LONDON, March 2, 2011 /PRNewswire/ --
Tetragon Financial Group Limited ("TFG") is a Guernsey closed-ended investment company that currently invests primarily in selected securitized asset classes and aims to provide stable returns to investors across various credit and interest rate cycles. TFG is traded on the Euronext Amsterdam by NYSE Euronext under the ticker symbol "TFG", and commenced operations on 1 August 2005.
In this performance report, unless otherwise stated, we report on the consolidated business incorporating TFG and Tetragon Financial Group Master Fund Limited (the "Master Fund").(1) We refer to TFG and the Master Fund together as the "Company."
TFG's investment objective is to generate distributable income and capital appreciation. To achieve this objective, and to aim to provide stable returns to investors across various interest rate and credit cycles, 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 favorable transactions. 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.
(1) TFG invests substantially all its capital through the Master Fund, in which it holds a 100% share.
Letter to Shareholders 2010 Performance at a Glance Investment Manager's 2010 Highlights Financial Results Investment Portfolio Summary Investment Manager's Report Investment Portfolio Overview Fair Value Determination of TFG's CLOs Cash Flow Modeling Assumptions Application of Discount Rate Portfolio Corporate Actions Financing Sources and Hedging Activity Capital Distributions 2010 Asset Management Platform Summary, Outlook and Strategy Financial Review 2010 Description of Business Risk Factors End Notes
Tetragon Financial Group Limited
2010 Audited Consolidated Financial Statements
Tetragon Financial Group Master Fund Limited
2010 Audited Consolidated Financial Statements
TO OUR SHAREHOLDERS
We are pleased to present what we believe are very strong operating and financial results for 2010, which reflect the following key themes:
- TFG's portfolio of collateralized loan obligation ("CLO") equity has generally weathered the financial storms of 2008 and 2009 well and has recovered strongly. Key performance metrics for the Company's U.S. CLO investments have, on average, returned to, or exceeded, expected long-term norms. European CLOs, which constitute a significantly smaller share of TFG's portfolio and have mostly lagged behind the performance of U.S. CLOs, are also beginning to show some encouraging signs of potential recovery. - Cash flows from CLO investments increased significantly year-over-year in 2010, and we believe there is further potential for growth in the coming year. - TFG also continued to execute on its current strategy of diversifying its income stream into asset management platforms and investments both within and beyond the leveraged loan market. - The completion of the acquisition and integration of LCM Asset Management LLC ("LCM") in early 2010 was successful and has, as planned, provided a platform for TFG to take what we believe is a leading role in the new issue CLO market and to exploit CLO manager consolidation opportunities. - During Q3 2010, after reviewing many investment opportunities in asset management platforms, TFG entered into a venture with GreenOak Real Estate ("GreenOak"), which has provided for an equity interest in the business as well as co-investment opportunities at discounted fee levels in future investment programs. - The strong investment performance experienced during 2010 has enabled the company to increase dividends throughout the year and to continue its share buy-back program.
In contrast to the volatility and uncertainty which characterized the prior two years, 2010 witnessed a gradual stabilization of macroeconomic conditions and improvements in corporate credit quality, particularly in the United States. Numerous indicators reflected these positive trends, including: declines in leveraged loan defaults and fewer downgrades to Caa1/CCC+ and below, gains in leveraged loan prices, robust activity in the new issue high yield bond and leveraged loan markets, and a rally in secondary CLO debt and equity prices. In the context of these conditions, TFG's CLO investment portfolio outperformed average market default and Caa1/CCC+ holdings. For example, TFG's 2010 corporate loan default rate reached a level below the WARF-implied annualized default rate used as a historical average within TFG's cash flow modeling framework.(1) In addition, a number of TFG's U.S. CLOs also outperformed certain long-term norms. Cushions to the junior-most O/C tests for certain of TFG's U.S. CLOs improved beyond initial levels reached as of their effective dates. European CLOs, on the other hand, continued to underperform their U.S. counterparts. Despite this, we have seen encouraging signs of potential recovery in the European CLO portfolio and continue to hold these investments with a long-term view.
These portfolio-wide improvements helped drive the significant increase of TFG's investment cash flows from approximately $153.0 million in 2009 to $262.7 million in 2010. In addition, CLO managers were generally able to reinvest funds within their CLOs into wider-spread assets and, in some cases, assets with LIBOR floors. This in many cases led to a widening of the excess interest margin available for distribution to the equity tranches of these CLOs. The overall strengthening of junior-most O/C tests allowed a number of TFG's investments, especially U.S. CLOs, to resume their equity distributions. We believe that, absent an unforeseen macroeconomic shock or other potential widespread financial disruption, these positive trends will continue, which should allow for further increases to cash flows from CLO investments in 2011.
2010 was also a year of strategic expansion of TFG's asset management platform. The integration of LCM into TFG's platform has been smooth and we believe that the LCM team had a very successful 2010. LCM's assets under management grew from approximately $2.5 billion at the end of 2009 to approximately $3.0 billion at the end 2010. This growth was a result of the assumption of collateral management duties of a U.S. CLO and the issuance of LCM VIII, a new U.S. CLO, in which the Company acquired a majority stake in the equity tranche.
The successful execution of LCM VIII was a considerable achievement for the team as we believe it was the only arbitrage-driven U.S. CLO closed in 2010 where a significant portion of the equity tranche was sold to investors unaffiliated with the collateral manager. We believe that this was a testament to LCM's strong market reputation and ability to attract third-party capital. In addition, during Q1 2010, TFG launched a direct U.S. loan investment program leveraging LCM's credit expertise to generate attractive risk-adjusted returns while seeking to ensure appropriate liquidity.
In an effort to continue its transformation into a broad-based financial services firm that functions not only as an investment holding company, but also as a firm that owns interests in multiple operating businesses, TFG acquired a 10% interest in a new multi-jurisdictional real estate venture, GreenOak, in Q3 2010, along with access to future co-investment opportunities in investment programs managed by GreenOak at discounted fee levels.(2) Having evaluated a number of opportunities during the year, we chose to invest in GreenOak because we believe this investment will strengthen TFG's asset management capabilities and along with LCM, form a foundation for the platform as we look for opportunities both within and beyond the leveraged loan asset class.
TFG's strong performance during 2010 has allowed the Company to continue to return value to its shareholders. In the first quarter of the year TFG paid a dividend of $0.06 per share, followed by increased dividends of $0.08 per share in each of Q2 and Q3 2010. On 25 February 2011, the Company announced a further increase in the dividend to $0.09 per share with respect to Q4 2010, to be paid on 25 March 2011.(3) We are also pleased to note that TFG's share price experienced positive momentum during the year. An investment in TFG's shares on 31 December 2009 would have grown by approximately 55% during the year via capital appreciation and dividend income.(4) In addition, on 1 October 2010, TFG announced the continuation of its share repurchase program. In 2010, the Company repurchased 5,742,119 TFG shares at an average price of $4.45 per share for a total value of approximately $25.5 million.
Turning to the broader landscape, U.S. corporate credit and macroeconomic fundamentals are projected to continue to improve over the near to mid-term. With this in mind, we are optimistic in our outlook for both TFG's investment portfolio and its asset management platform, which we will look to continue to expand. We expect that TFG's U.S. CLO investments will continue to improve in 2011, and although substantial systemic problems remain unresolved in Europe, we believe there are encouraging signs for the long-term performance of our European CLO portfolio. Furthermore, having recalibrated certain of TFG's modeling assumptions to reflect, among other things, lower credit loss expectations for 2011, we expect to continue to review those assumptions, as well as the discount rates applied to projected cash flows for purposes of calculating the fair value of the Company's CLO investments, and adjust such inputs when appropriate.
While we expect that cash flows from the Company's CLO investments will remain substantial in 2011, we are nonetheless mindful that CLO equity tranches, like their underlying loan assets, are amortizing instruments, with reinvestment periods typically ending six to seven years before their legal maturities. Our expectation of considerable, but naturally declining cash flows will necessitate the redeployment of the Company's capital over the next several years in order to maintain our desired returns. This redeployment may come in the form of, among others, investments in new issue or secondary CLOs and loans, investments in asset management firms and capital distributions to shareholders. We are particularly focused on growing our asset management platform by supporting LCM and GreenOak, and by seeking other investment opportunities both within and outside the leveraged loan asset class. We believe that TFG's transition beyond an investment holding company to an owner of interests in multiple operating companies across diversified asset classes will ultimately create significant value for our fellow shareholders.
Board of Directors
28 February 2011
2010 PERFORMANCE AT A GLANCE
Investment Manager's 2010 Highlights:
In the context of improving fundamental, corporate credit and capital markets conditions, TFG achieved the following:
Cash Flow: The Company experienced a significant improvement in cash generation in 2010, with CLO investment cash receipts of approximately $262.7 million, up from approximately $153.0 million in 2009.
