. Says Alan Kosan, head of private equity research at investment adviser Rogerscasey in Darien, Conn.: "Five years from now, these firms will still be owning the companies and hoping they grow out of the high valuations."

Emily Thornton is an associate editor for BusinessWeek.