LONDON, March 6, 2012 /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, equity, interest rate and real estate cycles. TFG is traded on the NYSE Euronext in Amsterdam 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").(i) 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 credit, equity, interest rate and real estate 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.
The Company maintains two key business segments: an investment portfolio and an asset-management platform.
(i) TFG invests substantially all its capital through the Master Fund, in which it holds a 100% share.
Contents Letter to Shareholders 1 2011 Performance at a Glance 5 Investment Manager's 2011 Highlights 5 Financial Results Summary 6 Investment Portfolio Summary 6 Investment Manager's Report 7 Investment Portfolio Overview 7 Asset Management Platform 9 Portfolio Corporate Actions 9 Financing Sources and Hedging Activity 10 Capital Distributions 2011 10 Summary, Outlook and Strategy 11 Financial Review 2011 14 Consolidated Income Comparison 14 EPS Attribution 15 Financial Highlights 15 Cash Flow from Operations 16 Net Assets 16 Fair Value Determination of TFG's CLOs 17 Cash Flow Modeling Assumptions 17 Application of Discount Rate 19 Description of Business 20 Risk Factors 24 End Notes 27
Tetragon Financial Group Limited
2011 Audited Consolidated Financial Statements
Tetragon Financial Group Master Fund Limited
2011 Audited Consolidated Financial Statements
TO OUR SHAREHOLDERS
We are pleased to report that TFG posted strong results in 2011 despite mixed and often challenging market conditions. We believe the financial results for both of TFG's business segments (its investment portfolio and its growing asset management platform) reflect the underlying strength and positive momentum of the Company. Key financial metrics for TFG's consolidated businesses include:
- Earnings per Share: - Distributions: TFG - Net Asset Value Increased to $3.46 in paid or declared $0.395 ("NAV") per Share: Grew 2011, up 10% compared to per share in 2011, an to $12.71, an increase 2010, mainly driven by the increase of 27% over of 34% from Q4 2010 and continued strong credit 2010. We also used over 96% above the level at performance of the $35.0 million to buy the end of 2009. underlying U.S. loan back shares below NAV. portfolio, accessed via both CLOs and direct loan investments and supported by another strong year for LCM, TFG's loan management platform.
The following charts show the split of net assets by asset class at the end of 2011 ($1,474,355,249) and 2010 ($1,137,546,494), respectively.
2011 $1,474,355,249 U.S. CLOs $1,024,016,687 $1,474,355,249 100% Euro CLOs $123,363,841 Direct Loans $107,122,589 Asset Managers $7,643,641 Real Estate Funds $2,407,367 Cash Less Net Liabilities $209,801,124 2010 U.S. CLOs $833,695,319 $1,137,546,494 77% Euro CLOs $98,981,420 Direct Loans $97,598,898 Asset Managers $5,213,343 Cash Less Net Liabilities $102,057,514
Investment Portfolio Segment: Leveraging TFG's core strengths in corporate credit, accessed mainly via CLOs, while diversifying into other asset types.
TFG's U.S. CLO and direct loan portfolios performed well through the volatility of 2011.
- Cash Flows: TFG - Collateral - CLO Returns: generated $411.6 million Performance: U.S. CLO Weighted-average IRRs of cash flows from its CLO equity investments on CLO equity equity investments in 2011 performed well in terms investments rose to versus $262.7 million in of defaults and CCC 17.6%, up from 15.1% at 2010, up 57% as net holdings, with 100% the end of Q4 2010. As interest margins improved.(2010: 100%) of such of the end of 2011, TFG CLOs passing their had indirect exposure junior-most O/C tests, to leveraged loans although CLO equity totaling approximately investments in Europe $18.4 billion via such did not fare as well. CLOs.
By holding the majority of CLO equity tranches, TFG has added further opportunities to deliver value to shareholders in 2011.
TFG typically takes majority equity stakes in CLO structures. We believe that this approach has served shareholders well and that the CLO portfolio has been able to weather the financial storms of the past few years, in part because of our long-term focus. In addition, TFG has continued to actively explore opportunities arising out of reorganizations and other personnel changes affecting its CLO managers. In some cases, these opportunities have resulted in TFG receiving a portion of ongoing management fees from the affected CLO managers, which has been a tangible benefit to shareholders: in 2011 alone, such management fees totaled approximately $6.7 million (excluding fees earned by LCM Asset Management LLC, "LCM").
The performance of TFG's other loan investment assets has also been positive. The direct loan portfolio, which totaled approximately $107.1 million at the end of 2011, generated $0.9 million of net realized gains and $5.8 million of interest income and accrued discounts in 2011. The loan portfolio did not suffer any defaults during the year.
TFG has been among the market leaders in CLO new issuance as the primary market re-opened.
TFG continued to add CLO equity investments in 2011, investing approximately $47.2 million in two new issue CLOs (one of which is managed by LCM) and $15.7 million in four secondary CLOs, which were deals already represented in the CLO portfolio. In addition, as of the end of 2011, we had anticipated investing into two new issue CLOs (including an LCM-managed CLO), which have since closed in Q1 2012 (totaling $42.3 million of CLO equity investments).
TFG further diversified its investment portfolio during 2011 and early 2012.
- Mezzanine Tranches: TFG recently - Real Estate: TFG sought to invested $1.1 million in a mezzanine increase its holdings of real debt tranche of a U.S. CLO already estate assets by investing in represented in TFG's CLO equity vehicles managed by GreenOak Real opportunities in mezzanine debt Estate, LP ("GreenOak"). Through tranches where TFG controls the the end of 2011, TFG held optional call rights. approximately $2.4 million of equity in commercial real estate assets in Japan and the United States and had committed to make further investments into both of GreenOak's U.S. fund and its Japan fund, which had its first closing early in 2012.
We will continue to seek to diversify the investment portfolio across asset classes and types, industries, geographies and investment duration.
Asset Management Segment: Furthering the goal of building a broad-based financial services firm.
We remain committed to growing our asset management businesses. We believe that TFG owning or having stakes in asset management businesses may provide repeatable income streams and reduced fees paid to third-party managers.
In 2011 LCM again delivered strong performance and business growth.
