|By PR Newswire||
|March 1, 2013 02:03 AM EST||
LONDON, March 1, 2013 /PRNewswire/ --
Letter to Shareholders 1 Key Metrics Earnings - Return on Equity 4 Earnings - Earnings per Share 5 NAV per Share 5 Dividends 6 Cash Flows and Uses of Cash Share Repurchases 7 TFG's Business Segments Investment Portfolio Investment Portfolio Overview 8 Portfolio Composition and Outlook 8 Corporate Loans 9 U.S. Pre-Crisis CLOs 9 U.S. Post-Crisis CLOs 10 European CLOs 10 Direct Loans 11 Equities 11 Convertible Bonds & Credit 11 Real Estate 11 Financing Sources, Hedging Activity and Other Matters 12 TFG Asset Management Overview 13 Polygon Transaction 13 Asset Management Brands 15 LCM 15 GreenOak Real Estate 16 Polygon Funds 17 Third-Party Fee Income 19 2012 Financial Review Financial Highlights 20 Statement of Operations 2010-2012 22 Statement of Operations by Business Segment 23 EPS Attribution 24 Consolidated Balance Sheet 24 Consolidated Cash Flow from Operations 25 Shares Reconciliation 25 Appendices Appendix I: Directors' Statements 26 Appendix II: Fair Value Determination of TFG's CLO Equity Investments 27 Appendix III: CLO Market Commentary 30 Appendix IV: Additional CLO Portfolio Statistics 32 Appendix V: Additional Corporate Information 36 Appendix VI: Risk Factors 40 Endnotes 44 Tetragon Financial Group Limited 2012 Audited Financial Statements Tetragon Financial Group Master Fund Limited 2012 Audited Consolidated Financial Statements
TFG SHAREHOLDER LETTER
The company had another successful year in 2012 with a return on equity ("RoE") of 20.8%. This return was considerably above both our average RoE of 14.1% since IPO and our over-the-cycle target of 10-15%. We also achieved a significant step forward with the acquisition of Polygon. This further diversifies the business and, we believe, makes our long-term RoE target more sustainable and less volatile through the addition of fund management capabilities, third-party assets under management ("AUM") and an asset management infrastructure.
There are two themes that continue to be uppermost in our minds as we review 2012 and plan for the years ahead. The first has been a key premise since TFG's inception - namely our belief that for certain financial assets we can create better ownership structures, which improve shareholders' risk-adjusted returns when compared to traditional banking models. We believe that TFG has accomplished this for corporate loans through its corporate structure and the use of collateralized loan obligations ("CLOs") with matched funding, which may provide a more efficient way for investors to access corporate loans at reduced costs and with lower risks compared to a traditional bank loan model. We believe that recent regulatory changes in the banking sector may provide new opportunities in the coming years. The second theme we have sought to exploit is, in our view, well understood within the asset management industry and it lies in the basic characteristics of investment return income and asset management fee income. As a general matter, in contrast to investment return income, asset management fee income is generally repeatable, and therefore less volatile. We propose that if an asset manager generates strong returns for its investors, returns to the asset manager itself may outpace the return on assets to investors on a RoE basis. Given this phenomenon and the high correlation between the performance of an asset manager and its funds, it is a potentially significant benefit for TFG to own all or a part of the asset managers with whom it invests.
In light of these themes, 2012 was an exciting year for the company in which it demonstrated the enduring benefits of the former theme and enhanced the prospects of the second theme through the acquisition of Polygon Management L.P. and certain of its affiliates (collectively, "Polygon") in October 2012 (the "Polygon Transaction"). We believe that the acquisition of Polygon provides the company with an important platform for future growth which may enable us to generate a higher and potentially more stable RoE over the long-term. We continue to seek to build a company that generates a meaningful and sustainable RoE for its shareholders.
The acquired Polygon investment fund managers and the purchase of the remaining interests in LCM Asset Management LLC ("LCM"), our loan manager, and a further interest in GreenOak Real Estate L.P. ("GreenOak"), all should provide strategic and financial benefits to TFG. Equally important, TFG also acquired Polygon's entire scalable global infrastructure upon which all of Polygon's and TFG's existing asset management businesses have been run. TFG now hosts and runs all of its asset management businesses on this platform and we believe new businesses can be seamlessly and efficiently added, providing further operational leverage.
Our plan is for TFG to continue to grow its existing asset management businesses, namely LCM, GreenOak and Polygon, and also seek to add new asset management businesses over time. In addition to providing new drivers for future growth, TFG's expanding asset management platform may also enable the company to better manage the capital allocation of its resources across more diverse asset classes and types, which may lead to better risk-adjusted returns.
We believe that the benefits of paying less fees to third-party managers, adding asset management fee income to TFG's investment portfolio returns, enhancing the ability to invest in products with preferential fee terms across a variety of asset classes and types, as well as adding new businesses with return and diversification benefits, should all contribute to generating a high and repeatable RoE for TFG shareholders.
DIVIDENDS AND SHARE REPURCHASES
In line with our policy of delivering a sustainable progressive growth in dividends to shareholders, we are pleased to have declared dividends of $0.47 per share for the full year 2012, a 19.0% increase over 2011. In addition, $175.6 million was used to repurchase 18.7 million shares during 2012. $150.0 million of this share repurchase was executed successfully via a tender offer using a "modified Dutch" auction process conducted on the company's behalf by Deutsche Bank AG.
Much of the value delivered in 2012 was a result of structures built and investments made in preceding years. Our philosophy has always been one of investing and building for the long term and we will continue to seek opportunities to do this.
The primary driver of 2012 results was the performance of U.S. CLO equity investments in transactions created prior to 2008 (we refer to these throughout this Annual Report as "U.S. Pre-Crisis CLOs"). These CLOs continue to benefit from many structural features that were included at their inception. They are also currently benefitting from having recycled their investments into wider spread loans over the last few years whilst maintaining their inexpensive financing. Their strong performance has also been supported by relatively low current loan default levels as benign credit conditions continue in the U.S. economy. In contrast, European economies have shown much slower recovery and, by extension, the 2012 performance of the company's European CLO deals has not met our expectations. Since European CLOs share certain structural features with U.S. Pre-Crisis deals, such as their historically low financing costs, we continue to hope for improved returns if European economies can recover in the near-term.
During 2012, we continued to make new investments across a broad spectrum of asset classes: loans (primarily through CLOs), real estate (through GreenOak), equities (through Polygon) and convertible bonds (through Polygon). We increased the weighting to those investments via the three brands on the TFG platform, where we can capture the asset management fee income as well as more tax-efficient investment returns, to create a more diversified and stable earnings profile for the long-term.
We are pleased with the CLOs we participated in this year (both LCM and third-party deals). We have also seen GreenOak source high-quality deals and remain confident of the long-term potential of owning income-producing hard assets, such as real estate. Finally, we like the risk / reward profile offered in the various Polygon funds. Overall, we are excited about the prospects for all of these investments and are hopeful that diversifying our holdings across multiple asset classes and strategies may reduce the correlation across the company's investments over the long-term.
In addition to its financial investments, the asset management business, which is an aggregation of all of the company's streams of fee income, grew materially in 2012, generating EBITDA of approximately $15.0 million for the year, and ending the year with $7.7 billion of client AUM.[(1)] We are confident that all three brands currently on TFG's asset management platform will continue to perform well and grow third-party assets under management in 2013.
OUTLOOK FOR 2013
The goals for the company in 2013 are:
1. To deliver 10-15% RoE per annum to shareholders.
2. To manage more of TFG's shareholder funds on the TFG asset management platform.
3. To grow client AUM and fee income managed by TFG asset managers.
4. To add further asset management businesses to the TFG platform, broadening and diversifying the company's ability to achieve our RoE targets over various credit, equity, interest rate, real estate and business cycles.
Taking each of these in turn:
RoE on Investments: Since its IPO in 2007, TFG's average RoE has been 14.1%. As noted above, our long-term target is a 10-15% per annum increase in net value to shareholders. This long-term target must be understood in the context that our returns will most likely fluctuate with LIBOR. LIBOR directly flows through some of our investments and, as it can be seen as the risk-free short-term rate, it should affect all of our investments. In high-LIBOR environments we would expect to achieve higher sustainable returns, just as in low-LIBOR environments we would expect to achieve lower sustainable returns.
Shareholder Funds Managed on the TFG Asset Management Platform: Of TFG's non-cash NAV of approximately $1.4 billion at year-end, approximately 27.4% is currently managed by asset managers in which TFG has an ownership interest. We are seeking to increase that proportion year-on-year over the medium to long-term. In 2012, approximately 77.7% of new investments were made with managers in which TFG had an ownership interest. Over time, as the company moves a greater share of its investment portfolio into investments managed by TFG-owned asset managers (albeit remaining mindful of the benefits of asset manager diversification), we expect to see a reduction of fees paid away to third parties.
Client AUM and Fee Income Growth: In 2012, client AUM grew from approximately $5.0 billion to $7.7 billion. The company is committed to growing AUM to generate greater fee income, and in 2013 we will continue marketing to new clients and building brand awareness. Given TFG's approach of investing substantial amounts of its funds alongside the investors in such Funds, the institutional strength of its infrastructure and the strong historic performance of all of its funds, we are hopeful that 2013 will be a good year for raising client assets in these funds.
New Businesses: TFG's ability to provide exposure to various asset classes and investments more efficiently than may be provided by banks has become increasingly relevant over the past few years. Furthermore, we believe that certain capital and regulatory constraints currently being imposed on traditional banks are likely to provide new opportunities for financial companies with TFG's structure and expertise in the coming years. We expect to evaluate a number of such opportunities during 2013. We look forward to adding excellent managers with high risk-adjusted RoE businesses which are appropriately correlated to TFG's existing businesses.
In summary, in 2013 we expect to focus on consolidating the business changes executed during 2012, exploiting the synergies arising between TFG and the businesses and interests acquired in the Polygon Transaction and continuing to invest for growth over the long-term.
The Board of Directors
1 March 2013
TFG KEY METRICS
Strong underlying business performance and the transformational acquisition of Polygon in Q4 2012 underscored a highly successful year for Tetragon.
We, the Investment Manager,[(2)] continue to focus on three important metrics when assessing how value is being created for, and delivered to, shareholders:
- Earnings: measured both as RoE and earnings per share ("EPS"), reflecting the operating performance of TFG.
- Net Asset Value ("NAV") per Share: reflecting how value is being accumulated within the business.
- Dividends and other distributions: reflecting how value has been returned to shareholders.
We look at each of these measures below.
EARNINGS - RETURN ON EQUITY
- The company targets a long-term RoE in the range of 10-15% per annum.
- 2012 RoE of 20.8% reflected a continuation of above-target returns for TFG, primarily driven by the ongoing strength of the U.S. Pre-Crisis CLO portfolio (please see the review of the Investment Portfolio on pages 8-12 of this Annual Report for further details).
- Although recent years have been volatile given the financial crisis and subsequent strong recovery, since TFG's April 2007 IPO, TFG has generated on average RoE of approximately 14.1% per annum.
EARNINGS - EARNINGS PER SHARE
- TFG generated EPS of $1.38 during Q4 2012, giving a full year U.S. GAAP EPS of $3.15 (2011: $3.46) and Adjusted EPS[(3)] of $2.70 (see Figure 19 on page 24 of this Annual Report for a detailed review of EPS).
- EPS continues to be primarily driven by the strength of TFG's U.S. Pre-Crisis CLO portfolio, supported by the continuation of benign credit conditions in the United States. That said, the level of EPS generated in 2012 by the CLO portfolio was lower than in 2011 by over $1.00 as CLO performance moderated towards more normalized levels.
- In Q4 2012, we recalibrated certain of the inputs used in modeling the fair value of the CLO portfolio (including certain default and discount rate inputs) in response to, among other things, changes in observable data, which added approximately $0.50 of EPS after fees (see Appendix II for further detail).
- While the asset management business segment's contribution to EPS is currently small, we expect it to grow in 2013 as we begin to see the benefit of the Polygon Transaction alongside the ongoing profitability of LCM.
- The acquisition of Polygon using shares added $0.48 of U.S. GAAP EPS, which will unwind as the relevant assets are amortised over the coming years. We have deducted this gain when calculating both the RoE and the Adjusted EPS[(4)] of $2.70. We discuss the accounting for the Polygon Transaction in more detail in the 2012 Financial Review on page 21 of this Annual Report.
- The purchase of an additional 13.0% holding in GreenOak as part of the Polygon Transaction resulted in a write-up of the 10.0% share already held by TFG, with a $0.07 increase in EPS.
NAV PER SHARE
Pro Forma Fully Diluted NAV per Share ended the year at $14.65, up 15% on the year.
As described in the Supplemental Information to the December 2012 monthly update, published on TFG's website on 31 January 2013, we have introduced a new measure of Pro Forma Fully Diluted NAV per Share, which seeks to reflect certain potential changes to the total number of non-voting shares outstanding over the next few years, which may be utilized in the calculation of NAV per Share. Specifically, in order to calculate Pro Forma Fully Diluted NAV per Share, the number of shares used to calculate U.S. GAAP NAV per Share has been adjusted to incorporate:
- Shares which have been used as consideration in the Polygon Transaction and applicable stock dividends relating thereto, and which are held in escrow and are expected to be released and incorporated into the U.S. GAAP NAV per Share over a five-year period.[(5)]
- The number of shares corresponding to the applicable intrinsic value of the options issued to the Investment Manager at the time of the company's IPO with a strike price of $10.00, to the extent such options are in the money at period end. As of 31 December 2012, the TFG share price was $9.67 and therefore such options were out of the money.[(6)]
In addition to the strong underlying performance of the company described above in the Earnings per Share section, the NAV per Share was significantly enhanced by TFG purchasing, in a modified Dutch tender offer (the "Offer") 15,384,615 TFG non-voting shares at a price of $9.75 for approximately $150.0 million.
As the purchase price of the Offer was significantly below the prevailing U.S. GAAP NAV per Share this had the effect of increasing U.S. GAAP NAV per Share by $0.85.[(7)]
Dividends per Share ("DPS"): TFG declared quarterly dividends for 2012 totalling $0.47 per Share, a 19% increase on 2011.
