Summary and Thesis:

At current levels, we believe that Tetragon Financial (ENXTAM:TFG) represents a highly compelling risk reward profile: it is extremely undervalued on a reported basis, even more so on an economic basis, and management is highly incentivized to see the share price meaningfully higher than current levels.

Specifically: TFG trades at a 40% discount to reported NAV and a 50%+ discount to intrinsic value. Downside protection is very strong not only because of fundamental value but also because management is highly incentivized to see the share price above $10/share – management owns 13.4mm shares directly and owns 12.5mm options with a $10/share strike price and an April 26, 2017 expiration. We believe that management will want to see TFG’s share price significantly higher well in advance of the option expiration date.

Because TFG is not alone in the universe of vehicles trading at a discount to reported NAV, to contextualize TFG’s mispricing we methodically evaluated the broad universe of ≈400 listed investment vehicles. Based on our analysis, which accounts for size and liquidity factors, TFG is the most discounted entity on an NAV basis and possesses one of the highest earnings yields. Moreover, TFG has amongst the best long-term track records of compounding NAV for those vehicles in existence prior to the GFC. Additionally, whereas most vehicles have experienced meaningful narrowing of their discounts over the last 18-24 months (a continual process since the GFC), TFG’s discount is significantly wider now than it was at the end of 2012 or at any point during 2013. In short, TFG is extremely undervalued on relevant relative value metrics as well.

While we remain very mindful of the issues associated with TFG’s corporate and compensation structure, we have concluded that the combination of severe undervaluation, expected return on assets, and – despite the potential for misalignment – management’s historical and ongoing capital return efforts create a highly compelling opportunity.

TFG has previously been written up on VIC and has also recently seen activity in its Q&A threads. We refer to those write-ups as well as the Company website for basic background on the Company. We will try to shed new light on various issues brought up in the Q&A discussion: namely, confirmation of NAV and questions around management actions, incentives, and alignment.

Simplified, the two most relevant questions regarding TFG are: 1) what is the value of TFG’s assets; 2) what is the value of TFG’s assets within the TFG structure.

Therefore, our write-up will focus on: 1) valuation of TFG’s assets – first the CLOs and then the asset management business; 2) commentary on management and current corporate structure; 3) paths towards value realization over the next 12-18 months.

We believe TFG would represent a highly attractive investment in any market: there is minimal risk of fundamental downside and there is a very reasonable case for 70%-100%+ upside over the next 12-18 months.  

Overview of Company and Assets:

TFG is primarily involved in the ownership and management of CLO equity tranches, but also owns and manages a broader assortment of alternative assets.

Since the beginning of 2012, TFG has experienced material diversification of its investment portfolio. Specifically, TFG has seen CLOs as a % of its investment portfolio decline materially. At YE 2012, CLOs were 86.1% of the investment portfolio (76.5% including Cash and CE); at 1Q14, CLO’s were 66.3% of TFG’s investment portfolio (61.8% including Cash and CE).

TFG’s non-CLO assets are primarily comprised of investments in hedge funds managed by Polygon (where TFG also owns 100% of the management company), investments in real estate managed by GreenOak Real Estate (where TFG also owns 23% of the management company) and opportunistic direct investments.

Presented below is a snapshot of TFG’s investment assets as of 1Q14:

Valuation of CLOs:

We believe that part of TFG’s discount is likely due to the opacity and mark-to-model nature of CLO assets (in TFG’s case, those dynamics are likely magnified by the management perception/reputational issues).  TFG does not disclose the identities of its CLOs and reports their value on a mark-to-model DCF basis, making it difficult for investors to gain sufficient comfort around reported NAV and valuation. Therefore, to better understand and independently value the CLOs, we worked with Codean, a firm that specializes in the valuation of CLOs.[1]

Working with the Codean, we were able to independently and thoroughly identify, analyze, value and scenario test the vast majority of TFG’s 80+ CLOs. Based on our analysis, the value at which TFG holds its CLOs is more than 10% below the value TFG could realize if it were to liquidate all of the underlying loans in its CLOs at par and redeem its liabilities at par, the book value equivalent used by standard financial institutions.  However, CLOs, especially pre-GFC CLOs, tend to be worth more than their spot liquidation price due to their low cost (LIBOR + 55bps) and long duration funding structure.[2] Furthermore, we were able to stress test TFG’s portfolio under a variety of interest rate, prepayment rate, reinvestment rate, default rate, recovery rate, and discount rate scenarios.

