Tetragon Financial Group (TFG.NA)

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Tetragon Financial Group (TFG.NA) Darrell Mark Leong Darrell.leong@stern.nyu.

1 Tetragon Financial Group (TFG.NA) Darrell Mark Leong Company description In 2002, Reade Griffith (formerly from Citadel), Alexander Jackson (formerly from Highbridge) and Paddy Dear (formerly from UBS) founded Polygon Investment Partners. In May the following year, Polygon launched its flagship hedge fund, the Polygon Global Opportunities Fund, which soon became famous for its investments in convertible credit and eventdriven equity. When its AUM started to get too big (reaching $8B at its peak), Griffith and Dear decided to spin off its CLO business, which became Tetragon Financial Group. Tetragon IPO-ed in 2007 on the Amsterdam Exchange. Today, buying into Tetragon Financial Group gives you a stake in a closed-end fund that consists of two main assets (1) An investment portfolio consisting $1.8 billion of financial assets and (2) TFG Asset Management, a global alternative asset management business with $10.5 billion of client assets under management (AUM). Fig1 Investment Portfolio TFG s main business is the managing of its investment portfolio, which generated 64% of LTM revenues and 86% of LTM EBITDA. As can be seen in Figure 2, this portfolio primarily consists of US Collateralized Loan Obligations (CLOs) originated pre- (1.0) and post- (2.0) crisis, but also includes investments in European CLOs, direct loans, and equities and credit through TFG s subsidiary, Polygon.

2012 2013 H1 2014 Investment Portfolio U.S. CLO 1.0 914.8 738.1 535.9 U.S. CLO 2.0 174.0 198.1 252.3 U.S. Direct Loans 114.1 34.0 24.7 European CLOs 125.6 184.3 145.1 Equities (in Polygon) 46.4 221.

2 H Investment Portfolio U.S. CLO U.S. CLO U.S. Direct Loans European CLOs Equities (in Polygon) Credit and Convertible Bonds Real Estate Cash Hedges 4.5 Other Equities, Credit, Convertibles & Distressed 84.4 Total 1, , ,680.5 CLO (% total) 76.5% 63.4% 55.5% Fig 2 U.S. CLO 1.0 (% total) 57.7% 41.8% 31.9% CLOs are best thought of in terms of their balance sheet. Like a synthetic bank, owners of the CLO profit through the funding spread between its asset yield and its liability yield. (1) Their assets include securitized pools of leveraged loans 1, which are floating rate 2 and have a 5-7 year maturity, with an average facility size of $650M, and limited call protection. They are also normally secured on the borrower s assets, with strict covenants. (2) Their liabilities are tranched 3. This implies a cash flow waterfall when it comes to payment of principal and interest, with the senior notes getting the proceeds first (should the Manager choose not to reinvest them), followed by the mezzanine, and then the residual equity. TFG s portfolio is primarily made up of majority stakes in CLO equity, which limits its access to principal repayments but also allows it to negotiate more favorable deal terms. Because of its majority stake, TFG gets decent call options and refinancing rights, which have come in extremely handy in the low-rate environment of the past few years, allowing the company to reduce its average cost of capital. It is also worth noting the declining portion of U.S. CLO 1.0s as a % of the total Investment Portfolio. The typical life-span of a CLO includes (1) the ramp up period, where the CLO manager uses the funds he raises to acquire assets (2) the reinvestment period, where the collateral manager is permitted to actively trade the underlying assets or use excess cash flows to purchase new ones (3) the amortization period, where all cash flows are then used to pay down outstanding notes As can be seen in Fig 3, most of TFG s CLOs are nearing the end of their reinvestment date. This has profound implications for the company in terms of: (1) higher NAV volatility because the fair value of most of its CLO holdings approaches liquidation value and not the discounted future cash flows (2) the need for management to reinvest the proceeds from the unwinding of CLOs in today s lower rate environment, and deciding on what to invest in Fig3 1 Large, corporate loans, typically rated BB or B to companies that are already highly levered. 2 Most CLOs float at a spread above the LIBOR 3 Including senior, mezzanine notes, and equity

As can be seen from the decreasing proportion of CLOs in TFG s Investment Portfolio, management s obvious answer to (2) above is to increase its exposure to other asset classes.

