Is the Party Over for Aubrey McClendon

J.A. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Chesapeake Energy (NYSE: CHK) is now in the news and no doubt wishes it wasn’t. The CEO, Aubrey McClendon, with his penchant for living on leverage, has reportedly borrowed over one billion dollars using his ownership in Chesapeake wells as collateral.  The media is now concerned about this almost two decades old agreement granting the CEO and founder participation rights in Chesapeake’s wells (FWPP). McClendon is granted up to a 2.5% interest that belongs solely to him and his debt is non-recourse to Chesapeake. It has been benignly neglected by both the board and investors over the years and in fact was resoundingly approved for continuance by shareholders in 2005. What makes it a hot topic today is the quiet accumulation of a substantial amount of debt by McClendon using these wells as collateral and the potential conflict of interest between the lender and Chesapeake. One might argue since they are his property, he has the right to use them in whatever way he sees fit. Unfortunately, that has not always worked out for shareholders as McClendon’s tendencies to love leverage in his personal finances has come back to bite shareholders in the past-- non-recourse or not. 

Damage control

Since the story of the loans hit the media, the Board of Directors has been busy defending the FWPP and distancing McClendon's finacial activities from the company.

On April 20 the board issued a statement that the Founders Well Participation Program (FWPP) runs with complete shareholder approval and the Board of Directors is fully aware of McClendon’s financing activities

By April 26 McClendon’s FWPP agreement was amended and will end in 2015. The board also stressed that McClendon would issue a separate accounting of his financing activities and they retracted the previous statement that the board was fully aware of his financial activities and corrected it to the board is generally aware of the use of FWPP interests to obtain loans.

Accounting of founder well participation plan

The FWPP allows McClendon to buy up to 2.5% of all the wells that will be spudded by CHK in the upcoming year. He buys all of them or none of them. This has been interpreted by the board as an alignment of his interests with shareholders. Contrary to outside perception, these wells are not a big source of cash. The well interest is, in fact, not profitable at all. Looking at three years worth of costs and expenses, you might ask why he wants to be involved in this expensive form of shareholder alignment.

<img src="/media/images/user_69/fwpp_large.jpg" />

The wells do not generate any cash, but they are an asset with some value that allows McClendon to borrow against them Depending on the valuation measure, they are worth between $410 million (valued by the PV 10 required by the SEC) or $852 million if a looser interpretation and a lower discount rate is used.  By taking out loans, he is able to pay the expenses and have some cash left over. The fact these are in the red does need to concern him if he can use them as collateral. 

Loans and FWPP expense from the 2010 proxy

Taking a look at his loans, and expenses, we see nearly $300 million left after paying the 2008-Q1 2011 well expenses. 

<img src="/media/images/user_69/loan_large.jpg" />

It was the size of the loans and the potential conflicts of interest between the lender, McClendon and Chesapeake that brought the FWPP arrangement to the attention of the media, unhappy shareholders, and finally the SEC in April. McClendon's biggest personal lender is EIG Global Energy Partners who is also a financier to Chesapeake. That raises the inevitable question of conflict of interest. Were McClendon’s loans part of a quid pro quo for favorable terms for EIG that were not in the best interest of CHK shareholders? Some analysts believe EIG and their investors were in a position to insist on sweeter terms when dealing with Chesapeake as part of a package that included loans to the CEO.

From EIG’s website: 

EIG Global Energy Partners has a singular focus on being the preeminent provider of institutional capital to the energy sector globally.

We see ourselves as the consummate niche investor. We only invest in energy projects, companies, and related infrastructure. Within these sectors there is very little we haven't seen or done. Since 1982, with $11 billion deployed in over 260 energy projects and companies around the globe, EIG has demonstrated its commitment to the energy industry throughout the peaks and troughs of business and commodity cycles.

As recently as November 2011, EIG and its limited partners were buying $1.25 billion in preferred shares from Chesapeake to monetize Utica shale projects. The yield was a generous 7% and had a repurchase value of 10% IRR or a return of 1.4X on the initial investment. The last preferreds I bought yielded 4% and promised me the capital back—maybe.

This is not a particularly favorable arrangement for CHK shareholders.

Reuter’s reported   that McClendon received a total of over $1 billion loan from an affiliate of EIG Global Energy Partners. The Energy Fund XV (an EIG fund) loaned McClendon $500 million and Energy Fund XIV loaned him $375 million.  The investments in McClendon were pitched to EIG fund holders as a way to profit from the wells that would create good returns. As we can see, there are no profits from the wells—at least on paper. It might not work out to be the profitable investment story shareholders in the funds were spun . If McClendon’s stake is running in the red, there is a good chance the other 97.5% is not generating much cash either.

Answering the call for more transparency, there was a supplemental disclosure from McClendon outlining the founder affiliates he uses to manage his FWPP holdings, the value of those holdings, and the loan amounts. His filing admits to a total loan value of $846 million and not the $1 billion that has been quoted in the press. It would be fortunate if the loan amount is not in the billions of dollars since the assets backing these loans are only valued at $852 million and to get a value that high, the non-standard PV 9 calculation was used. The PV 9 used by McClendon includes proved undeveloped that the PV 10 SEC approved measure does not.

If the standard PV 10 is used the value drops to $410 million. Does this make EIG a bit nervous about the expected profits on those wells? 

This is from McClendon's separate filing. It shows the three limited liability corporations, their ownership in the wells, that value and the loans against them.

<img src="/media/images/user_69/wells_large.jpg" />

While no recourse goes back to Chesapeake, the board has bailed McClendon out of highly leveraged misadventures in the past. In 2008 the board hastily renegotiated McClendon’s contract in order to extricate him from a margin call. That involved a $75 million signing “bonus” to be used to pay the partner well expenses. Otherwise he would not have made it. The board also bought $12 million worth of antique maps one could argue the company might do without. If it happens again, it could cost considerably more and his assets won’t cover it. 

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