TFG continues to pursue a progressive dividend policy with a target payout ratio of 30-50% of normalized sustainable earnings, recognizing the long-term target RoE of 10-15%. The Q4 2012 dividend of $0.135 per share brings the cumulative DPS since TFG's IPO to $2.26 per share. Please see "Dividends and other Distributions" in Appendix V of this Annual Report.
- Of the $50.3 million of dividends paid in 2012, approximately 24.0% of shareholders elected to take shares rather than cash pursuant to the company's optional stock dividend program.
CASH FLOWS AND USES OF CASH
2012 was another strong year in terms of cash generation for TFG, with the CLO portfolio generating $127.6 million in Q4 2012, bringing the 2012 total to $459.3 million, up approximately 12.0% compared to 2011. As described in more detail in the Investment Portfolio section of this Annual Report, the main source of cash flows was the U.S. Pre-Crisis CLO portfolio, reflecting a combination of low defaults and elevated loan spreads relative to the low cost of liabilities on these deals.
With the new issue market for U.S. CLOs significantly more active in 2012 than in 2011, TFG invested $112.1 million into the equity tranches of new CLO issues, managed by LCM as well as by third-party managers. In line with the stated strategy of diversifying TFG's investment portfolio beyond CLOs, following the Polygon Transaction (described in more detail on page 21 of this Annual Report), in Q4 2012 TFG made initial allocations of capital totalling $55.0 million into various Polygon funds. TFG also invested $25.0 million into real estate opportunities managed by GreenOak.
Finally, TFG used approximately $175.6 million to repurchase shares at a discount to NAV, including $150.0 million via a tender offer in Q4 2012 (described more fully below), and $38.3 million to pay cash dividends during 2012.
At the end of 2012, TFG's cash balance was $175.9 million or approximately 10.9% of net assets.
Share repurchases: During 2012, TFG used $175.6 million of cash to repurchase shares which added approximately $1.12 to the NAV per share.
- Life-to-date through the end of 2012 TFG's share repurchase program resulted in the repurchase of approximately 34.8 million shares at an aggregate cost of $257.5 million.
- During Q4 2012, TFG bought back $150.0 million of shares in a tender offer, bringing the total value bought back in 2012 to $175.6 million.
- The repurchase program, during periods where TFG's shares have been trading at a discount to NAV, has been one useful tool available to the manager to accrete value for TFG shareholders. The program was recently extended in January 2013.[(8)]
TFG's BUSINESS SEGMENTS:
Asset Management Platform
(TFG Asset Management)
INVESTMENT PORTFOLIO OVERVIEW
In 2012, we continued to increase the company's exposure to real estate and leveraged loans by making new investments in GreenOak-managed funds and equity tranches of CLOs managed by LCM as well as third-party managers. In addition, the acquisition of Polygon led to new investments in Polygon funds, which allowed the company to expand into new asset classes, including equities, credit and convertible bonds.
The U.S. corporate loan portfolio accessed via CLO equity, which comprises the majority of TFG's investment assets, drove investment returns in 2012 and performed strongly in the context of a benign U.S. loan default environment and favorable reinvestment conditions for U.S. Pre-Crisis CLOs. Other investments similarly performed well in 2012, and we continue to look to further increase our ownership of investment assets both within and beyond the loan asset class.
PORTFOLIO COMPOSITION AND OUTLOOK
The following chart shows the split of net assets by asset class for each of the prior three years. Total net assets at each year-end were $1,621.4 million (2012), $1,474.4 million (2011), and $1,137.5 million (2010).
TFG's net assets, which totalled $1,621.4 million at the end of 2012, currently consists mainly of:
• corporate loans, both directly owned and indirectly owned through CLO investments;
• equity, credit, and convertible bonds owned through Polygon fund investments;
• real estate (owned through GreenOak fund investments or similar arrangements); and
The bulk of the investment portfolio consists of TFG's CLO investments, with a fair value of $1,214.4 million as of the end 2012, and the direct loan portfolio, with a fair value of $114.1 million at year-end. TFG's investments in Polygon funds and real estate funds totaled $56.5 million and $25.7 million, respectively, as of the end of 2012.
The following chart summarizes certain performance metrics for each asset class in TFG's investment portfolio.
Dec 2012 NAV LTM Performance LTD Performance Asset Type (in $MM) [ii] [iii] U.S. Pre-Crisis CLOs [i] $ 914.8 38.8 % 21.7 % U.S. Post-Crisis CLOs $ 174.0 12.4 % 12.4 % U.S. Direct Loans $ 114.1 8.5 % 6.6 % European CLOs $ 125.6 19.4 % 7.6 % Equities $ 46.4 3.2 %[iv] N/A Convertible Bonds and Credit $ 10.1 0.7 %[iv] N/A Real Estate $ 25.7 N/A N/A
(i) "U.S. Pre-Crisis CLO" and "U.S. Post-Crisis CLO" refers to U.S. CLOs issued before and after 2008, respectively. TFG owns $1.75 million notional in a CLO debt tranche. Such investment is excluded from these performance metrics.
(ii) For CLOs and direct loans, calculated as the total return. The total return is calculated as the sum of the aggregate ending period fair values and aggregate cash flows received during the year, divided by the aggregate beginning period fair values for all such investments. LTM performance for U.S. Post-Crisis CLO is weighted by the end of 2012 fair values. U.S. Post-Crisis CLO equity investments which were made during the year, and which therefore lack a full year of performance, are annualized. The LTM performance for European CLOs excludes the impact of any changes in the EUR-USD exchange rate on TFG's fair values and cash flows received for such investments.
(iii) For CLOs, the LTD performance metric used is the IRR, weighted by the amortized costs brought-forward of each investment. IRRs are calculated taking into account historical cost, cash flows received, and future projected cash flows. For direct loans, the LTD performance metric used is the annualized total rate of return.
(iv) Note that for Polygon-managed funds (Equities and Convertible Bonds) LTM returns are presented as the actual return for TFG's period of investment from 1 December to 31 December 2012. TFG invests in Polygon-managed funds on a preferred fee-basis.
TFG's exposure to the corporate loan asset class (whether held directly or indirectly via CLO equity investments) totaled $1,328.5 million at the end of 2012 ($1,254.5 million at the end of 2011) and remained diversified, with 77.0% in U.S. broadly-syndicated senior secured loans, 13.5% in U.S. middle-market senior secured loans and 9.5% in European senior secured loans.[(9)]
TFG's CLO equity investments, which comprise the majority of its exposure to corporate loan assets, represented indirect exposure of approximately $18.4 billion par value of leveraged loans. TFG's total notional invested in the equity tranches of such deals was approximately $1.7 billion. We view the difference between the par value of indirect loan exposures and TFG's notional amount of equity as an approximation of TFG's portion of the non-recourse debt "borrowed" via CLOs to fund the purchase of such loan assets. At the end of 2012, this difference was $16.7 billion.
When reporting on our corporate loan exposures, we find it useful to further segment such investments into the following classes:
• U.S. Pre-Crisis CLOs
• U.S. Post-Crisis CLOs
• European CLOs
• Direct U.S. Loans
U.S. PRE-CRISIS CLOs
As of the end of 2012, TFG had equity investments in 53 U.S. Pre-Crisis CLOs and one investment in the debt tranche of a U.S. Pre-Crisis U.S. CLO.[(10)] The U.S. Pre-Crisis CLO equity investments had total fair value of $914.8 million as of 31 December 2012, compared with $958.6 million at the end of the prior year.
TFG's investments in U.S. Pre-Crisis CLO equity continued to perform well in 2012, as low credit losses combined with wider loan spreads and, in some cases, LIBOR floors to generate an attractive arbitrage funding gap between the underlying asset spread and the low debt costs typical of such U.S. Pre-Crisis CLOs (e.g., approximately 3-month LIBOR+50 bps), leading to strong cash flow generation for these investments. During 2012, TFG's U.S. Pre-Crisis CLO investments produced cash flows of $415.6 million ($3.67 per average outstanding share), compared with $379.7 million ($3.21 per average outstanding share) generated during 2011.[(11)]
We believe that these investments will continue to perform well in the near-term as loan default rates are expected to remain below their historical average. Significantly, the soundness of these CLO structures remains robust as at the end of 2012, all deals in this segment were passing their junior-most O/C tests.[(12)] Although we believe that cash flows from TFG's U.S. Pre-Crisis CLOs will remain strong throughout most of 2013, we are mindful of the fact that the majority of these deals will begin amortizing in 2013-2014, and as such, their cash flow generation capacity will naturally begin to diminish. Furthermore, we believe that the impact of a potential increase in near-term defaults may be magnified for certain deals that have exited their reinvestment periods and have no or limited ability to reinvest principal proceeds into new loans. Whilst we remain focused on the impact of deterioration in corporate credit conditions, we believe this risk remains low in the short-term as we currently expect a benign default environment to continue in 2013. We do anticipate, however, that strong credit fundamentals, whilst a positive for CLO performance, are likely to provide support for continued spread tightening on bank loans. This compression would reduce the excess spread available for distribution to the equity tranches of CLOs. Finally, rising LIBOR rates would similarly be expected to reduce excess interest availability by decreasing the benefit of existing loan LIBOR floors, although we do not anticipate this to become a meaningful driver of performance in 2013.
U.S. POST-CRISIS CLOs
As of the end of 2012, TFG had made equity investments in eight U.S. Post-Crisis CLOs. Such investments had total fair value of $174.0 million as of 31 December 2012.
TFG's U.S. Post-Crisis CLOs performed well during the year. Through year-end, none of these investments had experienced an asset default and all O/C tests remain in compliance within each deal.[(13)]
During the year, we made five investments in the equity tranches of new issue U.S. Post-Crisis CLOs, totalling $112.1 million at cost, including three deals managed by LCM. All such investments were majority equity stakes. In addition, two new issue CLOs, including one managed by LCM, were due to close in February 2013, but are not reflected in this Annual Report. In 2012, TFG's U.S. Post-Crisis CLO investments produced cash flows of $19.9 million ($0.18 per average outstanding share), compared with $5.1 million ($0.04 per average outstanding share) in the prior year.[(14)]
We believe that TFG's U.S. Post-Crisis CLO investments will continue to generate attractive risk-adjusted returns. Similar to U.S. Pre-Crisis CLOs, we expect that a benign loan default environment will prove beneficial to their performance. However, such investments are expected to be more negatively impacted by loan spread tightening than earlier vintages, given their higher funding costs (typically averaging 3-month LIBOR+200 bps or more) and longer remaining reinvestment periods. As CLO loan assets prepay and these proceeds are reinvested, a spread-tightening environment would see the arbitrage gap in such deals contract, perhaps dramatically, and returns to the equity tranches, such as those held by TFG, to decrease. Conversely, underlying loan spread tightening would be expected to increase the value of the equity call option as well as the likelihood that the CLO's liabilities can be refinanced to lower, then-applicable market levels. The ability to pursue these arbitrage management actions is a key factor behind our strategy of acquiring majority equity stakes.
As we proceed in 2013, we expect to consider the balance of these offsetting forces in the management of the company's U.S. Post-Crisis CLO portfolio. We expect to continue to make additional investments in new issue U.S. Post-Crisis CLOs as long as they offer attractive risk-adjusted returns and sufficient arbitrage management flexibility, whether managed by LCM or third-party CLO managers.
As of the end of 2012, TFG had made equity investments in 10 European CLOs. Such investments had total fair value of $125.6 million as of 31 December 2012.
The performance of TFG's European CLO equity investments in 2012 has remained challenged, although certain deals continued to produce meaningful cash flows. During 2012, TFG's European CLO investments generated cash flow of €18.7 million or (€0.16 per average outstanding share), compared with €19.0 million (€0.16 per average outstanding share) in the prior year.[(15)] As of the end of 2012, 65% of all of TFG's European CLO investments were passing their junior-most O/C tests, weighted by fair value, and 60% were passing when weighted by number of deals.[(16)]
We continue to believe that the outlook for European economies, and by extension the outlook for European CLOs, remains subject to significant headwinds. We expect that weak economic growth, significant corporate leverage and volatile capital markets will continue to expose European CLOs to further default and downgrade risks with their negative impact exacerbated by the limited structural and collateral quality cushion of many European transactions. We, therefore, expect that cash flows from TFG's European CLO portfolio will remain subdued and volatile, both in the near and longer term.
The following graph shows the evolution of TFG's CLO equity investment IRRs over the past three years.
As of the end of 2012, TFG had U.S. direct loan investments with a total fair value of $114.1 million and par value of $114.3 million. The direct bank loan portfolio performed well during 2012, generating $0.2 million of net realized gains and earning $5.6 million of interest income and discount premium. In 2010, we believed that there was an attractive opportunity within the U.S. broadly syndicated loan asset class, and that owning loans directly on TFG's balance sheet would allow the company to benefit from a "pull-to-par" from then-current trading levels. We believe that this strategy has largely paid off, with the total return of TFG's direct loan portfolio since inception totaling approximately 19.8%, assuming bid-side marks as of the end of the 2012.
Although we believe that a well-selected portfolio of bank loans may still be attractive, allowing for income-earning potential and providing reasonable liquidity, the pace of spread compression has changed the risk-reward dynamics of owning bank loans outright. We have, therefore, significantly reduced our exposure to direct loans in early 2013.
As of the end of 2012, TFG held $46.4 million of investments (at fair value) in Polygon-managed equity funds. Currently, these fund strategies are primarily focused on European event-driven equity and mining equities-related investments. Fund investments were made on 1 December 2012, and through the end of the year had returned 3.2% to TFG.
CONVERTIBLE BONDS AND CREDIT
As of the end of 2012, TFG held $10.1 million of investments (at fair value) in a Polygon-managed convertibles fund. The fund investment was made on 1 December 2012 and through the end of the year had returned 0.7% to TFG.
As of the end of the year, TFG held $25.7 million of investments (at fair value) in GreenOak-managed real estate funds and vehicles. Such investments include numerous commercial and residential properties across Japan, the United States and Europe.
