Editing Tetragon Financial Group

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'''Tetragon Financial Group (Tetragon) focuses on alternative asset classes offering excess risk-adjusted returns (ie ‘intrinsic alpha’). This includes private equity holdings in alternative asset managers, investments in funds, as well as balance sheet investments in alternative assets. Tetragon posted a 14.1% NAV total return in FY21 in US dollar terms and so far saw only an 0.6% NAV decline in 2022 until end-April. It continues to make distributions to shareholders through NAV-accretive share buybacks (it completed a US$42m tender offer in April 2022) and dividends (with its LTM payout implying a 4.1% yield).'''

TFG Asset Management remains the largest asset in Tetragon’s portfolio (45% share of NAV) and management reiterated its intention to at least partially exit this position, with the sale of individual asset managers now more likely than an initial public offering (IPO) of the whole entity. In this context, Edison Investment Research notes that TFG Asset Management’s valuation reflected in Tetragon’s end-April NAV equals c 1.3x Tetragon’s current market capitalisation. Within TFG Asset Management, management considers LCM (valued at 29% of Tetragon’s current market cap) and BentallGreenOak (23% of market cap) as being more mature, while the largest position Equitix (71% of market cap) is still in its growth phase.

While the global economy recovers from the pandemic-induced slowdown, investors are now mostly concerned about high inflation and monetary tightening, as well as uncertainties on global supply chains and trade routes (further exacerbated by lockdowns as part of China’s ‘zero-COVID’ policy, and sanctions on Russia following its invasion on Ukraine). The World Bank recently reduced its expected GDP growth in Europe to 2.5% in 2022 from 4.2% earlier (mostly due to rising energy prices) and cut the US growth forecast by 1.2pp to 2.0%. With slowing growth and high inflation, investors are likely to be drawn to (1) assets benefiting from rising interest rates or having embedded inflation protection and (2) alternative assets, which are exhibiting low correlation to equities.

In the near term, the rising interest rates should have a positive impact on collateralised loan obligation (CLO) cash flow generation, especially by increasing the residual cash flow to CLO equity tranches. Since the beginning of 2022, three-month Libor increased from 0.21% to the current 2.20% (27 June) and given the record-high inflation (the US CPI hit a 40-year high of 8.5% in March 2022) the consensus expectation is for the Federal Reserve to continue raising rates throughout 2022. In the long run, however, the increasing cost of debt may translate into higher default rates and collateral quality deterioration. In this scenario, cash flow would be redirected from equity (and potentially also junior debt) tranches due to internal test breaches. So far, the default rate in the United States has increased only slightly (0.6% on a last 12 months (LTM) basis) and is expected to reach 1.5% in 2022 and be in the 1.25–1.75% range in 2023 according to Fitch. This compares to c 4% recorded at the pandemic peak (September 2020) and over 10% in late 2009 as a result of the global financial crisis (Fitch). Tetragon is currently invested only in US-based CLOs, predominantly in equity tranches. Tetragon is exposed to the CLO market in several ways. It owns a 100% stake in CLO manager LCM and CLO-investing asset manager Tetragon Credit Partners (TCIP). Tetragon also invests in TCIP-managed funds, as well as directly into CLOs managed predominantly by LCM but also third-party managers. The combined exposure amounts to 19% of Tetragon’s NAV.

Tetragon Financial Group is a closed-ended investment company traded on the London Stock Exchange (LSE) and Euronext Amsterdam. It invests in a broad variety of asset classes with exposure to public and private equities and credit (including distressed securities and structured credit), convertible bonds, real estate, venture capital, infrastructure, bank loans and TFG Asset Management, a diversified alternative asset manager. The company is domiciled in Guernsey and was founded in August 2005. Before 2018 Tetragon invested through the Tetragon Master Fund, which was amalgamated with Tetragon that year to simplify the structure and reporting. Tetragon’s shares were admitted to trading on Euronext Amsterdam in April 2007 and listed on the Specialist Fund Segment of the LSE in November 2015 (ticker: TFG). In April 2018, an additional sterling LSE market quote was introduced under the ticker TFGS and cash dividends may be elected by investors to be paid in sterling, instead of the company’s base operating and reporting currency (US dollars). The quoted shares available to investors on the listed exchanges do not hold any voting rights.

Tetragon is ultimately controlled by its co-founders Reade Griffith and Paddy Dear. They control the voting shares of the company, as well as Tetragon’s investment manager – Tetragon Financial Management (TFM). They co-founded Polygon, which is wholly owned by TFG Asset Management, in 2002. TFM’s investment committee, which determines Tetragon’s investment strategy and approves every major investment, comprises Griffith and Dear as voting members, and Stephen Prince (Head of TFG Asset Management), who all have experience in alternative investments. Tetragon and TFG Asset Management employees cumulatively held 34.5% of outstanding non-voting shares of Tetragon at end-April 2022.

