Little Risk, Big Rewards in Buyout Deals

As leveraged buyouts surge, hedge funds and other savvy investors are cleaning up with insurance policies aimed at protecting bondholders

by Steve Rosenbush

Another day, another huge leveraged buyout. Student-loan company Sallie Mae became the latest company going private as it agreed Apr. 16 to a $25 billion acquisition by private equity firm J.C. Flowers (see BusinessWeek.com, 4/16/07, "A Premium Bid for Sallie Mae").

Lots of money, to be sure, with plenty of financial winners. Yet those clearing the biggest gains in the deal could be hedge fund traders who made side bets on derivatives linked to Sallie Mae's debt. Those traders took out insurance policies on the price of Sallie Mae (SLM) debt. The price of such policies, known as credit default swaps (CDSs), rises when a leveraged buyout is announced because higher debt boosts the odds of a default. In other words, with relatively little money up front, investors are able to significantly increase the payoff by correctly forecasting potential buyout targets.

For example, the price of CDSs on Sallie Mae bonds rose from 40 basis points to 100 basis points during the past week, allowing traders to collect about $450,000 for every $10 million worth of bonds that they insured. "They are cheap to buy, yet the rewards are pretty high," says Robert Discolo, head of hedge fund strategies at AIG Global Investment Group (AIG) in New York.

Big Potential Payoff

Prices and returns vary, but a trader can often earn $800,000 or more for every $400,000 invested. That's because a CDS typically costs about 0.4% of the underlying value of the bonds, according to Tim Backshall, chief credit derivatives strategist at New York-based Credit Derivatives Research. It costs about $400,000 to insure $100 million worth of bonds, he says. The value of the policy increases about $4,000 every time the value of the bonds rises by 0.01%, or 1 basis point.

Buyouts such as the Sallie Mae deal are usually welcomed most by equity investors, who stand to receive a hefty premium on their shares' market price. But private equity firms borrow at least $4 or $5 for every dollar of equity they invest in a takeover (see BusinessWeek.com, 3/28/07, "Prospecting for Private Equity Targets"). That sudden surge of debt onto the balance sheet can pose a problem for bondholders, as greater leverage often leads to lower bond ratings, reflecting the increased odds of default.

That's why investment banks created the CDS market about 10 years ago. In the past two or three years, as private equity activity has boomed, the CDS market has taken off. The underlying value of the insured bonds is around $45 trillion, and fees generated from those deals are worth at least $20 billion. "The credit-default-swaps market quickly has become a critical tool for hedge funds," Backshall says.

The Price of Protection

A few weeks before the Sallie Mae deal, traders made a huge profit on "protection" for supermarket chain Kroger (KR). The price of a five-year CDS on Kroger debt rose from 45 basis points to 100 basis points in a day, before dropping to 60 basis points on Apr. 16 as buyout talks subsided, according to Backshall. "Traders are on a hair trigger now," Backshall says. A CDS on Tribune (TRB) rose from 55 basis points last year to 140 basis points in February and 370 basis points on Apr. 16.

Backshall helps traders find CDSs that, in his view, don't fully reflect the probability of a buyout. He says he has been recommending that traders buy "protection" on building supply outfit Mohawk Industries (MHK), which currently costs about 60 basis points. He also thinks a CDS for newspaper company Gannett (GCI) is a good buy at 46 basis points.

As the CDS market grows, traders have developed new ways to play. Sometimes they bet on "baskets" of stocks that reflect a sector. If even one company is bought out, it can prove profitable, Backshall says. They also make bets on the relative value of long- and short-term insurance policies. A CDS can provide as little as one year of protection, or as much as 10 years. Longer maturities tend to be more expensive. The entire pricing scheme can be upset by a buyout, creating opportunities for traders to make money.

Lowered Risk

The CDS market also has benefits for private equity, according to Phil Phan, professor of management at the Lally School of Management & Technology at Rensselaer Polytechnic Institute. "The existence of such insurance lowers the risks associated with buyouts, making it easier for private equity firms to raise capital from pension funds," Phan says. (See BusinessWeek.com, 11/7/06, "The Money Behind the Private Equity Boom.")

The CDS market does pose risks for investors, though. Hedge funds typically borrow 20 to 30 times the equity they put into a CDS trade. If the investment goes bad, they still must repay the debt. They also need to make sure that they are buying a CDS from a credible seller, who will pay off the policy in case of an actual default.

For now, the rewards far outweigh the risks. The buyout boom shows no sign of slowing during the immediate future, and for the hedge funds, that's the time horizon that matters the most.

Rosenbush is a senior writer for BusinessWeek.com in New York.