Through year-end, TFG has received distributions of over $2.0 million across two real estate investments. The first distribution for a Japanese investment vehicle resulted in a realized IRR of approximately 70.7% for TFG's investment. We expect a final distribution to be made on this vehicle in 2013. The second distribution was made with respect to an asset sale within a U.S.-focused real estate fund, and resulted in gross returns to the fund of over 35.7% (before fees paid to GreenOak). We expect further distributions in 2013. The company will continue to fund investment capital commitments into GreenOak projects in 2013 and we remain excited about the long-term potential of owning income-producing hard assets, such as real estate properties.
FINANCING SOURCES, HEDGING ACTIVITY AND OTHER MATTERS
As of the end of 2012, TFG had no outstanding debt and the net cash on its balance sheet stood at $175.9 million, compared to $211.5 million at the end of 2011.
TFG had no direct credit hedges in place at the end of 2012, but employed certain foreign exchange rate and "tail risk" interest rate hedges to seek to mitigate its exposure to Euro-USD foreign exchange risk and a potential significant increase in U.S. inflation and/or nominal interest rates, respectively. We review our hedging strategy on an on-going basis as we seek to address identified risks to the extent practicable and in a cost-effective manner.
TFG ASSET MANAGEMENT
We believe that the key metrics to measure the asset management business are the following:
• Performance of the underlying funds: this is the return the company will receive on its investments in the funds and is, of course, the most important of many criteria we monitor for delivering value to each manager's clients. We believe performance is a leading indicator for other key metrics below. All funds managed by TFG's asset management brands (currently Polygon, LCM and GreenOak) had positive returns in 2012.
• Gross revenues: composed primarily of management and performance fees from clients, and totalled $36.7 million in 2012.
• "EBITDA equivalent": totalled $15.1 million in 2012 (as shown below).
• AUM: totalled $7.7 billion at 31 December 2012, up from approximately $5.0 billion at 31 December 2011.
TETRAGON FINANCIAL GROUP
TFG Asset Management Statement of Operations 2012
TFG AM $MM Fee income [i] 36.7 Interest income 0.2 Total income 36.9 Operating, employee and administrative expenses [i] (20.1 ) Noncontrolling interest (1.7 ) Net income - "EBITDA equivalent" [ii] 15.1 Performance fee allocation to TFM (2.3 ) Amortisation expense on management contracts (1.2 ) Net income before taxes 11.6 Income taxes (3.6 ) Net economic income and U.S. GAAP net income 8.0
(i) Nets off cost recovery on "Other fee income" against this cost contained in "operating, employee and administrative expenses". Operating costs also removes amortisation from the U.S. GAAP segmental report.
(ii) "EBITDA equivalent" of $15.1 million reconciles to $15.6 million reported as segmental income in TFG Master Fund Audited Financial Statements 31 December 2012, by adding back Noncontrolling interest of $1.7 million and subtracting Amortisation expense of $1.2 million
With its acquisition of Polygon in 2012, we believe that TFG has transformed and expanded its asset management business from two stakes in asset managers to an active, fully-operating asset management business with multiple funds, brands and business lines. TFG now has not just a broader range of investment talent and investment products, but as important, the infrastructure platform upon which all its asset management businesses are run. TFG will seek to continue to grow these businesses and intends to add new ones over time.
We believe the strategic benefits that the Polygon Transaction brings to TFG are:
• Fee income
° A platform for TFG to generate higher RoE to its shareholders by adding asset management fee income to its investment portfolio returns.
° Reduction of fees paid away to third-party managers in investments with its own asset managers, which should increase the RoE to TFG shareholders, all else being equal.
° Increased stability of RoE to TFG shareholders as asset management fee income, whilst correlated to the investment returns, may be less volatile than the portfolio investment income.
° TFG shareholder RoE should become more stable through diversification of assets (currently loans, real estate and equities).
° This diversification should be enhanced by TFG's ability to attract new asset management businesses onto its global platform.
The Polygon Transaction was carefully considered by the Board and relevant independent committees as the company sought to ensure that the transaction was in the best interests of TFG's shareholders.[(17)] Any new Polygon businesses will be grown within and for the benefit of TFG. Tetragon Financial Management LP ("TFM") will continue to act as the investment manager to TFG and Tetragon Financial Group Master Fund Limited (the "Master Fund") under the terms of the investment management agreement dated 26 April 2007.
All of TFG Asset Management's brands performed well in 2012, with every fund returning positive performance for the year and all brands raising AUM from new and existing clients. TFG remains committed to investing in and growing its asset management business and sees this as a key way to negotiate and achieve the best returns on the company's investments. TFG's acquisition of Polygon, amongst other things, provides TFG Asset Management with the necessary global infrastructure to be able to continue the growth of the asset management platform across a broad range of asset classes and geographies.
For existing and new products, TFG Asset Management is focused on certain key principles for it and its clients' investments:
• Focus: Funds are generally dedicated to specific opportunities.
• Liquidity: Product liquidity is designed to match the liquidity of the underlying assets in each fund.
• Capacity: Capacity is carefully managed to seek to ensure that performance and liquidity are not compromised.
• Performance: Leading investment teams provide products that are very competitive and offer returns across various market cycles.
• Transparency and client communication: The managers work closely with clients to ensure that they understand each fund, its returns and risks.
• Trust: The goal is a strong alignment of interest between clients and investment managers.
ASSET MANAGEMENT BRANDS
TFG Asset Management currently has three key asset management brands: LCM, GreenOak Real Estate and Polygon.
Summary of Asset Management AUM ($ Billions) Brand 31 December 2012 31 December 2011 LCM $ 4.3 $ 3.3 GreenOak [i] $ 2.3 $ 0.6 Polygon [ii] $ 1.1 $ 1.1 Total $ 7.7 $ 5.0
(i) Includes funds and advisory assets.
(ii) AUM for Polygon Recovery Fund LP, Polygon Convertible Opportunity Master Fund, Polygon European Equity Opportunity Master Fund, Polygon Mining Opportunity Master Fund, and Polygon Global Equity Master Fund, as calculated by GlobeOp Financial Services. Includes, where, relevant, investments by Tetragon Financial Group Master Fund Limited.
LCM is a specialist in below-investment grade U.S. broadly-syndicated leveraged loans that was established in 2001. Farboud Tavangar acts as senior portfolio manager.
At 31 December 2012, LCM's total CLO loan assets under management stood at $4.3 billion. During 2012, LCM issued three new CLOs:
• LCM X - $410 million, 15 February 2012
• LCM XI - $485.5 million, 24 May 2012
• LCM XII - $518.3 million, 4 October 2012
In addition, LCM XIII, a $519 million CLO,[(18)] priced on 25 January 2013 and closed on 26 February 2013, bringing the total number of CLOs currently under management to twelve. LCM continued to perform well during 2012, with all LCM Cash Flow CLOs[(19)] remaining in compliance with their junior O/C tests and current on all senior and subordinated management fees.
Through the Polygon Transaction, TFG increased its ownership interest in LCM from 75% to 100%.
GREENOAK REAL ESTATE
GreenOak is a real estate-focused principal investing and advisory firm established in 2010. GreenOak continued to execute on its business growth strategy, including increasing client commitments to its funds. At 31 December 2012, assets under management totalled approximately $2.3 billion. Through the Polygon Transaction, TFG now has increased its ownership interest in GreenOak from 10% to 23%. The Principals and Founders are John Carrafiell, Sonny Kalsi and Fred Schmidt.
During 2012, GreenOak made the following progress:
• GreenOak U.S. fund, which had its first close in February 2011, had its final close in August 2012 with $303.0 million, including co-investment capital. The U.S. fund is targeting primarily commercial assets in gateway cities such as New York, Los Angeles, Boston, Miami, and San Francisco.
• GreenOak Japan fund had its first close in January 2012 and has closed approximately $140 million of capital commitments as of December 2012. The final closing is anticipated in the summer of 2013, with a target of $240 million. Target investments here are primarily Tokyo-based office assets.
• GreenOak Europe had managed accounts of approximately $1.2 billion at the end of 2012. The team has been focusing on distressed assets and recapitalization opportunities, primarily in the United Kingdom.
• GreenOak continues to execute on advisory assignments on behalf of select strategic clients with mandates in Europe, Japan and the United States.
Polygon was founded in 2002. At the time of the Polygon Transaction, its principals were Reade Griffith, Paddy Dear and Mike Humphries, who joined in 2009. There are currently three Polygon fund products which are open for external investment in the following strategies: convertibles, European event-driven equities and mining equities. In addition, Polygon manages a private equity fund. Total assets under management were $1.09 billion at the end of 2012.
Summary of Polygon Funds Assets Under Management ($ Millions) 31 December 2012 Annualized Fund 2012 Performance Performance European Event-Driven Equity [i] $ 230.1 1.40 % 13.07 % Convertibles [ii] $ 259.3 11.46 % 24.03 % Mining Equities [iii] $ 24.3 4.05 % 7.03 % Private Equity Vehicle [iv] $ 559.6 13.20 % 8.92 % Other Equity [v] $ 15.1 8.94 % 7.70 % Polygon Funds Total AUM [vi] $ 1,088.4
(i) The fund began trading 8 July 2009 with Class B shares which carry no incentive fee. Class A shares commenced trading on 1 December 2009. Returns from inception through November 2009 for Class A shares have been pro forma adjusted to match the Fund's Class A share terms as set forth in the Offering Memorandum (1.5% management fee, 20% incentive fee and other items, in each case, as set forth in the offering Memorandum). From December 2009 to February 2011, the table reflects actual Class A share performance on the terms set forth in the Offering Memorandum. From March 2011, forward, the table reflects actual Class A1 share performance on the terms set forth in the Offering Memorandum. Class A1 share performance is equivalent to Class A share performance for prior periods.
(ii) The fund began trading with Class B shares, which carry no incentive fees, on 20 May 2009. Class A shares of the Fund were first issued on 1 April 2010 and returns from inception through March 2010, have been pro forma adjusted to match the Fund's Class A share terms as set forth in the Offering Memorandum (1.5% management fee, 20% incentive fee over a hurdle and other items, in each case, as set forth in the Offering Memorandum).
(iii) The fund began trading with Class B1 shares, which carry no incentive fees, on 1 June 2012. Returns shown here have been pro forma adjusted to account for a 2.0% management fee, a 20% incentive fee, and non trading expenses capped at 1%, in each case, as to be set forth in further definitive documents.
(iv) Inception 8 March 2011. Individual investor performance will vary based on their high water mark. Currently the majority of Class C share class investors have not reached their high water mark, so their performance is the same as their gross performance.
(v) The fund began trading with Class B/B1 shares, which carry no incentive fees, on 12 September 2011. Returns shown here have been pro forma adjusted to account for a 2.0% management fee and a 20% incentive fee, in each case, as to be set forth in further definitive documents.
(vi) The AUM noted above includes investments in the relevant strategies by TFG (other than in respect of the Private Equity Vehicle, which was at the time of the Polygon Transaction, and remains a closed investment strategy.
Convertibles: Polygon's convertible strategy started in May 2009, and invests primarily in convertible securities in Europe and North America. The strategy is led by CIO Mike Humphries. The team aims to capitalize on a favourable competitive landscape and a differentiated approach to investing in the asset class. The focus is on idiosyncratic, catalyst-driven ideas. A constrained portfolio size ensures that even smaller convertible issues can be included in the portfolio and allows the team to navigate a market where the broad "cheapness" of the asset class and sources of opportunities are cyclical. The approach has been successful, with the portfolio showing strong relative performance and low correlation to other funds and indices; annualized performance since inception is 24.0% and full-year performance was 11.5% for 2012.
Assets under management in this strategy were $259.3 million at 31 December 2012.
European Event-Driven Equities: This strategy started trading in July 2009. The team invests primarily in the major European equity markets, with an Event-Driven focus. Reade Griffith is the CIO. The portfolio intends to capitalize on the significant opportunity set that persists in Europe and aims to exploit: valuation dislocation in European equities, the recapitalisation and deleveraging of corporate balance sheets via new equity issuance, the improvement of credit and financing markets, and M&A deals which are expected to further increase over the next few years. Despite a particularly volatile year for European markets in 2012, the strategy returned 1.5% for the year, with positive returns for last six months. Annualized performance from inception is 13.1%.
Assets under management for the strategy were $230.1 million at 31 December 2012.
Mining Equities: This strategy launched in June 2012, and is currently building its portfolio. This strategy is led by Mike Humphries and Peter Bell and it focuses primarily in the equities of global mining companies, many of them based on gold. The team targets a broad range of companies across stages of mine development and deposit type. The mining sector presents a high dispersion between top and bottom quartile performers annually which provides an attractive universe for our long/short investment strategy.
Assets under management for the strategy at the end of December 2012 were approximately $24.3 million. Performance from inception through to the end of 2012 was 4.1%.
Private Equity: Polygon manages a portfolio of private and less-liquid public assets which are being sold down in a closed-ended investment vehicle with AUM of approximately $559.6 million at 2012 year-end. To date, the portfolio has returned $265.0 million of cash to its partners since inception in March 2011. The product is supported by range of Polygon investment teams on a position-by-position basis with customized exit plans for each asset. Performance in 2012 was 13.2%. TFG has not invested directly in this product; however, it is the beneficiary of certain contracted management fee income (the Fund's "carried interest" was not included in the Polygon Transaction).
THIRD-PARTY FEE INCOME
In addition to the fee income generated by the three asset management brands, TFG also currently receives asset management fee income derived from a number of one-off and long-term fee sharing arrangements with third-parties.
In this section we present consolidated financial data incorporating TFG and its 100% subsidiary, Tetragon Financial Group Master Fund Limited, and provide comparative data for 2011 and 2010.
TETRAGON FINANCIAL GROUP
Annual Financial Highlights
2012 2011 2010 U.S. GAAP Net Income ($MM) $ 357.2 $ 410.4 $ 385.2 Net Economic Income ($MM) $ 306.2 $ 410.4 $ 385.2 U.S. GAAP EPS ($) $ 3.15 $ 3.46 $ 3.15 Adjusted EPS ($) $ 2.70 $ 3.46 $ 3.15 Return on Equity 20.8 % 36.1 % 47.7 % Net Assets ($MM) $ 1,621.4 $ 1,474.4 $ 1,137.5 U.S. GAAP Shares Outstanding (MM) 98.8 116.0 120.1 U.S. GAAP Net Asset Value per Share ($) $ 16.41 $ 12.71 $ 9.47 Pro Forma Fully Diluted Shares (MM) 110.6 116.0 120.1 Pro Forma Fully Diluted NAV per Share ($) $ 14.65 $ 12.71 $ 9.47 Dividend per Share ($) $ 0.470 $ 0.395 $ 0.310
In TFG's 2012 financial highlights, we introduce several new metrics which we believe may be helpful in understanding the progress and performance of the company going forward:
- Return on Equity (20.8%): Net Economic Income ($306.2 million) divided by Net Assets at the start of the year ($1,474.4 million).