The investment manager focuses on alternative asset classes that it believes offer ‘intrinsic alpha’ (excess returns relative to their assessed investment risk) and aims to diversify its portfolio of assets that are relatively uncorrelated with broader financial markets. New investment analyses include evaluations of risk/reward, correlation, duration and liquidity characteristics. Tetragon searches for managers it believes to be high-quality specialists with successful track records and aims to invest not only into managed funds, but into the manager as well to supplement its returns with stable fee income and capital appreciation from growing third-party capital.

Tetragon acknowledges the importance of ESG factors in sustainable investing and sees evidence demonstrating a link between ESG performance and financial performance. In the investment process, the investment manager integrates ESG factors as supplementary information to investment decisions to help identify drivers of risk and return. It has also adopted a Statement on the UK Modern Slavery Act in its operations. Tetragon also reports against the Code of Corporate Governance of the AIC. The ESG policy is reviewed annually and TFM’s Investment Committee and Risk Committee are responsible for overseeing ESG integration. Edison Investment Research notes that Tetragon’s investment manager (Tetragon Financial Management) has not disclosed any ESG-related targets for its own operations. With respect to its governance structure, Edison notes that Tetragon’s listed shares are all non-voting (the only voting shares are held indirectly by its two co-founders. Neither Tetragon nor Tetragon Financial Management has been assigned any external ESG rating at present.

Tetragon is managed by Tetragon Financial Management (TFM). TFM was founded and is owned by the co-founders of Tetragon (Reade Griffith and Paddy Dear), who also founded Tetragon in 2005 and launched Polygon in 2002 (currently wholly owned by Tetragon). While Tetragon pays management fees to TFM, in terms of decision making it can be viewed as a self-managed entity, because the investment manager is owned and run by the same two individuals who indirectly own voting shares of Tetragon.

Tetragon continues to see TFG Asset Management as its main value driver going forward, which was the case in each financial year from 2017–21. Tetragon aims to continuously expand the entity with new managers, asset classes and strategies and its aggregate assets under management (AUM) reached US$37bn at end FY21 (a 14% five-year CAGR). While Tetragon still considers an IPO of the whole entity as a viable exit route, it now expects that exit transactions of individual asset managers within TFG Asset Management are more likely in the mid-term. Currently, TFG Asset Management comprises nine asset managers, two of which Tetragon considers relatively mature. In the case of three it sees further potential for high growth, while the remaining four are in the early stages of development (see the Asset allocation section for more details on TFG Asset Management managers).

As at end-April 2022, Tetragon’s NAV stood at US$2.7bn across various alternative asset allocations. TFG Asset Management remains its largest portfolio holding (making up 45% of the NAV). It is a wholly owned subsidiary, holding (mostly) majority stakes in alternative asset management companies generating stable fee income from AUM of US$37bn (at end-2021) in infrastructure, real estate, CLOs and private equity as well as hedge funds (see details below). Tetragon invests predominantly into strategies of these companies (42% of Tetragon’s portfolio at end-March 2022). The remaining 14% of the portfolio is Tetragon’s direct investments (7%) and assets managed by third-party managers (7%).

Tetragon’s quoted assets portfolio (‘other equities and credit’, 6% of portfolio at end-April 2022) is concentrated in several high-conviction positions, including in particular tech and biotech stocks. Its real estate investments are executed through or alongside BentallGreenOak’s managed private equity-style funds and co-investment vehicles that focus on opportunistic investments in the US, Europe and Asia (except for the Paraguayan farmland managed by Scimitar). Litigation Finance is a new endeavour for Tetragon and comprise funds managed by Contingency Capital (investing in legal assets). These make up only a minor part of Tetragon’s portfolio for now (c 1% of NAV at end-March 2022).

Tetragon posted a 14.1% NAV per share total return (TR) in dollar terms (15.2% in sterling terms) in FY21, which is slightly below the results of broad equity markets (19% by MSCI AC World Index) and slightly above the peer group average (see Exhibit 9). Having said that, Edison Investment Research notes that Tetragon targets returns with a low correlation to broader markets and the FY21 return is in line with its long-term NAV performance (10-year average annual return of 12.3%). Moreover, Tetragon reported a 17.3% return on equity (RoE) in FY21, which is ahead of its 10–15% target. The largest single contributor to Tetragon’s return in FY21 was the revaluation of Equitix, adding US$348.8m to Tetragon’s NAV (14.1pp NAV attribution out of 17.9pp from TFG Asset Management). Excluding TFG Asset Management, the remaining assets contributed 6.8pp to the NAV increase (a US$167m uplift).

'''Exhibit 4b: Price, NAV and benchmark total return performance (%)<ref name=":1" />'''

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In Exhibit 9, Edison Investment Research presents a sterling-based comparison of Tetragon with eight members of the AIC Flexible Investment sector. Edison notes that the Flexible Investment sector varies widely in terms of investment strategies and mandates, and Tetragon’s investment approach is very diversified, which renders none of the companies a perfect direct comparator. Tetragon shows above-average NAV returns in every presented period, and over the long term (five-year and 10-year return) is the top performer in the peer group. Meanwhile Tetragon’s share price performance has lagged the group (it was one of the worst performing over three and five years), leading to the widest discount to NAV, despite Tetragon’s shares being the second-best performing over a one-year period. Currently, Tetragon’s shares trade at a 65% discount to end-April NAV, compared to the peer average of 12%.

