March 31 (Bloomberg) -- Apollo Global Management LLC, the private-equity firm run by Leon Black, and Colony Capital LLC may start funds to participate in the Obama administration’s program to buy distressed mortgage debt from U.S. banks.

The firms are among buyout groups that are considering raising as much as $1 billion each to invest in government- backed deals, said people familiar with the matter who asked not to be identified because the discussions are private. Apollo and Colony may reduce their usual fees to lure investors who might otherwise be wary of betting on a recovery in real estate markets, the people said.

“It’s a business that will be here for a while, and it’s a grind-it-out business,” Thomas Barrack, chairman of Los Angeles-based Colony, said in an interview, referring to distressed investing. “Some of the private-equity groups are equipped for that, and investors will pick and choose.”

U.S. Treasury Secretary Timothy Geithner, who outlined two public-private investment plans on March 23, is counting on buyout firms and hedge funds to lead as much as $1 trillion in purchases of toxic assets from ailing lenders. Private-equity managers have been looking for new opportunities since the seizure of credit markets in June 2007 all but ended their ability to take companies private in leveraged buyouts.

Barrack declined to comment on the specifics of fund raising, as did Anna Cordasco, a spokeswoman for New York-based Apollo.

‘Hottest Strategies’

Distressed securities include loans and low-rated, high- yield bonds that are having trouble meeting interest and principal payments. Investors can profit if prices rebound or the securities are swapped for equity in a restructuring. Distressed loans usually trade below 90 cents on the dollar and bonds below 70 cents.

“Partnering with the government on these assets may be one of the hottest strategies for private-equity firms,” said Kelly DePonte, a partner at San Francisco-based Probitas Partners, which advises buyout firms.

The government’s role in buying such securities increases the risk of a political backlash. Public and congressional outrage over bonuses paid to executives at American International Group Inc. and Wall Street banks raised concern among some investors that private-equity managers might face similar outcries if they’re seen as too successful in their toxic-asset investments.

No Guarantees

“There’s a question of whether the rules around Geithner’s plan will remain the same,” said Thomas Vartanian, a partner at law firm Fried Frank Harris Shriver & Jacobson LLP in Washington. “No one can guarantee what Congress will do.”

Starting fresh funds to invest with the government may insulate their other holdings from scrutiny.

“Hiving off a fund for government programs may protect wary investors from additional oversight,” said DePonte of Probitas Partners.

A typical private-equity fund pools money from institutional investors such as pension funds and endowments that pay 2 percent of assets annually and 20 percent of profits from a successful sale of an investment, also known as carried interest. The new funds may seek a lower management fee and carry, the people said.

Sidecar Vehicles

Some firms also are weighing so-called sidecar vehicles to existing funds as a way to buy the assets, the people said. That approach would allow the firms to make more immediate investments from fund commitments already in place.

Pacific Investment Management Co., the world’s largest bond-fund manager, and BlackRock Inc. both said on March 23 that they are considering funds that would invest in mortgage debt alongside the U.S.

Private-equity firms largely have been absent during the credit crisis that enveloped world markets in mid-2007 as a slump in home values triggered a rise in mortgage defaults. The lack of credit eliminated a main tool in their buyout arsenal and some deals that required little or no debt and that targeted financial firms ended badly in some cases.

TPG Inc., the private-equity firm run by David Bonderman, last year bought a minority stake in Washington Mutual Inc. The Fort Worth, Texas-based firm lost about $1.3 billion in September when the government bailed out the bank.

Distressed Roots

Buying distressed real-estate securities would hearken back to the early days of Apollo and Colony. Both firms were formed in the early 1990s and set about acquiring debt at deep discounts.

Apollo, created in 1990 by former Drexel Burnham Lambert Inc. executives Black, Joshua Harris and Marc Rowan, in part made its name by making $2 billion with Credit Lyonnais SA on high-yield bonds acquired from insolvent Executive Life Insurance Co. for 50 cents on the dollar.

Colony, which has invested more than $39 billion since Barrack founded the firm in 1991, actively bought from the Resolution Trust Corp., which disposed of assets from failed lenders after the savings-and-loan crisis of the 1980s.

“People remember how much money was made with the RTC,” said Fried Frank’s Vartanian. “These new programs will be watched closely.”

To contact the reporters on this story: Jason Kelly in New York at jkelly14@bloomberg.net; Jonathan Keehner in New York at jkeehner@bloomberg.net

Last Updated: March 31, 2009 10:14 EDT