Description

 As a follow-up to our recent posting on F&C Asset Management equity, we would like to additionally recommend that investors take a look at F&C's outstanding subordinated bonds.

Bonds                         Amount Out.           Maturity                    Price                          Yield to Call

*Assumes bonds called in 2016. If not called bonds mature on 12/20/2026 and coupon becomes L+269

Investment Thesis: F&C Asset Management ("FCAM" or the "Company") is a decent investment manager with £92.7B assets under management ("AUM") that offers a large margin safety in its subordinated debt. FCAM's recently underwent a demerger (spin-off) as Friends Provident ("FP") distributed its 52% ownership in FCAM to its shareholder on July 3^rd (please see FCAM Equity write-up for more information). FCAM's bond suffer from extreme revulsion, priced at 54 cents on the dollar, from its complexity and the uncertainty in future yield. There is only £35M of debt senior to the bonds (£293M total debt) while FCAM has £223M of cash on its balance sheet. The bonds have YTC of ~20%.

Business Description: FCAM is diversified investment management group that manages £92.7B of assets (as of March 31, 2009) for a combination of insurance (59% of AUM), institutional (28%) and retail clients (13%). FCAM was formed through the merger of F&C Group and ISIS Asset Management in 2004. FCAM maintains a diversified and defensive asset base which includes: fixed income (62% of AUM), equities (21%), real estate (9%), money markets (6%), and alternatives (2%). FCAM manages FP's insurance assets under a long-term contract (2014) which guarantees that the Company is at least EBITDA breakeven. FCAM does suffer from a low average fee margin (22.9 bps) due to its high percentage of insurance assets. Its average fee margin has grown 6% over since 2006 as its fees on new business are 30% higher than those that outflow.

Bond Features: FCAM's 6.75% bonds have some unusual features which are partially why they are priced so attractively. The bonds were issued in 12/2006 and underwritten by JP Morgan and The Royal Bank of Scotland. For the first ten year (until 2016) the bonds are payable annually (on December 20^th) and bear a fixed interest rate of 6.75%. On 12/20/2016, FCAM has the option to extend the bonds for another ten years until 2026. If the Company extends the bonds then the interest rate changes to L+269 and payable quarterly. These bonds have no covenants and FCAM also has an interest deferral clause where it can defer the payment of all interest on the bonds until maturity (2026). Although these two features sound terrible for bondholders they actually pose very little risk to the investment thesis.

• Interest cannot be deferred if a dividend is paid and FCAM is extremely committed to its dividend. UK asset managers somewhat trade on a dividend yield basis and it is very unlikely that FCAM would completely cut its dividend.
• Throughout its entire existence, FCAM has always paid a dividend and management stated that they want to distribute 2/3 of retained earnings as such. The Company paid a 6p dividend (9% yield) last year and I expect it to be the same this year.
• FCAM also has £223M of cash on its balance sheet which alone could easily fund its dividend (~£30M) and interest expense (~£18M). This does not include the ~£62M or more in EBITDA that FCAM should generate annually.
• The option to extend the bonds makes the YTM calculation impossible (if extended to 2026) as it depends on the future 3-month LIBOR rate. It is also silly to assume that LIBOR will be at its current all-time low of 0.65% in seven years and stay at that rate for the next ten years. Since 1990, LIBOR has averaged a rate of 4.49% (median of 5.03%). At an average LIBOR rate above 4.06%, FCAM would be paying a larger coupon on this floating rate then it paid at the fixed rate of 6.75%. This should be somewhat of a psychological barrier and from speaking with management it seemed that they would want to refinance this debt in 2016 barring any extreme circumstances.

Long Merits:

• Bond Valuation: 1.1x Net Debt/2009E EBITDA and 7.0x EBITDA/net cash interest expense
• o The market value of FCAM's debt trades below the cash on its balance sheet.
• Defensive: FCAM is diversified by asset class, client type and geography. Fixed income is its largest asset class, which should be more resilient in an economic downturn.
• Cost Reduction: FCAM decreased costs in 2008 (compared to 2007) and has a cost cutting and rationalization plan that could save ~£23m in annual expenses.
• Spin-off Dynamics: Friends Provident ("FP") is distributed its 52% ownership in FCAM to its shareholder on July 3^rd.
• Ownership Clarity: Management estimated that FCAM lost at least ~£2B of new institutional assets because of ownership uncertainty. UK institutional assets usually have a 3^rd party consultant's approval before they invest with any fund manager. Last year numerous consultants took FCAM funds off their buys lists because of the corporate uncertainty. Since the announcement of the spin-off in March, six leading firms of investment consultants have reinstated their buy recommendations that had previously been on hold
• Fund Performance: FCAM stated that 76% of its equity assets outperformed their benchmarks over the last year and 67% outperformed over the last 3 years. This could lead to asset growth in this higher margin segment.
• Share Repurchases: In May 2009, FCAM approved a share repurchase program that would allow them to buy approximately 10% of its outstanding shares over the next 15 months.

Risks:

• A decline in the overall level of the equity or bond markets.
• Continued net outflows either due to poor relative performance (fixed income has had average performance).
• o Have had net outflows every year since 2004.
• Failure to gain higher margin business from retail clients.
• Inability to renegotiate or extend long-term insurance contracts could lead to large outflows after 2014.
• Weakness in the Euro will impact earnings and AUM as FCAM is heavily biased toward Europe (€-denominated assets are 58% of AUM) and 80% of cost are in sterling (this Euro exposure is only 50% hedged).

Closest Comp Henderson 5/2012 debt trades at 89.5%, 10.77 YTC (6.5% coupon)

Catalyst

De-merger unlocks shareholder value and/or creates a re-pricing in the value of the bonds.