Presented below is a summary of the analyses performed on TFG’s CLO portfolio as of the end of 2013:

-          Par Value – Represents the residual equity value that TFG would yield if it were to liquidate all of the underlying loans in its CLOs at par and redeem its liabilities at par; this value is the most comparable metric to book value used by standard financial institutions

-          Total Cash-Flows TFG Case – Represents total cash flows (undiscounted) to TFG in a scenario where all CLOs run through maturity and the various input assumptions (default rates, prepayment rates, reinvestment rates) provided in the TFG report are used

-          TFG Case Model 10% Discount – Represents the Total Cash Flow TFG Case with all cash flows discounted at a 10% rate

-          Elevated Losses Model 10% Discount – Represents Total Cash Flows with all cash flows discounted at a 10% rate but elevated loss assumptions are used (4.5% default rate with 60% recovery through 2015 and 3.0% default rates and 60% recovery thereafter; TFG assumes 2.2% default rate through maturity for US CLOs and 2.6% through 2014 and 2.1% thereafter for European CLOs)

Based on the analysis, we are highly comfortable with TFG’s reported NAV for its CLOs. Employing a 10% discount rate (lower than the discount rate used by TFG[3], but in line with the implied IRRs for new issue CLOs and market clearing prices for secondary equity stakes in pre-crisis CLOs)[4], TFG’s CLO NAV is understated by $2+/share. Even assuming a significantly higher loss rates than either TFG or the broader senior loan market assumes, TFG’s CLO NAV is very well protected.

Presented below are summary snapshots of certain CLOs in TFG’s portfolio:

For reference, on an aggregate basis TFG’s largest exposures are First Data, Las Vegas Sands, HCA, Berry Plastics, and Aramark, each representing ≈90 to ≈110bps of total assets.

TFG Asset Management (TFG AM):

TFG Asset Management is comprised of three businesses:

1)     LCM (wholly owned by TFG)[5] – CLO manager with $4.9bn in AUM

2)     GreenOak Real Estate (23% owned by TFG)[6] – real estate investment manager with $4.1bn in AUM

3)     Polygon (100% owned by TFG)[7] – multi-strategy hedge fund manager with $910mm in AUM

On an LTM basis, TFG AM generated $28.5mm in adjusted EBITDA (effectively a pre-tax income number and because TFG’s taxes are de-minimis, effectively a cash net income number). Critically: the $28.5mm EBITDA figure does not include any contribution from GreenOak. GreekOak’s financials are not consolidated in TFG’s financials (neither in the income statement nor in the adjusted segment financials). Rather, GreenOak is held on TFG’s balance sheet as an equity investment and any change in the balance sheet valuation is run through what is functionally an equity earnings line.

However, GreenOak (i.e. TFG’s 23% stake) is the only portion of TFG AM which is included in TFG’s reported NAV. As of YE 2013, TFG’s 23% stake in GreenOak was valued at $28.4mm (the $28.4mm valuation corresponds to 6.5x-10.5x earnings and 3-5% of AUM; at YE 2012, the stake was held at $18.1mm, corresponding to 2%-5% of AUM).[8]

The remaining portion of TFG AM – i.e. the portion that generated $28.5mm in LTM EBITDA – is not captured in reported NAV.

The shorthanded approach to valuing alternative asset management companies is an AUM based methodology. However, of course, not all AUM are created equal. For example, whereas Polygon hedge funds typically charge 2% & 20%, CLO management fee income generally comprises senior and subordinated fees and in aggregate these fees range from 25 bps to 50 bps per annum of collateral under management and a hurdle based incentive fee.[9]

Accordingly, AUM based valuation approaches are very difficult. For reference, however, the average valuation for US listed alternative investment firms as a % of AUM (subtracting out net cash and investments and net accrued performance fees) is 9.9% although the range is quite wide (FIG is the lowest at just under 3.0% and OZM is the highest at 17.0%) and the median stands at 7.0%. At min/median/mean levels, we would arrive at valuations of $205mm/$475mm/$675mm for TFG AM.

