Tetragon Financial Group (TFG_NA) was ably described by hawkeye901 more than a year ago. To save space, I will refer readers to his previous write-up for the business description as well as the detailed annual report and year-end summary put out by the management team. While the stock has risen by $3.50/shr over the past year, the stated NAV has increased by a comparable amount and the actual NAV is dramatically higher due to improved market conditions.
TFG today owns 70 CLO equity tranches across 28 managers. Stated NAV is $10.00 per share as of the end of February which includes $2/shr of cash and direct ownership of loans. We think that NAV per share should exceed $13 (75% higher than the current share price of $7.50) by the end of 2011 and can grow rapidly from there. NAV is meaningfully understated because management's models use a variety of assumptions that are legacy holdovers from the financial crisis. However, those assumptions are slowly being changed to reflect market reality and the process is part of what will drive a rapid increase in NAV from current levels.
There are multiple components to value accretion that will occur during 2011:
- Baseline IRR: The current IRR projected on the portfolio of CLO equity is 15.1%. When applied to the NAV comprised of CLO equity (i.e. excluding cash and securities) and deducting the 25% take for management, the baseline IRR should result in accretion during 2011 of approximately 90c per share.
- Share repurchase program: Management has repurchased about 5% of shares over the last year and releases a weekly update on the program. We anticipate that they will continue to buy stock back over the course of the year and by purchasing stock at a material discount to NAV, will result in accretion of approximately 30c per share.
- ALR Reversal: The Accelerated Loss Reserve, or ALR, is a reserve that was taken in two steps back in Q4 2008 and Q1 2009 relating to anticipated losses to the CLO equity. As it turned out, the majority of those losses never materialized. The improvement in the underlying loan environment has prompted management to begin releasing those reserves back into NAV; an initial partial release in Q3 2010 was followed by a second partial release in Q4 2010. The gross amount of the remaining ALR is $258 million. Net of their fee, this will result in accretion of approximately $1.60 per share to TFG shareholders.
- Better than modeled performance: The NAV model assumes a 2.2% default rate for 2011 and 3.2% for 2012 through 2014. It also assumes recoveries of 71% on defaulted loans. To be clear, even if the losses come in exactly as modeled, the ALR would still be reversed back into NAV eventually. They are two separate sources of potential value. However, defaults have been running substantially better than modeled. Each month as defaults come in better (or worse) than modeled, the delta flows through to NAV. NAV at December 31, 2010 was $9.47 per share and through the first two months of this year, it has increased to $10.00 per share, or by 53c per share. Of that increase, roughly 15c per share is attributable to the baseline IRR and perhaps another 5c per share from repurchase accretion, leaving 33c per share as accretion from "better than modeled" performance during the first two months. Defaults will likely tick up from their current low rates, but it's not unreasonable to expect at least $1 per share of contribution from this source in 2011.
Adding those components arrives at $13+ per share in 2011 year-end NAV (versus the $9.47 2010 year end NAV). While the ALR reversal is a one-time factor, the baseline IRR, the share repurchase accretion and the bonus from performance vs. model should continue beyond 2011, adding at least $2 per share in NAV on an annual basis versus a stock price stock of $7.50 today. We think NAV per share will approach $16 by the end of 2012.
There are several reasons why the stock is cheap, but it is reasonable to think that many of these factors will abate over time or recede as Tetragon becomes better known.
- It trades in Amsterdam despite being based in New York
- The underlying asset class is arcane
- The only real public comparable in the US is the much better known and KKR-branded KKR Financial (KFN)
- Only very recently did a domestic analyst pick up coverage of Tetragon
- Management receives 25% of accretion in NAV with no high-water mark
- Management aggressively marks down the portfolio for a double-dip with no high water mark
- Capital markets close to refinancing companies in 2013/2014 time frame
- Dramatic economic slowdown results in meaningfully higher default rates
Disclosure: We and our affiliates are long Tetragon. We may buy / sell shares in the future. This is not a recommendation to buy or sell shares.
Potential catalysts include an increase in the dividend (4.8% yield today), additional analyst coverage, the ALR reversal, or simply the rapid accretion of NAV relative to today’s share price.