Portfolio Management: The Company realized value from its majority (or significant) positions in seven CLO investments during 2010, by positively affecting the outcome of certain corporate governance actions within those transactions, and by increasing our economics via upfront consent fees or long-term fee sharing arrangements.
CLO Investment Performance: The Company's portfolio of CLO investments as a whole out-performed market-wide averages across several key performance metrics, including:
- Defaults: TFG's 2010 corporate loan default rate fell to approximately 1.7%, down from 6.5% recorded as of the end of Q4 2009, and approximately 11% below the 1.9% lagging 12-month institutional U.S. loan default rate, based on the total par amount outstanding, reported by S&P/LCD for the 12-months ending on 31 December 2010.(5) TFG's 2010 corporate loan default rate was also approximately 24% below the 2.2% annual WARF-implied default rate used as a historical average rate within TFG's cash flow modeling framework. - Collateral Coverage Test (O/C) Compliance: As of 31 December 2010, 100% of TFG's U.S. CLOs and approximately 94% of TFG's CLO investments on a portfolio-wide basis were passing their junior most O/C tests, when measured on a number of transactions basis.(6) This compared favorably with the U.S. market-wide average of approximately 92.0% of U.S. CLOs estimated to be in compliance with their junior O/C tests as of the end of 2010.(7)(8) - Credit Quality: The weighted-average percentage of corporate obligors rated Caa1/CCC+ or below in our 70 CLO investments ended the year at 8.3% compared to an approximate 7.9% weighted-average maximum level permitted under the terms of our investments.(9) This statistic was considerably lower than the market-wide median level of CCC-rated asset holdings among U.S. CLOs - estimated to be approximately 8.6% as of the end of Q4 2010.(10)
Direct Loan Investments: In Q1 2010, TFG launched a direct U.S. loan investment program leveraging LCM's credit expertise to generate attractive risk-adjusted returns while ensuring appropriate liquidity. As of 31 December 2010, the direct loan portfolio totaled approximately $100.0 million in par amount and $97.6 million in fair value and had generated $1.1 million of net realized gains through the end of Q4 2010.
Cash Reserves and Corporate-Level Borrowings: The Company had no outstanding corporate-level borrowings during all of 2010 and its net cash position stood at $103.4 million.(11)
Capital Distributions, Dividends and Share Repurchases: The Company maintained dividends throughout 2010 and increased its dividend for Q4 2010 to $0.09 per share. The Company also announced the continuation of its share repurchase program. Overall in 2010, the Company purchased 5,742,119 TFG shares at an average price of $4.45 per share for a total value of approximately $25.5 million.
2010 PERFORMANCE AT A GLANCE (continued)
Investment Manager's 2010 Highlights (continued):
Asset Management Platform
TFG also continued to execute on its current strategy of diversifying its income stream into asset management platforms.
LCM Developments: LCM achieved strong operating and financial performance during 2010. Assets under management grew from approximately $2.5 billion at the end of 2009 to approximately $3.0 billion at year-end 2010. This growth was a result of the assumption of collateral management duties on Hewett's Island IV, a U.S. CLO, and the issuance of LCM VIII, a new U.S. CLO, in which TFG acquired a majority stake in the equity tranche. As of 31 December 2010, all senior and subordinated CLO management fees on LCM Cash Flow CLOs were current and taking into account all LCM-managed vehicles, the gross income year-to-date for LCM totaled $12.6 million.(12) Pre-tax profit for the entire LCM business, of which TFG owns 75%, reached approximately $5.8 million for the same period.
GreenOak Investment: In Q3 2010, TFG acquired a 10% equity interest in GreenOak. GreenOak is a real estate focused principal investing and advisory firm formed in 2010 to capitalize on opportunities in the rapidly changing landscape of real estate investing. It is a highly focused platform currently executing on advisory assignments and continuing to evaluate funds in select markets where we believe the GreenOak principals and local teams have deep, longstanding market presence, access and experience. As reported previously, we currently do not expect to see operating income benefits from the venture in the immediate future as it is a medium-term investment.
Net Income: Consolidated net income of $385.2 million was recorded in 2010 against a loss of $315.1 million for 2009. This strong return to profit was driven by, among other things, significant improvements in the credit quality and structural strength of the Company's CLO investments. Value was captured through increased actual cash receipts versus projections and an increase, and greater confidence in, expected future cash flows.
Earnings per Share (EPS): Consolidated EPS for 2010 was $3.15 compared to a loss of $2.50 for 2009. The EPS recorded during the second half of the year was particularly strong, mirroring improvements in the structural strength and collateral quality of TFG's investment portfolio experienced during the latter half of the year.
Cash Flows from Operations: Total cash receipts from CLO investments in 2010 reached approximately $262.7 million (or $2.16 per weighted average share) compared to approximately $153.0 million in 2009 (or $1.21 per weighted average share) as certain CLO investments saw the resumption of distributions to the equity tranches and general improvements in the excess interest margin available for distribution.(13)
Dividend: During 2010, TFG paid a dividend of $0.06 per share with respect to Q1 2010, followed by an increased dividend of $0.08 per share paid with respect to each of Q2 and Q3 2010. The dividend was increased further to $0.09 per share with respect to Q4 2010, which is payable in March 2011.
Leverage: TFG had no outstanding borrowings during all of 2010.
Net Asset Value (NAV) per Share: NAV per share at the end of 2010 was $9.47, up from $6.47 at the end of 2009, reflecting overall improvements in performance and distributions to shareholders.
Portfolio Size: As of the end of 2010, the fair value of TFG's CLO investment portfolio totaled approximately $932.7 million with exposure to approximately $17.5 billion of leveraged loans. The fair value of the direct loan portfolio totaled approximately $97.6 million.
2010 PERFORMANCE AT A GLANCE (continued)
Investment Portfolio Summary:
CLO Portfolio Composition: As of the end of 2010, TFG's performing CLO portfolio consisted solely of 70 CLO investments managed by 28 external CLO managers and LCM. The number of external CLO managers fell to 28, owing to certain manager consolidations that were announced during the year.
IRRs: The weighted-average IRR as of the end of 2010 was 15.1%, up from 11.9% at the end of 2009.
Performance Fee: Performance fees of $22.3 million, $16.5 million, and $39.3 million were paid with respect to Q1, Q2 and Q3 2010, respectively. A performance fee of $41.5 million was accrued in Q4 2010 in accordance with TFG's investment management agreement and based on a "Reference NAV" with respect to Q3 2010. The hurdle rate for the Q1 2011 incentive fee has been reset at 2.9507% (Q4: 2.9385%) as per the process outlined in TFG's 2010 Audited Financial Statements and in accordance with TFG's investment management agreement.(14)
INVESTMENT MANAGER'S REPORT
As of 31 December 2010, the fair value of TFG's performing CDO investment portfolio totaled approximately $932.7 million and was 100% invested in CLO transactions while the fair value of the direct loan portfolio totaled approximately $97.6 million. TFG's CLO portfolio continued to be diversified across underlying asset classes and geographies, with approximately 74.1% of risk capital invested in CLOs with primary exposure to U.S. broadly syndicated senior secured loans, 16.3% in CLOs with primary exposure to U.S. middle market senior secured loans, and 9.6% in CLOs with primary exposure to European broadly syndicated senior secured loans.(15)(16)
Having gone through the financial storms of 2008-2009, the Company's CLO investments rebounded strongly during the year, benefiting from improving fundamental and capital market conditions, particularly in the United States. Positive gains were registered across key structural and credit quality metrics. As of the end of Q4 2010, approximately 98% of TFG's CLO investments were passing their junior-most O/C tests, weighted by fair value, up from approximately 87% as of the end of 2009.(17) When measured on a number of transactions basis, 62, or approximately 94%, of the Company's CLO investments were passing their junior-most O/C tests, an increase from 41, or approximately 68%, at the end of Q4 2009.(18) The Company's U.S. CLOs, which represented approximately 89.4% of the total fair value of TFG's CLO investment portfolio as of 31 December 2010, experienced the most significant improvements during the year with 100% of these deals passing their junior-most O/C tests as of the end of Q4 2010.(19)(20) This statistic outperformed the market-wide average of U.S. CLOs passing their junior O/C tests estimated to be approximately 92.0% as of the end of Q4 2010 (when measured as % of transactions).(21) While credit improvements in TFG's European CLOs lagged the performance of U.S. transactions, the share of TFG's European CLOs in compliance with their junior-most O/C tests also increased during the year to 83% by fair value and 60% when measured by number of transactions as of the end of Q4 2010, up from 41% and 20% respectively, as of the end of 2009. We believe that the faster pace of recovery of U.S. CLOs versus their European counterparts was a function of not only the differences in GDP growth rates in the two regions, but also of less favorable legal and market characteristics of selected European loan markets and certain structural features of European CLOs.