LCM, TFG's loan management business, grew pre-tax income 41% year-over-year (ending 2011 at $8.2 million) and assets under management by nearly 15 (ending 2011 at $3.4 billion). To date, all senior and subordinated management fees on LCM Cash Flow CLOs (2) remain current.
We note that the carrying value of this business on TFG's balance sheet is approximately $0.1 million.
LCM: Assets Under Management History ($MM) Deal Name Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Pre-Acquisition CLOs $ 2,354 $ 2,341 $ 2,314 $ 2,268 $ 2,238 Post-Acquisition CLOs $ - $ - $ - $ 671 $ 671 Total $ 2,354 $ 2,341 $ 2,314 $ 2,939 $ 2,909
LCM: Assets Under Management History ($MM) Deal Name Q2 2011 Q3 2011 Q4 2011 Pre-Acquisition CLOs $ 2,161 $ 2,076 $ 2,036 Post-Acquisition CLOs $ 1,322 $ 1,323 $ 1,323 Total $ 3,484 $ 3,399 $ 3,359
GreenOak has gained significant momentum in recent months and we believe it is well-placed for accelerated growth in 2012.
GreenOak continues to build its real estate investment management and advisory business and has assembled a high-quality team of over 30 real estate professionals operating in London, Munich, Tokyo, New York and Los Angeles. During 2011 and early 2012, GreenOak:
- Had its first closing for both a U.S. and a Japanese real estate fund, - Secured a significant number of high-quality advisory engagements with clients in the United States and Europe, and - Identified and closed opportunistic transactions in the United States and Japan.
GreenOak: Assets Under Management History ($MM) AUM Q4 2010 Q4 2011 Q1 2012* Europe 505 491 1,598 U.S. - 96 131 Japan - 17 17 Total GreenOak AUM 505 605 1,745 * Projected as of March 6, 2012 (1) Estimated as of the date of this report.
Based on GreenOak's planned growth in 2012 and 2013, we expect that TFG may invest in excess of the $100.0 million of co-investment capital into real estate that was anticipated under the GreenOak agreement.
Outlook: Continuing to invest in diverse and attractive asset classes while building a broad-based asset management firm.
As we look toward 2012, we are cautiously optimistic on the outlook for TFG's investments and asset management businesses. Barring another global recession or long-term disruption in financial markets, we expect that the Company's U.S. indirect and direct loan investments will continue to perform well and contribute to TFG's ability to:
- Deliver growing earnings per share,
- Build the NAV per share of the business by making new investments across multiple asset classes and by growing the asset management platform and
- Distribute capital to shareholders.
We have a positive view of TFG's U.S. CLOs given the expectation of continuing low defaults, healthy O/C cushions within the CLOs and the favorable net interest margin expansion that has occurred over the last few years. At the same time, we believe the gross cash flow potential of the Company's existing CLOs may decline somewhat over the medium term as more CLOs reach the ends of their reinvestment periods and rising U.S. LIBOR rates dampen the benefit of LIBOR floors. We expect the Company to continue to evaluate investment opportunities both within and beyond the leveraged loan asset class and to explore early call and/or refinancing opportunities for its existing CLO equity portfolio.
Our outlook for the performance of the European CLO portfolio remains closely linked to the condition of Euro-zone economies and, in particular, the resolution of Europe's sovereign debt issues, the nature of fiscal tightening in the region and the de-leveraging of European financial institutions, all of which will have an impact on the region's growth prospects and ability of loan issuers to adjust their capital structures in order to avoid default. Given the significant O/C and credit quality pressure under which many European CLOs remain, we therefore maintain a less positive view on the near-term prospects of these assets.
In 2012, LCM and GreenOak will continue their fund-raising as they seek to grow third-party assets under management and add new advisory mandates. Although it may take time to fully realize all of the benefits of building and integrating existing and potentially new asset management businesses into the platform, we believe that we are making good progress in that direction. We expect to continue to advance this effort throughout 2012, including by evaluating other asset managers for acquisition. We remain of the view that TFG's continued diversification to owning interests in multiple operating entities across a range of asset classes will ultimately create significant long-term value for our shareholders.
Board of Directors
2 March 2012
2011 PERFORMANCE AT A GLANCE
Investment Manager's 2011 Highlights: (3)
In the context of mixed but improving fundamentals for U.S. corporate credit and periodically volatile capital markets, TFG achieved the following:
- Cash Flow: The Company experienced continued gains in cash generation in 2011, with CLO equity investment cash receipts of approximately $411.6 million (or $3.48 per weighted average share), up from approximately $262.7 million (or $2.16 per weighted average share) in 2010, due to general improvements in the excess interest margin available for distribution within TFG's U.S. CLOs and the resumption of distributions to the equity tranches of certain of TFG's European CLO equity investments. (4)
- CLO Equity Investment Performance: The Company's portfolio of CLO equity investments realized value through the Company's majority (or significant) equity positions and, as a whole, out-performed market-wide averages across several key performance metrics:
- CLO Portfolio Management: The Company was able to realize value from its majority (or significant) equity positions in three specific CLO investments during 2011 due to opportunities arising out of certain manager consolidations, change of control transactions or other management company or personnel changes within those transactions, and in connection therewith increased our economics in such deals via upfront consent fees or long-term fee sharing arrangements.
- Defaults: TFG’s lagging 12-month corporate loan default rate fell to approximately 0.4% as of the end of Q4 2011, down from 1.7% recorded as of the end of Q4 2010.(5) TFG’s 2011 corporate loan default rate was also approximately 82% below the 2.2% annual WARF-implied (6) default rate used as a historical average rate within TFG’s cash flow modeling framework.
- Collateral Coverage Test (O/C) Compliance: As of the end of 2011, 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.(7) TFG’s U.S. CLOs continued to perform particularly well during the year, increasing their O/C test cushions and reducing low-rated asset holdings.