- Net Economic Income (+$306.2 million): removes the initial U.S. GAAP impact of the Polygon Transaction (-$54.8 million) from, and adds back the associated accounting entry of share based employee compensation (+$3.8 million) to, the U.S. GAAP net income (+$357.2 million).
- Pro Forma Fully Diluted Shares (110.6 million): adjusts the U.S. GAAP shares outstanding (98.8 million) for the impact of Escrow Shares (as defined below) used as consideration in the Polygon Transaction and associated stock dividends (+11.8 million) (see also page 21 of this Annual Report) and for the potential impact of options issued to TFG's investment manager at the time of TFG's IPO (the "Investment Management Options"). The Investment Management Options were out of the money at the end of 2012, so had no impact at year end.
- Adjusted EPS ($2.70): calculated as Net Economic Income ($306.2 million) divided by weighted average U.S. GAAP shares outstanding (113.3 million).
- Pro Forma Fully Diluted NAV per Share ($14.65): calculated as Net Assets ($1,621.4 million) divided by Pro Forma Fully Diluted shares (110.6 million).
We also introduce a split of the Statement of Operations between the two segments of TFG's business - the Investment Portfolio and TFG Asset Management.
Figure 17 shows the overall Statement of Operations for TFG. Interest income has continued to increase year-on-year as the IRRs on the CLO portfolio have continued to increase. For further information, please see the review of the Investment Portfolio on pages 8-12 of this Annual Report. Fee income has also grown strongly, reflecting both the ongoing growth of LCM's income and the Q4 2012 impact of acquiring Polygon's investment fund and private equity businesses as well as Polygon's 25% of LCM. Other income represents cost recovered by TFG Asset Management for providing services to non-TFG businesses supported by the TFG platform, including TFM.
Administration and other expenses have grown following the addition of the Polygon operating businesses.
The ongoing strong performance shown in unrealized gains in 2012 reflects a continuation of the trend of the CLO portfolio generating returns materially above its weighted-average IRR. Under U.S. GAAP, we recognise the IRR through the interest income line and any other performance is reflected in the "net change in unrealised appreciation".
As announced on 29 October 2012, TFG acquired Polygon's asset management businesses and infrastructure platform, along with Polygon's interests in LCM and GreenOak, for an aggregate of 11,685,940 TFG non-voting shares which will be held in escrow (together with related stock dividends, the "Escrow Shares"), the substantial majority of which will vest over three to five years. The accounting for the acquisition under U.S. GAAP results in us, among other things, showing:
- That certain assets (management contracts) were acquired for which there was no initial payment from a U.S. GAAP perspective; the value of the Escrow Shares is recognised through the Statement of Operations as "Employee share-based compensation" over the five-year deferral period. Consequently, we see (1) a day-one gain in the Statement of Operations reflecting the value acquired for the Polygon businesses and the minority interests acquired in GreenOak - this gain is sometimes described as a "bargain purchase" in U.S. GAAP parlance - and (2) a charge for employee share based compensation, representing the initial few months of the transaction consideration.
- An amortization charge for the management contracts with such amortization reflecting a three year period for private equity contracts and 10 years for hedge fund contracts.
- No value being acquired for the acquisition of Polygon's 25% share of LCM. Under U.S. GAAP this is treated as being a transaction with the Master Fund in its capacity as owners, so no separate asset or goodwill is recognized as a result.
- An unrealized gain on re-valuing the 10% of GreenOak that TFG already owned. Such unrealized gain is part of the total of $186.3 million.[(20)]
In order to reflect a more representative measure of operating performance, the U.S. GAAP net income number has been adjusted for the "bargain purchase" gain and the share based employee compensation charge described above in order to arrive at a Net Economic Income. Net Economic Income has also been used as TFG's return metric to derive the 2012 Return on Equity of 20.8%.
As disclosed in the October 2012 TFG monthly update, no incentive fees were earned or paid as a result of the Polygon Transaction, as it was treated as a capital adjustment for the applicable calculations. Overall in 2012, performance fees of $86.2 million were earned by the Investment Manager, of which $30.2 million were accrued in Q4 2012.
STATEMENT OF OPERATIONS 2010-2012
TETRAGON FINANCIAL GROUP
Annual Statement of Operations 2010-2012
2012 2011 2010 $MM $MM $MM Interest Income 235.6 209.1 178.9 Fee Income 36.7 23.1 15.1 Other Income 6.8 - - Investment and Management Fee Income 279.1 232.2 194.0 Management and Performance Fees (109.8 ) (144.0 ) (133.5 ) Other Operating and Administrative Expenses (46.4 ) (26.4 ) (10.7 ) Total Operating Expenses (156.2 ) (170.4 ) (144.2 ) Net Investment Income 122.9 61.8 49.8 Net Change in Unrealised Appreciation in Investments 186.3 358.6 336.0 Goodwill Arising on Acquisition of Polygon 54.8 - - Realised Gain on Investments 5.3 0.9 1.1 Realised and Unrealised Losses from Hedging and FX (6.8 ) (5.1 ) 2.1 Net Realised and Unrealised Gains from Investments and FX 239.6 354.4 339.2 Income Taxes (3.6 ) (3.8 ) (2.4 ) Noncontrolling Interest (1.7 ) (2.0 ) (1.4 ) U.S. GAAP Net Income 357.2 410.4 385.2 Reverse Goodwill Arising on Acquisition of Polygon (54.8 ) - - Add Back Employee Share Based Compensation 3.8 - - Net Economic Income 306.2 410.4 385.2
STATEMENT OF OPERATIONS BY BUSINESS SEGMENT
TETRAGON FINANCIAL GROUP
Annual Statement of Operations by Segment 2012
Investment Portfolio TFG AM Total 2012 $MM $MM $MM Interest Income 235.4 0.2 235.6 Fee Income - 36.7 36.7 Other Income - 6.8 6.8 Investment and Management Fee Income 235.4 43.7 279.1 Management and Performance Fees (107.5 ) (2.3 ) (109.8 ) Other Operating and Administrative Expenses (14.5 ) (28.1 ) (42.6 ) Total Operating Expenses (122.0 ) (30.4 ) (152.4 ) Net Investment Income 113.4 13.3 126.7 Net Change in Unrealised Appreciation in Investments 186.3 - 186.3 Realised Gain on Investments 5.3 - 5.3 Realised and Unrealised Losses from Hedging and FX (6.8 ) - (6.8 ) Net Realised and Unrealised Gains from Investments and FX 184.8 - 184.8 Income Taxes - (3.6 ) (3.6 ) Noncontrolling Interest - (1.7 ) (1.7 ) Net Economic Income 298.2 8.0 306.2 Reverse Goodwill Arising on Acquisition of Polygon - - 54.8 Add Back Employee Share Based Compensation - - (3.8 ) U.S. GAAP Net Income 357.2
TETRAGON FINANCIAL GROUP
TFG Earnings per Share split 2010-2012
Component 2012 2011 2010 CLOs $ 3.65 $ 4.76 $ 4.18 Fee Income $ 0.32 $ 0.20 $ 0.12 Direct Loans $ 0.07 $ 0.03 $ 0.05 Other Income $ 0.15 - - Goodwill arising on acquisition of Polygon $ 0.48 - - Hedging Derivatives and Options ($ 0.10 ) ($ 0.04 ) $ 0.01 Expenses and Taxes ($ 1.41 ) ($ 1.47 ) ($ 1.20 ) Noncontrolling Interest ($ 0.01 ) ($ 0.02 ) ($ 0.01 ) U.S. GAAP EPS $ 3.15 $ 3.46 $ 3.15 Adjustments to get to Net Economic Income ($ 0.45 ) - - Net Economic Income EPS $ 2.70 $ 3.46 $ 3.15 Weighted Average Shares 113,346,744 118,444,858 122,165,663
CONSOLIDATED BALANCE SHEET
TETRAGON FINANCIAL GROUP
2012 2011 $MM $MM Assets Investments, at Fair Value 1,440.4 1,264.4 Intangible Assets - Management Contracts 43.4 0.1 Cash and Cash Equivalents 175.9 211.5 Amounts Due from Brokers 13.1 15.8 Derivative Financial Assets - Interest Rate Swaptions 7.6 7.2 Derivative Financial Assets - Forward Contracts - 6.7 Other Receivables 15.8 2.9 Total Assets 1,696.2 1,508.6 Liabilities Other Payables and Accrued Expenses 61.7 30.8 Amounts Payable on Share Options 6.6 1.6 Income and Deferred Tax Payable 4.3 1.8 Derivative Financial Assets - Forward Contracts 2.2 - Total Liabilities 74.8 34.2 Total Equity Attributable to TFG 1,621.4 1,474.4
Please see Appendix II for information on the Fair Value determination of TFG's CLO equity investments.
CONSOLIDATED CASH FLOW FROM OPERATIONS
TETRAGON FINANCIAL GROUP
Cash Flow from Operations - 2010-2012
2012 2011 2010 $MM $MM $MM Operating Activities Operating Cash Flows Before Movements in Working Capital After Dividends Paid to Guernsey Feeder 368.2 251.3 151.6 Increase in Payables 12.5 2.6 2.3 Cash Flows from Operating Activities 380.7 253.9 153.9 Investment Activities Proceeds on Sales of Investments 89.6 122.3 71.0 Purchase of Investments (292.8 ) (217.3 ) (205.7 ) Cash Flows from Operating and Investing Activities 177.5 158.9 19.2 Amounts Due / (to) from Broker 2.7 (11.6 ) 1.6 Purchase of Shares (176.1 ) (34.8 ) (25.5 ) Net Dividends Paid to Shareholders (38.3 ) (38.3 ) (29.0 ) Distribution to Noncontrolling Interest (1.8 ) (3.2 ) (0.1 ) Cash Flows from Financing Activities (213.5 ) (87.9 ) (53.0 ) Net (Decrease) / Increase in Cash and Cash Equivalents (36.0 ) 71.0 (33.8 ) Cash and Cash Equivalents at Beginning of Period 211.5 140.6 174.4 Effect of Exchange Rate Fluctuations on Cash and Cash Equivalents 0.4 (0.1 ) - Cash and Cash Equivalents at End of Period 175.9 211.5 140.6
Shares 31 Dec 2012 Reconciliation Shares (millions) Legal Shares Issued and Outstanding 133.75 Less: Shares Held in Subsidiary 16.60 Less: Shares Held in Treasury 6.50 Less: Escrow Shares 11.84 U.S. GAAP Shares Outstanding 98.80 Add: Manager (IPO) Share Options - Add: Escrow Shares 11.84 Pro Forma Fully Diluted Shares 110.64
The Directors of TFG confirm that (i) this Annual Report constitutes the TFG management review for the twelve month period ended 31 December 2012 and contains a fair review of that period and (ii) the 2012 audited financial statements accompanying this Annual Report for TFG have been prepared in accordance with applicable laws and in conformity with accounting principles generally accepted in the United States of America.
FAIR VALUE DETERMINATION OF TFG'S CLO EQUITY INVESTMENTS
In accordance with the valuation policies set forth on the company's website, the values of TFG's CLO equity investments are determined using a third-party cash flow modeling tool. The model contains certain assumption inputs that are reviewed and adjusted as appropriate to factor in how historic, current and potential market developments (examined through, for example, forward-looking observable data) might potentially impact the performance of TFG's CLO equity investments. Since this involves modeling, among other things, forward projections over multiple years, this is not an exercise in recalibrating future assumptions to the latest quarter's historical data.
Subject to the foregoing, when determining the U.S. GAAP-compliant fair value of TFG's portfolio, the company seeks to derive a value at which market participants could transact in an orderly market and also seeks to benchmark the model inputs and resulting outputs to observable market data when available and appropriate.
Forward-looking CLO Equity Cash Flow Modeling Assumptions Recalibrated in Q4 2012:
The Investment Manager reviews and, when appropriate, adjusts in consultation with TFG's audit committee, the CLO equity investment portfolio's modeling assumptions as described above. At the end of Q4 2012, certain key assumptions relating to defaults were recalibrated. Those relating to recoveries, prepayments and reinvestment prices were unchanged from the previous quarter.
U.S. CLOs - Default Assumptions Recalibrated
For the U.S. deals, near-term default assumptions were unchanged but medium-term default multiples were reduced to reflect, among other things, the perceived decline in concern over the so-called "maturity wall". These changes, which are detailed in the figure below, had a positive impact on the undiscounted future projected cash flows of the U.S. deals.
Current Prior Variable Year Assumptions Assumptions CAD R 1.0x 1.0x WARF-implied WARF-implied default rate default rate 2013 (2.2%) (2.2%) 1.0x 1.5x WARF-implied WARF-implied default rate default rate 2014 (2.2%) (3.3%) 1.25x 1.5x WARF-implied WARF-implied default rate default rate 2015-2016 (2.7%) (3.3%) 1.25x 1.0x WARF-implied WARF-implied default rate default rate 2017 (2.7%) (2.2%) 1.0x 1.0x WARF-implied WARF-implied default rate default rate Thereafter (2.2%) (2.2%)
Recovery Rate Until deal maturity 73 % 73 %
Prepayment Rate Until deal 20.0% p.a. on loans; 20.0% p.a. on loans; maturity 0.0% on bonds 0.0% on bonds
Reinvestment Price Until deal maturity 100 % 100 %
European CLOs - Default Assumptions Recalibrated
For the European deals, an elevated default multiple was maintained in the near term, but the medium term multiple was recalibrated higher bringing it in line with the U.S. deals, and reflecting some of the enhanced risks during that period, including the percentage of loans maturing. For European deals, this change resulted in a reduction in future undiscounted projected cash flows.