In the U.S., we believe that the positive credit trends of 2010 were mainly grounded in improving corporate earnings as well as greater capital markets liquidity, which facilitated significant reductions in the size of the so called "maturity wall." Within the sample universe of publicly filling S&P/LSTA Index issuers, for example, Q3 2010 EBITDA rose by approximately 24%, on the heels of the implementation of cost rationalization measures and/or top-line growth.(22) Furthermore, the stabilization of macroeconomic fundamentals and low interest rates drove strong investor demand for leveraged loan and high yield bond assets, fueling a surge of new issue activity in those markets. Accordingly, 2010 total U.S. institutional loan volumes was up over 300% on the year, totaling $158.0 billion in 2010.(23) Similarly, high yield bond new issue volume rose over 70%, year-over-year, reaching a record $284.0 billion in 2010.(24) A significant portion of these proceeds was used to repay or extend upcoming loan maturities. As a result, approximately $154.0 billion of institutional loans due by year-end 2014 have been extinguished bringing the amount of S&P/LSTA Index loans that are due by year-end 2014 to $265.0 billion, down from $418.0 billion at the end of 2009.(25) In addition, amend-to-extend activity continued, as approximately $50.0 billion of institutional loans launched such extensions during 2010, up from $23.0 billion in 2009.(26) The positive U.S. loan market story was rounded out by continued increases in secondary loan prices and a declining number of obligors rated Caa1/CCC+ or below. The S&P/LSTA Index returned approximately 10.1% during 2010, reaching an average price of 93.6% of par at the end of the year.(27) Finally, the rolling 3-month CCC downgrade rate fell to just 0.07% as of the end of December 2010, down from an average of 3.26% recorded during 2009.(28)
With accelerating U.S. loan prepayments, which rose from approximately 15.6% in 2009 to 27.7% in 2010,(29) many U.S. CLOs were able to rotate a meaningful share of their portfolios into wider-spread new issue loans. In addition, U.S. CLO portfolios continued to benefit from amendment fees, spread increases, and the introduction of LIBOR floors, which further increased the excess interest margin available for distribution to equity tranche holders, such as TFG. Accordingly, equity distributions of U.S. CLOs improved significantly in 2010, as reflected in the over 70% increase in cash receipts from investments experienced by TFG's CLO portfolio during 2010 versus the prior year. TFG's direct bank loan portfolio also benefited from these constructive trends, generating $1.1 million of net realized gains through the end of 2010.
The European leveraged loan market, on the other hand, continued to be weighted-down by sluggish E.U. GDP growth and sovereign debt problems in a number of member countries. Nonetheless, European primary issuance volumes recovered from their 2009 lows. During 2010, approximately EUR42.4 billion of new issue leveraged loans were brought to market in Europe, up from EUR15.4 billion in 2009.(30) In addition, the S&P European Leveraged Loan Index (ELLI) returned 8.4% (excluding currency effects), ending the year at a weighted average bid price of 91.6% of par, as the share of ELLI constituents priced at 90% or above rose to 61% as of 31 December 2010 from 40% at the end of June 2010.(31) In the European CLO context, the slow and uneven pace of macroeconomic recovery was reflected in only modest average gains in European CLO O/C test cushions and persistently high Caa1/CCC-rated asset holdings. Accordingly, the percentage of European CLOs passing their junior O/C test increased to only 60% as of the end of Q4 2010, up from 46% as of the end of Q4 2009.(32)(33) Furthermore, the performance of European CLOs was characterized by significant variance among transactions of the same vintage, reflecting, among other factors, the impact of differing exposures to certain periphery countries and legal jurisdictions as well as collateral manager quality and deal structure.
Consistent with the significant credit quality and price gains experienced by the leveraged loan market, secondary CLO debt and equity prices posted an impressive rally during 2010, particularly during the latter half of the year. Mezzanine debt and equity tranches experienced the most significant gains - with mezzanine tranches gaining from 13-26 points in 2010.(34) Bid-list activity rose by approximately 50% to $18.0 billion in trading during 2010 as mezzanine tranches accounted for approximately 39% of this volume, in contrast to previous years when trading activity was dominated by originally AAA-rated or other senior debt.(35)
Primary CLO issuance activity also began to recover during 2010, with a pick-up in the issuance of arbitrage-driven transactions in the U.S. During 2010, 39 CLO transactions were priced globally totaling approximately $89.0 billion, with over 50% of this volume consisting of European balance sheet deals.(36) Nonetheless, several U.S. arbitrage CLOs totaling approximately $3.3 billion were priced during the year, signaling a revival of arbitrage-driven CLO issuance. Having demonstrated their relative resilience through the 2007-2009 recession and financial crisis, we expect that arbitrage CLOs will remain an important vehicle for accessing diversified leveraged loan risk. Arbitrage CLO equity is typically characterized by a relatively high current yield and low duration, which we believe provide for a compelling return profile for certain investors. Furthermore, with interest rates expected to rise in the mid to long-term, the floating-rate basis of leveraged loans is expected to serve as an important driver of capital inflows into the loan and CLO markets. Consequently, market participants anticipate that 2011 may see continued momentum in primary U.S. arbitrage CLO issuance with volumes of $15.0 to $20.0 billion.(37) This constructive view is grounded in the expectation that fundamental conditions continue to improve or remain stable, and that the funding spread, or the difference between the weighted-average asset spread and liability plus management/administrative costs, will remain wide enough to provide investors with attractive risk-adjusted returns, on both an absolute and relative basis. This will require that, among other factors, credit loss expectations remain low and CLO new issue liability spreads keep pace with leveraged loan spread tightening, which is expected to take place as the U.S. economy recovers.
FAIR VALUE DETERMINATION OF TFG's CLO INVESTMENTS
In accordance with the Company's valuation policies as set forth on the Company's website, the values of TFG's CLO 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 historic, current and potential market developments on the performance of TFG's CLO 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 our inputs and resulting outputs to observable market data when available and appropriate. Fundamentally, the valuation process involves two stages. In stage one, future cash flows for each deal in the CLO portfolio are modeled, using base case assumptions. This generates both the investment IRRs, which are used to drive the recognition of income, and the associated amortized cost. In stage two, a discount rate reflecting the perceived level of risk is applied to those future cash flows to generate a fair value for each investment. Due to elevated market risk premia over the last two years, among other factors, this effective discount rate has typically been higher than the deal's IRR and therefore, in such instances, has resulted in a fair value which is lower than the deal's amortized cost. The difference between these two figures, on an aggregate basis across the CLO portfolio, has been characterized as the "ALR Fair Value Adjustment" or "ALR."(38)
FORWARD-LOOKING CASH FLOW MODELING ASSUMPTIONS
The Investment Manager reviews, and adjusts as appropriate the CLO investment portfolio's future modeling assumptions to factor in historic, current and potential market developments on the performance of TFG's CLO investments. During this year certain key modeling assumptions were recalibrated at the end of Q1 2010 with a further recalibration at the end of Q4 2010.
At the end of Q4 2010, certain key assumptions were as indicated below (listed in no particular order): (39)
- Constant Annual Default Rate ("CADR"): The assumed CADR was approximately 2.2%, which is 1.0x the WARF-implied base-case default rate, until the end of 2011 and approximately 3.2%, or 1.5x the WARF-implied base-case default rate, for 2012-2014 before returning to 1.0x the WARF-implied base-case default rate thereafter. - Recovery Rate: The assumed recovery rate was approximately 71%, or 1.0x the original base-case assumed weighted-average recovery rate for the life of each transaction.(40) - Prepayment Rate: Loan prepayments were assumed to be 20% p.a. or 1.0x the original base-case prepayment rate with a 0% prepayment rate on bonds throughout the life of each transaction. - Reinvestment Price and Spread: The assumed reinvestment price for 2011 was 99% of par, a level that generates an effective spread over LIBOR of approximately 285 bps on broadly syndicated U.S. loans, 316 bps on European loans, and 355 bps on middle market loans. From the beginning of 2012 onwards, the reinvestment price assumption remains at par until the maturity of each of our investments.
These recalibrations, which were described in more detail in the Q1 2010 and Q4 2010 Performance Reports, were intended to better align TFG's cash flow modeling assumptions with observable market data. The changes at the end of Q1 2010 did not have a significant impact on fair value and sought to reduce near-term loss assumptions whilst recognizing the heightened risk around the so-called "maturity cliff" of 2012-2014. Subsequently, the Q4 2010 recalibration continued the adjustment of near-term assumptions to reflect, among other things, the improving market default outlook, as well as the actual performance of TFG's CLO portfolio. These Q4 2010 changes resulted in an increase in fair value of approximately $32.7 million relative to the immediately preceding assumptions utilized.
