Funds Tinker With Defused Chesapeake Convertibles: Street Whispers

NEW YORK ( TheStreet) - Hedge funds BlueMountain Capital Management and Daniel Loeb's Third Point are jumping into embattled oil and gas driller Chesapeake Energy ( CHK) by way of convertible bonds, and this time they think the trade won't blow up in their face.

In contrast to convertible bond arbitrage plays that netted hedge funds billions in losses in 2005 when General Motors ( GM) and auto parts supplier Visteon ( VC) faced takeover speculation and tender offers from the likes of investors such as Kirk Kerkorian, a change of wording makes BlueMountain and Third Point poised to benefit from any deal activity.

That's because while a takeover - called a "change of control event" - used to blowup convertible arbitrage strategies, a new standard to convert bond holdings into stock after an acquisition signals that both BlueMountain and Third Point could see a large gain from their bets, were Chesapeake to be acquired.

In 2005, a Deutsche Bank analysis calculated that takeover speculation netted hedge funds $32 billion in losses tied to backfired convertible bond arbitrage strategies because the gains on long bond bets were muted from M&A, while short stock investments plummeted.

After a subsequent change in the language surrounding convertible issuance, a UBS Asset Management white paper highlights that new provisions now compensate convertible bond holders for takeovers by giving investors a put right (often at par) if an acquisition takes place. The new feature "offers protection against the possibility of an acquirer with a substantially worse credit quality," added UBS in the white paper.

Amid a flurry of asst sales from Chesapeake Energy and speculation that its shale oil and gas assets would fit nicely in the larger exploration portfolios of super majors like ExxonMobil ( XOM) or Chinese drillers, BlueMountain and Third Point's convertible bond bets stand out as an interesting development for the Oklahoma City-based company, after it settled an activist push and board overhaul launched by leading shareholders Southeastern Asset Management and Carl Icahn in June.

In second quarter holdings released on Tuesday, Third Point and BlueMountain disclosed they bought Chesapeake Energy convertible bonds worth $5 million and $6 million, respectively, for an approximate 20% discount to their face value, according to 13F filings with the Securities and Exchange Commission. In the bonds, BlueMountain has the right to convert every $1,000 of its $6 million in principal for 19.38 shares at a conversion price of $51.58, while Third Point can convert every $1,000 of its $5 million in principal for 11.65 shares at a conversion price of $85.81.

The filings also show Chesapeake bonds were Third Point and BlueMountain's only convertible bets within large portfolios of stocks and options highlighted by investments in Yahoo! ( YHOO) and News Corp ( NWSA), respectively. BlueMountain, a noted credit investor, recently helped to unwind JPMorgan's ( JPM) "London Whale" trade.

Chesapeake Energy shares closed Tuesday trading at $19.21, meaning that in the absence of a takeover bid, the stock would need to more than double to give BlueMountain the ability to convert to stock, and they would need to more than quadruple for Third Point. While the impact of a takeover isn't spelled out in the press release of Chesapeake's respective May 2007 and May 2008 convertible offerings, wording indicates that the hedge funds would stand to gain.

Holders of the convertible notes may require Chesapeake to repurchase some or all of the convertible notes, "in the event of certain change of control transactions, at 100% of the principal amount plus accrued interest," Chesapeake's bond filings state. "In general, upon conversion of a note, the holder of such note will receive cash equal to the principal amount of the note and Chesapeake common stock for the note's conversion value in excess of such principal amount."

The bond issues also carry yields of between 2.25% and 2.5% and mature in 2037 and 2038 respectively, giving investors a long window to play a Chesapeake share recovery.

In second quarter 13F filings with the SEC, Chesapeake's largest shareholder Southeastern Asset Management, run by Mason Hawkins, bolstered its leading stock position in Chesapeake by roughly 3.5% in the second quarter, buying up roughly 3.12 million shares. The share increase puts Southeastern's stake in Chesapeake Energy at nearly 90 million shares, or roughly 13.5% of the company, according to SEC filings.

After disclosing a stake that amounts to roughly $1 billion or 7.5% of Chesapeake's stock, activist investor Carl Icahn's filings show he didn't add to his position in the driller, which is the second leading producer of natural gas in the U.S. to ExxonMobil.

In June, Southeastern and Icahn's activist campaign led to a reshaping of Chesapeake's board, highlighted by the separation of co-founder Aubrey McClendon's CEO and chairman role. In the overhaul, McClendon was replaced as chairman by former ConocoPhillips ( COP) chair Archie Dunham, but maintains his chief executive role.

Chesapeake also elected four other independent members to its nine-member board of directors, including three proposed by the company's largest shareholder Southeastern Asset Management and one proposed by Icahn. Those elections and Dunham's replacement of embattled CEO McClendon as chairman came as a quick response to calls for drastic change that will help Chesapeake better manage its finances as a cash crunch looms.

Year-to-date shares are off over 14% and nearly 40% in the past 12 months, amid concerns about its balance sheet, loans taken out by CEO McClendon tied to a 2.5% personal investment in wells that the company has drilled over the years, a federal investigation into allegations of price fixing in land acquisitions made by Chesapeake and rival Encana, as well as the decline in natural gas pricing to a level that remains uneconomic for many drilling companies.

In second quarter earnings, Chesapeake said it expects $7 billion in divestitures during the third quarter, helping to propel overall 2012 asset sales to over $14 billion.

Those sales are seen by analysts and ratings agencies as key to the company's outlook and have been a key management benchmark for most of 2012, as revelations about CEO McClendon's personal dealings and federal investigations into the company's operations cloud its outlook.

For more hedge fund investments, see why Moore Capital fled JPMorgan and why John Paulson is winning from merger arbitrage bets amid a rocky 2012.

-- Written by Antoine Gara in New York