- Credit Quality: The weighted-average percentage of corporate obligors rated Caa1/CCC+ or below in our 77 CLO investments ended the year at 7.0%.(8) For TFG’s U.S. CLO equity investments, the weighted-average percentage of CCC assets was 5.5%, with a weighted-average maximum permitted level of 8.4%. In comparison, the market-wide median CCC asset holdings of U.S. CLOs were estimated to be approximately 7.7% as of the end of Q4 2011.(9)
- Direct Loan Investments: As of 31 December 2011, TFG owned liquid U.S. bank loans with an aggregate par amount of approximately $111.1 million and total fair value of $107.1 million. The underlying businesses performed well during the year, with no defaults registered in the direct loan portfolio. For the year, net realized gains totaled approximately $0.9 million. In addition, the direct loan portfolio earned $5.8 million of interest income and discount premium during the year.
- Further Investment Portfolio Diversification:
- Mezzanine CLO Debt Tranches: The Company recently invested $1.1 million in a mezzanine debt tranche of a U.S. CLO already represented in TFG's CLO equity portfolio. We see particular opportunities in mezzanine debt tranches where TFG controls the call rights of the CLO.
- Real Estate: TFG sought to increase its holdings of real estate assets by investing in vehicles managed by GreenOak. Through the end of 2011, TFG held approximately $2.4 million of commercial real estate assets in Japan and the United States and had committed to make further investments into both its U.S. fund and its Japan fund, which had their first closings early in 2012. Over the short/medium term, the Company may invest in excess of the $100.0 million of co-investment capital into real estate that was anticipated under the GreenOak agreement.
- Cash Reserves and Corporate-Level Borrowings: The Company had no outstanding corporate-level borrowings during all of 2011 and its net cash position stood at $211.5 million as of 31 December 2011.(10)
2011 PERFORMANCE AT A GLANCE (continued)
- Asset Management Platform
TFG's asset management operating businesses achieved strong performance outcomes during 2011.
- LCM Developments: LCM achieved solid operating and financial performance in 2011. Assets under management grew from approximately $3.0 billion at the end of 2010 to approximately $3.4 billion at year-end 2011. This growth was a result of the issuance of LCM IX, a new U.S. CLO, in which TFG acquired a majority position in the equity tranche. Early in 2012, the team closed another new issue CLO, LCM X, which totaled $410.0 million, bringing the assets under management to approximately $3.8 billion at February 2012 month-end. As of 31 December 2011, all senior and subordinated CLO management fees on LCM Cash Flow CLOs(11) were current and taking into account all LCM-managed vehicles, the gross fee income year-to-date for LCM totaled $16.4 million. Pre-tax profit for the entire LCM business, of which TFG owns 75%, reached approximately $8.2 million for the same period.
- GreenOak Developments: 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. TFG owns a 10% equity interest in GreenOak. Throughout 2011, GreenOak continued to build its real estate investment management and advisory business. They have assembled a high quality team of over 30 real estate professionals operating in London, Munich, Tokyo, New York and Los Angeles. During the year, GreenOak achieved a number of key milestones, including having first closings for its U.S. and Japanese real estate funds and securing a significant number of high-quality advisory engagements with clients in the United States and Europe. We believe that as of March 2012 month-end, assets under management will have grown to approximately $1.75 billion.
- Capital Distributions, Dividends and Share Repurchases: TFG declared a dividend of $0.105 per share for Q4 2011, after increasing it from $0.09 per share to $0.10 per share in each of the prior two quarters. TFG also announced the continuation of its share repurchase program in October 2011. Overall in 2011, TFG purchased 5,075,380 TFG shares at an average price of $6.94 per share for a total value of approximately $35.2 million.
Financial Results Summary:
- Net Income: Consolidated net income of $410.4 million was recorded in 2011 as compared with $385.2 million in 2010. This strong performance was driven by, among other things, significant improvements in the excess interest margins and structural strength of the Company's CLO equity 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 2011 was $3.46 compared to $3.15 for 2010.
- Net Asset Value (NAV) per Share: NAV per share at the end of 2011 was $12.71, up from $9.47 at the end of 2010, reflecting overall improvements in performance and distributions to shareholders.
- Cash Flows from Operations: Cash flows from operating activities increased by approximately $100.0 million, year-over-year, to $253.9 million as of 31 December 2011, primarily driven by the increase in cash from CLO equity detailed above.
Investment Portfolio Summary:
- Investment Portfolio Size: As of the end of 2011, the fair value of TFG's investment portfolio totaled approximately $1,264.4 million comprised mainly of approximately $1,147.4 million of CLO equity investments and $107.1 of direct loan investments. The CLO equity investments represented indirect exposure to approximately $18.4 billion of leveraged loans.
- CLO Portfolio Composition: As of the end of 2011, TFG's performing CLO portfolio consisted solely of 77 CLO investments managed by 27 external CLO managers and LCM. The number of external CLO managers fell to 27, owing to certain manager consolidations that were announced during the year.
- IRRs: The weighted-average IRR as of the end of 2011 was 17.6%, up from 15.1% at the end of 2010.
