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Bet Against LBOs as Buyout Concerns ‘Unrealistic,’ Goldman Says

Leveraged buyout speculation is triggering an “unrealistic” surge in the cost of hedging against losses on the debt of potential takeover targets, according to Goldman Sachs Group Inc.

Investors can profit by selling credit-default swaps on a basket of LBO candidates including Gap Inc., Dell Inc. and 13 other companies, strategists led by Charles Himmelberg and Alberto Gallo in New York said in a report. The trade can withstand two buyouts within the group, they said.

“While a pick-up in LBO deals is definitely likely in 2011, we show that market spreads on many ‘LBO candidates’ are currently priced for a very sharp increase comparable to 2006 levels,” the strategists wrote. “These expectations are unrealistic, given the current constraints in leveraged financing and the lower leverage in current deals, compared to pre-crisis. We therefore think investors who have been short LBO candidates should take profits to avoid being hurt by the upcoming rally in spreads.”

The cost of default swaps has surged on speculation companies might get taken over by private equity firms, which typically use debt to finance their transactions, hurting current bond investors, Goldman said. The market is pricing in an average 17 percent probability that buyouts of the 15 candidates will succeed, which is “extremely high” by historical standards, the strategists wrote. That makes the cost to buyers of credit protection “hefty,” they said.

LBOs Accelerate

LBOs have been accelerating with deal volume reaching $120 billion this year, compared with $135 billion in 2008 and 2009 combined, according to data compiled by Bloomberg. A record $1.3 trillion of deals were done in the so-called buyout boom of 2006 and 2007. Private-equity firms pool money from investors and obtain debt to finance takeovers with the intention of selling the companies later for a profit.

Investors should sell five-year credit-default swap protection on the 15 companies, according to the report. The other candidates are Seagate Technology Plc, J.C. Penney Co., Hasbro Inc., Jones Group Inc., Fortune Brands Inc., Avnet Inc., Arrow Electronics Inc., Expedia Inc., Sara Lee Corp., AmerisourceBergen Corp., ConAgra Foods Inc., McKesson Corp. and Cardinal Health Inc.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

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