Current Prior Variable Year Assumptions Assumptions CAD R 1.5x 1.5x WARF-implied WARF-implied default rate default rate 2013-2014 (3.1%) (3.1%) 1.25x 1.0x WARF-implied WARF-implied default rate default rate 2015-2017 (2.6%) (2.1%) 1.0x 1.0x WARF-implied WARF-implied default rate default rate Thereafter (2.1%) (2.1%)
Recovery Rate Until deal maturity 68 % 68 %
Prepayment Rate Until deal 20.0% p.a. on loans; 20.0% p.a. on loans; maturity 0.0% on bonds 0.0% on bonds
Reinvestment Price Until deal maturity 100 % 100 %
These key average assumption variables include the modeling assumptions disclosed as a weighted average (by U.S. dollar amount) of the individual deal assumptions, aggregated by geography (i.e. U.S. and European). Such weighted averages may change from month to month due to movements in the amortized costs of the deals, even without changes to the underlying assumptions. Each individual deal's assumptions may differ from this geographical average and vary across the portfolio.
The reinvestment price, assumptions about reinvestment spread and reinvestment life are also input into the model to generate an effective spread over LIBOR. Newer vintage CLOs may have a higher weighted-average reinvestment spread over LIBOR or shorter reinvestment life assumptions than older deals. Across the entire CLO portfolio, the reinvestment price assumption of 100% for U.S. deals and European deals with their respective assumed weighted-average reinvestment spreads, generates an effective spread over LIBOR of approximately 284 bps on broadly syndicated U.S. loans, 272 bps on European loans, and 328 bps on middle market loans.
Application of Discount Rate to Projected CLO Equity Cash Flows:
2005 - 2007 Vintage Deals:
In determining the applicable rates to use to discount projected cash flows, an analysis of observable risk premium data is undertaken. Observable risk premia such as BB and BBB CLO tranche spreads decreased late in Q3 2012 and we noted in TFG's Q3 2012 performance report that we would continue to monitor closely over the course of Q4 2012 whether these reductions were sustained, before considering a reduction in applicable discount rates. In Q4 2012 observable data has confirmed the re-rating of CLO risk, albeit the trend has continued at a slower pace. For example, according to Citibank research, the spread on originally BB-rated U.S. CLO tranches decreased from approximately 11% at the end of Q2 2012 to 8% as of the end of September 2012 and further reduced to approximately 7% at the end of December.[(21)]
As a result of the observed continued tightening of these spreads and overall reduction in risk premia, the discount rates for the U.S. deals have been reduced to 17.5% for strong deals and to 22.5% for other deals.
Per Citibank research, European originally BB-rated tranche yields have followed a similar trajectory to U.S. spreads over the last two quarters, reducing from 22% at the end of Q2 2012 to 16% at the end of Q3 2012 before a further reduction to 14% in Q4 2012. As a result of this reduction in risk premia, the discount rates for European deals have been reduced to 27.5%, which are still significantly above the U.S. deal discount rates, reflecting in part the ongoing uncertainty surrounding Europe.
Previously on average, the discount rate being applied to the future cash flows was greater than the weighted-average IRR on pre-crisis deals, so the aggregate fair value for both U.S. and European deals was lower than its amortized cost. The difference between these two figures was characterized as the "ALR Fair Value Adjustment" or "ALR". Post this recalibration this is no longer the case for U.S. deals so there is no ALR to report in respect of such deals. For European deals at the end of Q4 the ALR stands at $86.6 million compared to $97.9 million at the end of Q3.
2010 - 2012 Vintage Deals
The applicable discount rate for newer vintage deals is determined with reference to each deal's specific IRR, which, in the absence of other observable data points, is deemed to be the most appropriate indication of the current risk premium on these structures. At the end of Q4 2012, the weighted-average discount rate (and IRR) on these deals was 12.4%. Such deals represented approximately 14.3% of the CLO equity portfolio by fair value (up from 12.8% at the end of Q3 2012). We will continue to monitor observable data on these newer vintage transactions to determine whether the IRR remains the appropriate discount rate.
Effect on Fair Value and Net Income of Recalibration of Certain Inputs into the CLO Model
Overall, the net impact of the recalibration of certain forward-looking default assumptions and discount rates described above led to an overall increase in fair value of the total CLO equity portfolio of approximately $71.4 million, or $53.6 million in bottom line net income.
CLO MARKET COMMENTARY
- 2012 U.S. leveraged loan defaults remain low: The U.S. lagged 12-month loan default rate rose slightly during Q4 2012 and stood at 1.27% by principal amount as of the 2012, up from 1.00% as of the end of Q3 2012.[(22)] In comparison, the same rate was 0.17% at the end of 2011.[(23)] According to S&P, the consensus among loan portfolio managers is for default rates to continue to increase in 2013 but remain below the historical average of 3.31%.[(24)]
Similarly, TFG's lagging 12-month loan default rate rose to 1.4% by the end of 2012, up from 1.0% in the third quarter and 0.8% as of the end of 2011.[(25)] The graph below shows three-year history for both TFG and the U.S. market-wide loan default rates.
- U.S. primary loan issuance surges while European volumes remain subdued: Institutional U.S. loan issuance rose to $90.6 billion in Q4 2012, up from $84.3 billion in Q3 2012, bringing the 2012 total to a five-year high of $295.0 billion.[(26)]Despite a rebound in European primary loan issuance during Q4 2012, total European new issue loan volume fell to €28.5 billion in 2012, down 34% from 2011.[(27)] Importantly, a significant share of this year's issuance came from Yankee loans as European issuers took advantage of strong U.S. market conditions tapping the U.S. for €21.7 billion in paper in 2012, the highest annual total on record.[(28)] Given Europe's dormant post-crisis new issue CLO market and significant share of existing CLO vehicles reaching the end of their reinvestment periods (80% Euro CLOs will end their reinvestment periods in 2013), near-term European primary loan issuance is likely to continue to suffer from declining local demand.[(29)]
- Opportunistic U.S. loan re-pricing activity remains robust: U.S. loan issuers reduced spreads on $51.2 billion of loans in 2012 as compared with $69.9 million in 2011.[(30)] Strong re-pricing activity was paralleled by tightening new issue loans spreads, lower OIDs and LIBOR floors as well as a general shift toward more issuer-friendly terms, such as covenant-lite structures and higher leverage multiples.[(31)] Market participants anticipate that, absent an unforeseen macroeconomic or geopolitical shock, 2013 may see a continuation of this year's re-pricing wave as a significant share of existing issuers see the expiration of their soft-call periods in 2013.[(32)]
- U.S. and European loan prices post significant gains: U.S. secondary loan prices rose during Q4 2012, as the U.S. S&P/LSTA Leveraged Loan Index returned 1.42% for the quarter, bringing 2012 returns to 9.66%, a notable increase from the 1.52% return posted in 2011.[(33)] Similarly, the S&P European Leveraged Loan Index ("ELLI") returned 9.39% during 2012 (ex. currency effects).[(34)] We believe that strong technical market conditions, rising demand for loans via robust CLO issuance, benign credit conditions, as well as reduced macroeconomic uncertainty around the U.S. "fiscal cliff" and Euro-zone sovereign debt problems, all contributed to the strength of this rally.
- U.S. repayments remain robust but decline in Europe: The U.S. S&P/LSTA Leveraged Loan Index repayment rate rose to 15.3% during Q4 2012, up from 7.3% in Q3 2012, bringing the 2012 total to 38%, down slightly from 40% in 2011.[(35)] Repayments within the S&P European Leveraged Loan Index ("ELLI") declined to €17.8 billion during 2012, versus €38.9 billion in 2011.[(36)]
- "Maturity wall" erosion continues: At the end of 2012, the amount of S&P/LSTA Index loans maturing in 2013 declined to $4.7 billion, representing just 1.0% of all outstanding performing loans.[(37)] This is down significantly from the $29 billion which was due to mature in 2013 as of the end of 2011.[(38)] We believe this reduction in 2013 maturities may keep U.S. near-term loan default rates below the historical average, which would be beneficial for our CLO equity investments. Taking a slightly longer-term view, approximately 70.6% of USD-denominated loans are set to mature between 2016-2018, while the European market remains more exposed to near-term maturities with 73.6% of Euro-denominated loans set to mature over 2015-2017.[(39)]
- U.S. CLO O/C ratios improve while European O/C levels decline year-over-year: During 2012, average O/C ratios of U.S. CLOs steadily improved while European CLOs saw incremental O/C cushion erosion. According to Morgan Stanley, the median junior O/C test cushion for U.S. CLOs rose to 4.63% at the end of 2012[(40)] up from 3.88% as of the end of 2011.[(41)] Conversely, the median junior O/C test cushion for Euro CLOs declined to 0.26%at the end of 2012[(42)] vs. 1.76% at the end of 2011, reflecting a pick-up in defaults and continued weakness of credit fundamentals.[(43)] We anticipate that the divergence in U.S. and Euro CLO performance metrics is likely to continue in 2013.
- U.S. and European CLO debt spreads tighten: Average secondary U.S. CLO debt spreads tightened across the capital structure at the end of 2012 vs. 2011 reflecting increased investor appetite and the continued search for yield. Average secondary U.S. CLO prices rose from $4-$5 points at the AAA-level to $15-$25 points for mezzanine tranches on significant BWIC volumes.[(44)] U.S. new issue spreads saw similar spread tightening, with AAA spreads remaining "stickier" than mezzanine tranches. European secondary CLO prices also recorded significant gains although Euro CLO paper remains priced below U.S. comparables for a number of fundamental and technical reasons.[(45)]
- U.S. new issue arbitrage CLO market expansion gains speed and depth: U.S. arbitrage CLO issuance rose dramatically during 2012 as 116 deals totaling $53.5 billion were priced during the year, up from $12.4 billion and 27 vehicles in 2011.[(46)] This pick-up in issuance was accompanied by continued expansion of the CLO buyer base and growing diversification of CLO managers, as the number of managers issuing deals in 2012 rose to 55 from 24 in 2011, including 13 first-time CLO managers.[(47)]
ADDITIONAL CLO PORTFOLIO STATISTICS
- CLO Portfolio Credit Quality: The weighted-average WARF across all of TFG's CLO equity investments stood at approximately 2,599 as of the end of Q4 2012. Each of these foregoing statistics represents a weighted-average summary (weighted by initial cost) of all of our deals. Each individual deal's metrics will differ from these averages and vary across the portfolio.