- Performance Fee: Performance fees of $55.5 million, $26.2 million, and $19.2 million were paid with respect to Q1, Q2 and Q3 2011, respectively. A performance fee of $23.2 million was accrued in Q4 2011 in accordance with TFG's investment management agreement and based on a "Reference NAV" with respect to Q3 2011. The hurdle rate for the Q1 2012 incentive fee has been reset at 3.2304% (Q4: 3.0255%) as per the process outlined in TFG's 2011 Audited Financial Statements and in accordance with TFG's investment management agreement.(12)
INVESTMENT MANAGER'S REPORT
As of the end of 2011, the fair value of TFG's investment portfolio totaled approximately $1,264.4 million, comprised mainly of TFG's indirect loan portfolio, accessed via its investments in CLO equity tranches, which totaled approximately $1,147.4 million, and the direct loan portfolio of $107.1 million. TFG's exposure to the loan asset class remained diversified, with approximately 74.9% (invested directly or indirectly via CLO equity investments) in U.S. broadly-syndicated senior secured loans, 15.3% in U.S. middle-market senior secured loans and 9.8% in European broadly-syndicated senior secured loans.(13)(14)
The corporate credit market in the United States was marked by significant volatility during 2011. Through the first seven months of the year, the S&P/LSTA Index saw average monthly market price gains of 0.39% as demand for leveraged loans soared, in part as a result of $26.3 billion of capital inflows into loan mutual funds.(15) This upward trend, however, quickly reversed itself. In August, concerns over the sovereign debt crisis in Europe and fears of a global double-dip recession, in addition to S&P's downgrade of the sovereign debt of the United States and the U.S. Federal Reserve's announcement that it would seek to keep short-term rates low through at least mid-2013, led to capital flight out of the leveraged loan market and a loss of 4.4% during the month for the S&P/LSTA Index.(16) In late 2011, investor sentiment improved once again and the loan index ended with a 1.5% gain for the year.(17)
We believe that notwithstanding these market price swings, U.S. credit fundamentals continued to improve. Since June 2009, publicly-filing S&P/LSTA Index issuers have generated average year-over-year EBITDA growth of 16%.(18) Capital market activity also remained strong, with 2011 U.S. institutional loan volumes up 46% from 2010, reaching $232.0 billion, and U.S. leveraged loan issuance similarly increasing by 60%.(19) High-yield bond issuance, on the other hand, fell 25% to $218.0 billion, as there was little need to refinance immediate maturities in 2011.(20) Though the pace of maturity schedule adjustment slowed towards the end of 2011, the size of the so-called "maturity wall" continued to be reduced through repayments and extensions. During 2011, issuers in the S&P/LSTA Index had reduced loan maturities due through 2014 by $131.5 billion, compared with $183.1 billion in 2010. Most of this activity occurred in the first half of 2011, as more issuers sought to defer extensions as the year progressed. Despite these positive credit trends there were some latent concerns. The percentage of obligors rated CCC+ or below in the S&P/LSTA Index ticked up to 9% as of the end of 2011, from 6% the prior year, and the percentage of constituents trading below a price of 70% of par likewise increased to 7%, from 2%, over the same period.(21) Notwithstanding the increase in certain measures of stress, the overall positive credit environment led to defaults for the S&P/LSTA Index hitting a 54-month low of 0.17%, by principal amount, for the year.(22)
The European leveraged loan market also experienced significant swings during the year with the S&P European Leveraged Loan Index ("ELLI") return ending close to flat with a 0.36% gain in 2011 (excluding currency effects).(23) Unlike in the United States, however, volumes in Europe never meaningfully recovered from a late summer lull, as European institutional loan volume fell to €2.6 billion in Q4 2011, the lowest level since the final quarter of 2009. Despite this slowdown, European institutional loan volume increased slightly from 2010, ending 2011 with €22.1 billion. Certain credit metrics in Europe also showed considerably more stress than in the United States. As of the end of 2011, 12% of the constituents of the ELLI were rated CCC+ or below, up from 7% at the end of the prior year, and 17% were trading below a price of 70%, compared with 10% at the end of 2010. Meanwhile, the lagging 12-month default rate for the ELLI ended 2011 at 4.1%, more than double the 2010 rate.(24)
As in the underlying loan markets, CLO performance in the United States and Europe evolved along diverging paths. We believe that U.S. CLOs generally benefitted from the benign default environment and expanding net interest margins, which were achieved through, among other things, amendment fees, investments into wider-spread loan assets and LIBOR floors. These positive factors contributed to strong cash flow distributions to CLO equity holders, such as TFG. For the year, the gross cash flow from TFG's U.S. CLO equity investments reached $378.6 million. TFG's direct bank loan portfolio also performed well, and generated $0.9 million of net realized gains and $5.8 million of interest income and accrued discounts in 2011.
As of the end of the year, 100% of TFG's U.S. CLOs by fair value and 100% by number were passing their junior-most O/C tests.(25) U.S. CLOs represented approximately 89.2% of the total fair value of TFG's CLO equity investment portfolio as of 31 December 2011. In comparison, the market-wide average of U.S. CLOs estimated to be passing their junior O/C tests as of the end of Q4 2011 was approximately 93.9% (when measured on a percentage of transactions basis).(26)
PORTFOLIO OVERVIEW (continued)
TFG's European CLOs, in contrast, continued to lag the performance of its U.S. CLO transactions as O/C test cushions remained stressed due to defaults and persistently high Caa1/CCC-rated assets, among other factors. At 31 December 2011, European CLOs represented approximately 10.8% of TFG's CLO equity investment portfolio. Approximately 75% 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. We believe that this divergence in performance was due to, among other factors, slower growth in key European economies, more challenging capital market conditions, lower obligor diversification, as well as certain structural features of European CLOs which rendered them more sensitive to ratings migration.
New CLO issuance continued to pick up during 2011, although mainly in the United States and still not near the peak volumes of the 2006-2007 period. There were 28 U.S. arbitrage CLOs issued during 2011, putting the total annual primary volume at $12.3 billion, up from $3.6 billion in 2010.(27) The primary market for European arbitrage CLOs remained closed, however, as no such deals were issued during 2011. Including balance sheet deals, global CLO issuance stood at $101.8 billion for the 2011 year and was dominated by European balance sheet CLOs which totaled $89.6 billion.(28)
Although we expect European cash flow arbitrage CLO issuance to remain depressed in 2012, we anticipate U.S. arbitrage CLO issuance volumes to increase in the coming year, provided that liability spreads keep pace with tightening in underlying loan spreads so as to preserve attractive equity returns. With both U.S. interest rates and corporate default rates expected to remain low in the near to medium term, the relative yield pick-up of CLO debt and equity tranches may offer compelling risk-adjusted returns for certain investors. In addition, given the importance of CLOs as a provider of liquidity for the leveraged loan market, new CLOs, or other types of long-term loan investing vehicles, may need to be issued as older-vintage CLOs reach the end of their reinvestment periods and effectively withdraw a significant amount of capital from the loan market. Though down from its historic levels, we believe CLOs remain the largest type of buyer of new issue leveraged loans, making up over 40% of the overall market.(29) We also believe that when properly constructed, they may offer investors an attractive economic exposure to leveraged loans and will continue to be an important part of the loan market going forward.
TFG's direct U.S. bank loan portfolio totaled approximately $111.1 million in par amount and fair value of $107.1 million as of 31 December 2011 and performed well during the year, with no defaults registered. Net realized gains for the year totaled approximately $0.9 million and the portfolio earned $5.8 million of interest income and discount premium during 2011. Going forward, we expect to continue to maintain our direct exposure to bank loans and to take advantage of market opportunities to realize gains and/or acquire additional assets.