An earnings based approach is more appropriate. The difficulty in evaluating alternative asset managers is analyzing valuation/earnings on a disaggregated basis, distinguishing between earnings generated from management fees, performance fees, and balance sheet assets. Using our own figures as well as KBW’s, we conclude that the market is applying 13x-15x for management fee earnings and 6x-8x for performance fee earnings for alternative asset management companies [note: that conclusion is conservative relative to KBW which applies 16x-18x management fee earnings and 9x performance fee earnings for its price targets].

Traditional asset managers currently trade at a trade at median LTM EBITDA and net income multiples of 12.0x/20.5x and NTM EBITDA and net income multiples of 11.0x/17.5x.

Importantly, relative to most alternative asset management firms, a very significant majority of TFG’s fees are from management fees and not performance fees. Presented below is a breakdown is TFG’s fees for 2012 and 2013 (TFG provides the breakdown of fees between management and performance only on an annual basis):

For 2013, TFG AM’s consolidated EBITDA margin was 37.0%. Management fee earnings typically come in at higher margins than performance fee earnings. To be conservative, however, we will assume that both management fee and performance fee earnings are generated at the consolidated 37.0% margin. That implies $23.6mm in management fee earnings and $4.9mm in performance fee earnings on an LTM basis (scaling up 2013 figures to LTM). Applying appropriately conservative multiples in all cases but the Bull case, we arrive at a valuation for TFG AM of $161.3mm-$364.9mm or $1.52-$3.45/share.

Consolidated Valuation:

The table below presents current NAV plus the adjustments for the economic value of TFG’s CLOs and the value of TFG AM not captured in NAV – as the table presents, TFG current trades at a 45%-55% discount to intrinsic value, implying 84%-126% upside from the current share price:

Comments on Management, Structure, and Paths Towards Value Realization:

As presented above, we are highly confident that the value of TFG’s assets is substantially higher than the current share price. However, the relevant question we must now address is what is the value of TFG’s assets within the TFG structure?

There are various reasons why TFG trades at a sharp discount to NAV. Its structure, assets and accounting are fairly complex. It has no sell side analyst coverage. The Company is domiciled in Guernsey, listed in Amsterdam, has primary offices in the UK, and the majority of its assets are US based loans and securities.

However, we believe the most significant reason is the partly deserved and partly undeserved perception that management, because of the Company’s corporate and compensation structure, is ‘bad’ and therefore intrinsic value is not likely to be realized under an identifiable time frame.

While we wholly avoid companies lead by management teams possessing certain unsavory characteristics, we do believe that the concept of ‘bad management’ tends to be over generalized, and that appropriate category distinctions need to be made:

-          Category one: management lacks the requisite skill or incentive to run the business and/or allocate capital properly. Unless there is an opportunity for activism, we believe such situations should be avoided.

-          Category two: management overpays themselves at the expense of shareholders. While we find this distasteful, if the expense is transparent and taken into account for valuation purposes, sufficient undervaluation and management competence can serve as an offset.

-          Category three: management is unwilling or indifferent to make decisions which could quickly and significantly increase the share price (buybacks, spin-offs, sale of assets or company, etc.). If substantially undervalued, we believe these situations can be compelling.

Despite the steep discount the market applies to TFG, management has proven to be very capable CLO investors, the core business activity of TFG, as well as savvy investors in other asset classes. Since its IPO in April 2007, TFG has realized an 11.1% IRR if we value TFG today at reported NAV (at the midpoint of our intrinsic value estimate, the IRR increases to 13.6%). That compares very well to the S&P 500’s 3.9% CAGR, and is also a meaningfully higher return than that achieved by certain very well regarded hedge funds with publicly traded vehicles that trade at or above NAV. Accordingly, TFG management does not fall into Category one; rather, we believe TFG management falls partly into Category two and squarely into Category three.

While we do believe that a discount to NAV is certainly warranted due to certain structural weaknesses of the external management agreement, our view is that the current discount more than sufficiently compensates shareholders for the structural lacunas in place at TFG.

We will evaluate TFG management in the context of three items:

1)     Structural weaknesses of the external management agreement

2)     TFG’s acquisition of Polygon Management L.P.