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Tetragon does not target any specific dividend payout ratio. Tetragon’s board declares dividends, based on the recommendation of the investment manager, subject to the approval of Tetragon’s voting shareholder and adherence to applicable law. Edison Investment Research notes, as described in capital structure section on page 13, that all voting shares are ultimately owned by the co-founders. Dividends are paid quarterly in May, August, November and March each year. Additionally, Tetragon regularly buys back shares from the market, with the programmes conducted through a Dutch auction at a price close to the market price of the shares, resulting in NAV accretion.

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Tetragon’s 10-year average discount to NAV stands at 45% compared to the usual range of 10–30% seen in alternative assets and private equity investment companies. Tetragon’s current discount is wider than its long-term average and stands at 65% as of 24 June 2022. Tetragon did not return to pre-COVID-19 dividend payments (see Exhibit 10) and its current dividend yield stands at 4.1%, whereas before the onset of the pandemic-induced sell-off it stood at 6.5% (despite a 20% higher share price). However, Edison notes that Tetragon’s current yield is still the second highest in the peer group (see Exhibit 9). Lower dividend payments may also be partially offset by recently reintroduced buybacks.

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Tetragon does not use structural gearing and uses external debt financing only to temporarily bridge the gap between new investments and realisations to take advantage of arising investment opportunities. Tetragon had a minor net debt position as at end-April 2022 of US$57.1m (2.1% of its NAV) and has been fully invested since late 2019. This compares to a significant cash reserve kept historically to maintain flexibility for opportunistic investments (2015–18 average net cash at 18% at year-end). Tetragon has a US$250m revolving credit facility in place, which was fully drawn as at end-March 2022. The current allocation should limit the portfolio’s cash drag, while available cash leaves Tetragon with ample dry powder to pursue new opportunities; Edison Investment Research calculates that Tetragon had c US$193m (or 7% of its NAV) available to invest as at end-April 2022.

The facility has an interest rate of three-month US Libor +3.25%, and Tetragon is also obliged to pay a servicing fee of 0.015% of the total amount and non-usage fee of 0.5% on the undrawn amount. In 2021 the total costs of the credit facility totalled US$5.1m (FY20: US$6.2m), which translates to 0.2% of Tetragon’s opening NAV. During the year, Tetragon repaid US$25m of the facility on a net basis.

Tetragon pays a 1.5% pa management fee to TFM based on its net assets calculated monthly. TFM is also eligible to receive a quarterly incentive fee at a rate of 25% on the increase in NAV (before any dividends or other relevant capital adjustments such as share repurchases) above a hurdle. The latter is calculated as the higher of the two prior quarter-end NAVs (adjusted for dividends and capital adjustments) plus a hurdle rate, which is equal to three-month US dollar Libor plus 2.65% per year (currently c 2.86% for Q121). If the hurdle is not met in any calculation period, the shortfall is not carried forward to future periods, which effectively means the high-water mark applies only to the two prior quarters. Edison Investment Research alsos note that as at end-2021 Tetragon had US$104.1m of accrued fees (3.7% of NAV).

Reade Griffith and Paddy Dear are owners of TFM. Mr Griffith is also employed by TFG Asset Management and is the chief investment officer of Polygon’s event-driven European equity strategies. His current contract has been in place since July 2019 and includes US$9.5m paid in cash upon signing, US$3.75m paid in 2020 and up to 5.6m shares to be granted over seven years depending on performance (of which 0.3m were granted in FY21), which are held in escrow. The employment agreement replaces an earlier agreement, which included a US$0.1m annual salary.

Tetragon’s issued share capital consists of 10 voting shares and 139.7m non-voting shares. The voting shares are indirectly owned by the co-founders and are not entitled to any distributions; however, the co-founders also hold large stakes in Tetragon’s non-voting shares. At end-2021 90.2m shares were outstanding (96.4m on a fully diluted basis after accounting for potential dilution from equity-based awards). Tetragon holds 38.5m shares in treasury and further 10.9m in an escrow account (dedicated to fulfilling certain equity-based compensation obligations), and in total shares held by Tetragon make up 35% of the shares issued. Co-founders and employees own 34.7% of the non-voting shares outstanding as at end-January 2022.

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Tetragon’s board comprises five directors, three of whom are independent. Each board member stands for re-election by Tetragon’s voting shareholders each year at the AGM, with the voting shares controlled by Reade Griffith and Paddy Dear, the non-independent board directors appointed in 2007 and 2005, respectively. Both are co-founders of Tetragon, Polygon and TFM and are employed at various levels of the structure, including TFG Asset Management and Polygon.