ALL CLOs Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 2012 2012 2012 2012 2011 2011 2011 2011 2010 2010 2010 2010 Caa1/CCC+ or Below Obligors: 6.0% 6.4 % 5.7 % 6.2 % 7.0 % 7.0 % 7.2 % 7.6 % 8.3 % 9.6 % 10.5 % 11.1% WARF: 2,599 2,605 2,578 2,588 2,624 2,614 2,642 2,664 2,671 2,658 2,706 2,762
U.S. CLOs Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 2012 2012 2012 2012 2011 2011 2011 2011 2010 2010 2010 2010 Caa1/CCC+ or Below Obligors: 4.5% 4.9 % 4.2 % 4.8 % 5.5 % 5.5 % 5.8 % 6.5 % 6.9 % 7.9 % 8.4 % 9.4 % WARF: 2,524 2,528 2,491 2,504 2,533 2,522 2,542 2,591 2,622 2,610 2,648 2,719
EUR CLOs Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 2012 2012 2012 2012 2011 2011 2011 2011 2010 2010 2010 2010 Caa1/CCC+ or Below Obligors: 11.7% 12.2% 11.6% 11.1% 12.3% 12.0% 12.3% 11.4% 13.1% 15.3% 17.4% 16.8% WARF: 2,896 2,903 2,910 2,900 2,948 2,941 2,997 2,914 2,837 2,817 2,898 2,907
CLO EQUITY PORTFOLIO DETAILS
AS OF 31 DECEMBER 2012
Original Deal End of Wtd Avg Original Invest. Cost Closing Year of Reinv Spread Cost of Funds Transaction Deal Type ($MM USD)(i) Date Maturity Period (bps)(ii) (bps)(iii) Transaction 1 EUR CLO 37.5 2007 2024 2014 358 55 Transaction 2 EUR CLO 29.7 2006 2023 2013 391 52 Transaction 3 EUR CLO 22.2 2006 2022 2012 391 58 Transaction 4 EUR CLO 33.0 2007 2023 2013 407 48 Transaction 5 EUR CLO 36.9 2007 2022 2014 400 60 Transaction 6 EUR CLO 33.3 2006 2022 2012 362 51 Transaction 7 EUR CLO 38.5 2007 2023 2013 377 46 Transaction 8 EUR CLO 26.9 2005 2021 2011 368 53 Transaction 9 EUR CLO 41.3 2007 2023 2013 399 50 Transaction 10 EUR CLO 27.0 2006 2022 2012 373 50 EUR CLO Subtotal: 326.3 383 52 Transaction 11 US CLO 20.5 2006 2018 2012 359 45 Transaction 12 US CLO 22.8 2006 2019 2013 374 46 Transaction 13 US CLO 15.2 2006 2018 2012 399 47 Transaction 14 US CLO 26.0 2007 2021 2014 408 49 Transaction 15 US CLO 28.1 2007 2021 2014 470 52 Transaction 16 US CLO 23.5 2006 2020 2013 440 46 Transaction 17 US CLO 26.0 2007 2021 2014 363 40 Transaction 18 US CLO 16.7 2005 2017 2011 350 45 Transaction 19 US CLO 1.2 2005 2017 2011 350 45 Transaction 20 US CLO 26.6 2006 2020 2012 458 52 Transaction 21 US CLO 20.7 2006 2020 2012 458 53 Transaction 22 US CLO 37.4 2007 2021 2014 474 53 Transaction 23 US CLO 19.9 2007 2021 2013 369 66 Transaction 24 US CLO 16.9 2006 2018 2012 425 46 Transaction 25 US CLO 20.9 2006 2018 2013 441 46 Transaction 26 US CLO 27.9 2007 2019 2013 444 43 Transaction 27 US CLO 23.9 2007 2021 2014 570 51 Transaction 28 US CLO 7.6 2007 2021 2014 570 51 Transaction 29 US CLO 19.1 2005 2018 2011 445 66 Transaction 30 US CLO 12.4 2006 2018 2012 472 67 Transaction 31 US CLO 9.3 2005 2017 2012 338 52 Transaction 32 US CLO 24.0 2007 2021 2014 354 59 Transaction 33 US CLO 16.2 2006 2020 2012 375 56 Transaction 34 US CLO 22.2 2006 2020 2012 382 50 Transaction 35 US CLO 23.6 2006 2018 2012 437 52 Transaction 36 US CLO 28.4 2007 2021 2013 472 46 Transaction 37 US CLO 9.3 2005 2017 2011 351 50 Transaction 38 US CLO 23.7 2007 2021 2013 359 42 Transaction 39 US CLO 7.8 2005 2017 2011 339 70 Transaction 40 US CLO 13.0 2006 2020 2011 419 39 Transaction 41 US CLO 22.5 2006 2020 2013 375 48 Transaction 42 US CLO 22.4 2007 2021 2014 400 47 Transaction 44 US CLO 22.3 2006 2018 2012 336 54 Transaction 45 US CLO 23.0 2006 2018 2012 317 46 Transaction 46 US CLO 21.3 2007 2019 2013 335 51 Transaction 47 US CLO 28.3 2006 2021 2013 347 47 Transaction 48 US CLO 23.0 2006 2019 2013 366 46 Transaction 49 US CLO 12.6 2005 2017 2011 370 40 Transaction 50 US CLO 12.3 2006 2018 2012 368 40 Transaction 51 US CLO 18.0 2007 2020 2013 407 53 Transaction 53 US CLO 0.6 2004 2016 2011 354 61 Transaction 54 US CLO 0.5 2005 2017 2012 354 56 Transaction 55 US CLO 0.3 2005 2017 2011 358 39 Transaction 56 US CLO 23.0 2007 2019 2014 393 42 Transaction 57 US CLO 0.6 2007 2019 2014 393 42 Transaction 58 US CLO 21.8 2007 2019 2014 390 49 Transaction 59 US CLO 0.4 2007 2019 2014 390 49 Transaction 60 US CLO 18.8 2010 2021 2014 433 198 Transaction 61 US CLO 29.1 2007 2021 2014 354 45 Transaction 62 US CLO 25.3 2007 2020 2013 384 42 Transaction 63 US CLO 27.3 2007 2021 2013 405 53 Transaction 64 US CLO 15.4 2007 2021 2013 455 38 Transaction 65 US CLO 26.9 2006 2021 2013 382 47 Transaction 66 US CLO 21.3 2006 2020 2013 357 49 Transaction 67 US CLO 27.3 2007 2022 2014 354 46 Transaction 68 US CLO 19.3 2006 2020 2013 415 48 Transaction 69 US CLO 28.2 2007 2019 2013 399 44 Transaction 70 US CLO 24.6 2006 2020 2013 328 52 Transaction 71 US CLO 1.7 2006 2018 2012 368 40 Transaction 72 US CLO 4.8 2007 2019 2014 393 42 Transaction 73 US CLO 1.9 2007 2019 2014 393 42 Transaction 74 US CLO 5.5 2007 2019 2014 390 49 Transaction 75 US CLO 32.7 2011 2022 2014 429 168 Transaction 76 US CLO 1.9 2006 2018 2012 317 46 Transaction 77 US CLO 14.5 2011 2023 2016 438 212 Transaction 78 US CLO 22.9 2012 2023 2015 525 217 Transaction 79 US CLO 19.4 2012 2022 2015 476 215 Transaction 80 US CLO 22.7 2012 2022 2016 480 185 Transaction 81 US CLO 21.7 2012 2024 2016 506 216 Transaction 82 US CLO 25.4 2012 2022 2016 476 206 US CLO Subtotal: 1282.0 409 70 72 Total CLO Portfolio: 1608.3 404 66 68
CLO EQUITY PORTFOLIO DETAILS (CONTINUED)
AS OF 31 DECEMBER 2012
Figure 27 (continued)
Current Current Jr- Jr-Most O/C Annualized ITD Cash Cost of Funds Most O/C Cushion at (Loss) Gain Received as Transaction bps)(iv) Cushion(v) Close(vi) of Cushion(vii) IRR(viii) % of Cost (ix) Transaction 1 59 (2.49)% 3.86 % (1.15)% 0.0 % 29.6 % Transaction 2 53 0.15 % 3.60 % (0.56)% 8.3 % 65.1 % Transaction 3 67 1.92 % 5.14 % (0.46)% 11.9 % 103.1 % Transaction 4 47 3.96 % 5.76 % (0.31)% 14.1 % 86.4 % Transaction 5 60 2.24 % 5.74 % (0.65)% 9.3 % 62.8 % Transaction 6 60 (0.92)% 4.70 % (0.85)% 6.5 % 49.7 % Transaction 7 45 0.82 % 3.64 % (0.49)% 5.1 % 31.9 % Transaction 8 53 0.04 % 4.98 % (0.67)% 10.2 % 87.1 % Transaction 9 46 (0.30)% 6.27 % (1.15)% 7.4 % 43.4 % Transaction 10 52 (1.00)% 4.54 % (0.86)% 4.8 % 32.7 % EUR CLO Subtotal:54 0.40 % 4.84 % (0.74)% 56.4 % Transaction 11 45 5.30 % 4.55 % 0.12 % 20.7 % 158.1 % Transaction 12 46 5.30 % 4.45 % 0.14 % 20.9 % 154.0 % Transaction 13 47 4.66 % 4.82 % (0.02)% 20.5 % 167.6 % Transaction 14 50 3.85 % 5.63 % (0.30)% 19.2 % 133.8 % Transaction 15 48 3.62 % 4.21 % (0.11)% 29.4 % 181.2 % Transaction 16 45 3.31 % 4.44 % (0.17)% 21.3 % 163.3 % Transaction 17 40 4.63 % 4.24 % 0.07 % 23.4 % 156.0 % Transaction 18 50 9.89 % 4.77 % 0.72 % 20.0 % 172.9 % Transaction 19 50 9.89 % 4.77 % 0.72 % 23.8 % 167.1 % Transaction 20 52 3.74 % 5.28 % (0.25)% 22.6 % 170.7 % Transaction 21 52 3.23 % 4.76 % (0.24)% 19.3 % 148.3 % Transaction 22 53 3.29 % 5.00 % (0.30)% 21.9 % 141.0 % Transaction 23 66 3.19 % 4.98 % (0.32)% 20.7 % 150.2 % Transaction 24 47 5.21 % 4.17 % 0.16 % 17.8 % 129.5 % Transaction 25 46 6.23 % 4.13 % 0.35 % 22.7 % 158.1 % Transaction 26 44 4.45 % 4.05 % 0.07 % 19.7 % 131.3 % Transaction 27 51 11.61 % 6.11 % 0.92 % 32.6 % 198.6 % Transaction 28 51 11.61 % 6.11 % 0.92 % 43.6 % 119.6 % Transaction 29 109 7.33 % 4.82 % 0.35 % 18.7 % 161.5 % Transaction 30 71 3.04 % 5.16 % (0.33)% 19.3 % 138.4 % Transaction 31 57 3.19 % 5.02 % (0.24)% 16.3 % 168.0 % Transaction 32 59 4.07 % 5.57 % (0.28)% 21.3 % 135.7 % Transaction 33 81 4.76 % 6.99 % (0.33)% 14.3 % 137.7 % Transaction 34 50 4.49 % 6.66 % (0.36)% 19.0 % 143.8 % Transaction 35 53 1.65 % 5.00 % (0.51)% 20.7 % 164.7 % Transaction 36 56 2.31 % 5.18 % (0.49)% 20.6 % 137.8 % Transaction 37 67 6.16 % 4.34 % 0.25 % 15.7 % 150.9 % Transaction 38 42 4.04 % 5.07 % (0.18)% 27.9 % 175.2 % Transaction 39 100 7.26 % 3.15 % 0.57 % 9.9 % 87.2 % Transaction 40 42 N/A N/A N/A 22.2 % 166.9 % Transaction 41 49 4.30 % 4.71 % (0.07)% 21.6 % 160.6 % Transaction 42 48 5.19 % 3.92 % 0.22 % 21.7 % 141.1 % Transaction 44 67 2.35 % 4.16 % (0.27)% 12.2 % 115.2 % Transaction 45 46 2.07 % 4.46 % (0.40)% 10.6 % 95.4 % Transaction 46 51 2.49 % 4.33 % (0.33)% 9.9 % 83.4 % Transaction 47 43 2.91 % 4.34 % (0.23)% 21.3 % 159.7 % Transaction 48 46 2.37 % 5.71 % (0.54)% 16.8 % 118.2 % Transaction 49 43 3.79 % 3.94 % (0.02)% 12.8 % 111.4 % Transaction 50 40 3.16 % 4.25 % (0.17)% 13.8 % 110.7 % Transaction 51 53 4.22 % 4.47 % (0.05)% 21.5 % 145.7 % Transaction 53 95 17.71 % 4.00 % 1.68 % 49.4 % 303.2 % Transaction 54 66 6.99 % 3.69 % 0.43 % 58.4 % 812.6 % Transaction 55 45 6.49 % 3.59 % 0.39 % 61.9 % 758.2 % Transaction 56 42 4.77 % 4.53 % 0.04 % 23.2 % 156.4 % Transaction 57 42 4.77 % 4.53 % 0.04 % 50.0 % 803.2 % Transaction 58 49 3.74 % 4.04 % (0.05)% 25.5 % 161.5 % Transaction 59 49 3.74 % 4.04 % (0.05)% 53.6 % 1,107.1 % Transaction 60 198 4.48 % 4.50 % (0.01)% 11.3 % 27.7 % Transaction 61 45 3.49 % 4.04 % (0.10)% 18.1 % 113.8 % Transaction 62 42 4.69 % 5.20 % (0.09)% 21.9 % 157.6 % Transaction 63 53 3.02 % 4.78 % (0.32)% 19.7 % 130.8 % Transaction 64 38 N/A N/A N/A 22.9 % 132.4 % Transaction 65 48 3.09 % 4.96 % (0.31)% 14.6 % 102.2 % Transaction 66 49 3.68 % 4.05 % (0.06)% 22.3 % 162.5 % Transaction 67 45 4.03 % 4.38 % (0.06)% 20.4 % 136.5 % Transaction 68 48 5.74 % 4.41 % 0.22 % 27.2 % 194.1 % Transaction 69 44 7.20 % 5.61 % 0.28 % 26.0 % 177.5 % Transaction 70 52 5.32 % 6.21 % (0.15)% 19.0 % 136.3 % Transaction 71 40 3.16 % 4.25 % (0.17)% 28.4 % 70.1 % Transaction 72 42 4.77 % 4.53 % 0.04 % 22.1 % 59.3 % Transaction 73 42 4.77 % 4.53 % 0.04 % 22.1 % 59.3 % Transaction 74 49 3.74 % 4.04 % (0.05)% 24.0 % 62.0 % Transaction 75 168 4.49 % 4.05 % 0.29 % 13.4 % 30.0 % Transaction 76 46 2.07 % 2.43 % (0.06)% 46.7 % 63.2 % Transaction 77 213 5.46 % 5.04 % 0.40 % 14.7 % 10.9 % Transaction 78 217 4.74 % 4.00 % 0.78 % 15.1 % 18.5 % Transaction 79 215 4.20 % 4.00 % 0.23 % 10.0 % 12.6 % Transaction 80 185 4.22 % 4.17 % 0.07 % 13.8 % 7.9 % Transaction 81 217 4.17 % 4.00 % 0.57 % 11.2 % 0.0 % Transaction 82 206 4.09 % 4.00 % 0.35 % 9.7 % 0.0 % US CLO Subtotal: 4.28 % 4.61 % (0.02)% 127.9 % Total CLO Portfolio: 3.49 % 4.66 % (0.16)% 113.4 %
(i) The USD investment cost fixes the USD-EUR exchange rate of European CLOs at the same rate to avoid the impact of skewed weightings and FX volatility.
(ii) Par weighted average spread over LIBOR or EURIBOR (as approproate) of the underlying loan assets in each CLO's portfolio.
(iii) Notional weighted average spread over LIBOR or EURIBOR (as appropriate) of the debt tranches issued by each CLO, as of the closing date of each transaction.
(iv) Notional weighted average spread over LIBOR or EURIBOR (as appropriate) of the debt tranches issued by each CLO, as of the most recent trustee report date.
(v) The current junior-most O/C cushion is the excess (or deficit) of the junior-most O/C test ratio over the test requirement, as of the latest trustee report available as of the report date.
(vi) The junior-most O/C cushion at close is the excess (or deficit) of the junior-most O/C test ratio over the test requirement that was expected on each deal's closing date. Please note that two of TFG's investments are so called "par structures" which don't include a junior O/C test. They have been marked by an "N/A" in the relevant junior-most O/C test columns.
(vii) Calculated by annualizing the change from the expected closing date junior-most O/C cushion to the current junior-most O/C cushion.
(viii) Calculated from TFG's investment date. Includes both historical cash flows received to-date and prospective cash flows expected to be received, based on TFG's base case modeling assumptions.
(ix) Inception to report date cash flow received on each transaction as a percentage of its original cost.
Additional Corporate Information
DESCRIPTION OF BUSINESS
TFG (company number 43321) is a Guernsey company traded on NYSE Euronext in Amsterdam under the ticker symbol "TFG" that aims to provide stable returns to investors across various credit, equity, interest rate and real estate cycles. The company maintains two key business segments: an investment portfolio and an asset-management platform. Both business segments cover a broad range of assets including bank loans, real estate, equities, credit and convertible bonds. TFG currently invests primarily through long-term funding vehicles, such as collateralized loan obligations.
TFG's asset-management platform ("TFG Asset Management") currently consists of Polygon Global Partners ("Polygon"), LCM Asset Management LLC ("LCM") and GreenOak Real Estate L.P. ("GreenOak"). TFG Asset Management L.P. is registered as an investment adviser under the U.S. Investment Advisers Act of 1940 and one of its investment management entities, Polygon Global Partners LLP, is authorised and regulated by the United Kingdom Financial Services Authority. The Company is seeking to realize the benefits of building and integrating existing and potentially new asset management businesses into the platform. In turn, the Company will continue to advance this effort throughout 2013, including by evaluating other asset managers.