3)     TFG’s record of returning capital to shareholders

Structural weaknesses of the external management agreement:

We will highlight 3 weaknesses of TFG’s external management agreement:

1)     Fee structure

2)     Lack of high-water mark

3)     Non-voting classification of shares

In short: in vacuum (i.e. absent other issues), we do not believe TFG’s fee structure justifies the Company trading at a discount to NAV; we do believe that TFG’s lack of a high water mark justifies the Company trading at a discount to NAV; we believe that the non-voting classification of TFG’s public shares – in the context of the lack of high water mark and other factors – further contributes to the discount to NAV. 

Fee structure:

TFG’s fee structure is higher than peers. However, it is not dramatically so, but the fee differential is heightened in an extremely low LIBOR environment.  TFG’s fee structure is a 1.5% management fee and a 25% incentive fee over a hurdle rate of LIBOR + 2.647858% (accordingly, at inception in April 2007, TFG’s effective hurdle rate would have been ≈8.0% – given CLO’s general earnings leverage to LIBOR (higher LIBOR is better), the LIBOR based hurdle rate is defensible).

From the perspective of publicly listed CLO vehicles, TFG’s closest peers are KKR Financial (NYSE:KFN), Carador Income Fund (LSE:CIFU), Volta Finance (ENXTAM:VTA), and the recently IPO’d (June 2014) Fair Oaks Income Fund (LSE:FAIR). KFN’s fees are a 1.75% management fee and 25% incentive fee over an 8% hurdle. Carador fees are 1.5% management fee and a 13% incentive fee over a 6% hurdle. Volta’s fees are a 1.5% management fee and a 20% incentive fee over a 10% hurdle rate. Fair Oaks’ fees are a 1% management fee and a 15% incentive fee over a 7% hurdle rate.

There are a few publicly listed hedge funds such as Third Point (LSE:TPOU) and Brevan Howard (LSE:BHME, LSE:BHGE, and LSE:BHCG), all of which charge 2% and 20% with no hurdle rate. 

In the context of peers’ fees, we must also discuss peers’ valuation.

Investors readily accept high fees to invest in non-listed CLO funds and various other alternative investment classes. Investors do not demand a discount to NAV to invest in such assets so long as they believe that on a net of fee basis the returns are sufficiently attractive.

In the public markets, TFG’s peers trade at dramatically narrower discounts to NAV: KKR has announced the acquisition of KFN at an acquisition price of 121% of NAV (and KFN regularly traded at parity or premium to NAV prior to the acquisition); Carador trades at 97% of NAV; Volta trades at 91% of NAV; Fair Oaks trades at 103% of NAV.

For the publicly listed hedge fund vehicles: TPOU trades at 96% of NAV and BH’s three listed hedge funds trade at 93%, 95%, and 102% of NAV. (All of those vehicles also posses lower trading liquidity than TFG).[10]

For reference – of the referenced listed hedge funds, TPOU, BHME, and BHGE have public track records going back to the time of TFG’s inception (or close thereto). Moreover, GLRE is a close equivalent of a listed hedge fund and trades at (with a hedge fund fee structure) 1.2x TBV: The respective CAGRs for those funds since the time of TFG’s inception are all meaningfully below TFG’s aforementioned IRR of 11.1% (or 13.6%):

-          Third Point[11] – 9.1%

-          Brevan Howard Macro[12] – 9.9%

-          Brevan Howard Global[13] – 4.5%

-          Greenlight[14] – 9.0%

In short, we believe that TFG’s fee structure, in the context of its absolute returns and in the context of listed and non-listed vehicles with similar fee structures, does not – absent any other issues – justify TFG trading at a discount to NAV.

Lack of high-water mark:

The most significant negative that can be levied against TFG’s structure is TFG’s lack of a high water mark: unlike the vast majority of other alternative asset funds (listed and unlisted), TFG’s incentive fee does not take into account a high water mark (more specifically, the high water mark effectively resets every quarter). The unpleasant result of that dynamic was experienced during the 2008/9 period when NAV was marked down significantly and then promptly recovered. Management was able to take incentive fees on the recovery of NAV and thereby effectively double-dipped on their incentive fee allocation.