APPLICATION OF DISCOUNT RATE TO PROJECTED CASH FLOWS AND ALR
Over the first half of the year the effective discount rate applied to the CLO portfolio was in the 28-30% range, which represented a significant spread over the prevailing BB-rated CLO tranche yields. As described in the Q3 2010 Performance Report a combination of a significant decline in observable risk premia and continued improvements in the credit quality and structural strength of many of TFG's CLOs, led to a modification of the discount rates being applied to future expected cash flows.
The 23% discount rate applied to the stronger portion of TFG's CLOs still represents a significant spread over observable yields on BB-rated CLO tranches, but also reflects a recognition that the risk premium demanded on CLO equity has fallen from the peak levels reached during the financial crisis. For the remainder of the portfolio a 30% discount rate has been maintained. When these changes were implemented in Q3 2010 the impact was to increase the carrying value of certain CLO investments and the aggregate portfolio fair value increased by approximately $43.0 million.
Over the course of Q4 2010 and into early 2011 certain observable data and research suggested that this risk premium has been declining further, as evidenced by significant tightening of credit and CLO debt spreads. From a valuation perspective, however, we are mindful of potential volatility, and have therefore maintained the existing discount rates at the end of Q4 2010. Going forward, if, among other things, observable risk premia demonstrate sustainability at these reduced levels it is likely that the aforementioned discount rates will be reduced.
Through the valuation process described above, as at the end of 2010, the ALR has been reduced to approximately $258.0 million as compared to approximately $349.0 million at the start of the year.
PORTFOLIO CORPORATE ACTIONS
TFG and the Investment Manager continued to leverage the Company's majority (or significant) ownership positions in certain CLO transactions to monitor the performance of its CLO investments and to affect the outcome of certain corporate actions so as to protect or enhance the value of those investments. During 2010, TFG consented to the transfer of the Hewett's Island IV CLO transaction onto the LCM platform. In addition, TFG facilitated the appointment of a sub-advisor on two of its CLOs and the outright assignment of collateral management responsibilities on four additional transactions. We expect that these management changes will have a positive effect on the long-term performance of the affected CLOs and will therefore enhance the value of TFG's investments. Due in large part to its majority (or significant) ownership strategy, TFG will also receive a significant share of ongoing management fees in these deals (in the case of Hewett's Island IV, LCM will receive 100% of the ongoing management fees), further improving the economics of these investments.
We believe that these developments highlight the ability of the Investment Manager to create and capitalize upon synergies between TFG's contractual rights, majority (or significant) ownership positions and access to an in-house asset management platform. We expect to continue to utilize these strategic assets to take advantage of similar opportunities to enhance the value of TFG's CLO investments and/or asset management platform in the coming years.
FINANCING SOURCES AND HEDGING ACTIVITY
As of 31 December 2010, TFG had no outstanding debt and the net cash on its balance sheet stood at $103.4 million, compared to $151.6 million at the end of 2009. In addition, the Company owned a direct bank loan portfolio, with a fair value of approximately $97.6 million as of the end of Q4 2010.
As of 31 December 2010, the Company had no credit hedges in place but employed hedges to mitigate its exposure to Euro-USD foreign exchange risk. 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. In the future, our hedging strategy may include the use of single name or index credit hedges, foreign exchange rate hedges, and interest rate hedges, among others.
The Investment Manager continues to examine ways to improve liquidity for TFG shares through, for example, improved analyst and broker coverage, investor communication and "non-deal" road shows. In 2010, the average daily trading volume for TFG shares on Euronext Amsterdam by NYSE Euronext increased to approximately 235,000 from approximately 150,000 in 2009. The Company currently expects to continue to publicly list its shares solely on Euronext Amsterdam by NYSE Euronext as it believes that exchange is favorably suited to address relevant legal, regulatory, liquidity and other commercial considerations.
CAPITAL DISTRIBUTIONS 2010: DIVIDENDS AND SHARE REPURCHASES
The Company has sought to continue to return value to its shareholders. During 2010 TFG paid a dividend of $0.06 per share with respect to Q1 2010, followed by an increased dividend of $0.08 per share paid with respect to each of Q2 and Q3 2010. The dividend was increased further to $0.09 per share with respect to Q4 2010, and will be paid on 25 March 2011. This will result in a total dividend of $0.31 per share for the year.(41)
During 2010, the Company repurchased 5,742,119 TFG shares at an average price of $4.45 per share for a total value of $25.5 million, which brought the total number of shares purchased under the share repurchase program to 11,025,162 at an average price of $4.24 per share. On 1 October 2010, TFG announced the continuation of its share repurchase program. We continue to be confident in the long-term prospects of TFG and believe that the purchase of shares in the market may, at appropriate price levels below NAV, represent an attractive use of TFG's free cash.
Finally, TFG remains focused on returning capital to its shareholders in a manner consistent with protecting the prospects of the Company and pursuing other investment opportunities, both within and beyond the leveraged loan asset class.
ASSET MANAGEMENT PLATFORM
The Company remains committed to its current strategy of expanding its asset management platform and its efforts to continue its transformation into a broad-based financial services firm that functions not only as an investment holding company, but also as a firm that owns interests in multiple operating businesses.
LCM achieved strong results during 2010, characterized by robust performance of its CLOs and growth of assets under management. As of 31 December 2010, all of LCM Cash Flow CLOs continued to pay senior and subordinated management fees and enjoyed significant cushions to their junior-most O/C tests. Taking into account all LCM-managed vehicles, the gross income year-to-date for LCM totaled $12.6 million. Pre-tax profit for the entire LCM business, of which TFG owns 75%, reached approximately $5.8 million as of 31 December 2010.
LCM Asset Management Performance Snapshot Q4 2010 Q3 2010 Q2 2010 Q1 2010 Gross Fee Income ($MM) $3.4 $3.0 $2.9 $3.3 Pre-tax Income ($MM) $1.1 $1.4 $1.4 $1.9
LCM's assets under management grew from approximately $2.5 billion at the end of 2009 to approximately $3.0 billion at year-end 2010. On 8 October 2010, LCM assumed the management of a U.S. CLO, Hewett's Island IV, with the consent of TFG (as a majority equity holder) and certain other debt investors. LCM also closed a new issue CLO, LCM VIII, on 23 November 2010. We were particularly pleased with the successful execution of LCM VIII as we believe it was the only arbitrage-driven U.S. CLO issued in 2010 where a significant portion of the equity tranche was sold to investors unaffiliated with the collateral manager, highlighting LCM's positive market reputation.
In addition, during Q1 2010, TFG launched a direct U.S. loan investment program leveraging LCM's credit expertise to generate attractive risk-adjusted returns while ensuring appropriate liquidity.(42) The portfolio earned $2.7 million of interest income and discount premium and generated approximately $1.1 million of net realized gains from inception through the end of Q4 2010. No defaults or downgrades were registered in the direct loan portfolio. We expect to continue to leverage LCM's expertise to manage TFG's direct bank loan portfolio.
Looking forward, we expect to continue to support the growth of LCM's business via primary CLO issuance, managed accounts, and CLO manager consolidation, as well as other strategic opportunities. We anticipate that, market conditions permitting, LCM will be able to continue to grow its assets under management in a measured and disciplined manner that leverages LCM's expertise, investment style, and performance track record.
During Q3 2010, after evaluating a number of opportunities during the year, TFG acquired a 10% interest in a new multi-jurisdictional real estate venture, GreenOak.(43) GreenOak is a real estate focused principal investing and advisory firm formed in 2010 to capitalize on opportunities in the rapidly changing real estate investing landscape. The firm was founded by John Carrafiell, Sonny Kalsi and Fred Schmidt, collectively, the "GreenOak Founders," who previously worked together for more than a decade at Morgan Stanley managing various real estate businesses.
In exchange for its 10% equity interest in GreenOak, TFG agreed to provide GreenOak with, among other things, a working capital loan of up to $10.0 million (a portion of which has been funded as of year-end) and a $100.0 million co-investment commitment (the "GP Co-Investment") that is expected to fund up to a limited fixed percentage amount of any GreenOak sponsored investment program with TFG retaining the option to invest further amounts.(44) TFG's GP Co-Investment (including amounts invested at its option) will benefit from discounted fees in the applicable investment program. As of year-end, there had been no drawings on the GP Co-Investment. TFG also granted to the GreenOak Founders options with respect to approximately 3% of TFG's listed shares (exercisable after five years and subject to further conditions) at a strike price of $5.50.
