Description

Tetragon Financial Group ("Tetragon") is being severely mispriced by the market, in my view, and as a result, I believe it represents a rare opportunity to make a tremendous return with limited downside risk.  The company trades at 58% of its net asset value of around $6.00 per share.  Additionally, I believe NAV should grow meaningfully over the next year, possibly to over $7.50.  Tetragon should trade at roughly NAV over time which would result in a rough one-year double from a recent price of $3.50.  I believe the risk is low as 40% of the current market cap is represented by unencumbered net cash and the company should generate around 30% of its market cap in cash annually over the next few years.  The company's current buyback program can drive further upside.

Background

Tetragon is an investment company that was publicly listed on the Amsterdam Stock Exchange in early 2007 to invest in the equity tranches of collateralized loan obligations ("CLOs").  Needless to say, this did not work out particularly well and by the middle of 2009, the stock price had declined by approximately 90% in value.  As you may know, CLOs are securitization structures that are used to fund the purchase of senior secured leveraged loans.  The underlying bank loan market values have vastly improved over the past few quarters from a low of below 70% of par to recent levels of over 90% of par.  The historical loss on this asset class has been very low owing to its senior secured position and fairly short duration.  In a CLO, generally around 93-94% of the structure is funded with debt and the equity tranche generally owns the bottom 6-7% of the structure.  Because the underlying loans generate more interest income than the cost of the securitized debt, the structure generates positive spread income of ~150bps per annum before credit loss and ~100bps under historical loss experience which would allow the equity to earn around 15% returns under historical loss experience. 

As the market turned down 12 to 18 months ago, some of these CLOs began "trapping" cash to pay off the senior debt in the securitization.  Currently, 40% of Tetragon's CLOs are not in compliance with these coverage tests which means Tetragon is not receiving any cash flow from them.  Tetragon currently is generating $130 million of cash flow per year out of a total potential of ~$200 million. The trapping is triggered by the number of CCC assets and defaults in the pool and therefore the level of downgrades/defaults has a significant impact on Tetragon's cash flow.  During 2009, the market fear was that downgrades and defaults would continue to rise and dramatically lower cash flow to Tetragon.  However, given the significantly improved credit markets over the past year, it is now likely that the cash flows to Tetragon will increase over the coming quarters to a level greater than $130 million per year. 

Over the past two years, Tetragon wisely paid down all corporate debt and built up a very large cash cushion from a combination of these significant cash inflows and a reduction in the dividend.  The company currently has $175 million of unencumbered cash at the parent company or around $1.40 per share based on 125 million shares outstanding (net of shares repurchased).  In addition to its cash balance, Tetragon owns $1.35 billion of CLO equity (at cost) that is well diversified across 61 CLOs, which we believe currently trade in the market at ~40% of cost which would imply a market value of $540 million or $4.30 per share.  Combined with the cash balance and net of $22 million of liabilities, this represents a net asset value of around $5.50 per share.  The market for CLO equity is not very liquid and I believe the fundamental value can and should be significantly higher even under draconian loss assumptions.  Based on the company's own modeling of annual loss estimates ~6% and recovery rates of 55% (both of which I believe are likely to prove way too conservative), the NAV is around $6.50 per share.

Additionally, as I stated earlier, these CLO equity investments are generating at least $130 million per year in cash flow to Tetragon, so I estimate the company will have around $2.45 per share in cash in one year's time, which is almost 70% of the current market cap - even if the cash flows do not improve from more of the CLOs coming back into compliance with their triggers.  I believe that CLO equity is fundamentally worth substantially more than 40% of cost given underlying loan prices, the recovery in the credit markets and the value of having cheap funding of around L+50.  At a price of just 50% of cost, the net asset value in one year would increase to $7.80 per share. 

Another way to think about this investment is that you are paying only $2.10 net of cash for a company that generates distributable cash flow of around $1.00 per year, representing a multiple of barely 2x free cash flow.  And as I mentioned earlier, the cash flow should be increasing as less of the CLOs trap cash given improved credit markets.

Other Thoughts on Valuation

As I mentioned above, even under the company's harsh assumptions, the NAV is $6.50 per share.  There are a few other data points we can use to help value Tetragon.  Tetragon traded at $5-6 per share shortly pre-Lehman bankruptcy and loan prices have now fully recovered and the company has generated around $1.75 per share in cash since then - which could indicate a reasonable trading level of close to $7.

Also, the company's closest publicly-traded comp is KKR Financial (KFN) which currently trades at around 85% of NAV despite it having lower than average quality CLOs and higher fees (KFN has 7% expense / equity ratio vs. 2% for Tetragon).

Finally, the potential value for CLO equity in a reasonable credit environment can be enormous.  Given the structure's L+50 funding with a duration well in excess of the assets, the equity garners significant value from having locked in below market financing costs and yet it can reinvest in loans with higher spreads than was possible several years ago.

Upside from Calyon Deal

In November, the company announced an agreement to purchase a CLO management platform and CLO equity portfolio from Calyon.  While I don't believe the purchase price is material (undisclosed), this deal could add meaningful upside to my estimates since I believe the terms of the deal were largely struck before the CLO loan rally and Calyon was in essence a forced seller as it wanted to fully exit this business.

Other Considerations

Finally, some other considerations:

• Buybacks:  Tetragon realizes the value inherent in its stock and has been buying back around 500k shares per month.  Given the current discount to NAV, this can create significant value. 

• Reinstatement of dividends:  The company intends to pay out 30-50% of net income which would mean a dividend yield of up to 15% on the current price.  Given the company's growing cash balance, it is possible they reinstate the dividend in the near-term which would be a great catalyst.

• Fees:  the entity currently pays fees to the manager of 1.5% of equity and a 25% performance fee above L+265 on any growth in NAV above the current estimate of $6.50 per share.

Catalyst

Buybacks, reinstatement of dividends, increases in NAV