Value Investors Club / Tarpon Investment Group (TARP11 BZ)

Description

Tarpon Investment Group is a leading Brazilian fund manager that publicly listed its management company in early 2007. The stock has a market cap of $195 mm USD despite the company having over $172 mm in cash and investments in its own funds, providing investors an attractive combination of limited downside and potentially huge upside given the management company’s bright prospects.

In the recent drawdown Tarpon has held up well relative to its Brazilian peers and has many attributes you’d look for in an investment firm – a strong performance track record, a Buffett-esque approach to investing, locked-up capital from a diversified base of global institutional investors, a young and hungry team with large personal investments in the company’s funds and a lucrative fee structure. Tarpon has seen steady inflows, raising capital for its funds each quarter since its IPO. Even during the large drawdown of the past 4 months they have raised additional capital, bringing in $78 mm from outside investors on Oct. 31^st.

Tarpon manages approximately $1.1 B and generated over $45 mm in management and incentive fees in 2007 alone. While its incentive fees will be down for the foreseeable future, the company is profitable off of its management fees and the current price is cheap even using draconian assumptions for future performance and asset flows. The management team agrees and has recently been using its large cash hoard to buy back its shares and invest more in its own funds, and has stated that is will likely continue to buy back shares as long as they trade close to NAV (cash + the company’s investments in its own funds).

History and Background

In 2002 Tarpon was launched with $1 mm in assets by José Carlos Magalhães to pursue a long-only, value based investment strategy in the Brazilian market. Through 2005 it built its asset base with primarily Brazilian investors, reaching over $400 mm in assets by the end of that year. Tarpon’s flagship long-only fund has returned over 34% annualized since its launch vs. just over 27% for the Bovespa, and is beating the index again this year (-20.7% vs. -28.3% through 9/30/08, in USD).

In 2005 Tarpon gained attention when it launched and completed the first hostile tender offer in Brazil since 1979, leading a consortium in an offer of over $440 mm for steel company Acesita. This investment turned into more than a five bagger for Tarpon by the time ArcelorMittal concluded its acquisition of Acesita in early 2008.

2006 was another major stepping stone for the company, when it launched the Tarpon All-Equities Fund, a “hybrid equity” vehicle with initial capital from a handful of large U.S. endowments and foundations. The new fund had two purposes: to improve the firm’s investor base and to allow Tarpon to pursue private equity and other less liquid investment opportunities. The different funds are quite similar, with the same core public equity positions, but the All-Equities Fund contains a handful of additional private and less liquid positions.

This new fund has become the focus of the firm in recent years and is now close to half of Tarpon’s assets. When the company IPO’d in 2007, the management team put 70% of the proceeds into the All-Equities Fund and added an additional $50 of internal capital to the fund on Oct 31^st of this year. This fund has returned -23.3% YTD through September vs. -28.3% for the Bovespa, and has annualized at 18.7% since its Oct-06 launch vs. 24.2% for the Bovespa. While not as impressive as the numbers for Tarpon’s other strategy, this is a much shorter time frame and for what it’s worth the portfolio appears to have outperformed significantly in October and November. While Tarpon does not manage to the index, its funds are long-only and it does not try to time the market, so the overall market results do need to be considered when thinking about their performance.

The company and its employees remain the largest investor in its funds, with over $200 mm invested alongside its clients. Tarpon has successfully diversified its investor base since 2006, with the majority of its external capital now coming from US institutions:

Tarpon Investor Base (9/30/2008)
By Region	% of AUM
Americas (ex-Brazil)	66%
Brazil	19%
Europe	12%
Asia and Middle East	3%
By Type
Endowments and Foundations	23%
Management Company and Employees	21%
Sovereign Wealth Funds and Pensions	18%
Fund of Funds	12%
High Net Worth	10%
Banks	6%
Other	6%
Family Offices	5%

This alone is a major competitive advantage for Tarpon, particularly now when many of its peers with more retail-focused investor bases are seeing massive outflows and being forced to liquidate positions. Over recent years Tarpon has continually looked to extend the notice periods and improve the gates of its funds. At the end of the 3rd quarter, the funds’ average withdrawal notice period was equivalent to 482 days. The All-Equities Fund, which has accounted for the bulk of Tarpon’s inflows since its launch, has a 3-year initial hard lock-up as well as a side-pocket for any illiquid positions. Tarpon’s average management fee across its funds is 1.4% and it has a 20% incentive fee over LIBOR for the majority of its capital.

Tarpon’s ability to continually raise assets with such stringent terms speaks to the team’s reputation in the Brazilian market and amongst institutional investors. It worked with global investors such as TCI (Chris Hohn’s London-based hedge fund) on the Acesita deal, which was a major success. In addition Eton Park is Tarpon’s largest external shareholder, owning over 15% of the company. Eton Park has a significant presence in Latin America and co-invested in Tarpon’s recent private investment in real estate developer Direcional. These anecdotes and other references suggest that Tarpon is an extremely well-connected firm, especially for such a young group focused on a single emerging market. Over 93% of the firm’s assets (and all of its recent inflows) were also sourced internally, so the majority of the fees go straight to Tarpon.

