Tetragon Financial Group — Positive Q317 performance; Q417 tender offer

Tetragon’s NAV increased by US$28.6m to US$2,010.4m in the third quarter of FY17, with NAV per share rising from US$20.22 to US$20.37, as illustrated in Exhibit 2. NAV total return in the third quarter was 1.6%, continuing the positive progression recorded in the first half of the year (see our August 2017 update note), and bringing NAV total return to 4.5% for the first nine months of 2017. Investment income and gains totalled US$57.2m during the third quarter, with positive contributions made by all asset classes other than hedge fund strategies. Net income for the third quarter was US$40.2m, after US$16.2m in operating expenses and management fees and US$0.8m interest expense. US$12.0m was paid out in cash dividends and other capital transactions added US$0.4m.

Other equities and credit, comprising direct balance sheet investments, was the best performing asset class during the quarter, recording a US$23.0m gain, with six individual investments each contributing US$2.0m or more. Tetragon added to its investments in this asset class during the quarter and, alongside the gains, this lifted Tetragon’s other equities and credit exposure to 9.9% of NAV (see Exhibit 1).

TFG Asset Management recorded a US$20.4m gain, principally due to growth in the underlying businesses. Other than start-up Hawke’s Point (valued at US$0.8m), all of the six asset managers saw valuation uplifts during the quarter, notably Equitix with a gain of US$14.0m, which remained Tetragon’s second largest holding, despite being refinanced during the quarter, with Tetragon receiving a distribution of US$87.4m. Total assets under management across the TFG Asset Management businesses increased from US$20.2bn to US$21.0bn during the quarter, primarily due to Equitix closing the oversubscribed fund-raising for its fourth fund at its £750m cap in the period.

Bank loans recorded an overall gain of US$15.7m, with US and European CLOs and TCI II (US multi-manager CLO equity) all making positive contributions during the quarter, with the largest gain of US$8.6m from LCM-managed US CLOs. There were significant cash inflows from both LCM-managed and third-party managed US CLOs, as well as European CLOs, during the quarter, which totalled US$67.3m, while a net US$18.6m was added to the investment in TCI II.

Hedge fund strategies recorded a US$5.2m loss during the quarter due to declines in the Polygon European Equity Opportunity Fund and the Polygon Distressed Opportunities Fund. However, this asset class recorded a US$9.0m net gain for the first nine months of FY17, largely due to the strong performance of the Polygon European Equity Opportunity Fund during the first half of the year.

Real estate recorded a modest US$1.3m gain in the quarter, with c US$20m of new investments broadly matching distributions, both primarily in GreenOak’s European investment vehicles, which held Tetragon’s exposure to this asset class steady at c US$170m.

There was a US$2.0m gain on Tetragon’s substantial net cash position, which increased from US$400.0m at end-June 2017 to US$484.4m at end-September 2017, primarily due to the US$84.7m distribution received on the refinancing of Equitix.

During the third quarter, Tetragon declared and distributed a US$0.1750 dividend for Q217, which was 4.5% higher than the Q216 dividend of US$0.1675. Since the quarter end, Tetragon has declared a US$0.1750 dividend for Q317 to be paid on 24 November 2017. This continues the historical pattern of the quarterly dividend being increased in the second and fourth quarters, and held steady in the first and third quarters.

Tetragon’s fully diluted share count increased from 98.0m to 98.7m during the third quarter of 2017. An increase in the fully diluted share count from the issue of shares as scrip dividends in the quarter was partly offset by a decrease in the intrinsic value of in-the-money options resulting from the 1.2% decline in Tetragon’s share price over the period.

On 31 October 2017, Tetragon announced a planned tender offer to purchase up to US$65m of its own shares and, on 8 November 2017, announced the commencement of the offer. This is being conducted as a ‘modified Dutch auction’, with shareholders able to tender their Tetragon shares at prices ranging from US$12.60 to US$14.00 per share. The tender offer is scheduled to expire on 7 December 2017, with the final determined purchase price to be announced on 12 December 2017 and settlement promptly thereafter.

Based on the prevailing US$20.37 NAV per share at end-September 2017, the purchase price range equates to a discount of 31% to 38%, making the tender offer accretive to NAV per share. Assuming the offer is fully subscribed, there would be a 1.5% to 2.1% uplift to NAV per share, which would increase Tetragon’s NAV total return from 4.5% for the first nine months of 2017 to between 6.1% and 6.7%, prior to including the net income generated in the fourth quarter of the year.

Tetragon had US$38.0m drawn against its US$150.0m credit facility at end-September 2017, with a US$484.4m net cash position, equating to 24.1% of net assets. Excluding any other cash flows in the fourth quarter of the year, the US$65m tender offer would reduce net cash to US$419.4m, which would equate to 21.6% of the adjusted end-September 2017 net assets. This compares with the US$400.0m net cash Tetragon held at end-June 2017, which represented 20.2% of net assets, and outstanding cash commitments of less than US$300m at end-September 2017.

Jeff Herlyn, who has been a principal of Tetragon’s investment manager, Tetragon Financial Management, since its formation in May 2005 and is one of the six members of the investment committee, has indicated his intention to retire in September 2018. His background is in CLOs and he is also a member of the investment and management committees of TCIP and TCI II.

As illustrated in Exhibit 3, Tetragon’s share price discount to NAV has followed a narrowing trend since February 2016, but has only partly reversed the widening that occurred over the previous three years. The current 35.9% discount is modestly narrower than its 39.2% five-year average but appreciably wider than its five-year low of 20.4%, which suggests that significant scope remains for the discount to continue narrowing.

Exhibit 4 shows a comparison in sterling terms of the seven AIC Flexible Investment sector funds that have a market cap of more than £100m. Tetragon’s NAV total return leads the peer group by a considerable margin over three, five and 10 years to end-September 2017, even though its performance over one year is at the lower end of the peer group range. Tetragon’s share price discount to NAV has narrowed meaningfully over the last year but remains the widest in the peer group, which suggests substantial scope for further narrowing relative to peers as well as relative to its historical levels. Tetragon’s ongoing charge is at the top of the peer group range and it is among the minority of funds to charge a performance fee, while its structural cash position means that it has no net gearing at a corporate level, similar to the majority of peers. Tetragon’s 5.3% dividend yield ranks as the highest in the peer group, significantly ahead of the 2.2% average yield.