Tetragon Financial Group (TFG.

NA)
Darrell Mark Leong
Darrell.leong@stern.nyu.edu

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
TFGs 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 TFGs subsidiary, Polygon.

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2012
Investment Portfolio
U.S. CLO 1.0
U.S. CLO 2.0
U.S. Direct Loans
European CLOs
Equities (in Polygon)
Credit and Convertible Bonds
Real Estate
Cash
Hedges
Other Equities, Credit, Convertibles & Distressed
Total
CLO (% total)
U.S. CLO 1.0 (% total)

2013

H1 2014

914.8
174.0
114.1

738.1
198.1
34.0

535.9
252.3
24.7

125.6
46.4
10.1
25.7
175.9

184.3
221.7
84.2
60.8
245.9

145.1
192.6
120.2
95.1
225.7
4.5

1,586.6
76.5%
57.7%

1,767.1
63.4%
41.8%

84.4
1,680.5
55.5%
31.9%

Fig 2

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 rate2 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 borrowers assets,
with strict covenants.
(2) Their liabilities are tranched3. 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.
TFGs 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 TFGs 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 todays lower rate environment,
and deciding on what to invest in

Fig3

Large, corporate loans, typically rated BB or B to companies that are already highly levered.
Most CLOs float at a spread above the LIBOR
3
Including senior, mezzanine notes, and equity
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2

As can be seen from the decreasing proportion of CLOs in TFGs Investment Portfolio, managements 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 TFGs business, TFG Asset Management, the majority of which was acquired in October
2012. 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 Polygons multistrategy hedge funds, that specialize in alternative investments 4, $450M AUM (today $1.52B)
(4) $25M 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 managements 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 AMs 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

Polygons strategies include European Event-Driven Equity, Convertibles, Mining Equities, Distressed Opportunities, Special
Situations, and a Private Equity Vehicle
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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 TFGs 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 Polygons 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

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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 one has the unique opportunity to buy Tetragons 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 todays 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) TFGs ownership structure severely disadvantages common shareholders.

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Fig 11
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 TFGs 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 TFGs book).

Fig 12

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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

10%
11%
12%
13%
14%
15%

10%
1.00
0.91
0.83
0.77
0.71
0.67

11%
1.10
1.00
0.92
0.85
0.79
0.73

RoE
12%
1.20
1.09
1.00
0.92
0.86
0.80

13%
1.30
1.18
1.08
1.00
0.93
0.87

14%
1.40
1.27
1.17
1.08
1.00
0.93

15%
1.50
1.36
1.25
1.15
1.07
1.00

Current Price
Current NAVPS
Current P/NAV

11.37
16.88
0.67

Average P/NAV
Implied Upside

0.97
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
1.25. Comparing that to TFGs 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 todays trading levels.
Balance Sheet Analysis
Since the majority of TFGs portfolio consists of CLOs (see Fig 2), an accurate valuation of the companys 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 disclosure5 (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

Instead of naming the specific tranches, TFG calls them Transaction X.

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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 Moodys
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

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 TFGs CLO 1.0s are in runoff, and the reliability of the companys Mark-to-model valuation, we are
confident that it will be able to offload these CLOs in todays market at least at Book Value (NAV).
When TFGs 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 TFGs 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 Q2 2014. 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%.

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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 TFGs 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 KFNs Investment Portfolio, and a good proportion of the
remainder being in special situations and private equity.

Fig 18

This was a 5% premium to NAV paid by the KFNs 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 Companys indentures.

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KKR x KFN Transaction

Transaction Value

2372.29

KFN Book Value

Implied P/NAV
Post 10% Haircut

2579.10
0.92
0.83

Current TFG Financials

Current Price
Current NAVPS
Current P/NAV
Implied Upside

Fig 19
11.37
16.88
0.67
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 TFGs current trading multiples.
Earnings Power Value
Having established that TFGs 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 TFGs 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 TFGs
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).
2011

2012

2013

LTM

Adjusted

Consolidated
Interest income
Fee income
Unrealised Polygon performance fees
Other income - cost recovery
Investment and management fee income
Incom e ex cost recovery

209.1
16.4
6.7
232.2
225.5

235.6
36.7
6.8
279.1
272.3

204.8
74.3
21.1
300.2
300.2

180.3
76.6
25.8
1.1
283.8
282.7

180.3
76.6
25.8
1.1
283.8
282.7

Management and performance fees

Other operating and administrative expenses
Total operating expenses

(28.6)
(7.6)
(36.2)

(36.7)
(33.3)
(70.0)

(90.0)
(84.8)
(174.8)

(86.4)
(96.1)
(182.5)

(86.4)
(96.1)
(182.5)

Greenoak Adjustm ent

Adjusted EBITDA
% Margin

189.3
84%

202.3
74%

7.4
125.4
42%

10.3
100.2
35%

15.9
116.1
41%

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Fig 20

TFG AM not consolidated into Balance Sheet

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.
2011
TFGAM
Interest income
Fee income
Unrealised Polygon performance fees
Other income - cost recovery
Investment and management fee income
Incom e ex cost recovery
% Total

2012

2013
0.2
36.7

0%

Management and performance fees

Other operating and administrative expenses
Total operating expenses
EBITDA
% Margin
% Total

0%

LTM

6.8
43.7
36.9
14%

0.3
74.3
21.1
95.7
95.7
32%

0.3
76.6
25.8
1.1
103.8
102.7
36%

(1.7)
(30.1)
(31.8)
5.1
14%
3%

(6.7)
(75.0)
(81.7)
14.0
15%
11%

(8.8)
(79.7)
(88.5)
14.2
14%
14%

EBITDA Multiple
Implied EV
Shares Outstanding
Im plied EV/Share

12.0
170.40
106.60
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 AMs 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
Adjusted NAVPS

16.9
18.5

Adjusted Share Price

Current Share Price
Implied Upside

16.6
11.4
46.3%

Fig 22

Tying it all together, adding $1.60 to TFGs 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.
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 TFGs management did indeed do this over 2008-2009,
at the expense of shareholders dividends.

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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.
Related Party Transactions
Until August 8 this year, the company was fighting a lawsuit filed by Leon Cooperman, manager of Omega Advisers.
This lawsuit has since been thrown out, lifting one of the larger sources of overhang surrounding the stock price, and
catalyzing its rise since then.
Cooperman alleged 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 acquisition6. 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.
One can also argue that despite the TFGs 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.

Conclusion
The thesis is a simple one. 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.

Assuming that buybacks increase the stock price less stock would be needed
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