Tarpon’s long-term capital also allows it to invest with a truly long-term time frame. The firm’s key tenets are its focus on intrinsic value, contrarian approach, portfolio concentration, and a long-term owner perspective. It will usually have around 10 public equity positions at one time, and focuses on small and mid-caps that are more likely to be mis-priced. Unlike most Brazil-focused funds you will not find CVRD or Petrobras in their portfolio, which together account for over 30% of the Bovespa Index. The firm doesn’t short, use derivatives, make macro bets, or use leverage in its funds.

Tarpon has 13 investment professionals, allowing the team to perform deep fundamental research and get actively engaged with the management teams of its companies. Tarpon’s team members are generally young Brazilian natives (Magalhães himself is in his 30’s) with either banking experience (Goldman, Morgan Stanley, JP Morgan, Merrill Lynch, etc.) or MBA’s (Stanford, Columbia, University of Chicago) from the U.S. Some have also worked at other leading Brazilian investment firms such as Hedging Griffo (one of the largest hedge funds in Brazil, owned by CSFB) and GP Investimentos (the largest PE firm in Brazil).

The back office team members also have strong resumes, including legal experience at Skadden Arps and accounting experience at E&Y. While all of this doesn’t mean Tarpon’s funds will perform well, it helps them raise assets, allows the firm to employ global best practices, and generally elevates the firm’s profile. Tarpon’s management team is transparent and speaks English, even holding their conference calls in English and putting transcripts on their website.

Valuation

It’s important to point out that Tarpon has two main methods of generating profits – earning fees and investing its own capital – and it helps to separate them when looking at the firm’s numbers. While the table below suggests that Tarpon’s management fees are not enough to cover its costs, a large portion of the costs are performance-based bonuses and thus tied to the incentive fee. For example in the most recent quarter where there was no incentive fee earned, management fees were R$9.1 mm and total costs were R$7.1 mm. Of that R$7.1 mm almost R$5 mm was stock option plan compensation which doesn’t have any cash impact. So overall the company still generates plenty of cash off of its management fees alone.

The numbers below are shown in Reals, which have had an exchange rate between 1.6 and 2.4 to the USD in recent years:

Tarpon Basic Financials (R$ mm)	2006	2007	2008 (Q1-Q3)
Management Fees	5.8	20.4	26.1
Incentive Fees	22.3	62.4	39.6
Total Revenue	27.2	81.6	65.7
Total Costs (including stock options)	1.0	34.5	32.3
Operating Income	26.3	47.3	33.4
Investment Performance	0.2	1.8	(17.0)
Total Net Income	24.5	48.7	17.4

With Tarpon’s funds down significantly it is unlikely to see any large incentive fees for quite a while due to the funds’ high-water marks, although that does not apply to the capital recently raised and any additional new capital that comes in going forward. While it is impossible to predict the company’s future earnings with any level of certainty, this is clearly a good business if Tarpon can keep its clients happy and continue to raise even a small amount of new capital.

Given Tarpon’s unpredictable earnings the downside protection offered by the company’s cash and fund investments (NAV) is the real key to this story. On 9/30 it had R$12.04/share in NAV and no debt. The NAV has taken a hit due to fund performance the past two months and I estimate the current NAV is $R9.75/share.

	9/30 NAV ($R mm)	Est Change in Mkt Value	Addition/ Withdrawal*	Extra Write-down	Est Current NAV (R$ mm)	In USD
Cash & equivalents	228	0	-73	0	155	$66
Public Equity	193	-55	66	0	203	$87
Private Equity	52	0	0	-26	26	$11
Other	23	-6	0	0	17	$7
Total	496	-61	-7	-26	401	$172
Per Share	12.04	-1.49	-0.18	-0.63	9.75

Tarpon took R$73 mm of its cash and invested it in the All-Equities Fund on 10/31/2008, so the estimated drawdown on that investment is -10%, less than the -29% drawdown assumed since 9/30 for the initial 193 mm of public equity positions. I’ve cut the value of Tarpon’s PE positions in half to be conservative, despite the fact that they are likely to get marked down by such a large degree anytime soon. Tarpon’s PE positions aren’t highly-leveraged financial engineering plays, but rather less liquid but similar stories to their public positions.

I estimated the public equity performance since 9/30 using holding data from Factset and adding in Gerdau at an estimated 10% position size, which the firm has mentioned is a top 5 position. The return data is as of the close on Monday, so may have varied slightly since:

Position	9/30/08 Weight	Return since 9/30 (in USD)
Pao De Acucar	28.1%	-9%
Comgas	15.7%	-30%
Celesc	13.4%	-38%
Porto Seguro	10.2%	-32%
Gerdau	10.0%	-47%
Banco Daycoval	6.8%	-35%
SP Alpargatas	4.0%	-43%
Springs Global	3.3%	-41%
Invest Tur Brasil	2.6%	-27%
Marisa	2.6%	-40%
CIA Hering	2.4%	-31%
Trisul	0.8%	-41%
Weighted Return	100%	-28.6%

Applying the same assumptions to the firm’s overall asset base, and adding in the recent inflows, Tarpon is now managing approximately $1.1 in assets.