Then, TFG exchanged 11.76M non-voting shares valued at $97M for Polygon (the initial fund that spun it off).

3 As can be seen from the decreasing proportion of CLOs in TFG s Investment Portfolio, management s obvious answer to (2) above is to increase its exposure to other asset classes. TFG Asset Management (TFGAM) generates sustainable management fees This brings us to the other part of TFG s business, TFG Asset Management, the majority of which was acquired in October Then, TFG exchanged 11.76M non-voting shares valued at $97M for Polygon (the initial fund that spun it off). In exchange, it acquired (1) a 13% stake in Greenoak, a real-estate focused principal investing firm, in addition to the 10% it already owned, $1.9B AUM (today $3.9B) (2) the remaining 25% stake in LCM, completing the 75% it previously owned, $4.5B AUM (today $5.1B) (3) all of Polygon s multistrategy hedge funds, that specialize in alternative investments 4, $450M AUM (today $1.52B) (4) $25 in contracted management fee income over 3-4 years, implying a $72M purchase price for the rest of the business This segment contributed 36% of LTM revenues and 14% of LTM EBITDA a figure that has been increasing rapidly as a result of management s explicit diversification strategy away from CLOs. The thinking behind this is that TFG AM provides a more sustainable and stable income base, as the residual income from its CLO 1.0s decreases. TFG AM s funds have performed spectacularly, and AUM has done the same, growing at an annual rate of 17% since acquisition (see Fig 4,5). Furthermore, the merger of the two entities allowed TFG to get preferential deals when buying CLO equity originated by LCM. Fig 4 Fig 5 4 Polygon s strategies include European Event-Driven Equity, Convertibles, Mining Equities, Distressed Opportunities, Special Situations, and a Private Equity Vehicle

Strong Management Team with History of Prudent Capital Allocation As mentioned earlier, TFG is still being run by the richly qualified team that founded it Patrick Dear and Reade Griffith.

Dear was formerly Managing Director and Global Head of Hedge Fund Coverage at UBS Warburg Equities, and Co-Head of European sales trading, execution, arbitrage sales, and flow derivatives.

4 Strong Management Team with History of Prudent Capital Allocation As mentioned earlier, TFG is still being run by the richly qualified team that founded it Patrick Dear and Reade Griffith. Dear serves as Principal, Director, and as a Member of Investment Committee. He is primarily in charge of riskmanagement and the day-to-day operations of the business. Dear was formerly Managing Director and Global Head of Hedge Fund Coverage at UBS Warburg Equities, and Co-Head of European sales trading, execution, arbitrage sales, and flow derivatives. Griffith also serves as Principal, Director, and as a Member of Investment Committee. He was the Founder and Chief Executive Officer at Citadel Investment Group (Europe) Ltd., which he joined in 1998, and was responsible for running the global event driven arbitrage team in Tokyo, London, and Chicago for the firm. The Investment Committee who manages TFG s Investment Portfolio also has a star-studded resume, all of whom have extensive experience in securitized credit instruments. Jeffrey Herlyn and Michael Rosenberg, also founders of Tetragon, served as Managing Directors and Co-Heads of the Global CDO Group at UBS AG, where they were responsible for a group focused on structuring, originating and distributing CDOs in addition to managing the secondary CDO trading desk. Prior to that, they served as a Managing Directors at JPMorgan and Co-Heads of the firm's North American CDO Group. The Investment team at TFG AM is as strong. Olivier Blechner, who heads the distressed opportunities team, was a Research Director at Alden Global Capital LLC, a Partner and Portfolio Manager at TPG Credit Management and was the Head of European Credit Opportunities at Sandell Asset Management. CIO Mike Humphries, who heads the Convertibles and Mining Equities was a founding principal of MKM Longboat. The results that this team delivers is reflective of their resume book, as is evidenced by Polygon s rapid AUM growth (see Fig 5). Management are also prudent capital allocators, having bought back cumulatively $324.5M worth of shares since 2007, almost equal to 40% of previous shares outstanding. It maintains a dividend payout policy of 30-50% of EPS, and has returned an increasing amount of money to shareholders, as is evidenced by Figures 6 and 7. This is especially important for TFG today, as it slowly winds down its CLO 1.0 portfolio. Should management be unable to find appropriate investment opportunities that exceed their cost of capital, it can be counted on to return this cash to shareholders, who can then invest it at higher rates of return. Fig 6,7