TFG also sought to increase its holdings of real estate assets by investing in vehicles managed by GreenOak Real. Through the end of 2011, TFG held approximately $2.4 million of commercial real estate assets in Japan and the United States and had committed to make further investments into both its U.S. fund and its Japan fund, which had its first closing early in 2012. Based on GreenOak's planned growth in 2012 and 2013, we expect that TFG may invest in excess of the $100.0 million of co-investment capital into real estate that was anticipated under the GreenOak agreement.
ASSET MANAGEMENT PLATFORM
The Company remains committed to expanding its asset management platform and its efforts to become more of a broad-based financial services firm that owns interests in multiple operating businesses.
LCM continued to perform well during 2011, as it grew assets under management and produced robust profits. As of the end of 2011, 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 $16.4 million. 2011 pre-tax profit for the entire LCM business, of which TFG owns 75%, reached approximately $8.2 million.
LCM Asset Management Performance Snapshot Q3 Q2 Q1 Q4 Q2 Q1 Q4 2011 2011 2011 2011 2010 Q3 2010 2010 2010 Gross Fee Income ($MM) $4.3 $4.4 $3.9 $3.8 $3.4 $3.0 $2.9 $3.3 Pre-tax Income ($MM) $2.2 $2.2 $1.9 $1.9 $1.1 $1.4 $1.4 $1.9
LCM's assets under management grew from approximately $3.0 billion at the end of 2010 to approximately $3.4 billion at year-end 2011. During 2011, LCM closed a new issue CLO, LCM IX. A second new issue CLO, LCM X, was closed during Q1 2012. Both CLOs raised significant third-party capital, with TFG taking a majority stake of the equity tranche of both deals.
LCM also continued to lend its expertise to TFG's direct U.S. loan investment program. No defaults were registered in the direct loan portfolio during 2011. As of the end of 2011, the direct loan portfolio had a fair value of $107.1 million.
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.
Throughout 2011, GreenOak continued to build its real estate investment management and advisory business. They have assembled a high quality team of real estate professionals operating in multiple geographies. During 2011, GreenOak achieved a number of key milestones. They had first closings for their United States and Japanese real estate funds and closed on opportunistic transactions in both of those countries. GreenOak also secured a significant number of high-quality advisory engagements with clients in the United States and Europe. We believe that as of March 2012 month-end, assets under management will have grown to approximately $1.75 billion.
In 2012, LCM and GreenOak will continue their fund-raising efforts as they seek to grow third-party assets under management and add new advisory mandates. Although it may take time to fully realize all of the benefits of building and integrating existing and potentially new asset management businesses into TFG's asset management platform, we believe that we are making good progress in such efforts. We expect to continue to advance this effort throughout 2012, including by evaluating other asset managers for acquisition. We continue to believe that TFG owning or having stakes in asset management businesses may provide repeatable income streams and reduced fees paid to third-party managers.
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 manager consolidations, change of control transactions, or other management company or personnel changes within the CLO portfolio so as to protect or enhance the value of those investments. During 2011, TFG realized value in three CLO transactions by leveraging its ownership positions and entering into long-term fee sharing arrangements. Such management fees totaled approximately $6.7 million in 2011 (excluding fees earned by LCM). We expect to continue to utilize these strategic assets to take advantage of similar opportunities to enhance and protect the value of TFG's CLO equity investments and/or TFG's asset management platform.
FINANCING SOURCES, HEDGING ACTIVITY AND OTHER MATTERS
As of the end of 2011, TFG had no outstanding debt and the net cash on its balance sheet stood at $211.5 million, compared to $140.6 million at the end of 2010. In addition, the Company owned a direct bank loan portfolio, with a fair value of approximately $107.1 million as of the end of Q4 2011.
TFG had no direct credit hedges in place at the end of 2011, but employed certain foreign exchange rate and "tail risk" interest rate hedges to seek to mitigate its exposure to Euro-USD foreign exchange risk and a potential significant increase in U.S. inflation and/or nominal interest rates, respectively. We review our hedging strategy on an on-going basis as we seek to address identified risks to the extent practicable and in a cost-effective manner.
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 2011, the average daily trading volume for TFG shares on NYSE Euronext in Amsterdam fell to approximately 206,000 from approximately 235,000 in 2010. TFG currently expects to continue to publicly list its shares solely on NYSE Euronext in Amsterdam as it believes that exchange is favorably suited to address relevant legal, regulatory, liquidity and other commercial considerations. TFG has recently appointed Singer Capital Markets Ltd. to act as its corporate broker.
CAPITAL DISTRIBUTIONS 2011: DIVIDENDS AND SHARE REPURCHASES
The Company has sought to continue to return value to its shareholders. During 2011 TFG paid a dividend of $0.09 per share with respect to Q1 2011, followed by an increased dividend of $0.10 per share paid with respect to each of Q2 and Q3 2011. The dividend was $0.105 per share with respect to Q4 2011, and will be paid on 28 March 2012. This will result in a total dividend of $0.395 per share for the year.(30)
During 2011, the Company repurchased 5,075,380 TFG shares at an average price of $6.94 per share for a total value of $35.2 million, which brought the total number of shares purchased under the share repurchase program to 16,100,542 at an average price of $5.09 per share. On 28 October 2011, 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 whether in respect of its investment portfolio or asset management platform as well as both within and beyond the leveraged loan asset class.
SUMMARY, OUTLOOK AND STRATEGY
Despite mixed macro-economic conditions and significant financial market volatility, TFG posted strong results in 2011. We believe the financial results for both of TFG's business segments (its investment portfolio and its growing asset management platform) reflect the underlying strength and positive momentum of the Company. We will seek to build on such success and strength in 2012.