TFG is registered in the public register of the Netherlands Authority for the Financial Markets ("AFM") under section 1:107 of the Netherlands Financial Markets Supervision Act ("FMSA") as a collective investment scheme from a designated country.
TFG's investment objective is to generate distributable income and capital appreciation. To achieve this objective, Tetragon Financial Management LP (the "Investment Manager") seeks to identify opportunities, assets and asset classes it believes to be attractive and asset managers it believes to be superior based on their track record and expertise. It also seeks to use the market experience of the Investment Manager to negotiate favourable transactions and terms for its investments in asset classes and in asset managers. As part of this current investment strategy, the Investment Manager may employ hedging strategies and leverage in seeking to provide attractive returns while managing risk.
Tetragon Financial Management LP has been appointed the investment manager of TFG and the Master Fund pursuant to an investment management agreement dated 26 April 2007 (the "Investment Management Agreement"). The management and control of the Investment Manager is vested in its general partner, Tetragon Financial Management GP LLC (the "General Partner"), which is responsible for all actions of the Investment Manager. The General Partner is directly or indirectly controlled by Reade Griffith, Alexander Jackson and Paddy Dear, who also control TFG's voting shareholder. As the General Partner is responsible for all actions of the Investment Manager, any references to the Investment Manager in this Annual Report or in any of our disclosure shall be deemed to include a reference to the General Partner to the extent applicable. Mr. Griffith acts as the authorized representative of the General Partner and the Investment Manager.
The Investment Manager is registered as an investment adviser under the U.S. Investment Advisers Act of 1940.
The investment committee of the Investment Manager (the "Investment Committee") currently consists of Jeffrey Herlyn, Michael Rosenberg, David Wishnow, Reade Griffith and Paddy Dear and is responsible for the investment management of the portfolio and the business. The Investment Committee currently sets forth the investment strategy and approves each significant investment by the Master Fund.
The risk committee of the Investment Manager (the "Risk Committee") has the same composition as the Investment Committee. The Risk Committee is currently responsible for the risk management of the portfolio and the business and performs active and regular oversight and risk monitoring.
Polygon Global Partners LLP and Polygon Global Partners LP (together, the "Service Providers") provide the Investment Manager with certain services in relation to the company pursuant to a Services Agreement dated 30 April 2012. The Service Providers have been indirect subsidiaries of TFG since 28 October 2012, when TFG acquired TFG Asset Management L.P. (f/k/a Polygon Management L.P.) and certain of its affiliates. The Service Providers also provide operating, infrastructure and administrative services to LCM and GreenOak and to various Polygon managers pursuant to applicable services agreements. Polygon Global Partners LLP is authorised and regulated by the United Kingdom Financial Services Authority.
In recognition of the work performed by the Investment Manager in successfully arranging the global offering and the associated raising of new capital for the company, TFG granted to the Investment Manager options (the "Investment Management Options") to purchase 12,545,330 of TFG's Non-Voting Shares (before the application of potential anti-dilution) at an exercise price per share equal to the IPO offer price (U.S. $10). The Investment Management Options are fully vested and immediately exercisable on the date of admission to the NYSE Euronext in Amsterdam and will remain exercisable until the 10th anniversary of that date (i.e., 26 April 2017).
For more information on TFG's investment manager, including a summary of key terms of the Investment Management Agreement, please refer to TFG's website at http://www.tetragoninv.com.
CLO BUY-AND-HOLD STRATEGY
The emphasis of the Investment Manager's current CLO investment strategy for the company has been on the selection and structuring of investment positions that are then intended to be held for returns based on cash flows and other revenues to provide a stable stream of income for the company. The Investment Manager believes, for example, that its buy-and-hold strategy has allowed the company to take a long-term view on the expected cash flows from a CLO or other securitization vehicle. Market developments, however, have and may continue to, impact the fair value of a securitization vehicle and/or its underlying assets.
The company believes the Investment Manager's asset liability management and its strategy of taking majority (or substantial) positions in its CLO investments has made a CLO buy-and-hold strategy more attractive, as the Investment Manager may in certain cases influence the performance of a CLO investment through, among other things, the support of amendments to the CLO structure or the collateral management agreement.
State Street (Guernsey) Limited serves as the company's independent administrator and values the investments of the Master Fund on an ongoing basis. The NAV per Share is expected to fluctuate over time with the performance of TFG's investments. The NAV of TFG and the Master Fund and the NAV per Share are determined as at the close of business on the last business day of each fiscal quarter for purposes of calculating incentive fees. As TFG makes all of its investments through the Master Fund, TFG's NAV will equal the NAV of the Master Fund before any TFG specific liabilities, such as incentive fees. The company's valuation policies are set forth on the company's website at http://www.tetragoninv.com. The information on the "Valuation" page of the website supersedes any other disclosure by the company with respect to such information. Subject to the foregoing, additional information with respect to TFG's or the Master Fund's valuation policies may be found in each company's annual audited financial statements accompanying this Annual Report.
CERTAIN CORPORATE AND LISTING BACKGROUND
Shares of TFG (the "Shares") are publicly traded solely on the NYSE Euronext in Amsterdam under the ticker symbol "TFG". The Shares do not carry any voting rights other than limited voting rights in respect of variation of their class rights. The voting shares of TFG are owned by Polygon Credit Holdings II Limited, which is a non-U.S. affiliate of the Investment Manager. Polygon Credit Holdings II Limited is controlled by Reade Griffith, Alexander Jackson and Paddy Dear. The voting shares are not entitled to receive dividends.
The current exchange listing, corporate structure and governance and investment management arrangements of TFG were established to help foster the achievement of the company's investment objective. In particular, at the time of its initial public offering and in consultation with the company's underwriters and its legal and financial advisors, the Investment Manager concluded that NYSE Euronext in Amsterdam is favorably suited to facilitate the company's pursuit of its investment objective and to address relevant legal, regulatory, liquidity and other commercial considerations. Similarly, TFG's corporate structure and governance were designed to seek to position the company to best serve its investment objective as well as to address a variety of relevant considerations, including applicable legal requirements. For example, the TFG corporate structure and governance combined with the Investment Manager's actions in addressing financing risk helped the company effectively execute a buy-and-hold strategy that yielded positive results for the company's investment performance. The expansion of TFG's asset management platform may help facilitate a potential listing in the United States over the longer-term, which TFG continues to explore. U.S. markets tend to offer better research coverage, liquidity and valuations.
DIVIDENDS AND OTHER DISTRIBUTIONS
The company has sought to continue to return value to its shareholders, including through dividends and share repurchases.
TFG continues to pursue a progressive dividend policy with a target payout ratio of 30-50% of normalized earnings, based on the long-term target RoE of 10-15%.[(48)]
The Board of Directors will have the authority to declare dividend payments, based upon the recommendation of the Investment Manager, subject to the approval of the voting shares of TFG and adherence to applicable law, including the satisfaction of a solvency test as required pursuant to the Companies (Guernsey) Law, 2008, as amended.
The Investment Manager's recommendation with respect to the declaration of dividends (and other capital distributions) may be informed by a variety of considerations, including (i) the expected sustainability of the company's cash generation capacity in the short and medium term, (ii) the current and anticipated performance of the company, (iii) the current and anticipated operating and economic environment and (iv) other potential uses of cash ranging from preservation of the company's investments and financial position to other investment opportunities.
TFG has and may continue to also pay scrip dividends currently conducted through an optional dividend reinvestment program. If the Board of Directors declares a cash dividend payable by TFG, they will also (in their capacity as directors of the Master Fund) declare an equal dividend per share payable concurrently by the Master Fund.
TFG has and may also continue to engage in share repurchases in the market from time to time. Such purchases may at appropriate price levels below NAV represent an attractive use of TFG's excess cash and an efficient means to return cash to Shareholders. Any decision to engage in share repurchases will be made by the Investment Manager, upon consideration of relevant factors, and will be subject to, among other things, applicable law and profits at the time. The company also continues to explore other methods of improving the liquidity of its shares.
In accordance with applicable regulations under Dutch law, TFG publishes monthly statements on its website for the benefit of its investors containing the following information: the total value of the investments of the Master Fund; a general statement of the composition of the investments of the Master Fund; and the number of legal issued and outstanding shares of TFG.
In addition, in accordance with the requirements of NYSE Euronext in Amsterdam and applicable regulations under Dutch law, TFG provides annual and semi-annual reports to its shareholders, including year-end financial statements, which in the case of the financial statements provided in its annual reports, will be reported in accordance with U.S. GAAP and audited in accordance with international auditing standards as well as U.S. GAAS for regulatory purposes, if applicable. TFG also provides interim management statements to investors in accordance with section 5:25e of the FMSA. The NAV of TFG is available to investors on a monthly basis on the Company's website at http://www.tetragoninv.com.
OTHER LEGAL MATTERS
On 22 February 2011, TFG and the Master Fund and their six directors were served with proceedings in the Royal Court of Guernsey (the "Guernsey Proceedings") instigated by one of Company's former directors, Alexander Jackson. Mr. Jackson was given notice to vacate office as a director on 24 January 2011.[(49)]
On 12 July 2011, a shareholder derivative action was filed against the current and former directors of the Company and the Master Fund, the Investment Manager, the principals of the Investment Manager (each being an indirect equity holder of the Investment Manager) and an affiliated entity (the "Action").[(50)] On 14 February 2012, Judge Jed S. Rakoff of the United States District Court for the Southern District of New York rendered his decision, agreeing with defendants that the purported shareholder who brought the lawsuit failed to satisfy basic pleading requirements of derivative actions. The Court ordered the case dismissed in its entirety with prejudice. The time period for an appeal of the decision by the plaintiffs has lapsed.
On 19 December 2011, Mr. Jackson filed a claim against Patrick Dear and Reade Griffith in the High Court in London regarding Mr. Jackson's removal in January 2011 from the Board of Directors of TFG and the Master Fund (the "English Proceedings"). Each of TFG and the Master Fund took an interest in the English Proceedings given that they purported to impact TFG's constitution and matters that were already the subject of the Guernsey Proceedings. The defendants contended that Mr. Jackson's claim was without merit and following contested hearings the English Court of Appeal determined specific matters in Mr. Dear and Mr. Griffith's favour by a judgment dated 22 February 2013 and is currently considering whether or not, based on the determination of those matters, Mr. Jackson's claim should be dismissed or continue.
An investment in TFG (together with the Master Fund, the "Company") involves substantial risks and uncertainties. Investors may review a more detailed description of these risks and uncertainties and others to which the Company is subject on TFG's website at http://www.tetragoninv.com.
These risks and uncertainties include, among others, those listed below.
- Many of the Company's investments are in the form of highly subordinated securities, which are susceptible to losses of up to 100% of the initial investments, including losses resulting from changes in the financial rating ascribed to, or changes in the market value or fair value of, the underlying assets of an investment.
- CLO vehicles, which make up the majority of the Company's current investment portfolio generally invest in fixed income securities rated lower than Baa by Moody's or lower than BBB by S&P (or, if not rated, of comparable quality) and may be regarded as predominantly speculative with respect to the issuer's continuing ability to meet principal and interest payments. Moreover, market developments (including, without limitation, deteriorating economic outlook, rising defaults and rating agency downgrades) may impact the fair value of an investment and/or its underlying assets, as we experienced during the period from the third quarter of 2008 through the first half of 2009.
- Defaults, their resulting losses and other losses on underlying assets (including bank loans) may have a negative impact on the value of the Company's portfolio and cash flows received. In addition, bank loans may require substantial workout negotiations or restructuring in the event of a default or liquidation which could result in a substantial reduction in the interest rate and/or principal.
- The modeled cash flow predictions and assumptions used to calculate the IRR and fair value of each CLO investment may prove to be inaccurate and require adjustment. Factors affecting the accuracy of such modeled cash flow predictions include: (1) uncertainty in predicting future market values of certain distressed asset types, (2) the inability to accurately model collateral manager behavior and (3) the divergence of assumed variables from realized levels over the period covered by the model.
- Bank loans are generally subject to liquidity risks and, consequently, there may be limited liquidity if a Securitization Vehicle is required to sell or otherwise dispose of such bank loans.
- Many of the Company's investments in securitization vehicles are and will be illiquid and have values that are susceptible to changes in the ratings and market values of such vehicles' underlying assets, which may make it difficult for the Company to sell such holdings.
- As the Company becomes more of a financial services firm that functions as a company that owns operating companies, it may face difficulties as it invests in asset classes in which it does not have substantial experience.
- Direct investments in asset managers will expose the Company's business to additional risks, including: a decline in the price of securities, a more complex regulatory environment and competition.
- The Company may be exposed to counterparty risk, which could make it difficult for the Company to collect on the obligations represented by investments and result in significant losses.
- The Company's organizational, ownership and investment structure may create significant conflicts of interest that may be resolved in a manner which is not always in the best interests of the Company or the shareholders of TFG.
- The Investment Manager may devote time and commitment to other activities.
- Shares of TFG (the "Shares") do not carry any voting rights other than limited voting rights in respect of variation of their class rights. The holder of the voting shares of TFG will be able to control the composition of the Board of Directors and exercise extensive influence over TFG's and the Master Fund's business and affairs. Additional information on the organizational structure and corporate governance of TFG may be found on TFG's website at http://www.tetragoninv.com.
- The performance of many of the Company's investments may depend to a significant extent upon the performance of its asset managers (internal and external).
- The Company is subject to concentration risk in its investment portfolio, which may increase the risk of an investment in TFG.
- The Company's CLO investments are subject to (i) interest rate risk, which could cause the Company's cash flow, fair value of its assets and operating results to decrease and (ii) currency risk, which could cause the value of the Company's CLO investments in U.S. Dollars to decrease regardless of the inherent value of the underlying investments.
- TFG's principal source of cash will be the investments that it makes through the Master Fund. TFG's ability to pay dividends will depend on it receiving distributions from the Master Fund.