5 Framing the Opportunity Using LTM numbers, TFG currently trades at a 33% discount to NAV, and 6x earnings. From a balance sheet perspective, this means that we have the unique opportunity to buy Tetragon s portfolio of CLOs and Asset Management companies at 67 cents on the dollar. On top of that, this NAV has been compounding at a 5-year CAGR of 10% (see Fig 10). Fig 10 Understanding the Opportunity There are a few reasons why this bargain is available despite today s frothy equity markets. (1) TFG is listed in Amsterdam, an obscure foreign exchange, and has no analyst coverage, leading to it being overlooked by mainstream investors. (2) Its primary business is the management of CLOs, a form of CDO which has been widely vindicated for the 08 Financial Crisis, causing it to be shunned by most of the risk averse. (3) The risk that management squanders the proceeds from the expiring CLO 1.0s. (4) TFG s ownership structure severely disadvantages common shareholders. Fig 11

6 As can be seen in Fig 11, Polygon Credit Holdings II Ltd has 100% of the votes in TFG. Although public shareholders own a 100% economic interest in the company, they have no voting rights. This give management huge discretion to carry out activities to the disadvantage of shareholders. (5) It has also been vindicated in a litigation brought by a former shareholder, which relates to point (4) and calls into question management integrity. This is discussed in the risk section below. Despite that, we find that no matter how we slice and dice the situation, TFG is materially undervalued. Valuation Justified ROE To take a first pass at assessing TFG s book value, we used a back of the envelope measure normally used to evaluate financial companies. Assuming a cost of equity of 10%, a company that is able to earn 10% on its equity (equal to its cost of equity) should justifiably trade at book value (NAV). TFG has an over-the-cycle target ROE of 10-15% per annum. Logically speaking, if TFG were able to meet this target, the equity would deserve to trade at least at NAV. Management has met and exceeded this expectation over the last five years (see Fig 12), with a mean ROE of 14% and a median ROE of 20.8%. (The abnormally high ROEs in 2010 and 2011 were due to one-off revaluations of TFG s book). Fig 12 However, one might argue that a 10% COE would be reasonable for a sustainable business with no impending obstacles and a strong economic moat. To be conservative, we decided to sensitize the ROE against the COEs (see Fig 13) CoE RoE 10% 11% 12% 13% 14% 15% 10% Current Price % Current NAVPS % Current P/NAV % % Average P/NAV % Implied Upside 43% Fig 13 Assuming a 12 14% ROE, which is what TFG discounts its CLOs at, we get justified P/NAV ratios ranging from 0.71 to Comparing that to TFG s current P/NAV of 0.67, we see that we have a considerable margin of safety even if we use a 14% discount rate at a 10% ROE. Looking at this another way, the average of all the P/NAVs in that range is 0.97, implying a 43% upside to today s trading levels.

Balance Sheet Analysis Since the majority of TFG s portfolio consists of CLOs (see Fig 2), an accurate valuation of the company s book would involve a bottom-up analysis of the specific tranches that

However, since the company is extremely limited in terms of its disclosure 5 (see Fig 14), the closest we could get was to assess the assumptions TFG uses in the valuation of its portfolio and see if

7 Balance Sheet Analysis Since the majority of TFG s portfolio consists of CLOs (see Fig 2), an accurate valuation of the company s book would involve a bottom-up analysis of the specific tranches that it holds. However, since the company is extremely limited in terms of its disclosure 5 (see Fig 14), the closest we could get was to assess the assumptions TFG uses in the valuation of its portfolio and see if these were reliable (see Fig 15). Fig 14 Fig 15 From conversations with various professionals with extensive experience on CLO structuring and origination, we concluded that these assumptions were broadly in line with those market participants are using today and with Moody s implied default, recovery, and prepayment rates. We further encouraged by a marked improvement in the % of obligors below Caa1/CCC+ over the past 3 years (see Fig 16). Fig16 5 Instead of naming the specific tranches, TFG calls them Transaction X.

