Tetragon Financial Group — Improved returns but discount has widened

Tetragon delivered a strong relative performance in the first six months of 2018, with a +4.4% NAV total return and a 5.2% ROE, which excludes the share dilution effects of the stock dividend (dividend reinvestment) plan. This compares favourably to broad equity market returns, with the MSCI AC World and FTSE All-Share indices achieving total returns of -0.1% and 0.7% in US dollar terms in the half year. Net investment gains were US$144.6m in H118 and fair value net income was US$104.3m, compared with US$99.5m and US$70.0m respectively in H117. Annualised ROE for the half-year was 10.5%, within Tetragon’s long-term target 10-15% pa range, which is higher than the ROE achieved in each of the last four financial years (range: 6.3% to 8.9% on a like-for-like basis).

Apart from the hedge fund strategies category, which was negatively affected by a US$12m loss on Tetragon’s investment in the Polygon Distressed Opportunities Fund (wound down and closed during H118), all asset classes in the portfolio generated positive returns in the period, with half of the net investment gains coming from Tetragon’s stakes in the TFG Asset Management businesses. Tetragon’s net asset value increased by US$80.4m to US$2,074.9m during H118, with NAV per share rising from US$21.08 to US$21.64, as illustrated in Exhibit 2.

Within the US$72.5m gain from TFG Asset Management, the largest contribution was a US$44.1m gain on Tetragon’s investment in GreenOak Real Estate, comprising receipt of carried interest (performance fees), the first non-carry distribution and significant valuation gains. Valuation gains resulted from a material increase in AUM, which translates into much higher profitability. GreenOak’s AUM increased from US$7.6bn at end-December 2017 to US$9.4bn at end-June 2018.

Tetragon’s real estate investments generated a US$30.2m gain, including US$18.2m of gains on investments in GreenOak funds (primarily European and Asian funds). A US$12.0m gain was recorded on Tetragon’s Paraguayan farmland investments (managed by South American farmland specialist Scimitar), which were revalued by an independent valuation specialist during the period.

Other equities and credit, which comprises direct balance sheet investments, contributed a gain of US$20.6m in the half-year, with a US$29.5m gain on equity investments partly offset by a US$8.9m loss on a distressed credit position that has since been sold, leaving one remaining credit position. Positive returns were generated by six of the seven directly held equity investments, which comprise European and US-listed equities, with one of these holdings reaching US$49.9m and moving into Tetragon’s top 10 investments at end-June 2018 (see Exhibit 1).

During H118, Tetragon’s portfolio additions (including forex effects) totalled US$180.8m, with the most significant allocations made to hedge fund strategies and private equity. US$25.0m was added to the investment in Polygon European Equity Opportunity Fund, which was up 2.35% in H118, mainly driven by trades related to announced M&A situations, which represent around half of the fund’s portfolio at end-June 2018. US$24.7m was added to the investment in the Credit Suisse-managed QT Fund, which recorded a small gain in the half-year from its systematic data-driven investment strategies. US$20.0m was added to the Polygon Convertible Opportunity Fund, which generated a small gain in the half-year despite a negative event in a distressed trade during March, with an increased opportunity set due to the large number of new issues, particularly in the US.

During the half-year, Tetragon made a number of direct balance sheet investments that it believes are compelling idiosyncratic opportunities. US$40.0m was added to direct private equity investments; US$26.7m to private equity funds and co-investments; and US$15.6m was added to listed equity investments, including increased investment in one UK-listed equity and a new US-listed equity. At end-June 2018, direct balance sheet investments made up 14.2% of Tetragon’s NAV, spread across private equity, listed equity and credit (see Exhibit 1).

During the six-month period, Tetragon income and disposal receipts included US$102.5m from the closure of the Polygon Distressed Opportunities Fund, which was largely reallocated to other hedge fund strategies, as noted above. Other significant receipts were US$63.0m from CLO bank loan investments (primarily non-LCM US CLOs), as these continued to amortise, and US$23.5m from exiting direct listed equity investments.

