LBOs can significantly harm a company’s credit profile, and send its debt and credit default swap costs soaring, as the deals involve using debt to fund the acquisition.
Bank of America recommends buying protection on Lexmark, Pactiv, Lubrizol, Harris and U.S. Cellular in a basket trade, to benefit from, or hedge against, the risk of widening credit default swap spreads in the event the companies become LBO targets.
CDS on the companies were trading at 148 basis points, 89 basis points, 71 basis points, 53 basis points and 67 basis points, respectively, on Friday, according to Markit Intraday.
LBOs were popular in the low-cost credit markets from 2005 to 2007, when many companies also were able to undertake deals using debt with few restrictive terms.
The trend culminated in the $44 billion takeover of TXU Corp in 2007, the largest such deal ever made. TXU has since changed its name to Energy Future Holdings.
Unlike the recent LBO period, deals taken private this time are likely to be of smaller size, at less than $10 billion, and take on less leverage, though larger deals are not impossible, Bank of America said.
Other trading strategies that can be used to protect against LBO risk include buying an LBO candidate’s bonds and buying protection using CDS, on the assumption that bonds may be tendered for in a deal while the CDS would benefit from spread widening.
Companies often tender for shorter-dated bonds after an LBO to avoid having debt maturities ahead of new bank debt taken on to fund the purchase.
Buying protection using longer-dated CDS and selling protection with shorter-dated CDS could also benefit from so-called curve steepening in the CDS of a company taken private, as the market prices in more long-term default risk relative to the company’s short term default risk, Bank of America said. (Reporting by Karen Brettell; Editing by Andrea Ricci)