8 Given that the book value of a CLO approaches its par (redemption) value as the maturity date approaches, along with the fact that most of TFG s CLO 1.0s are in runoff, and the reliability of the company s Mark-to-model valuation, we are confident that it will be able to offload these CLOs in today s market at least at Book Value (NAV). When TFG s CLOs mature, an associated concern is regarding how management would deploy the excess cash that comes with the residual cash flow from the redemption of TFG s equity tranches. While the company has not encountered such a maturity wall before, we trust that, given its track record as prudent investors, management can be counted on to return cash to shareholders if no other higher RoE investments can be found. The last remaining moving variable in CLO valuation would be the discount rates used to projected CLO equity cash flows. Discount rates for US CLO Equity were reduced from 13% to 12% in Q This was justified by how TFG had managed to sell seven U.S. CLO 1.0 positions, all at or above their carrying values as calculated using a 13% discount rate, and other market related information, such as broker research and bid lists. For European CLOs, discount rates were reduced from 16% to 14%. This was justified by how European BB-rated tranche yields have continued exhibit stability at their current low levels, reducing the spread between them and the US CLO 1.0 BB spreads to below 2%. This follows a rate reduction at the end of 2013 from 17%. Because of recent geopolitical issues in Ukraine and Russia, our contact feels that this rate compression is on the aggressive side. However, the relatively small concentration of European CLOs in the Investment Portfolio gives us comfort. Additionally, since the only asset that TFG has on its balance sheet is its Investment Portfolio (see Fig 17), and the rest of the Investment Portfolio ex-clo are marked-to-market, we are comfortable taking a maximum haircut of 9% on the fund NAV to be conservative (the relative weight of TFG s European CLOs; this assumes that their effective value is 0). This still gives us a 24% NAV margin of safety and potential upside. Fig 17 Market Comparables When looking at market comparables we prefer to rely on data based on recent private transactions that actually took place. This is because we believe private buyers are more informed, and actual deals done are a better indication of market sentiment. In December 2013, KKR Fund Holdings, L.P. (NYSE:KKR) signed a definitive merger agreement to acquire KKR Financial Holdings LLC (NYSE:KFN) for $2.6 billion in stock. As Fig 18 shows, both companies are broadly similar in terms of the composition of their NAV, with CLOs making up 51% of KFN s Investment Portfolio, and a good proportion of the remainder being in special situations and private equity.

9 Fig 18 This was a 5% premium to NAV paid by the KFN s own management company, which would have material information on the actual worth of its book. We felt that this was especially important in view of CLO valuation being more often than not a black box for a third party like us, with no access to the Company s indentures. KKR x KFN Transaction Transaction Value KFN Book Value Implied P/NAV 0.92 Post 10% Haircut 0.83 Current TFG Financials Current Price Current NAVPS Current P/NAV 0.67 Fig 19 Implied Upside 23% As can be seen in Fig 19, KFN was bought out at an implied P/NAV of 0.92x. Taking a 10% haircut for conservatism, we see the potential for a 23% upside as compared to TFG s current trading multiples. Earnings Power Value Having established that TFG s portfolio is worth at least book value, we move on to TFG AM. Since the cash flows that these businesses throw off are primarily calculated off AUM, they are relatively stable, as long as the Funds face no huge withdrawals. Once again, KKR paid 8.7x normalized earnings for KFN, or 9.5x LTM earnings, a significant margin above the 5.7x normalized earnings TFG is currently trading at. GAAP Accounting Obfuscates True Value of TFGAM Because of TFG s multiple recent acquisitions, the true economic asset- and earnings-power value of the company is misrepresented on a GAAP basis. This is due to the induction of both majority- and minority- owned subsidiaries into TFG s corporate structure. GreenOak not consolidated into Income Statement Firstly, since TFG only owns 23% of Greenoak, it accounts for it using the equity method, such that its earnings are run through the balance sheet instead of the income statement, as a change in the fair value of the Greenoak equity investment. As a result, actual economic earnings are higher than GAAP earnings. If we reverse this change and add the $15.9M in EBITDA that Greenoak contributed, EBITDA margins increase from 35% to 41% (see Fig 20).

