Oct. 29 (Bloomberg) -- Lehman Brothers Holdings Inc., the fourth-biggest U.S. securities firm, set up a $3 billion fund to invest in leveraged loans that banks are selling at a discount.

The Lehman Brothers Loan Opportunity Fund LP raised $670 million in equity capital, including $130 million from the bank and its employees, New York-based Lehman said today in a statement. The firm will borrow up to 3.5 times the equity capital.

Lehman joins Oaktree Capital Management LP, BlackRock Inc. and Eaton Vance Corp. in taking advantage of a sale of loans by banks stuck with more than $250 billion of debt. Banks had committed to more than $340 billion in loans and high-yield bonds to finance buyouts before demand dried up in July.

The fund ``enables the firm and our clients to capitalize on dislocations in the credit markets,'' Michael J. Odrich, managing director and global head of private equity for Lehman, said in the statement.

Banks agreed to terms for leveraged buyouts in the first half of this year, before defaults on subprime mortgages made to borrowers with patchy credit histories caused credit markets to dry up.

The banks have cut prices to unload the LBO financing. Lenders syndicated $9.4 billion in loans on Kohlberg Kravis Roberts & Co.'s purchase of credit-card processor First Data Corp. for as low as 96 cents on the dollar.

Narrowed Discounts

Discounts have narrowed as high-yield bond funds and hedge funds have flocked to the loan market. Last week, bankers for New York-based KKR and TPG Inc. sold $7 billion of loans to finance the buyout of Energy Future Holdings Corp., the Texas power producer formerly known as TXU Corp., at 99.75 cents on the dollar. The banks still have as much as $17.5 billion of TXU loans still on their books.

Lehman, the seventh-largest arranger of U.S. leveraged loans, has so far avoided the write-offs taken by some of its competitors. Lehman reported a smaller third-quarter profit decline than analysts expected. Merrill Lynch & Co. lost $2.24 billion, related to $8.4 billion of writedowns for subprime mortgages, asset-backed bonds and loans. Citigroup Inc., the biggest U.S. bank, reported a 57 percent earning decline for the period, including $6.5 billion of costs for fixed-income trading and underwriting losses and consumer loans gone bad.

Investing the Money

Lehman has started investing the money ``for the past several weeks,'' said Michael Guarnieri, former head of credit research at the firm, who is helping manage the fund. ``On a risk-adjusted basis we find the investment opportunities for this fund to be attractive,'' he said. ``There is still a significant leveraged-loan backlog outstanding.''

The opportunity will exist as long as the loans remain on the banks' books, said Orin Kramer, board chairman of the $80 billion New Jersey State Investment Council, and a general partner with hedge fund Boston Provident LP. New Jersey gave $750 million to four investment managers in September to purchase buyout loans, including $400 million to BlackRock.

``This is not like football, where the game ends at 60 minutes,'' Kramer said. ``Until you tell me the banks have sold all the loans they ever intend to sell, then I will say it's over.''

Lehman may be late to the game, said Keith Berlin, a senior research analyst for Fund Evaluation Group LLC in Cincinnati, which advises pension funds on investments. ``Much, if not all, of the technical selling pressure is behind us,'' he said.

Managing the fund with Guarnieri are Thomas Kramer, co-head of leveraged finance within the asset management group, and Timothy Van Kirk, head of leveraged loans, also for the asset management group.

Kramer and Van Kirk joined Lehman in July when it purchased leveraged-loan manager LightPoint Capital Management LLC, which had $3.2 billion in assets under management. Kramer was chief executive officer of LightPoint.

To contact the reporter on this story: Pierre Paulden in New York at ppaulden@bloomberg.net

Last Updated: October 29, 2007 18:34 EDT