Merger arbitrage players in the credit-default swaps market are being taught a pricey lesson in CDS documentation, as the planned buyout of German broadcaster ProSieben by publisher Axel Springer has sent ProSieben's CDS spread rallying rather than widening. In a typical buyout the target company's credit-default swaps would transfer to the new entity, but in this EUR4.16 billion takeover there is expected to be no debt and there's no provision in CDS documentation for any transfer.
Credit protection on ProSieben has swooned to around 40 basis points from 150 bps since confirmation of the takeover at the end of the summer. Dealers said ProSieben liquidity has almost entirely dried up--so sellers late to catch on may have been caught out.
International Swaps and Derivatives Association documentation has provisions for succession of credit-default swaps in buyout situations, depending on the quantity of the target company's debt that is bought by the acquiring company. In the case of Axel Springer/ProSieben, the market seems to be pricing in a high probability of ProSieben being left debt free--and the debt not transferring to Axel Springer.
Strategists are warning current economic conditions mean this is a problem which could crop up again. Credit markets are full of LBO reports right now--and with many corporates cash rich the likelihood of corporates buying up debt in target companies is on the increase. This means players may have to think more carefully about traditional merger arbitrage plays in which they would go long the target name and short the acquiring name.
"Most people trade CDS as a commodity now, but this shows you need an understanding of the documentation," said one strategist. For a credit derivatives market right now driven by single-name news, particularly LBO rumors, a hard lesson in the effect documentation has on pricing in merger situations could have a broad impact on CDS prices. In a recent research report, strategists at Citigroup highlighted the possibility that players wising up to the twists of CDS succession events may unwind LBO-related short plays.