10 LTM Adjusted Consolidated Interest income Fee income Unrealised Polygon performance fees Other income - cost recovery Investment and management fee income Income ex cost recovery Management and performance fees (28.6) (36.7) (90.0) (86.4) (86.4) Other operating and administrative expenses (7.6) (33.3) (84.8) (96.1) (96.1) Total operating expenses (36.2) (70.0) (174.8) (182.5) (182.5) Greenoak Adjustment Adjusted EBITDA % Margin 84% 74% 42% 35% 41% TFG AM not consolidated into Balance Sheet Fig 20 However, since the remainder of TFG Asset Management (Polygon and LCM, ex Greenoak) is fully owned by TFG, it is consolidated into the income statement but not the balance sheet of the company, and there is no goodwill account. To value this portion of TFG (Asset Management), we focus on earnings power and EBITDA, since it primarily generates high-margin, high-quality recurring management fee income LTM TFGAM Interest income Fee income Unrealised Polygon performance fees Other income - cost recovery Investment and management fee income Income ex cost recovery % Total 0% 14% 32% 36% Management and performance fees (1.7) (6.7) (8.8) Other operating and administrative expenses (30.1) (75.0) (79.7) Total operating expenses - (31.8) (81.7) (88.5) EBITDA % Margin 14% 15% 14% % Total 0% 3% 11% 14% EBITDA Multiple 12.0 Implied EV Shares Outstanding Implied EV/Share 1.60 Fig 21 As can be seen in Fig 17, if we apply the conservative 12x EBITDA multiple usually used for traditional hedge funds on TFG AM s earnings, we derive an incremental value for it of $1.60/share. P/NAV Calculations Justified RoE 0.97 Market Comparables 0.83 Blended Multiple 0.90 Current NAVPS 16.9 Adjusted NAVPS 18.5 Adjusted Share Price 16.6 Current Share Price 11.4 Implied Upside 46.3% Fig 22

11 Tying it all together, adding $1.60 to TFG s current NAV Per share and applying a 0.90x NAV multiple derived from the former appraisals give us an implied share price of $16.60, a 46.3% upside. Risks One might argue that the market values TFG as such because of a few key risks. Related Party Transactions The company is currently fighting litigation against Leon Cooperman, manager of Omega Advisers. Cooperman alleges that the company abused its voting rights to overpay for the Polygon acquisition, forking out $98.5M for $54.8M worth of assets. He also took issue with how the company paid for the acquisition with stock, as opposed to drawing down its abundant cash balances, and carried out a buyback after buying back the stock, ensuring that TFG paid out more shares than they would have had the buyback been carried out before the acquisition 6. Also, since Griffith and Dear owned most of Polygon, they would have received more TFG stock, whose value would have then increased promptly after because of the buyback. However, one can argue that despite the TFG s voting structure, management interests are highly aligned with shareholders. Most of the stock options they received through the Polygon acquisition vest in 2017 at a strike price of $10, which gives them huge incentives to ensure that the stock price is significantly above that level. It trades at $10.89 today. Fee Structure TFG has no high watermark, which gives management a reason to mark-down CLOs, and then revalue them, booking an NAV gain and earning performance fees. Cooperman alleged that TFG s management did indeed do this over , at the expense of shareholders dividends. Once again, management is incentivized otherwise, given the huge amount of stock options they own writing down CLOs would cause TFG to book significant income statement losses (as it has in the past), and affect the price of the equity negatively. They are also paid management fees as a % of AUM, so reducing the AUM of the investment portfolio would decrease their management fees. Lastly, it was contractually agreed as part of the Polygon Acquisition that should any annual compensation actually paid to Griffith and Dear exceed an annual base salary of US$ 100,000, they would promptly return such excess amount to the Fund. As a result, most of their compensation comes from stock based options, aligning their incentives with equity holders. Conclusion While most retail investors would shy away from an investment like TFG due to its foreign listing, lack of coverage, and opaque management and voting structure, we found that we were able to gain comfort around those risks with the way management is financially incentivized and a huge margin of safety. No matter how you slice and dice it, this margin of safety is one that gives the opportunistic investor a chance to invest in a collection of seasoned CLOs that throw off cash at a 33% discount to book value, an investment we found hard to pass up. 6 Assuming that buybacks increase the stock price less stock would be needed

Tetragon Financial Group Limited 2016 Annual Report Investor Call

Tetragon Financial Group Limited 2016 Annual Report Investor Call 2 March 2017 THE INFORMATION CONTAINED HEREIN DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO PURCHASE ANY SECURITY