We believe that the GreenOak investment is a continuation of the TFG model of seeking to partner with superior asset managers. In addition, the investment is expected to diversify the Company's income stream and underlying asset exposure by providing it with access to the global real estate markets at attractive fee levels. We believe this venture will strengthen TFG's asset management capabilities and along with LCM, will form a foundation for TFG's asset management platform as we look for opportunities both within and beyond the leveraged loan asset class.
GreenOak is currently executing on advisory assignments and continuing to evaluate funds in select markets where we believe the GreenOak Founders and local teams have deep, longstanding market presence, access and experience. As reported previously, we currently do not expect to see operating income benefits from the venture in the immediate future as it is a medium-term investment.
SUMMARY, OUTLOOK AND STRATEGY
2010 was a year of significant improvement in the U.S. leveraged loan markets, characterized by gains in both credit quality and price levels. Having withstood the impact of the U.S. recession and disruption in global capital markets experienced during 2007-2009, U.S. CLOs, on average, experienced significant improvements in collateral quality, structural strength and current yields. While Europe continued to struggle with the consequences of the recession, financial crisis and sovereign debt issues of certain countries, the European leveraged loan and CLO markets also registered modest gains during 2010.
In the eyes of many market participants, the validity of the arbitrage cash-flow CLO model has therefore been once again tested and affirmed. Firstly, we believe that leveraged loans have proven to be an appropriate asset class for securitization, given their senior position in corporate capital structures and historically robust recoveries. Secondly, unlike market-value CLOs and total return swap (TRS) programs, which suffered from aggressive de-leveraging in the face of the price dislocation experienced in the depths of the crisis, cash flow CLOs generally benefited from being largely insulated from market-wide price declines.(45) Thirdly, structural protections which in the face of collateral quality deterioration diverted and/or shut off cash flows to junior and subordinated note holders in order to re-build asset coverage and/or de-leverage the structures, broadly performed as designed allowing for the restoration of cash flows to the equity tranches once the relevant O/C and/or reinvestment tests were brought back into compliance. Finally, and equally importantly in our view, the value of active management and manager selection has once again been borne out through this crisis, as evidenced by the wide range of performance outcomes among CLOs of the same vintage.
As outlined in previous reports, we believe that TFG's strategy of acquiring majority (or significant) equity positions, and maintaining an active, on-going dialogue with our portfolio collateral managers in monitoring the Company's CLO investments, has proven to be an appropriate investment approach to employ in the context of the CLO equity asset class. During 2010, this strategy has allowed us to facilitate the transfer of several CLO transactions to what we believe are more suitable management firms, including the transfer of a U.S. CLO transaction onto the LCM platform, and to appoint a sub-advisor on certain other CLOs. In addition to these management changes, which we believe will have a positive effect on the long-term performance of TFG's CLO investments, the Company will receive a significant share of ongoing management fees in these deals, further improving their economics.
With consensus default expectations for 2011 falling to historical average levels and growing confidence around the sustainability of the current macroeconomic recovery, we are encouraged about the prospects for TFG's investment portfolio. We anticipate that, absent an exogenous shock to certain key global economies or financial markets or other widespread financial market disruption, the Company's CLO investments will continue to generate significant cash flows during the upcoming year, supported by low credit losses, continued reinvestment at attractive yields, stable structural leverage, and the resumption of cash flows on certain CLO transactions which are currently breaching their junior-most O/C tests. In accordance with the Company's valuation policies, as set forth on the Company's website, we also expect to continue to evaluate the appropriateness of certain cash flow modeling assumptions used to generate the investment IRRs, which drive the recognition of income and the associated amortized cost, as well as the discount rates applied to those future cash flows to generate the fair value of each investment. We expect to remain particularly focused on monitoring the sustainability of the decline in observable risk premia on mezzanine CLO debt and equity tranches recorded during 2010, and expect that the aforementioned discount rates may be reduced should these reduced levels persist for a reasonable period of time.
We are also encouraged about the prospects for further growth of primary arbitrage CLO issuance, particularly in the U.S., which we believe will provide us with attractive third-party investments as well as opportunities to continue to grow LCM's asset management platform. Still a number of challenges remain on the horizon which we believe will need to be addressed before a return to normalized issuance levels is possible. First, the preservation of sufficient CLO equity arbitrage, driven primarily by the gap between asset spreads and liability costs, will require further tightening of CLO liability spreads, particularly at the AAA-rated level, as loan spreads trend lower in the context of improving economic conditions. Furthermore, regulatory uncertainty surrounding the implementation of risk retention rules in the United States and Europe may need to be clarified, before certain institutional investors, particularly banks, begin to participate in the new issue market in a meaningful way. Nonetheless, we anticipate that positive drivers of primary CLO issuance, such as the continued quest for yield, rising rates and relative attractiveness of leveraged loan returns, may tend to outweigh the negative factors, leading to continued growth in primary CLO issuance volumes. We believe that LCM will be well-positioned to take advantage of these CLO new issuance opportunities given its strong performance track record, and in our view, favorable market reputation.
Throughout 2008 and 2009, we were focused on preserving the Company's CLO investments, financial position, and long-term prospects, a strategy which was necessitated by the economic downturn and disruption in the capital markets that characterized that period. During 2010, with TFG's investment cash flows improved, we returned our focus to identifying opportunities, assets and asset classes that we believe to be superior based on their long-term track record, and to making investments that we believed could achieve this aim. To that end, TFG expanded its asset management platform with its acquisition of a 10% interest in GreenOak and increased its CLO investment portfolio through the purchase of a majority position in a new issue CLO, LCM VIII, as well as a small secondary equity purchase. The Company was also able to leverage LCM's expertise to make direct investments in loan assets, which totaled approximately $100.0 million in par amount at the end of the year.
In 2011, we expect to use TFG's strong cash flows to build value for shareholders in a variety of ways. In particular, we are focused on continuing TFG's transition beyond an investment holding company to an owner of interests in multiple operating companies across different asset classes. As such, we will look to continue to grow LCM's assets under management through the issuance of new issue CLOs and the assumption of existing management contracts, as well as to continue to provide the agreed support to GreenOak during the year. In order to strengthen and diversify our asset management businesses, we expect to continue to explore investment opportunities in management companies both within and beyond the leveraged loan market. With regards to our investment portfolio, we intend to evaluate potential investments in new issue CLOs, especially those managed by LCM. Furthermore, we will continue to seek opportunities to enact positive changes to our CLO investments. Finally, as we have done in the past, we will look to return capital to TFG shareholders through dividends, share repurchases or other means.
Please refer to the section entitled "Risk Factors" herein and a more complete description of risks and uncertainties pertaining to an investment in TFG on the Company's website at: http://www.tetragoninv.com.
FINANCIAL REVIEW 2010
2010 turned out to be a year of stellar performance for TFG, with a mix of strong portfolio performance and improving outlook for CLOs - the driving force behind the robust financial results recorded during the year. The first half of 2010 saw a continuation of the recovery that began in the latter half of 2009, with many deals curing junior O/C test breaches, switching-on equity cash flows, and benefiting from increased excess interest margins, thereby boosting future cash flow expectations. As we moved into the second half of 2010, CLO performance improved at a rapid pace, against a backdrop of improving expectations for the U.S. leveraged loan market and renewed investor appetite for CLO risk across all tranches. The last two developments were key drivers of the recalibration of assumptions and adjustment of discount rates applied to the deals, which further assisted the Company's performance.
CONSOLIDATED INCOME COMPARISON 2010 VS. 2009 2010 2009 Statement of Operations Consolidated Consolidated ($MM) ($MM) Interest Income 178.9 165.7 CLO Management Fee Income 12.6 - Other Income 2.5 1.2 Investment Income 194.0 166.9 Management and Performance Fees (133.5) (42.2) Other Expenses (10.7) (3.0) Total Operating Expenses (144.2) (45.2) Net Investment Income 49.8 121.7 Net Change in Unrealized Appreciation/(Depreciation) in Investments 336.0 (427.7) Realized Gain/(Loss) on Investments 1.1 - Realized and Unrealized Gains/(Losses) from Hedging and FX 2.1 (9.1) Realized / Unrealized Losses from Investments and FX 339.2 (436.8) Income Taxes (2.4) - Noncontrolling Interest (1.4) - Net Increase/(Decrease) in Net Assets from Operations 385.2 (315.1)
2010 net income of $385.2 million was driven by the combination of interest income ($178.9 million) and unrealized appreciation on investments ($336.0 million). As expected, this combined income was generated almost exclusively from the CLO portfolio, although the direct loan portfolio contributed approximately $4.5 million of income via interest and unrealized appreciation, with an additional $1.1 million of realized income. In addition, CLO management fee income from the LCM asset management platform contributed $12.6 million to investment income during the year, while other income from CLO corporate action consent fees approximately doubled to $2.5 million.