2011 witnessed broad improvement in U.S. credit conditions as leveraged loan defaults reached historical lows and significant progress was made in addressing the "maturity wall". TFG's U.S. CLOs equity investments continued to benefit from a favorable environment of low credit losses in the context of widening loan spreads, growing prevalence of LIBOR floors, and above-average prepayment rates. This environment allowed CLO managers with vehicles in active reinvestment periods (which represent the majority of TFG's CLO portfolio) to reinvest such proceeds into wider spread or below par assets, thereby increasing the deals' O/C cushions and excess interest margins distributable to equity holders (such as TFG). In addition, certain of TFG's U.S. CLOs benefitted from upgrades of their liabilities resulting in a termination of so called "restricted trading" conditions and the reinstatement of managers' trading flexibility both during and after the end of the reinvestment period. TFG's European CLOs, on the other hand, registered modest and generally short-lived improvement during the year, with European corporate credit performance overshadowed by continued systemic sovereign and fiscal problems in the region, resulting in persistently elevated Caa1/CCC+ asset holdings, defaults, and constrained capital markets.
We believe that the value of arbitrage cash flow CLOs' ability to capture the benefit of loan spreads (including expected default losses and liquidity/other non-credit related risk premia) while mitigating certain of these risk components has been demonstrated this year as TFG's CLO equity cash flows rose 57% year-over-year. With match-funded liabilities and limited exposure to loan market value risk compared to other investment vehicles, (31) arbitrage cash flow CLOs, and the equity tranche in particular, were able to benefit from the share of loan spread in excess of realized credit losses. Furthermore, both TFG's U.S. and European CLOs outperformed certain key market-wide performance metrics, such as default rates and average junior O/C test cushions, reflecting the value-added by collateral managers represented within the portfolio. In addition, TFG's majority (or significant) equity position and buy-and-hold strategy has allowed the Company to continue to protect or enhance the value of TFG's investments via consent rights on certain management changes as well as the negotiation of upfront consent fees or long term fee-sharing arrangements.
TFG's direct U.S. bank loan portfolio, which totaled approximately $111.1 million in par amount and fair value of $107.1 million as of 31 December 2011, continued to perform well during the year. The portfolio experienced no defaults during the year and generated net realized gains of approximately $0.9 million as well as $5.8 million of interest income and discount premium for 2011. We expect to continue to maintain our direct exposure to bank loans in the future.
During 2011, the Company continued to seek to diversify its investment portfolio across various asset classes and types (with different investment durations) as well as across a multitude of geographies. To this end, TFG invested $1.1 million in a mezzanine debt tranche of a U.S. CLO already represented in TFG's CLO equity portfolio. We believe that certain mezzanine debt tranches may offer attractive risk-adjusted returns given their credit enhancement levels, potential for price appreciation in light of improving credit quality, end of CLOs' reinvestment periods, and rating upgrades, as well as the favorable impact of early optional redemptions. Although we have previously focused exclusively on the equity tranches of CLOs, we may seek to make similar opportunistic mezzanine debt investments if and when appropriate. TFG also began growing its exposure to real estate assets by investing in vehicles managed by GreenOak. Through the end of 2011 TFG held approximately $2.4 million of commercial real estate assets in Japan and the United States. Based on GreenOak's planned growth in 2012 and 2013, we expect that TFG may invest in excess of the $100.0 million of co-investment capital into real estate that was anticipated under the GreenOak agreement.
SUMMARY, OUTLOOK AND STRATEGY (continued)
The Company also continued to make progress on the growth of its asset management platform. During 2011, the asset management businesses in which TFG holds ownership stakes achieved solid financial and operating results. LCM, of which TFG owns 75%, was able to raise significant third-party capital via new issue CLOs, including LCM IX and LCM X (which closed in February 2012) despite volatile loan prices and CLO liability spreads. Throughout the year, all of LCM's Cash Flow CLOs remained current on their senior and subordinated management fees and the team oversaw strong performance of TFG's direct loan portfolio, with the total business generating pre-tax profits of $8.2 million for the year. LCM also expanded its team by adding two investment professionals and we believe is well-positioned to capitalize on further capital-raising opportunities in 2012.
GreenOak, of which TFG owns 10%, also experienced strong positive momentum as it continued to build its real estate investment management and advisory business. The firm established a global footprint with a high-quality team of real estate professionals across multiple offices and regions. Key GreenOak operating milestones in 2011 and early 2012 included the first closing for a U.S. and a Japanese real estate fund, delivery of several advisory projects to clients in the United States and Europe as well as the sourcing and closing of opportunistic transactions in the United States and Japan.
We maintain a cautiously positive outlook for TFG in 2012 both in terms of its investment portfolio and asset management platform. In regards to TFG's investment portfolio, our view remains bifurcated with respect to TFG's U.S. and European leveraged loan holdings. Although we expect that, absent a global recession or financial markets disruption, U.S. CLOs and direct loan portfolio will perform well, we anticipate that TFG's European CLOs may continue to face both fundamental and technical headwinds.
As mentioned in our previous reports, 100% of TFG's U.S. CLOs remain compliant with their junior O/C tests and have built significant cushion to those tests as well as credit quality limits such as Caa1/CCC+ asset holdings. Furthermore, we share the consensus view that near-term U.S. leveraged loan default rates will remain below their historical average in 2012, given the significant reduction in "maturity wall" achieved over the past few years, the general strength of U.S. corporate balance sheets as well as continued strong earnings and cash flows of U.S. leveraged loan borrowers. All of these factors would be expected to contribute to continued strong U.S. CLO equity cash flows, although we expect that total receipts may be lower than in 2011 due to potential loan spread tightening, rising LIBOR rates which reduce the value of LIBOR floors, and a greater number of transactions reaching the end of their reinvestment periods as well as reaching certain CLO manager incentive fee IRR hurdles. In addition, we believe that further CLO liability ratings upgrades may create positive momentum for TFG's CLO portfolio by allowing a greater number of TFG's CLOs to potentially extend the benefits of their historically-tight liabilities beyond their reinvestment periods.
We anticipate that European CLOs, on the other hand, will remain more exposed to negative macro-economic conditions and financial markets volatility in the region due to the generally lower (or negative) cushion of their junior O/C tests, significant excess Caa1/CCC+ asset holdings, higher obligor concentrations and generally more punitive treatment of stressed asset haircuts in O/C ratios.
We are also optimistic on the outlook for TFG's real estate assets accessed via investments in certain GreenOak entities as we view GreenOak as a superior manager capable of accessing solid investment opportunities and achieving strong return outcomes.