- The ability of securitization vehicles in which the Company invests to sell assets and reinvest the proceeds may be restricted, which may reduce the yield from the Company's investment in those Securitization Vehicles.
- The shares of TFG may continue to trade below NAV. The NAV per Share will change over time with the performance of the Company's investments and will be determined by the Company's valuation principles. The fees payable to the Investment Manager will be based on NAV and changes in NAV, which will not necessarily correlate to changes in the market value of the shares of TFG.
- TFG and the Master Fund have approved a very broad investment objective and the Investment Manager will have substantial discretion when making investment decisions. In addition, the Investment Manager's strategies may not achieve the Company's investment objective.
- Shareholders will not be able to terminate the Company's investment management agreement. None of the Investment Manager or the Service Providers owe fiduciary duties to the shareholders of TFG.
- The Company may become involved in litigation that adversely affects the Company's business, investments and results of operations.
- If the Company's relationship with the Investment Manager and its principals were to end or such principals or other key professionals were to depart, it could have a material adverse effect on the Company.
- The Investment Manager's compensation structure may encourage the Investment Manager to invest in high-risk investments.
- The liability of the Investment Manager to the Company is limited and the Company's indemnity of the Investment Manager may lead the Investment Manager to assume greater risks when making investment related decisions than it otherwise would.
- The Shares are subject to legal and other restrictions on resale and the NYSE Euronext in Amsterdam trading market is less liquid than other major exchanges, which could affect the price of the Shares. TFG may decide in the future to list the Shares on a stock exchange other than NYSE Euronext in Amsterdam. There can be no assurance that an active trading market would develop on such an exchange.
- The performance of LCM and, in turn, the Company's operating results, may be negatively influenced by various factors, including the (i) performance of LCM-managed CLOs, which in general are subject to the same risks as the Company's CLO investments and are currently the primary source of LCM's revenues and (ii) ability of LCM to retain key personnel, the loss of whom may negatively affect LCM's ability to provide asset and collateral management services in a fashion, and of a quality, consistent with its prior practice. Furthermore, the Company's ownership of LCM may negatively impact certain aspects of the Company's CLO investment strategy and as a result the Company's performance as well as the Company's ability to diversify its investments across multiple asset managers.
- The performance of Polygon and, in turn, the Company's operating results, may be negatively influenced by various factors, including the (i) performance of Polygon-managed funds, and (ii) ability of Polygon to retain key personnel, the loss of whom may negatively affect Polygon's ability to provide asset management services in a fashion, and of a quality, consistent with its prior practice.
- GreenOak has a limited operating history and it may be unable to successfully operate its business or achieve its investment objectives. In connection with the transaction with GreenOak, the Company will invest its capital, directly and indirectly, in certain real estate investments. Real estate investments are subject to various risks and fluctuations and cycles in value and demand, many of which are beyond the Company's control.
- The asset management business is intensely competitive, with competition based on a variety of factors, including investment performance, the quality of service provided to clients, investor liquidity and willingness to invest, fund terms (including fees), brand recognition and business reputation. Our asset management business competes with a number of private equity funds, specialized investment funds, hedge funds, funds of hedge funds and other sponsors managing pools of capital, as well as corporate buyers, traditional asset managers, commercial banks, investment banks and other financial institutions (including sovereign wealth funds).
- Asset management and financial advisory businesses are subject to extensive regulation, which affects the Company's activities and creates the potential for significant liabilities and penalties. The possibility of increased regulatory focus could result in additional burdens on the Company's business. Recent legislative and regulatory changes in the United States, such as the Dodd-Frank Act, and the European Union, such as the Alternative Investment Fund Managers Directive and the European Market Infrastructure Regulation, could adversely affect the Company's business.
- As we have expanded and as we continue to expand the number and scope of our businesses, we increasingly confront potential conflicts of interest relating to our activities. Certain of our funds may have overlapping investment objectives, including funds that have different fee structures, and potential conflicts may arise with respect to our decisions regarding how to allocate investment opportunities among those funds. To the extent we fail to appropriately deal with any such conflicts, it could negatively impact our reputation and ability to raise additional funds or result in potential litigation against us.
- Poor performance of our managed investment funds and vehicles would cause a decline in our asset management revenue, income and cash flow, and could adversely affect our ability to raise capital for future investment funds.
- Our asset management business depends in part on our ability to raise capital from third-party clients. If we are unable to raise capital from third-party clients, we would be unable to collect management fees or deploy their capital into investments and potentially collect transaction fees or incentive fees, which would materially reduce our asset management revenue and cash flow.
- As the Company invests in new asset classes and as its asset mix changes, its revenues and profitability could be reduced.
- The Company may issue additional securities that dilute existing holders of Shares, including as a result of the exercise of the Investment Management Options.
The foregoing is not a comprehensive list of the risks and uncertainties to which the Company is subject.
BOARD OF DIRECTORS
Paddy Dear Reade Griffith Byron Knief*
Rupert Dorey* David Jeffreys* Greville Ward*
Registered Office of TFG and the Master Fund
Tetragon Financial Group Limited
Tetragon Financial Group Master Fund Limited
1st Floor Dorey Court
St. Peter Port, Guernsey
Channel Islands GYI 6HJ
Tetragon Financial Management LP
399 Park Avenue, 22nd Floor
New York, NY 10022
United States of America
General Partner of Investment Manager
Tetragon Financial Management GP LLC
399 Park Avenue, 22nd Floor
New York, NY 10022
United States of America
David Wishnow / Yuko Thomas
Andrew Garfield / Gill Ackers / Brian Buckley
KPMG Channel Islands Ltd
20 New Street
St. Peter Port, Guernsey
Channel Islands GYI 4AN
Sub-Registrar and Transfer Agent
One Wall Street
New York, NY 10286
United States of America
Issuing Agent, Dutch Paying and Transfer Agent
Kas Bank N.V.
1012 VT Amsterdam, The Netherlands
Legal Advisor (as to U.S. law)
Cravath, Swaine & Moore LLP
One Ropemaker Street
London EC2Y 9HR
Legal Advisor (as to Guernsey law)
St. Julian's Avenue
St. Peter Port, Guernsey
Channel Islands GYI 1WA
Legal Advisor (as to Dutch law)
De Brauw Blackstone Westbroek N.V.
Claude Debussylaan 80
1082 MD Amsterdam, The Netherlands
NYSE Euronext in Amsterdam
Administrator and Registrar
State Street (Guernsey) Limited
1st Floor Dorey Court
St. Peter Port, Guernsey
Channel Islands GYI 6HJ
(1) The $7.7 billion AUM includes LCM, Polygon and GreenOak managed assets. Please see Figure 11 of this Annual Report for additional details.
(2) Throughout this Annual Report, except within the letter to shareholders, references to "we" are to Tetragon Financial Management LP, TFG's Investment Manager.
(3) Adjusted EPS is calculated as Net Economic Income (as defined in the "Financial Review" section) divided by the weighted-average U.S. GAAP Shares outstanding during the year (113,346,744).
(4) Adjusted EPS is calculated as Net Economic Income (as defined in the "Financial Review" section) divided by the weighted-average U.S. GAAP Shares outstanding during the year (113,346,744).
(5) Please see the press release of 29 October 2012 noting TFG's acquisition of Polygon Management L.P. and certain of its affiliates.
(6) The intrinsic value of the options will be calculated as the excess of (x) the closing price of the shares as of the final trading day in the relevant period over (y) $10.00 (being the exercise price per share) times (z) 12,545,330 (being a number of shares subject to the options before the application of potential anti-dilution). The terms of exercise under the options allow for exercise using cash, as well as, with the consent of the board of the Company, certain forms of cashless exercise. Each of these prescribed methods of exercise may give rise to the issuance of a different number of shares than the approach described herein. If the options were to be surrendered for their intrinsic value with the board's consent, rather than exercised, the number of shares issued would equal the intrinsic value divided by the closing price of the shares as of the final trading day in the relevant period. This approach has been selected because we currently believe it is more reasonably illustrative of a likely outcome if the options are exercised. The options are exercisable until 26 April 2017.
(7) Please see the press release of 31 January 2013 for further details regarding U.S. GAAP NAV per Share movements.
(8) Please see the press release of 11 January 2013 announcing the continuation of TFG's share repurchase program.
(9) The CLO asset characterizations referenced above reflect the primary asset focus of the vehicles. These transactions, however, may allow for limited exposure to other asset classes including unsecured loans, high yield bonds, or structured finance securities.
(10) Please note that TFG may hold more than one investment in any CLO transaction within its portfolio.
(11) In each case using the weighted-average U.S. GAAP shares outstanding during the year (113,346,744).
(12) Based on the most recent trustee reports available as of 31 December 2012.
(13) Based on the most recent trustee reports available as of 31 December 2012.
(14) In each case using the weighted-average U.S. GAAP shares outstanding during the year (113,346,744).
(15) In each case using the weighted-average U.S. GAAP shares outstanding during the year (113,346,744).
(16) Based on the most recent trustee reports available as of 31 December 2012.
(17) Please see the TFG press release of 29 October 2012 noting TFG's acquisition of Polygon Management L.P., and certain of its affiliates.
(18) LCM XIII CLO will have a target loan par amount of $500.0 million.
(19) The LCM II, LCM III, LCM IV, LCM V, LCM VI, LCM VIII, LCM IX, LCM X, LCM XI, and LCM XII CLOs are referred to as the "LCM Cash Flow CLOs." The LCM VII CLO was a market value CLO previously managed by LCM, which was liquidated commencing in 2008, and is not included in the mentioned statistics. LCM I CLO has sold all of its assets and repaid all of its liabilities with excess proceeds distributed to equity holders as of 31 December, 2012, and is therefore not included in the mentioned statistics. In addition, these statistics do not include the performance of certain transactions that were developed and previously managed by a third-party prior to being assigned to LCM, some of which continue to be managed by LCM.
(20) Please see also the TFG monthly update for October 2012 released on 20 November 2012.
(21) Citi Global Structured Credit Strategy 22 January 2013
(22) S&P/LCD News, "Levered loan default rate rises modestly in 2012, but remains low," 3 January 2012.
(23) S&P/LCD News, "Levered loan default rate rises modestly in 2012, but remains low," 3 January 2012.
(24) S&P/LCD News, "Levered loan default rate rises modestly in 2012, but remains low," 3 January 2012.
(25) The calculation of TFG's lagging 12-month corporate loan default rate does not include certain underlying investment collateral that was assigned a "Selective Default" rating by one or more of the applicable rating agencies. Such Selected Defaults are included the S&P/LCD lagging 12-month U.S. institutional loan default rate discussed above. Furthermore, TFG's CLO equity and direct loan investment portfolio includes approximately 9.5% CLOs with primary exposure to European senior secured loans and such loans are included in the calculation of TFG's corporate default rate.
(26) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(27) S&P/LCD News, "(EUR) European 2012 loan volumes lag as crisis takes toll," 3 January 2013.
(28) S&P/LCD News, "(EUR) European 2012 loan volumes lag as crisis takes toll," 3 January 2013.
(29) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(30) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(31) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(32) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(33) S&P/LCD News, "Full Index analysis: Loans return 0.79% in December, 9.66% in 2012," 3 January 2013.
(34) S&P/LCD News, "(EUR) S&P ELLI: Loans lose 0.06%; YTD return is 9.72%, 27 December 2012.
(35) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(36) S&P/LCD News, "(EUR) Topical: Loan repayments fall but volumes outweigh issuance," 18 January 2013.
(37) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(38) S&P/LSTA Quarterly Leveraged Lending Review, Fourth Quarter 2012.
(39) Morgan Stanley CLO Market Tracker, 4 January 2013.
(40) Morgan Stanley CLO Market Tracker, 4 January 2013; based on a surveillance universe of 487 USD-denominated CLOs and 194 Euro-denominated CLOs.
(41) Morgan Stanley CLO Market Tracker, 9 January 2012; based on a surveillance universe of 461 USD-denominated CLOs and 192 Euro-denominated CLOs.
(42) Morgan Stanley CLO Market Tracker, 4 January 2013; based on a surveillance universe of 487 USD-denominated CLOs and 194 Euro-denominated CLOs.
(43) Morgan Stanley CLO Market Tracker, 9 January 2012; based on a surveillance universe of 461 USD-denominated CLOs and 192 Euro-denominated CLOs.
(44) Morgan Stanley CLO Market Tracker, 4 January 2013; based on a surveillance universe of 487 USD-denominated CLOs and 194 Euro-denominated CLOs.
(45) Morgan Stanley CLO Market Tracker, January 4 2013; based on a surveillance universe of 487 USD-denominated CLOs and 194 Euro-denominated CLOs.
(46) Morgan Stanley CLO Market Tracker, 4 January 2013; based on a surveillance universe of 487 USD-denominated CLOs and 194 Euro-denominated CLOs.
(47) Morgan Stanley CLO Market Tracker, 4 January 2013; based on a surveillance universe of 487 USD-denominated CLOs and 194 Euro-denominated CLOs.
(48) TFG's returns will most likely fluctuate with LIBOR. LIBOR directly flows through some of TFG's investments and, as it can be seen as the risk-free short-term rate, it should affect all of TFG's investments. In high-LIBOR environments, TFG should achieve higher sustainable returns; in low-LIBOR environments, TFG should achieve lower sustainable returns.
(49) By the Guernsey Proceedings, Mr. Jackson seeks to impugn TFG's decision of 29 July 2010, announced on 2 August 2010, to enter into a joint venture with GreenOak Real Estate (the "GreenOak Transaction"). The Proceedings are confined to claims for damages and other relief against the Company's directors, and do not seek to reverse or interfere with the GreenOak Transaction, which was implemented in the third quarter of 2010. The Company and its directors believe that there is no merit whatsoever in the Proceedings and will take all necessary steps to ensure the Proceedings are dismissed as quickly as possible. The Investment Manager has concluded that it is untenable for Mr. Jackson to continue in his current role as a consultant with respect to investment and risk matters relating to the Company and, therefore, is taking steps to ensure that he will no longer continue in that capacity, although he remains a shareholder of the Investment Manager.
(50) The Action made a series of allegations with respect to performance fees charged by the Investment Manager. TFG and its Board of Directors believed, and continue to believe, that the Action was factually and legally without merit.
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