As expected, expenses grew during the year, with incentive and management fees increasing to $133.5 million as a result of the increase in NAV and strong performance. The increase in other expenses to $10.7 million was primarily a result of the addition of LCM onto the TFG platform, which incurred $6.7 million of operating expenses.
CONSOLIDATED INCOME - 2010 QUARTER ON QUARTER COMPARISON
The quarter-on-quarter comparison of consolidated net income (see table below) reinforces the message of strong performance throughout the period, but with two stand-out quarters recorded at the end of the year.
TFG Quarterly Statement of Operations Statement of Operations Q4 Q3 Q2 Q1 Total 2010 2010 2010 2010 2010 ($MM) ($MM) ($MM) ($MM) ($MM) Interest Income from Investments 46.5 45.8 43.4 43.2 178.9 CLO Management Fee Income 3.4 3.0 2.9 3.3 12.6 Other Income 1.4 0.5 0.3 0.3 2.5 Investment Income 51.3 49.3 46.6 46.8 194.0 Management and Performance Fees (45.6) (42.7) (19.8) (25.4) (133.5) Other Expenses (3.5) (2.7) (2.6) (1.9) (10.7) Total Operating Expenses (49.1) (45.4) (22.4) (27.3) (144.2) Net Investment Income 2.2 3.9 24.2 19.5 49.8 Net Change in Unrealized (Depreciation) / Appreciation in Investments 128.8 121.3 31.4 54.5 336.0 Net Realized Gain / (Loss) on Investments 0.5 0.3 0.3 - 1.1 Realized / Unrealized Gains / (Losses) From Hedging and FX 1.2 0.2 0.7 - 2.1 Realized / Unrealized Gains / (Losses) from Investments and FX 130.5 121.8 32.4 54.5 339.2 Income Taxes (0.4) (0.4) (0.4) (1.2) (2.4) Noncontrolling Interest (0.3) (0.3) (0.6) (0.2) (1.4) Net Increase / (Decrease) in Net Assets from Operations 132.0 125.0 55.6 72.6 385.2
FINANCIAL HIGHLIGHTS TABLE
The table below illustrates a number of key financial and other metrics, certain of which have been the focus of previous parts of the Financial Review section. Cash generated by the CLO investment portfolio staged a strong comeback during 2010 as deals repaired themselves and cash flow payments to the equity tranches resumed. By the end of Q4 2010 cash receipts of $0.66 per share were the highest since the end of Q2 2008.
Financial Highlights Q4 2010 Q3 2010 Q2 2010 Q1 2010 Net Income ($MM) $132.0 $125.0 $55.6 $72.6 EPS ($) $1.09 $1.03 $0.45 $0.58 Cash Receipts ($MM)(46) $78.9 $71.8 $60.9 $51.1 Cash Receipts per Share ($) $0.66 $0.59 $0.50 $0.41 Net Cash Balance ($MM) $140.6 $187.9 $156.2 $172.6 Net Assets ($MM) $1,138 $1,019 $909 $867 Number of Shares Outstanding (million) 120.1 120.8 122.2 123.6 NAV per Share ($) $9.47 $8.43 $7.44 $7.02 DPS ($) $0.09 $0.08 $0.08 $0.06 Weighted Average IRR on Completed Transactions (%) 15.1% 13.7% 13.1% 12.3% Number of Investments(47) 70 68 68 68 ALR Fair Value Adjustment ($MM) $(258.0) $(274.7) $(330.7) $(339.5) (table continues) Q4 2009 Q3 2009 Q2 2009 Q1 2009 Net Income ($MM) $94.7 $31.2 $(26.7) $(414.3) EPS ($) $0.76 $0.25 $(0.21) $(3.29) Cash Receipts ($MM)(46) $38.4 $35.3 $31.9 $47.1 Cash Receipts per Share ($) $0.31 $0.28 $0.25 $0.37 Net Cash Balance ($MM) $174.4 $149.7 $123.8 $94.3 Net Assets ($MM) $807 $721 $693 $723 Number of Shares Outstanding (million) 124.8 126.2 125.9 125.7 NAV per Share ($) $6.47 $5.71 $5.50 $5.75 DPS ($) $0.06 $0.03 $0.03 $0.03 Weighted Average IRR on Completed Transactions (%) 11.9% 10.3% 9.2% 10.6% Number of Investments(47) 61 61 61 61 ALR Fair Value Adjustment ($MM) $(349.0) $(333.8) $(254.1) $(315.0)
CASH FLOW FROM OPERATIONS
2010 cash flows from operating activities increased by almost 90% year-over-year, reflecting the recovery in CLO cash flows described previously. In 2009 these cash flows were largely added to the overall cash balance as the Company took a protective stance towards the portfolio. By contrast, during 2010 TFG was able to allocate $126.9 million to net purchases of investments, in addition to increasing the share buy-back and dividend programs as well as paying incentive fees generated by the Company's strong performance.
Cash Flow From Operations 2010 2009 $MM $MM Operating Activities Operating Cash Flows Before 259.4 139.6 Movements in Working Capital Increase / (Decrease) in 2.3 (0.6) Payables Cash Flows from Operating 261.7 139.0 Activities Investment Activities Proceeds on Sales of 71.0 - Investments Purchase of Investments (205.7) - Cash Flows from Operating 127.0 139.0 and Investing Activities Amounts Due from Brokers 1.6 108.5 Net Purchase of Shares (20.3) (4.9) Dividends Paid to (34.2) (15.1) Shareholders Repayments on Repurchase and - (117.5) Swap Agreements Distribution to (0.1) - Noncontrolling Interest Incentive Fees Paid (107.8) - Cash Flows from Financing (160.8) (29.0) Activities Net (Decrease) / Increase in (33.8) 110.0 Cash and Cash Equivalents Cash and Cash Equivalents at 174.4 63.0 Beginning of Period Effect of Exchange Rate - 1.4 Fluctuations on Cash and Cash Equivalents Cash and Cash Equivalents at 140.6 174.4 End of Period
Net assets returned to levels last seen at the end of 2008, as the fair value of TFG's CLO portfolio bounced back strongly and, as mentioned previously, the Company added a portfolio of approximately $100.0 million of directly held U.S. leveraged loans. The $5.2 million of other investments represents the initial carrying value of the investment in GreenOak, the fair value of the working capital loan that TFG made to GreenOak, and the CLO management contracts held.
Consolidated Balance Sheet Summary 2010 2009 $MM $MM Investments in CLO Equity 932.7 655.2 Investments in Bank Loans 97.6 - Other Investments 5.2 - Cash and Cash Equivalents 140.6 174.4 Other Assets/Liabilities (37.2) (22.8) Net Assets Before Noncontrolling 1,138.9 806.8 Interest Noncontrolling Interest 1.4 - Total Equity Attributable to TFG 1,137.5 806.8
DESCRIPTION OF BUSINESS
TFG (company number 43321) is a Guernsey closed-ended investment company that currently invests primarily in selected securitized asset classes and aims to provide stable returns to investors across various credit and interest rate cycles. 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.
As described above, the Company's investment objective is to generate distributable income and capital appreciation. To achieve this objective, and to aim to provide stable returns to investors across various interest rate and credit cycles, 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 favorable transactions. 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.
From inception through 31 December 2010, the Tetragon Financial Group Master Fund Limited (company number 43322) has acquired CLO investments with an end-of-year fair value of approximately $932.7 million.
Senior secured bank loans represent the substantial majority of assets underlying the CLO portfolio. The Company currently gains exposure to these assets primarily through investments in the residual tranches or equity tranches of CLO products ("Residual Tranches") and also has had exposure through previous investments in the Residual Tranches of collateralized debt obligation products, which are both securitized interests in underlying assets assembled by asset managers and divided into tranches based on their degree of credit risk ("Securitization Vehicles").
The Company currently invests in a broad range of CLO products, utilizing 29 asset managers, and its underlying assets are diversified on a geographic and industry sector basis. Interest rate and funding risk are sought to be mitigated through the long-term matched funding embedded in the CLO structure (i.e., the assets acquired bear interest by reference to a floating rate similar to the funding source for those assets).
The Company remains committed to its current strategy of expanding its asset management platform and its efforts to continue its transformation into a broad-based financial services firm that functions not only as an investment holding company, but also as a firm that owns interests in multiple operating businesses.
The Company also owns a 75% interest in LCM, an asset manager with approximately $3.0 billion of loan assets under management as of year-end 2010 that yielded positive results for the Company's investment performance. The Company also owns a 10% an equity interest in GreenOak, which it views as a medium-term investment.
