LBO Crystal Ball

Moves in an arcane credit market can predict buyouts, a study suggests.
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There's more evidence that the fast-growing credit derivatives market can be a shareholder's best friend in predicting leveraged buyouts.

A new study by Credit Derivatives Research points to increased trading activity in the market for so-called credit default swaps on buyout targets. The New York-based firm looked at the swaps trading in advance of 30 takeover announcements.

A credit default swap is a contract under which a Wall Street bank or other so-called counterparty agrees to pay a bondholder in the event of a default.

Rising prices in the swap market imply investors see a greater likelihood that a company won't be able to pay back its lenders. By adding debt to a company's balance sheet, a leveraged buyout tends to raise the risk of default. So issuers of credit default insurance demand higher premiums, or swap prices.

The analysis found that in days and weeks leading up to the announcement of an LBO, the price of swaps written against possible default on target-company bonds often rose. The finding is notable because common sense dictates that the swap prices in an LBO should rise -- but only after public announcement of the deal.

Still, the study stops short of suggesting that insider trading is behind the moves. Some observers point instead to a herd mentality at Wall Street firms.

Credit default swaps are easily tradeable in the secondary market, which is largely controlled by Wall Street investment firms such as

Lehman Brothers

(LEH)

,

JP Morgan Chase

(JPM) - Get Report

,

Deutsche Bank

(DB) - Get Report

and

Bear Stearns

(BSC)

. Some of the biggest buyers and sellers of these specialized derivatives are yield-hungry hedge funds looking to bolster their returns.

There's growing suspicion on Wall Street that some of this harried trading may be driven by some market participants getting the inside word on an impending LBO. The analysis by Credit Derivatives Research will surely provide ammunition to those who think something fishy is going in the LBO market.

"Our analysis clearly shows increased risk in the CDS market prior to public announcements or rumors," says Credit Derivatives Research Strategist Tim Backshall, the study's author.

In many ways, the study confirms something that merger-arbitrage traders say they long have known about, which is the importance of keeping one eye on the CDS market.

"People look at this as a leading indicator," says a trader with one merger-arb firm. "If there is an LBO, there is a better than a 50-50 shot that the

swaps will have moved first."

It's something securities regulators and the business press also have begun to take note of, what with private equity firms pulling-off one mega-buyout after the other. It's been well documented that there was frenzied trading in credit default swaps tied to hospital chain

HCA

(HCA) - Get Report

, casino chain

Harrah's

(HET)

and

Freescale Semiconductor

(FSL)

in the weeks before the proposed buyouts of each of these companies was announced.

But proving insider trading is never easy, and some say rising swap prices don't prove anything about supposed insider trading. For one thing, the traders who work at Wall Street banks are some shrewdest players in the game. For another, everyone trying to game the stock and swap markets is constantly eyeing one another for a supposed edge, however slight.

Janet Tavakoli, a Chicago credit derivatives consultant who advises hedge funds and other savvy investors, points out that the banks writing swap contracts devour any information that can move a company's bonds.

For that reason, hedge funds will take note of any trading by a bank that writes a swap. They'll often mimic the bank's trades, assuming the bank knows something.

Even within firms, players are always on the lookout for what they hope might be a giveaway twitch.

Traders may start pushing up the price of a swap if the bankers at their firm start asking questions about the quality of a company's bonds. Tavakoli says those questions often are interpreted by traders as indicating something is up.

"You will have people on the loan desk going down to the trading desk and saying, 'What do you know about this name?" says Tavakoli. "On the CDS trading desk, the traders are on top of every bit of news about bonds."