There are differing views as to whether management was overly aggressive in marking down NAV in 2008/9. In our view, the mark-downs were most likely appropriate in the context of market dynamics at the time, and therefore management did not violate the investment management agreement nor act with legal malfeasance. Either way, however, management did profit handsomely from a structure that ought not to have been there in the first place. Shareholders felt abused and the lack of a high-water mark will – as long as it exists – perpetuate the potentiality that NAV could again be marked down and management could again double-dip. The lack of a high-water mark therefore serves as a justifiable reason for why shares should not trade at NAV.[15]

Non-voting shares:

Publicly traded TFG shares lack any voting rights and shareholders have no say in significant corporate transactions (such as the Polygon acquisition to be discussed). In a vacuum, lack of such rights (or severely diminished rights relative to shareholders controlling super-voting shares) is not wholly unusual. But when taken in association with the lack of high-water mark (and consequences thereof), questionable  actions by management (Polygon acquisition and associated), persistent discount to NAV and lack of sufficient steps taken to remedy the situation, the lack of shareholder voting rights has been a further source of grievance and thus further contributed to TFG’s discount to NAV.

TFG’s acquisition of Polygon Management L.P:

Next to management profiting from the lack of a high-water mark, TFG’s October 2012 acquisition of Polygon Management L.P. [16] is the second most controversial action taken by TFG management.

The acquisition of Polygon included 100% of Polygon’s asset management businesses and infrastructure platform, along with Polygon’s 25% interest in LCM (TFG owned 75% at the time) and 13% interest in GreenOak (TFG owned 10% at the time). Also included in the acquisition was ≈$25mm in contract management fee income from other products. At the time of the acquisition, Polygon had $450mm in AUM, LCM had $4.5bn, and GreenOak had $1.9bn.

On the the day of the acquisition announcement, TFG also announced a $150mm share repurchase tender offer.[17]

The acquisition of Polygon, the most important single event for the evolution of TFG AM, sparked significant controversy. The controversy emerged due to the related party nature of the transaction and the real and perceived flaws in the process. Indeed, it is the subject of a lawsuit brought forth by Leon Cooperman. Accordingly, analysis of the acquisition provides an important framework through which to evaluate management.

There are two elements to consider in the context of the Polygon acquisition:

1)     The valuation and strategic merits of the transaction

2)     The background and process of the transaction

Valuation and strategic merits of the transaction:

Analyzed objectively (i.e. assuming for these purposes that the transaction was actually truly arms length and setting aside the other issues surrounding TFG), our view is that the Polygon acquisition was performed at a valuation that was reasonable/defensible on existing AUM and earnings and more so when based on the growth the acquired entities have subsequently achieved. Moreover, we do believe the transaction achieved certain strategic benefits.

On a pro-rata basis, TFG acquired $1,822 in AUM. On an earnings basis, the acquired businesses generated ≈$13.8mm in 2013 EBITDA (excluding GreenOak).

Payment for the acquisition was made entirely in shares of TFG – 11,685,940 that will vest between 2015 and 2017.

There are legitimate questions as to how to think about the purchase price. The market price of TFG shares on the day before the announcement was $8.43. The day of the announcement the stock closed at $9.11. The average stock price for the remaining two months of the year was $9.50. Those levels imply a purchase a price was $98.5mm-$111.0mm. If we net out the $25mm in contractual management fees on other products and assume the net profit component of that is $12.5mm (the products are in run-off and therefore do not require the same sort of active management) and adjust for GreekOak in the EV/EBITDA calculation, we arrive at a residual purchase price implying 4.7%-5.4% of AUM and 5.5x-6.3x EBITDA. In the context of the previously discussed peer valuations, those valuations are reasonable.

However, we believe that purchase price should be determined by NAV/share (with perhaps a small discount owing to the illiquidity and delayed vesting of the shares). Based on NAV/share of $14.29 as of the date of the acquisition, the purchase price was $167mm. That purchase price implies 8.5% of AUM and 10.5x EBITDA – valuations that remain defensible, but certainly borderline. Taking into account that some growth was assumed in the purchase price, on run-rate AUM and 2014 EBITDA numbers the acquisition (based on NAV/share) was performed at reasonable multiples of 5.8% of AUM and 7.2x-8.2x EBITDA.

From the standpoint of strategic benefits, at a high level, the acquisition transitioned TFG from a dedicated CLO vehicle to a more diversified entity with material fee based earnings. Moreover, it provided TFG with highly capable managers to manage TFG’s own capital at no fees and also provides TFG avenues for capital light growth. 

The process and nature of the transaction:

Even if we are relatively untroubled by the objective valuation of the Polygon transaction, the background and process to the transaction certainly contain unpleasant elements. As mentioned, the acquisition is the subject of a lawsuit brought forth by Leon Cooperman.