On 22 February 2011, TFG and the Master Fund and their six directors were served with proceedings in the Royal Court of Guernsey (the "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.(48)
CERTAIN CORPORATE BACKGROUND
Shares of TFG (the "Shares") are publicly traded solely on the Euronext Amsterdam by NYSE Euronext 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 and the Service Providers (as defined below). 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, and continues to believe, after analyzing various listing alternatives within the United States and Europe, that Euronext 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.
Tetragon Financial Management LP (the "Investment Manager") 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. The General Partner and the Investment Manager are affiliated with Polygon Investment Partners LLP (together with its other affiliated management companies, other than the Investment Manager and the General Partner, "Polygon") which is controlled by Reade Griffith and Paddy Dear. 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. 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, Alexander Jackson and Paddy Dear (the "Principals") 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 currently consists of the Principals. 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 Investment Partners LLP and Polygon Investment Partners LP (together, the "Service Providers") provide the Investment Manager with certain services in relation to Company pursuant to a Services Agreement dated 26 April 2007. The Service Providers also provide operating, infrastructure and administrative services to LCM and GreenOak and to various Polygon managers pursuant to applicable services agreements.
INVESTMENT MANAGEMENT (continued)
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, the Company granted to the Investment Manager options (the "Investment Management Options") to purchase 12,545,330 of the Company's Non-Voting Shares 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 Amsterdam Exchange and will remain exercisable until the 10th anniversary of that date.
For more information on TFG's investment manager, including a summary of key terms of the Investment Management Agreement, please refer to the Company's website at http://www.tetragoninv.com.
HISTORICAL APPROACH TO INVESTMENTS
The Investment Manager has sourced investment opportunities both within and beyond the leveraged loan market through a variety of channels, including the Investment Manager's network of direct relationships with major commercial and investment banks and asset managers.
The current performing CLO investment portfolio is composed solely of substantial positions in the Residual Tranches of a broad range of CLO products. Residual Tranches will in most cases be unrated and represent the "equity" or "first loss" position of a CLO.
The Investment Manager believes by taking majority or substantial positions in the Residual Tranches, the Company may influence various features within a CLO or its applicable collateral management terms that could improve the value of its investment.
CLO ASSET CLASS SELECTION
The Investment Manager has to date focused primarily on utilizing CLO Securitization Vehicles to achieve its investment objective and has sought to employ a multiple asset class investment strategy, including through such Securitization Vehicles.
The Investment Manager has sought to select the Company's target asset classes following an analysis of key factors affecting returns; including (i) credit spread risk premiums, (ii) economic and credit cycles, and (iii) rating agency analyses.
As previously described, the asset class primarily represented in the Company's current CLO portfolio consists of leveraged loans, comprised of (a) broadly syndicated senior secured loans of U.S. borrowers; (b) broadly syndicated senior secured loans of European borrowers; and (c) middle-market senior secured loans of U.S. borrowers. Notwithstanding the Investment Manager's focus to date on the leveraged loan asset class, the Investment Manager has and may continue to seek to achieve its investment objective through investments in other opportunities, assets or asset classes, which may be unrelated to the leveraged loan asset class.
ASSET MANAGER SELECTION
In selecting asset managers, the Investment Manager has sought to take advantage of the significant experience of certain of the Principals. In conducting its assessment of an asset manager, the Investment Manager reviews certain aspects of such asset manager's business, such as the manager's reputation, personnel, research capabilities, financial strength, business infrastructure, asset manager ratings, and, generally, its ability to appropriately manage the underlying asset portfolio as well as its prior dealings with the Company or its Principals.
The Investment Manager has sought to select asset managers (including, LCM and GreenOak) that it believes to be superior and has looked to select asset managers with a demonstrated strength in the applicable market, fundamental analysis and the management of assets on a long-term basis consistent with its buy-and-hold strategy. Notwithstanding the acquisition of LCM, the Company expects to continue to seek and enjoy diversification of CLO asset managers.
ASSET MANAGER SELECTION (continued)
The Company believes that, as a result of (among other things) the reduction in CLO issuance volumes from 2008 through 2010, the CLO asset manager industry may continue to face some consolidation pressures as was evidenced in years past as several managers exited the market or otherwise reorganized, including certain of the Company's CLO managers. The Company realized value on several of its CLO investments in connection with such activity in 2010.
The Company continues to selectively explore strategic business opportunities in asset management, both within and beyond the leveraged loan market as such opportunities may offer, among other benefits, high quality, repeatable, income streams that diversify the Company's current income.
The Investment Manager has sought to diversify its exposures across underlying asset classes, industry sectors, geographies and asset managers. For risk management purposes, the Investment Manager analyzes risks and may where appropriate engage in hedging strategies on both a portfolio-wide basis as well as a single-name basis.
At any given time, certain geographic areas, asset types or industry sectors may provide more attractive investment opportunities than others and, as a result, the Company's investment portfolio may be concentrated in particular geographic areas, asset types or industry sectors. Please refer to the Company's monthly updates on the Company's website (http://www.tetragoninv.com) for a review of the Company's underlying investments' bank loan industry exposure for the relevant period. Due to the overlap of investments of different asset managers, there may be concentrations of individual credits from time to time.
The substantial majority of the Company's currently performing investments are in CLOs. Notwithstanding the efforts of the Investment Manager to diversify across underlying assets, the Company's investments (including, LCM) could face significant downward pressure as Securitization Vehicles, such as CLOs, generally come under increased market pressure. For example, 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. Similarly, the fee revenue earned by LCM, in its capacity as collateral manager to certain CLOs, may be negatively impacted by the performance of such CLOs underlying assets.
The emphasis of the Investment Manager's existing 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 Investment Manager may dispose of portfolio positions from time to time and may reallocate investments in the portfolio within and among asset classes on a discretionary basis. 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 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 Fund Services (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 incentive fees. The Company's valuation policies are set forth on the Company's website at 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.
The Company has sought to continue to return value to its shareholders, including through dividends and share repurchases.
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 methods of improving the liquidity of its shares.
Please refer to the section entitled "Risk Factors" herein and a more complete description of risks and uncertainties pertaining to an investment in TFG on the Company's website at: http://www.tetragoninv.com .
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 outstanding shares of TFG.
In addition, in accordance with the requirements of Euronext Amsterdam by NYSE Euronext 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. 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.
The Directors of TFG confirm that (i) this Annual Report constitutes the TFG management review for the twelve month period ended 31 December 2010 and contains a fair review of that period and (ii) the 2010 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.
An investment in TFG 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 the Company'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 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. - 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. Furthermore, no formal corporate governance code applies to TFG. Additional information on the organizational structure and corporate governance of TFG may be found on the Company'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 Euronext Amsterdam by NYSE Euronext 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 Euronext Amsterdam by NYSE Euronext. 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. - GreenOak is a newly formed entity with no prior 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 - As the Company invests in new asset classes and as its asset mix changes, its revenues and profitability could be reduced. - As the Company becomes more of a financial services firm that functions not only as an investment holding company, but also 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, regulatory environment, and competition. - 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.
LETTER TO SHAREHOLDERS
(1) TFG's corporate loan default rate for 2010 of 1.7% was approximately 24% below the 2.2% annual WARF-implied default rate used as a historical average rate within TFG's assumption framework. WARF is a par-weighted average of the Rating Factors of each of the assets in the collateral pool. A Rating Factor is a numerical value assigned to each rating category by Moody's. For example a "B2" rating has a Rating Factor of 2,720 whereas a B3 rating corresponds to a Rating Factor of 3,490. Please refer to "Moody's Approach to Rating Collateralized Loan Obligations", published on 31 December 2008 for additional information.
(2) Please refer to a press release as of 8 August 2010 titled "Tetragon Financial Group Limited ("TFG") to Pursue Real Estate Venture" for additional information.
(3) For additional information please refer to the Company's website at http://www.tetragoninv.com.
(4) Such return is based on the following assumptions: TFG shares were purchased at a price of $3.91 per share on 31 December 2009, quarterly dividends of $0.28 per share for the year were reinvested into the shares of TFG on each dividend ex-date during the year (1 March 2009 at $3.90 per share, 29 April 2010 at $4.38 per share, 3 August 2010 at $4.18 per share, and 1 November 2010 at $5.38 per share) and all shares were sold at the closing price of $5.70 per share on 31 December 2010.
2010 PERFORMANCE AT A GLANCE
(5) S&P/LCD U.S. Leveraged Lending Review 4Q 2010. Please note that TFG's investment portfolio includes approximately 9.6% CLOs with primary exposure to European broadly syndicated senior secured loans and such loans are included in the calculation of TFG's corporate loan default rate.