In addition to investing more in its own funds, Tarpon has also been buying back its own shares recently. As of Oct 31^st it had repurchased 5.2% of the free float and has the ability to buy 3.9% more. The proximity of the shares to the company’s NAV is a key consideration for management on this point:

“…regarding the share buyback, we believe that our shares are undervalued because they are really close to the net asset value while our business continues to remain very solid, with growth prospects and capacity to really deploy capital in a moment like this. If these market conditions persist, we will probably continue to buy back shares.” – Edoardo Mufarej, Tarpon Investor Relations Officer, Nov. 8^th 2008 Conference Call

Investment Portfolio

With over half of Tarpon’s NAV comprised of investments in its own funds, it’s also worth noting that the portfolio itself appears quite cheap. Tarpon is not the typical Brazil fund with a heavy allocation to commodity businesses like CVRD and Petrobras. In the public equity portfolio it owns a diverse set of businesses with generally low leverage, high ROE’s, and cheap valuations:

Company	Sector/Type	P/E (LTM)	EV/EBITDA (LTM)	Price/ Book	ROE (LTM)	Debt/ Ebitda	Div Yield
Pao De Acucar	food retailer	28.3	8.2	1.6	5.9%	2.9	0.6%
Porto Seguro	insurance	7.2	4.4	1.3	18.5%	N/A	5.6%
Comgas	utility	8.8	6.0	4.2	46.9%	1.5	9.7%
Celesc	utility	4.3	1.6	0.8	19.2%	0.2	7.6%
Gerdau	steel	3.7	3.5	1.0	31.1%	1.9	8.5%
Banco Daycoval	mid-market bank	3.9	5.4	0.6	16.8%	2.4	4.6%
Invest Tur Brasil	tourism	17.9	-0.6	0.5	2.9%	0.1	N/A
CIA Hering	retailer	6.5	2.9	1.2	19.4%	1.1	N/A
SP Alpargatas	sporting goods	11.7	5.7	0.8	7.1%	1.8	5.4%
Marisa	department store	13.3	4.3	0.9	13.7%	2.5	0.5%
Springs Global	textile company	N/A	N/A	0.2	11.7%	N/A	N/A
Trisul	real estate	5.2	3.9	0.3	10.6%	3.7	3.1%

This list is gathered from holdings data on Factset and from Tarpon disclosures, and might be missing a few smaller or more recently added positions. While Pao de Acucar does not appear cheap, its year over year earnings growth has been in the triple digits and it has benefited from the “Wal-Mart Effect” since it is a large scale food retailer. It has been one of the best performing stocks in Brazil this year, and it is also possible that Tarpon has scaled out of the position as a result.

Tarpon’s private equity portfolio includes positions in Direcional, BrasilAgro, and Brenco. Direcional is the low and middle income housing company mentioned earlier that Eton Park co-invested in. BrasilAgro is a public agriculture company that Xanadu972 did a good job writing up last year on VIC. Tarpon was a founding sponsor of the deal and received warrants to buy additional shares at the IPO price over the next 15 years. Brenco is Brazil’s largest renewable energy project, focused on exporting sugarcane ethanol. Co-investors in that deal include Vinod Khosla, James Wolfenson, Steve Case, and Ron Burkle. The company is run by Philippe Reichstul, the former CEO of Petrobras.

Risks

The stock is not terribly liquid, trading around half a million USD/day on average the past few months. In addition there is the obvious macro and currency risk of investing in a volatile emerging market. With any asset manager there is also the risk of talent leaving, but in this market that is less of a problem since there are fewer places to go and it’s a lot more difficult to start a new firm. Tarpon’s public status also gives it significant ability to incent valuable team members to stay on board.

Finally, Tarpon could also see some redemptions since even US endowments and foundations are having some liquidity issues. The funds’ lock-ups, gates, and staggered capital raises decrease the risk of any large or rapid outflow and the team does not expect any major issues there:

“On the redemption side I think we will not have ... we will continue to have net subscriptions in the third quarter. I see very limited amount of our investors what I would say at risk and that is mainly related to the fact that we have very limited fund-of-fund exposure. If we had more fund-of-fund exposure or distribution agreements I would be concerned, but most of our investors are really long-term oriented…I do not expect anything meaningful to come from that side.” – Edoardo Mufarej, Tarpon Investor Relations Officer, Nov. 8^th 2008 Conference Call

Catalyst

1) Continued share buybacks if price stays close to NAV
2) The Brazilian market could rebound and Tarpon’s fee income and investing profits could both increase significantly
3) The company could continue to raise capital for its funds

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			2008	2009
Price:	11.50	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	195	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT