The ability of private equity firms to reinvent themselves in times of crisis is astounding. Two minutes into a global credit panic, some of the world’s biggest funds are telling their investors not to worry.Why? Because some buy-out funds believe they can use their existing capital and new cash being raised to buy up the senior secured debt within their own portfolio companies. The really brave ones are boasting they will even be able to acquire some of the more expensive tranches of junior debt.They argue that by buying the debt – at a deep discount of course – they can make a profit when the necessary reconstruction plan is put into effect and generate a higher return on the underlying equity than a straightforward private equity deal would.

If the portfolio company suddenly tips into administration – and earnings can only go backwards from here – the private equity debt holder will have a guaranteed seat at the negotiating table. And if private equity firms are perfectly happy owning the equity within their portfolio companies, why on earth shouldn’t they feel the same way about owning the bonds and loans?

It sounds like a great scenario, but for whom?

On average, a standard buy-out held for between three and five years will produce a return on equity of 25-30 per cent. By comparison, the best return the firms can hope to generate by buying some of the debt in their portfolio companies is 8 to 9 per cent, or about the same as an asset manager could produce for a client.

Worse, if the credit crunch broadens to the wider economy, private equity groups could find themselves more exposed to risk than they intended and return next to nothing to their investors.

This mission creep must be the final insult to the lending banks. Private equity firms were already stretching their relationships with the banks by insisting on “cov-lite” and “toggle” instruments and the lenders are now paying the price. By selling the banks’ debt at a discount, they are only adding to the pain.

It makes one wonder what private equity will do next – buy oversold bank and commodity stocks? This is not why long-term investors gave them money and if they continue to stray from the path, it’s unlikely they’ll be able to raise money in the future.