May 11 (Bloomberg) -- Funds run by Bear Stearns Cos. own two- thirds of Everquest Financial Ltd., a firm that invests in debt backed by subprime mortgages and buyout loans that's planning an initial public offering of as much as $100 million.

The funds received the stake and $149 million in return for most of the $555 million in assets used to establish the firm in September, according to a U.S. Securities and Exchange Commission filing this week. A fund controlled by Michael J. Levitt, founder of Stone Tower Capital LLC, a New York-based asset manager specializing in leveraged-loan investments, owns 8.4 percent.

The IPO, announced May 9, may help the funds transfer risk to other investors. The funds buy some of the riskiest portions of collateralized debt obligations, which package loans, bonds and derivatives into new securities. Assets in CDOs may have lost as much as $25 billion of value as mortgage delinquencies rose this year, Lehman Brothers Holdings Inc. said last month.

The potential for conflicts of interest that would hurt investors buying such an IPO are ``mind boggling'' because buyers would need to rely on securities firms to assign prices to assets that have no ratings, don't trade often and are difficult to value, said Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago-based consulting firm.

Everquest, based in the Cayman Islands, plans to create more CDOs, which diversify and distribute risk so that some of the bonds produced get better credit ratings than the underlying assets. The firm focuses on so-called equity portions of CDOs, or unrated pieces with the highest risks and potential returns.

Raising Capital

Today, Marathon Real Estate Finance Inc., a New York-based investor in commercial-mortgage debt, filed for an IPO of as much as $200 million. Some of its portfolio -- a third of which will initially be riskier ``B'' notes, first-mortgage participation interests and mezzanine loans -- will be financed by selling off some of the debt in CDOs, the filing said.

CDOs have helped match booming demand for both high-yielding investments and high-rated bonds, drawing global money into risky U.S. asset classes including leveraged loans and mortgage for consumers with bad credit or high debt.

Raising capital for CDO equity, private equity or other risky investments through the creation of shareholder-owned companies instead of funds can eliminate the need for managers to worry about investor redemptions that force unplanned sales and locks in the investment dollars they earn fees on.

Highland Financial Partners LP, a vehicle investing in CDO equity managed by Dallas-based Highland Capital Management LP, filed April 27 for an IPO of as much as $50 million. Highland Capital oversees $33 billion in funds; Marathon Asset Management LLC, manager of Marathon Real Estate, manages $8 billion.

Shedding Risk

Jane Slater, a spokeswoman for New York-based Bear Stearns, the largest mortgage-bond underwriter, declined to comment. Levitt, also chief investment officer of Stone Tower, which oversees $7.7 billion, cited IPO rules barring comments.

Levitt and Ralph R. Cioffi, a senior managing director at Bear Stearns, will be co-chief executive officers of Everquest, which had $727 million in assets on Dec. 31 and a net asset value of $619 million, the filing said. Bear Stearns and Stone Tower will manage the portfolio; Bear Stearns will run the IPO.

Funds affiliated with Sam Zell's Equity Group Investments LLC contributed $6.4 million in Everquest's initial CDO equity and $18.6 million in cash for $25 million of shares, the filing said. Other investors put up $235 million in cash, including the fund affiliated with Levitt, which paid $50 million. Another Bears Stearns affiliate also has bought $25 million in shares.

About 36 percent of Everquest's portfolio on Dec. 31 was equity of CDOs of corporate bonds or loans, according to Bloomberg calculations based on the filing. The rest consisted of CDO equity backed by home- and commercial-mortgage bonds or asset-backed bonds, including other CDOs.

`Curious' Trend

The Bear Stearns funds this month sold Everquest derivatives that protect against default on $201 million of bonds, mainly of subprime loans, at an 80 percent discount to their value because the deal was agreed on in September, the filing said.

Global sales of CDOs this year through May 4 were up 44 percent to $179 billion from a year earlier, JPMorgan Chase & Co says. That compares to $14 billion of CDOs rated by Moody's Investors Service in all of 1996, Everquest said.

Many observers find it ``curious'' that a surge in subprime mortgage defaults hasn't resulted in a wave of disclosures of losses on CDO equity, Tavakoli said. The default rate for subprime loans packaged into bonds is the highest since at least 1997, according to Friedman Billings Ramsey Group.

The ``weighted average annualized cash return'' on the 17 CDO equity tranches that Bear Stearns Asset Management Inc. has bought was 24.5 percent through Dec. 31, the filing said.

Cioffi, who founded the two funds investing in Everquest in 2003, has worked since 1985 for Bears Stearns, where he was a ``principle force'' behind the firm's growth in CDOs and ``esoteric'' asset-backed bonds, it said. Levitt previously was a partner at private-equity firm Hicks, Muse, Tate & Furst Inc.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

Last Updated: May 11, 2007 19:49 EDT