Tetragon Financial Group (TFG NA) is a listed investment vehicle that owns equity in bank loan pools and is no stranger to VIC.  It was posted by Hawkeye901 in January 2010 and again in April of last year by Juice835.  I’ll skip the overview and suggest reading those instead, both for background and since each author accurately predicted the forthcoming increase in the company’s NAV, which has almost doubled over that time frame.  What makes this really interesting today is that despite the NAV rising from $10.00 to $12.40 since the last write-up, the stock has actually fallen from $7.50 to $6.30 over that same time frame and now trades at close to half of NAV:

It is likely that the NAV will continue to grow and the company is both buying back shares and paying a meaningful dividend (6.3% currently).  Despite the majority of the portfolio being invested in US bank loans, the stock is listed in Europe, it’s relatively illiquid (trades ~$900 K/day), and CLO remains a dirty word to most investors.  Combine those three facts with very high underlying fees and some other issues related to management and you have a perfect storm that has created an attractive risk/reward in my opinion.  I’ll cover the management issues in more detail later but even if one takes a negative view of the issue, I believe the stock is still too cheap. 

Valuation

Barring any major changes in market conditions NAV should increase from $12.40 today and approach $15/share by the end of the year through the following sources: 

• Cash flow from CLO portfolio: ~$1.20 contribution/share.  The portfolio’s baseline IRR is as high as it’s ever been at 16.8%.  The current market environment - increasing spreads but low defaults - is ideal for Tetragon’s model as it has low cost, locked in financing.  This contribution could be significantly higher if defaults remain low - the company is modeling a 3.2% default rate and 71% recovery rate on its portfolio for 2012-2014.  Actual defaults have been under 1% recently, and despite all the economic issues corporate balance sheets are generally quite strong. 
• Share buybacks: ~$0.30 contribution/share.  Tetragon has bought back 11% of its shares in recent years at an average cost of $4.98, and recently authorized an additional 5% buyback. 
• ALR Reversal: ~$0.75 contribution/share.  Tetragon still has $118 million in the Accelerated Loss Reserve, or ALR, which is likely to be “released” going forward.  This is basically an additional pool of reserves that was taken during the crisis, and has been steadily added back to NAV since.        

There are a few other bits and pieces that could contribute as well – in addition to the CLO portfolio Tetragon owns $110 mm of bank loans directly and also participates in the fee stream generated by its two partially owned asset managers, LCM and GreenOak Real Estate (“GORE”).  The nice part is that at the current discount significant NAV growth is not required to generate an attractive return to shareholders.  For example if NAV increased to just $14/share by the end of the year and the discount narrowed to 40%, that would imply a +33% return for the stock from current levels.    

The closest comp to TFG is KKR Financial (KFN), which currently trades right around book value. While KKR is a bigger name, is listed in the US, and is more liquid, the underlying assets (and high fees) are similar and Tetragon has actually performed better since its IPO, judged by book value growth with cumulative dividends added back:

If you’re worried about exposure to the space in general you could obviously consider hedging a long Tetragon position with a short in KFN.

Issues and Risks

The biggest issue for me is that the fee structure of Tetragon is excessive, with the investment manager getting a 1.5% management fee and 25% of gains over a LIBOR-based hurdle (currently around 3%), paid quarterly with no high water mark.  The lack of a high water mark looks especially bad when combined with the fact that the company wrote down its portfolio in excess of what its models were saying during the crisis (via the ALR) and have subsequently reversed that, earning incentives fees on the way back up for what turned out to be nothing but an accounting maneuver.  While the company claims it was simply being conservative with asset values during the financial crisis, it obviously looks bad to have earned an incentive fee because of this while many shareholders remained in the red.  Lee Cooperman of Omega Advisors, who owns 10% of Tetragon shares, has been vocal in his displeasure about this and another shareholder has filed suit again the company:  http://www.scribd.com/doc/60258760/Tetragon-Financial-lawsuit-by-Silverstein   

While the high fees are a real concern all of my estimates above are net of the 25% incentive fee, and while I don’t expect Tetragon to ever trade at book value if the fees stay this high it’s important to point out that KFN has a similar fee structure.  It’s also possible that Cooperman’s activism and/or the lawsuit have a positive outcome for shareholders – Cooperman is pushing for a handful of investor friendly items, including an increased dividend payout, ending incentive compensation based on the reversal of the ALR, and a cash tender for up to 10% of shares.   

In addition to the lawsuit above, one of the co-founders of the hedge fund that started Tetragon (Alexander Jackson of Polygon) is also suing the company after leaving over a dispute related to TFG’s deal with GORE (copy of that lawsuit also in the link above).  Essentially TFG and another entity controlled by Polygon’s partners teamed up to seed GORE, a real estate investment manager, and Jackson claims that the partners’ entity got the better deal at the expense of TFG shareholders (according to his suit they got a slightly higher ownership stake in the company while TFG put in more capital).  For what it’s worth GreenOak appears to be a very legitimate real estate operation, having been founded by the former co-heads of Morgan Stanley’s global real estate business, and is a very small position for TFG today.     

In addition to those risks, this remains a levered investment and there is a non-zero risk of TFG experiencing a permanent loss of capital if defaults spike.  They performed relatively well during the crisis, with default rates in the CLO portfolio remaining well below that of the overall market, and I take additional comfort in the senior positioning and high quality of the underlying bank loans, however this investment is not without risk, especially if we see another 2008 type of scenario. 

Conclusion

While there are some issues, at the end of the day I believe they are more than priced into the current stock price and that TFG represents an attractive risk/reward from here.  The investment gives you levered exposure to a relatively attractive asset class at a massive discount to fair value, in a vehicle that is returning capital to shareholders.  In the near-term NAV is likely to grow, and I believe the discount to that NAV is more likely to narrow than it is to widen. 

Disclaimer: my fund and/or I have a position (long or short) in this security and may trade in and out of this position without further notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment. 

• Continued cash flow generation and NAV growth
• Continued share buybacks and dividends
• Potential narrowing of discount to NAV
• Potential improvements from shareholder activism