Cooperman’s complaint focuses on the Polygon transaction but also addresses other issues, in particular the lack of a high-water mark (and the implications thereof) and the lack of shareholder voting rights.[18]

We completely sympathize with Cooperman’s sentiments, and find plenty to dislike about the background and process of the transaction. The related party nature of the acquisition coloured everything and that, combined with opacity around key items of the process, necessarily resulted in scepticism and controversy. Specifically:

-       Lack of disclosure on valuation of assets (i.e. no release of the Perella Weinberg fairness opinion )

-       Lack of disclosure on valuation of stock consideration paid (i.e. the only information provided was the number of shares issued, but not how the BoD or fairness option valued those shares)

-       Substantive questions over the independence of the ‘independent’ directors

-       No vote to stockholders (because of the non-voting classification of shares)

-       No background provided as to how Polygon initially acquired its interest in LCM and GreenOak (i.e. separately from TFG)

However, we also find certain flaws in Cooperman’s lawsuit. We are familiar with the nature of litigations motions. They are polemic in intent, and balanced logic unavoidably falls away. For example:

-       The motion attacks the all stock nature of the transaction as self-serving for management and not the most economically beneficial structure for shareholders. While that may be true, the consideration did mean that management did not ‘cash out’ in the transaction and does serve (on a longer-term basis) to further align shareholders and management.

-       The motion attacks the simultaneous $150mm tender as benefiting management (by increasing NAV/share and also resulting in management owning a greater percentage of the Company on PF basis). While that may be true, the tender also indisputably benefited shareholders. If management wants to screw over shareholders, there are easier and more pernicious ways to do so than accretively buying back ≈15% of the Company.[19]

The conflicts of interest, lack of disclosure around the objectiveness and independence of the Board of Directors, and general opacity were dangerous and irresponsible. But the information we have to condemn the acquisition is really just the omission of information. Management should have behaved radically different in terms of disclosure and clarity of process. Because they did not, shares have suffered as a result.

In the end, we don’t believe that the Polygon acquisition represents malfeasance by the Company. Rather, at worse, we believe that the acquisition indicates that TFG management thinks in a 1 for 1 framework: ‘if we’re going to do something good for shareholders, we’re going to get something in return.’ If indeed the case, we find that mentality utterly distasteful and dangerous. But at the current valuation, we are compensated for the risk. And we also believe that it may in part be that mentality which leads to actual value realization over the next 12-18 months.

TFG’s record of returning capital to shareholders:

In the context of discussing the external management agreement and the Polygon acquisition, it is critical as well to highlight TFG’s record of returning capital to shareholders: although the compensation structure for the external management agreement does not incentivize management to return capital to shareholders (simply: it reduces the amount upon which management fees and incentive fees are calculated), capital return has been significant. Since the beginning of 2012, TFG has repurchased $242.6mm of shares and paid cumulative dividends of $133.8mm (while increasing per share dividends by 43%). Said differently, since the beginning of 2012, TFG has returned $376.4mm to shareholders, representing greater than 50% of the market capitalization at the beginning of 2012 and ≈35% of the current market capitalization. Those are extraordinary numbers for any company, let alone one regularly accused of being shareholder unfriendly. [Even if we consider the Polygon acquisition and associated tender on a ‘net’ basis (shares repurchased in tender less shares issued in acquisition), TFG has returned $262.5mm, still a tremendous figure relative to TFG’s 2012 and current market capitalization].

Catalyst for value realization:

We believe that TFG’s current discount is excessive and more than sufficiently compensates shareholders for a host of risks. However, because of the structural lacunas in place and the real/perceived motives and actions related to the Polygon acquisition, we do not believe that TFG in its present state will trade at parity to NAV (let alone intrinsic value).

We believe that TFG management realizes that dynamic. Moreover, we believe that TFG management also realizes that the only sufficient remedy to the problem is an internalization of TFG’s management company. Lastly, and most importantly, we believe that TFG management will recognize that they are economically incentivized to internalize the management company on fundamentally fair terms – specifically, terms that are most likely to enable shares to trade at parity or premium to NAV post the internalization.