Finally, we are excited about the prospects for our asset management businesses. Although the risk-on/risk-off investment pattern which characterized 2011 may continue to pose challenges in 2012, we believe that the groundwork laid by the GreenOak team since inception as well as the quality of its advisory work and investment performance will generate returns in 2012. Similarly, given the increase in CLO new issuance volumes and LCM's demonstrated ability to access these capital markets even during challenging times, we anticipate that LCM will be able to continue to grow its assets under management via the addition of new CLO vehicles as well as other loan investment products. In addition to outside capital, both LCM and GreenOak will continue to manage a portion of TFG's own capital and we will look to support both asset managers by, among other things, supporting new investment funds (such as CLOs or real estate funds) and providing working capital when needed.
SUMMARY, OUTLOOK AND STRATEGY (continued)
Although it may take time to fully realize all of the benefits of building and integrating existing and potentially new asset management businesses into the platform, we believe that we are making good progress in that direction. We expect to continue to advance this effort throughout 2012, including by evaluating other asset managers for acquisition. We remain of the view that TFG's continued diversification to owning interests in multiple operating entities across a range of asset classes will ultimately create significant long-term value for our shareholders. We believe that TFG is well-positioned to capitalize on future opportunities in this space and to gain from potential synergies across the investment and asset management businesses.
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 TFG's website at: http://www.tetragoninv.com.
FINANCIAL REVIEW 2011
TFG posted strong results in 2011 despite mixed and often challenging market conditions. Year-on-year net income increased by approximately 7% to $410.4 million and as in 2010 the main driver of earnings continued to be the performance of the CLO equity portfolio, particularly the U.S. deals. Importantly, the non-CLO portfolio components of income continued to grow as well with the combined management fees from LCM and other fee sharing arrangements increasing by more than 50% to $23.1 million.
Costs and expenses broadly scaled up in line with performance and were only marginally higher when expressed as a percentage of gross income, at approximately 29%, due to an increase in legal expenses in the other expenses line.
CONSOLIDATED INCOME COMPARISON 2011 vs. 2010
The quarter-on-quarter and annual comparison of consolidated net income (see table below) shows the relative stability of the performance from the second quarter onwards.
TFG Quarterly Statement of Operations 2011 2010 Q4 Q3 Q2 Q1 2011 2011 2011 2011 Consolidated Consolidated Statement of Operations ($MM) ($MM) ($MM) ($MM) ($MM) ($MM) Interest income from Investments 55.1 53.6 52.0 48.4 209.1 178.9 CLO Management Fee Income 4.3 4.4 3.9 3.8 16.4 12.6 Other Income 2.9 0.8 1.5 1.5 6.7 2.5 Investment Income 62.3 58.8 57.4 53.7 232.2 194.0 Management and Performance Fees (28.6) (24.3) (31.2) (59.9) (144.0) (133.5) Other Expenses (7.6) (9.0) (4.1) (5.7) (26.4) (10.7) Total Operating Expenses (36.2) (33.3) (35.3) (65.6) (170.4) (144.2) Net Investment Income 26.1 25.5 22.1 (11.9) 61.8 49.8 Net Change in Unrealized (Depreciation) / Appreciation on Investments 58.5 50.5 65.0 184.6 358.6 336.0 Net Realized Gain / (Loss) on Investments 0.3 - - 0.6 0.9 1.1 Realized / Unrealized Gains / (Losses) From Hedging and FX (3.3) (7.1) 2.4 2.9 (5.1) 2.1 Realized / Unrealized Gains / (Losses) from Investments and FX 55.5 43.4 67.4 188.1 354.4 339.2 Income Taxes (0.7) (1.1) (1.0) (1.0) (3.8) (2.4) Noncontrolling Interest (0.6) (0.5) (0.4) (0.5) (2.0) (1.4) Net Increase / (Decrease) in Net Assets from Operations 80.3 67.3 88.1 174.7 410.4 385.2
EPS Performance Attribution Component 2011 2010 CLOs $4.76 $4.18 Direct Loans $0.03 $0.05 LCM - Fee Income $0.14 $0.10 Other Income $0.06 $0.02 Hedging Derivatives and Options ($0.04) $0.01 Expenses and Taxes ($1.47) ($1.20) Noncontrolling Interest ($0.02) ($0.01) Total EPS $3.46 $3.15 Weighted Average Shares 118,444,858 122,165,663
FINANCIAL HIGHLIGHTS TABLE
Financial Highlights Q4 2011 Q3 2011 Q2 2011 Q1 2011 Q4 2010 Q3 2010 Q2 2010 Q1 2010 Net Income ($MM) $80.3 $67.3 $88.1 $174.7 $132.0 $125.0 $55.6 $72.6 EPS ($) $0.69 $0.57 $0.74 $1.46 $1.09 $1.03 $0.45 $0.58 Cash Receipts ($MM) (32) $113.2 $105.1 $102.4 $90.9 $78.9 $71.8 $60.9 $51.1 Cash Receipts per Share ($) $0.97 $0.89 $0.86 $0.76 $0.66 $0.59 $0.50 $0.41 Net Cash Balance ($MM) $211.5 $155.6 $67.7 $147.0 $140.6 $187.9 $156.2 $172.6 Net Assets ($MM) $1,474 $1,414 $1,368 $1,298 $1,138 $1,019 $909 $867 Number of Shares Outstanding (million) 116.0 117.2 118.8 119.6 120.1 120.8 122.2 123.6 NAV per Share ($) $12.71 $12.06 $11.52 $10.85 $9.47 $8.43 $7.44 $7.02 DPS ($) $0.105 $0.10 $0.10 $0.09 $0.09 $0.08 $0.08 $0.06 Weighted Average IRR on Completed Transactions (%) 17.6% 16.8% 16.3% 15.8% 15.1% 13.7% 13.1% 12.3% Number of Investments (33) 77 75 75 74 70 68 68 68 ALR Fair Value Adjustment ($MM) $(128.7) $(118.0) $(133.8) $(155.7) $(258.0) $(274.7) $(330.7) $(339.5)
CASH FLOW FROM OPERATIONS
2011 cash flows from operating activities increased by 65% year-over-year to almost $254.0 million, primarily reflecting the strong performance from the CLO equity portfolio, but assisted by a growth in management fee income from LCM and other fee-sharing arrangements. Of this $95.0 million was used in the net purchase of new investments across CLOs, direct loans and real estate related investments. A further $73.1 million was returned to shareholders in the form of either dividends or share buybacks.