(6) Based on the most recent trustee reports available for our investments as of 31 December 2010.
(7) Morgan Stanley CDO Market Tracker, 5 January 2011; based on a sample of 477 U.S. CLO transactions.
(8) Please note that as of 31 December 2010, TFG's investment portfolio included approximately 9.6% CLOs with primary exposure to European broadly syndicated senior secured loans and such loans are included in the calculation of TFG's % of CLOs failing junior par coverage tests and % of Caa1/CCC+ or below rated assets. Since the market-level statistics cited above are limited to U.S. CLOs they may not be perfectly comparable to TFG's portfolio.
(9) Excess Caa/CCC+ or below rated assets above the transaction specific permitted maximum holding levels are generally haircut in our transactions at market value for purposes of the over-collateralization and/or interest reinvestment test ratios.
(10) Morgan Stanley CDO Market Tracker, 5 January 2011; based on a sample of 477 U.S. CLO transactions. Please note that as of 31 December 2010, TFG's investment portfolio included approximately 9.6% CLOs with primary exposure to European broadly syndicated senior secured loans and such loans are included in the calculation of % of Caa1/CCC+ or below rated assets.
(11) The net cash position is calculated as total cash less net liabilities.
(12) The LCM I, LCM II, LCM III, LCM IV, LCM V, LCM VI, and LCM VIII 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. 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.
(13) Based on a weighted average share count, excluding treasury shares, of 120.1 million for 2010 and 125.8 million for 2009.
(14) The hurdle rate is reset each quarter using 3M USD LIBOR plus a spread of 2.647858% in accordance with TFG's investment management agreement. Please see the TFG website, www.tetragoninv.com, for more details.
INVESTMENT MANAGER'S REPORT
(15) 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.
(16) As of 31 December 2010 TFG continued to hold two non-performing CDO investments, all of which were in the form of securitization vehicles other than CLOs. We do not expect to collect any additional cash flows from these investments.
(17) Based on the most recent trustee reports available for both our U.S. and European CLO investments as of 31 December 2010.
(18) Please note that the number of unique CLO transactions held by TFG has increased from 60 as of 31 December 2009 to 66 as of 31 December 2010.
(19) As of 31 December 2010, European CLOs represented approximately 9.6% of TFG's investment portfolio; approximately 83% of the fair value of TFG's European CLOs and 60%, when measured on a percentage of European transactions basis, were passing their junior-most O/C tests
as of the end of Q4 2010.
END NOTES (continued)
INVESTMENT MANAGER'S REPORT
(20) As O/C tests are breached, CLO structures may divert excess interest cash flows away from the equity tranche holders, such as TFG, to pay down the CLO's debt thereby curing the O/C breach via deleveraging. Accordingly, the affected investments ceased to generate cash flows to TFG or are expected to cease generating cash flows on the next applicable payment date. Once enough debt has been repaid to cure the O/C test breach, distributions of excess interest cash to equity holders may resume to the extent not precluded by the investments' realized or unrealized losses.
(21) Morgan Stanley CDO Market Tracker, 5 January 2011; based on a
sample of 477 U.S. CLO transactions.
(22) S&P/LCD Quarterly Review, Q4 2010.
(23) S&P/LCD Quarterly Review, Q4 2010.
(24) S&P/LCD Quarterly Review, Q4 2010.
(25) S&P/LCD Quarterly Review, Q4 2010.
(26) S&P/LCD Quarterly Review, Q4 2010.
(27) S&P Leveraged Commentary and Data, "Full Index analysis: Loans
return 10.13% in no-drama 2010." 4 January 2011.
(28) S&P/LCD Quarterly Review, Q4 2010.
(29) S&P/LCD Quarterly Review, Q4 2010.
(30) S&P Leveraged Commentary and Data, "(EUR) Leveraged loan volume recovers in 2010 after miserable 2009," 4 January 2011.
(31) S&P Leveraged Commentary and Data, "(EUR) S&P ELLI finishes 2010 with December rally," 13 January, 2011.
(32) Morgan Stanley CDO Market Tracker, 5 January 2011; based on a sample of 196 European CLO transactions.
(33) Morgan Stanley CDO Market Tracker, 8 January 2010; based on a sample of 207 European CLO transactions.
(34) Morgan Stanley CDO Market Tracker, 5 January 2011.
(35) Morgan Stanley CDO Market Tracker, 5 January 2011.
(36) Morgan Stanley CDO Market Tracker, 5 January 2011. Balance sheet deals are typically securitizations of bank-held portfolios and are motivated by capital relief goals rather than arbitrage opportunities.
(37) Morgan Stanley CDO Market Tracker, 5 January 2011.
FAIR VALUE DETERMINATION OF TFG's CLO INVESTMENTS
(38) The Accelerated Loss Reserve is transaction specific. The Accelerated Loss Reserve is a direct adjustment to the fair value of an investment to account for the potential impact of certain potential losses and the cumulative value of such adjustments is evidenced in TFG's financial statements.
FORWARD-LOOKING CASH FLOW MODELING ASSUMPTIONS
(39) Please note that TFG undertakes no obligation to update public disclosure with respect to these or other modeling assumptions, except as required by law.
(40) The base-case weighted-average recovery rate represents the weighted average of expected recoveries for each transaction based on our assumed recoveries on each asset class and each transactions' targeted asset mix, assuming 75% recovery on first-lien U.S. loans, 70% on first-lien European loans, 50% recovery on U.S. second-lien loans and mezzanine loans, and 30% recovery on high yield bonds.
CAPITAL DISTRIBUTIONS 2010: DIVIDENDS AND SHARE REPURCHASES
(41) For additional information please refer to the Company's website at http://www.tetragoninv.com.
(42) As of 31 December 2010, this direct loan portfolio totaled approximately $100.0 million in par amount with a fair value of $97.6 million.
(43) Please refer to a press release as of 8 August 2010 titled "Tetragon Financial Group Limited ("TFG") to Pursue Real Estate Venture" for additional information.
(44) In connection with the transaction, an affiliate of the Investment Manager, Polygon Management L.P. ("Polygon Management"), agreed to also provide GreenOak with a working capital loan and has made a limited co-investment commitment. Furthermore, certain Polygon Management affiliates entered into an agreement with GreenOak to provide operating, infrastructure and administrative services to the business. Polygon Management also provided the GreenOak Founders with an equity interest in Polygon. Polygon Management, in turn, received an equity interest in GreenOak.
SUMMARY, OUTLOOK AND STRATEGY
(45) Cash flow CLOs are not fully insulated from price declines in the underlying assets as a number of "stressed" asset categories, including excess Caa1/CCC+ and defaulted assets are typically carried at the lower of market value and rating-agency assigned recovery rate for O/C test purposes.
FINANCIAL HIGHLIGHTS TABLE
(46) Gross cash receipts from CLO portfolio.
(47) Excludes CDO-squared and ABS CDO transactions written off in October 2007. TFG continues to hold the economic rights to 3 of these written-off transactions.
DESCRIPTION OF BUSINESS
(48) By the 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.
BOARD OF DIRECTORS Paddy Dear Reade Griffith Byron Knief* Rupert Dorey* David Jeffreys* Greville Ward* *Independent Director SHAREHOLDER INFORMATION Registered Office of TFG and the Master Fund Tetragon Financial Group Limited Tetragon Financial Group Master Fund Limited Tudor House Le Bordage St. Peter Port, Guernsey Channel Islands GYI 3PF Investment Manager 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 Investor Relations David Wishnow/Yuko Thomas firstname.lastname@example.org Press Inquiries Brunswick Group Andrew Garfield/ Gill Ackers / Pip Green email@example.com +44(0)2074045959 Auditors KPMG Channel Islands Limited 20 New Street St. Peter Port, Guernsey Channel Islands GY1 4AN Sub-Registrar and Transfer Agent The Bank of New York One Wall Street New York, NY 10286 United States of America Issuing Agent, Dutch Paying and Transfer Agent Kas Bank N.V. Spuistraat 172 1012 VT Amsterdam The Netherlands Legal Advisor (as to U.S. law) Cravath, Swaine & Moore LLP One Ropemaker Street London EC2Y 9HR United Kingdom Legal Advisor (as to Guernsey law) Ogier Ogier House St. Julian's Avenue St. Peter Port, Guernsey Channel Islands GY1 1WA Legal Advisor (as to Dutch law) De Brauw Blackstone Westbroek N.V. Claude Debussylaan 80 1082 MD Amsterdam The Netherlands Stock Listing Euronext Amsterdam by NYSE Euronext Administrator and Registrar State Street Fund Services (Guernsey) Limited Tudor House Le Bordage St. Peter Port, Guernsey Channel Islands GYI 3PF