Currently, we can identify at least 13.4mm shares that TFG management directly owns (we believe the actual number is higher, but can find specific shareholdings for only 3 named executives). Additionally, management owns the aforementioned 12.5mm options with a $10/share strike and an April 26, 2017 expiration. Therefore, including the options, TFG management has economic exposure to at least 25.9mm shares.

We believe that management wants to see TFG’s share price significantly higher well in advance of the option expiration date and is accordingly likely to internalize the structure sometime over the next 12-18 months.

There are two questions relevant to the economics of the internalization:

1)     What price is paid upfront for the internalization of the management company?

2)     How much in residual operating expenses remain after the internalization?

The first question will directly determine what impact to NAV occurs as a result of the internalization. Both factors – separately and together – will have indirect consequences for how TFG shares ought to trade relative to NAV post the internalization. Shareholders need to feel they were treated fairly with the purchase price and shareholders cannot feel that they paid for the internalization of the management company but will continue to pay management through residual operating expenses.

‘Fair’ does not mean that TFG management should (or will) internalize the management company for a pittance. Indeed, we fully expect the check (or rather share issuance) for the management company to be a significant one. However, the internalization must be done at a price and the residual expenses must be sufficiently reasonable to ensure that shareholders feel they were treated fairly and that the real and perceived past misdeeds of management can be forgotten. If that occurs, we expect shares to trade at parity or premium to NAV/intrinsic value (as any well run and properly governed REIT, BDC, or internally managed asset management company does).

If TFG internalizes the management company on unfair terms, TFG shares will continue to trade at a significant discount to NAV (although even in that circumstance we do believe shares will trade at a considerably narrower spread than currently, as barring utter malfeasance residual expenses will not approach current expenses under the external management structure).

Moreover: it is critical that management provides full disclosure and transparency into the process for determining the internalization price. Shareholders need to understand all assumptions and valuation data points used.[20]

For our purposes, let’s assume that the management company is internalized for $250mm and that payment is made entirely in shares based on a per share price/value of NAV/share PF for the internalization [note: for purposes of this analysis we have not made the economic value adjustment for the portion of TFG AM not included in reported NAV (i.e. we are assuming it is worth $0); the logic follows the same if we do appropriately value TFG AM]. Using current NAV, PF NAV assuming a $250mm internalization would be $14.56/share and 17.2mm share would be issued. In total, management would own 43.1mm shares. At a 0% discount to NAV, management’s shares would have a market value of $627.0mm.[21]

Now let’s assume that management instead does the transactions at $450mm. Using current NAV, PF NAV assuming a $450mm internalization price would be $12.67/share. In that scenario, we believe shares are likely to continue to trade at a meaningful discount to NAV. At a 25% discount to NAV, management’s shares would have a market value of $583.5mm. 

The table below makes it very clear: TFG management will profit more if they perform the internalization at a fair price and shares trade closer to NAV than if they perform the internalization at an unfair price and shares continue to languish at a substantial discount to NAV:

Further, in addition to the direct benefit management will realize with a higher valuation for TFG, management (and other shareholders) will see the indirect benefit of shares trading at or above NAV: TFG will have the option of issuing shares at non-dilutive/accretive levels and using the equity capital markets as a funding vehicle for growth.

The analyses below highlights the extraordinarily favourable risk/reward that TFG possesses: even assuming a very high price for the internalization and assuming that shares continue to trade at a massive discount post internalization, there is very little downside to TFG shares from the current levels.[22] Moreover, investors must keep in mind that although the internalization will result in a reduction in NAV/share, on a go-forward basis NAV will grow at a ≈35% faster pace than pre-internalization as a result of the reduction in expenses.

The first scenario analysis assumes the internalization happens today and contains the following assumptions:

-          Starting point is current NAV /share ($16.92/share)

-          Value of TFG AM the (portion not capture in reported NAV) – $200mm

The second scenario analysis assumes the internalization happens in 18 months and contains the following assumptions:[23]

-          Starting point is current NAV / share + 15%

-          Internalization Purchase Price is +15% vs. initial assumptions to account for NAV growth

-          Value of TFG AM (the portion not captured in reported NAV) is $350mm

In short: even assuming the internalization is performed on unfair terms and shares continue to trade at a severe discount to NAV, there is minimal risk of fundamental downside (and in fact likely meaningful upside). Should the internalization occur at fundamentally fair terms, upside over the next 12-18 months is reasonably 70%-100%+.