Swap Spreads Negative … Time to Buy Private Equity?

Includes: BX, ERO, EVR, IEF, LQD, TLT
by: Brian Kelly

These are the trading days that we live for at Kanundrum Capital – macro news is making waves in the currency and fixed income markets, but the equity markets have yet to meaningfully respond. We have spent considerable effort documenting the flaws in the European “bailout” plan, and today the downgrade of Portugal finds us happily short EUR/USD. But what about that free money we promised in the headline – is this just a bait-and-switch … au contraire mon fraire.

Swap Spreads
For the first time in history the cost for a corporation to borrow (as measured by the 10 year swap rate) is lower than the cost of borrowing for the United States of America.

Mathematically, the swap spread is the interest rate charged on a fixed corporate loan minus the interest rate of the 10 year US Treasury note. Swaps and the derived spread are used by insurance companies and pension funds when pricing fixed income instruments to meet long term obligations. Additionally, the swap spread is used as a reference point for a wide swath of financial market prices.

Until the collapse of Lehman Brothers (OTC:LEHMQ) , most market participants thought that a ‘negative’ swap spread was mathematically impossible, since it would imply investors believe that they have a better chance of getting paid back by a corporation than by the US government. However, at the apex of the financial crisis, 30 year swap spreads did indeed go negative and have yet to return to "normal."

Free Money?
Typically such an anomaly would be closed by arbitrage, but the financial crisis has constrained risk taking. To exploit the anomaly, traders need to buy US Treasuries and sell short Swaps – easier said than done in a time when risk is a four letter word and traders do not know if they will be allowed to be in business next year.

So in theory, one could put the arb trade on and wait for the money to roll in, since presumably if the US government defaults then US corporation will also be on the edge of default. Alas, uncertainty over government regulation and the law of unintended consequences has resulted in a persistent anomaly.

So What?
Perhaps our explanation has left you a bit flat – we understand, it is an esoteric indicator – but when combined with the current IPO environment it has big implications for the US equity markets. In particular, we view the negative swap spread and the hot IPO market as bullish for private equity and bullish for the US equity market.

Since rates are low, the IRR for private equity investments is lower. To be sure, rates have been low for some time, but the IPO market has been non-existent. The recent uptick and positive activity in the IPO market gives private equity firms an exit strategy for portfolio companies. That is to say, if they buy a company they can reasonably expect to return it to the public in a "hot" IPO.

Since the swap spread is a reference point for all types of investments, a falling rate makes equities look cheap in the eyes of private equity. Therefore, our view is that private equity buyouts, including LBOs, could increase substantially.

The Trade
We shall be playing this emerging trend by initiating a long position in the private equity firm Blackstone Group (NYSE:BX) and in M&A advisory firm Evercore Partners (NYSE:EVR).

In our view, Blackstone should benefit from their ability to deploy substantial dry powder (unused capital) in this PE friendly environment. As well, the valuation of existing portfolio companies may rise with the IPO market. Evercore should benefit from increased advisory fees as the volume of deals increases.

Disclosures: Author long BX and EVR