Derivatives create new ways for betting on LBOs
Today, I take a look at how hedge funds are using insurance policies, known as credit default swaps, to make bets on companies they think are likely to be acquired in a leveraged buyout. link. Private equity investors typically look for a rate of return of 20% of higher. CDS's identified in a March report by Goldman Sachs could generate blowout returns, even by the rich standards of private equity.
The report says credit "protection" for retailer SUPERVALU could generate an internal rate of return of 74.7 if the company were taken out. That's because the price of the CDS would rise to reflect the increased probability of default associated with the higher debt level that LBOs typically bring. Buying "protection" for oil giant Sunoco could yield a return of 70.4%, and an insurance policy on healthcare services company AmerisourceBergen could produce a yield of 64.2%, Goldman says. Other top-five CDS picks included Electronic Data Systems, with a projected return of 56%, and Computer Sciences Corp., with a projected return of 53.6%. Many investors are betting on CDSs along with stocks and bonds of the underlying buyout target, in a strategy to boost returns.
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