During the six months to end-June 2018, Tetragon’s net cash position declined modestly from US$357.2m to US$349.3m, representing 16.8% of net assets. A substantial cash position is maintained to cover future commitments and also to provide scope for Tetragon to take advantage of opportunistic investments and new business opportunities. Tetragon’s outstanding cash commitments at end-June 2018 amounted to c US$260m, comprising investment commitments (GreenOak US$118m, TCI III US$65m, direct private equity funds US$9m), potential investments (Hawke’s Point US$69m), with additional financial resources required to cover ongoing dividends and fees. Tetragon currently has a US$150.0m revolving credit facility in place, of which US$38.0m was drawn at end-June 2018, unchanged since end-2016.

During the half-year, Tetragon’s Q417 and Q118 dividends, both US$0.1775 per share, became payable, with the total dividend distribution amounting to US$32.2m. US$24.0m was paid in cash, with the remaining US$8.2m reinvested under Tetragon’s optional stock dividend plan, resulting in 0.9m shares being issued from treasury. The Q218 dividend, which was increased to US$0.1800 per share, continuing the historical pattern of the quarterly dividend being increased in the second and fourth quarters and held steady in the first and third quarters, is payable on 24 August 2018.

Tetragon’s fully diluted share count increased from 94.6m to 95.9m during the first half of 2018. The increase of 1.3m shares comprises 0.6m in relation to the vesting of shares under equity-based compensation awards and 0.7m in relation to the issue of shares as scrip dividends.

In July 2018, Frederic Hervouet retired from Tetragon’s board after four years’ service as a non-executive director. This reduces the board to five directors, three of whom are independent. No immediate decision has been made by Tetragon regarding any possible addition to the board.

As illustrated in Exhibit 3 (left-hand chart), having narrowed steadily from 56.3% in February 2016 to 32.8% in December 2017, Tetragon’s share price discount to NAV has seen a widening trend emerge in 2018. While the current 39.9% discount is wider than its 37.8% one-year average, it is narrower than its three-, five- and 10-year averages of 41.8%, 40.6% and 43.6% respectively. Tetragon’s share price has declined in 2018, despite its NAV continuing to move higher, leading to a marked widening of its discount, with the share price at 30 June 2018 standing c 3% lower than a year earlier, while its NAV per share was c 7% higher. Exhibit 3 (right-hand chart) clearly illustrates the divergence in share price and NAV total return performance since December 2017. The decline in Tetragon’s share price accompanied a rise in equity market volatility, suggesting that increased investor risk aversion may have affected the share price, while returns from Tetragon’s diversified alternative asset portfolio appear largely unaffected by the change in stock market conditions.

Exhibit 4 shows a comparison in sterling terms of Tetragon with the other members of the AIC Flexible Investment sector that have a market cap higher than £100m. The investment mandates of the funds in the peer group vary widely and, while none is considered as a direct comparator for Tetragon, the peer group average provides a broad context for comparison. Tetragon’s NAV total return leads the peer group by a considerable margin over the 10 years to end-June 2018, which includes the 2008 global financial crisis that had a significant adverse effect on a number of funds in the group. Over one, three and five years, Tetragon’s NAV total return ranks second out of the peer group of 10, with returns significantly higher than the peer group average over three and five years. US dollar strength versus sterling over the three months to end-June 2018 largely offset the weakness in the second half of 2017, making currency effects less significant on sterling performance over one year. Over three, five and 10 years, US dollar strength versus sterling (+19.1%, +14.9%, +50.7% respectively) had a positive effect on performance in sterling terms.

Tetragon’s share price discount to NAV is at the wider end of the peer group range, but at a comparable level with two other funds, while four of its peers are trading at a premium to NAV. Tetragon’s ongoing charge is at the higher end of the peer group range and it is one of four funds that charge a performance fee. Similar to most of its peers, Tetragon has no corporate level net gearing, while its 5.5% dividend yield is the highest in the peer group, significantly above the 2.2% average yield. We note that if Tetragon’s discount was to fully unwind, the shares would have a yield of c 3.3%, still at the higher end of the peer group range.