Aug. 22 (Bloomberg) -- As 2008 dawned, Lone Star Funds founder John Grayken made clear to potential investors that his private-equity firm was in a race to profit from the biggest collapse in credit markets since the 1930s.

With more than $10 billion in deals since -- including yesterday's announcement that Lone Star had agreed to buy IKB Deutsche Industriebank AG, a German bank stung by subprime mortgages -- Grayken, 52, is aiming to lead the pack.

Distressed funds, such as Lone Star's, take wing in financial crises. They search for bargains amid the carnage, buying debt at deep discounts with the goal of selling it for profit, or converting it to equity to control a target company.

``It's a race among a number of different lenders to play this,'' Grayken told the Oregon Investment Council at a January meeting to discuss the Dallas-based firm's newest funds, a $7 billion pool focused on buying debt and $3 billion to target real estate. Lone Star spokesman Ed Trissell declined yesterday to comment.

Apollo Global Management LLC and KKR & Co. LP are also getting into distressed investing; each emphasized its goals in government filings last week. Leon Black, the former head of mergers and acquisitions at Drexel Burnham Lambert Inc., founded Apollo in 1990 with an initial plan to find cheap targets amid a U.S. recession.

``Everybody and their brother has raised a distressed fund,'' said Colin Blaydon, the director of the Center for Private Equity and Entrepreneurship at Dartmouth College's Tuck School of Business in Hanover, New Hampshire. ``It's a replay of the 1990-to-1992 period, when the crisis of the capital markets was junk bonds. There was a recession, and there were a lot of distress and restructuring deals.''

Distressed Bonds

Today's distress stems from a credit crunch triggered by last year's record defaults of subprime mortgages, those issued to the least credit-worthy borrowers. Banks and brokerages worldwide have recorded more than $500 billion of securities writedowns and increased costs related to bad loans, based on data compiled by Bloomberg.

The amount of bonds trading at distressed levels, or at yields at least 10 percentage points higher than similar Treasuries, has ballooned to $217 billion from $14 billion a year ago, according to Merrill Lynch & Co.'s U.S. High Yield Distressed Index.

After making a record $727 billion in announced deals last year, the private-equity industry slowed as financing dried up. This year there has been a 70 percent drop in announced private- equity deals, according to data compiled by Bloomberg.

Lone Star's 2008

Lone Star largely sat on the sidelines last year, limiting its activities to a handful of sales. As the credit crunch set in, the firm bought Accredited Home Lenders Holding Co. for $299 million.

This year has been a different story.

Lone Star last month bought $30.6 billion of Merrill Lynch's collateralized debt obligations at a 78 percent discount. Merrill Chief Executive Officer John Thain said in an interview at the time that the price reflected a lack of buyers.

``There really has been no liquidity until now,'' Thain said. ``There's no question this price was a bulk-sale price.''

The IKB purchase will cost about 150 million euros ($223 million), less than 20 percent of the amount the German government sought.

Oregon Retirement Fund

The Oregon Public Employees Retirement Fund put $600 million into Lone Star's latest vehicles after having been an investor since ``day one,'' said Brad Child, who helps manage the retirement portfolio as the senior real-estate investment officer at the state treasurer's office.

``Their track record and experience certainly play well into the economic environment today,'' Child said in an interview. ``They've proven that they can assess the market, go in and get their feet on the ground. They're very hands on with what they do and bring it to fruition.''

Mining for gold amid financial wreckage is familiar territory for Grayken, a former adviser to Texas billionaire Robert Bass who made his name finding value among distressed properties in the early 1990s after the savings-and-loan crisis.

Lone Star last month agreed to buy CIT Group Inc.'s home- lending unit for $1.5 billion and take on $4.4 billion of debt and other liabilities. In May Grayken bought part of a Bear Stearns Cos. unit that made U.S. mortgages through brokers for an undisclosed amount. Those purchases and others since January total $10.1 billion, based on data compiled by Bloomberg.

South Korea Probe

Lone Star was embroiled in a scandal in South Korea earlier this year. The firm's South Korea chief, Paul Yoo, faced charges of manipulating the stock price of Korea Exchange Bank's credit- card arm in 2003 to acquire the unit cheaply.

Grayken, who wasn't charged in the case, testified in South Korea in January and denied the allegations. While Yoo was convicted, an appeals court cleared him and the firm on June 24. Prosecutors have appealed to the country's Supreme Court to reinstate the conviction.

Among the risks Grayken faces now is that the lack of liquidity might continue, potentially diminishing profits. The complicated nature of the debt instruments is a marked difference from the early 1990s, Dartmouth's Blaydon said.

`` One of the questions is, `Is this distressed cycle going to look different because of all the complexity?''' Blaydon said.

To contact the reporter on this story: Jason Kelly in New York at jkelly14@bloomberg.net

Last Updated: August 22, 2008 00:01 EDT