Cash Flow From Operations 2011 2010 $MM $MM Operating Activities Operating Cash Flows Before Movements in Working Capital, after Dividends paid to Guernsey Feeder 251.3 151.6 Increase / (Decrease) in Payables 2.6 2.3 Cash Flows from Operating Activities 253.9 153.9 Investment Activities Proceeds on Sales of Investments 122.3 71.0 Purchase of Investments (217.3) (205.7) Cash Flows from Operating and Investing Activities 158.9 19.2 Amounts Due from Brokers (11.6) 1.6 Net Purchase of Shares (28.0) (20.3) Dividends Paid to Shareholders (45.1) (34.2) Distribution to Noncontrolling Interest (3.2) (0.1) Cash Flows from Financing Activities (87.9) (53.0) Net (Decrease) / Increase in Cash and Cash Equivalents 71.0 (33.8) Cash and Cash Equivalents at Beginning of Period 140.6 174.4 Effect of Exchange Rate Fluctuations on Cash and Cash Equivalents (0.1) - Cash and Cash Equivalents at End of Period 211.5 140.6
Consolidated Balance Sheet Summary 2011 2010 $MM $MM Investments in CLO Equity 1,147.4 932.7 Investments in Bank Loans 107.1 97.6 Other Investments 10.0 5.2 Cash and Cash Equivalents 211.5 140.6 Other Assets/Liabilities (1.5) (37.2) Net Assets Before Noncontrolling Interest 1,474.5 1,138.9 Noncontrolling Interest 0.1 1.4 Total Equity Attributable to TFG 1,474.4 1,137.5
FAIR VALUE DETERMINATION OF TFG's CLO EQUITY INVESTMENTS
In accordance with the Company's valuation policies as set forth on the Company's website, the values of TFG's CLO equity investments are determined using a third-party cash flow modeling tool. The model contains certain assumption inputs that are reviewed and adjusted as appropriate to factor in how historic, current and potential market developments (examined through, for example, forward-looking observable data) might potentially impact the performance of TFG's CLO equity investments. Since this involves modeling, among other things, forward projections over multiple years, this is not an exercise in recalibrating future assumptions to the latest quarter's historical data.
Subject to the foregoing, when determining the U.S. GAAP-compliant fair value of TFG's portfolio, the Company seeks to derive a value at which market participants could transact in an orderly market and also seeks to benchmark the model inputs and resulting outputs to observable market data when available and appropriate.
Fundamentally, the valuation process involves two stages:
- In stage one, future cash flows for each transaction in the CLO equity portfolio are modeled, using a market-standard modeling tool into which the applicable latest transaction details are loaded, and to which the base case assumptions are added.
- 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 transaction. Prior to the financial crisis, with TFG's CLO equity portfolio performing well in a generally benign credit environment, the IRRs on TFG's CLO equity investments were considered to adequately reflect the relative risk to their applicable cash flows and therefore, amortized cost reflected fair value. Due to elevated market risk premia observable in the marketplace during and since the financial crisis, among other factors, this effective discount rate used to derive fair value has typically been higher than each transaction's IRR and therefore, in such instances, has resulted in a fair value which is lower than the transaction's amortized cost. The difference between these two figures, on an aggregate basis across the CLO equity portfolio, has been characterized as the "ALR Fair Value Adjustment" or "ALR."
During Q4 2011, evidence of widening differences in expectations for performance outcomes of U.S. and European CLOs continued to mount, reflecting, among other factors, diverging economic outlooks for the U.S. and Europe, elevated market volatility and corresponding differences in investor appetite with respect to certain investment risks. As a result, it was deemed appropriate to reflect these differences via:
- adjustments to certain of the forward looking average modeling assumptions for U.S. CLO deals, and
- adjustments to the discount rates applied to the modeled cash flows for European deals.
FORWARD-LOOKING CASH FLOW MODELING ASSUMPTIONS
The Investment Manager reviews, and adjusts in consultation with the Company's audit committee, as appropriate, the CLO equity investment portfolio's modeling assumptions to factor in historic, current and potential market developments on the performance of TFG's CLO equity investments as described above. At the end of Q4 2011, certain assumptions for U.S. deals were recalibrated, based on, among other factors, certain observable data with respect to defaults and reinvestment prices. (34)
The key average assumption variables have been summarized in the table below and discussed on the following pages. The modeling assumptions disclosed below are a weighted average (by U.S. dollar amount) of the individual deal assumptions, aggregated by geography (i.e., U.S. and European). Each individual deal's assumptions may differ from this geographical average and vary across the portfolio. Previously, these modeling assumptions had been shown on an average aggregated portfolio level (again with individual deals varying across the portfolio).
FORWARD-LOOKING CASH FLOW MODELING ASSUMPTIONS (continued)
U.S. CLOs - Default and Reinvestment Prices Recalibrated
U.S. CLOs - Default and Reinvestment Prices Recalibrated Prior Variable Year Current Assumptions Assumptions CADR 1.5x WARF-implied 2012-2013 1.0x WARF-implied default rate default rate (2.2%) (3.3%) 1.5x WARF-implied 2014 1.5x WARF-implied default rate default rate (3.3%) (3.3%) 1.0x WARF-implied 1.5x WARF-implied default rate 2015-2016 default rate (3.3%) (2.2%) 1.0x WARF-implied 1.0x WARF-implied default rate Thereafter default rate (2.2%) (2.2%) Recovery Rate Until deal maturity 72% 72% Prepayment Rate 20.0% p.a. on 20.0% p.a. on loans; 0.0% on loans; 0.0% Until deal maturity bonds on bonds Reinvestment Price 2012 98% 100% Thereafter 100% 100% European CLOs - Unchanged Variable Year Current Assumptions Prior Assumptions CADR 1.5x WARF-implied 1.5x WARF-implied 2012-2014 default rate (3.1%) default rate (3.1%) 1.0x WARF-implied 1.0x WARF-implied Thereafter default rate (2.1%) default rate (2.1%) Recovery Rate Until deal maturity 68% 68% Prepayment Rate Until deal 20.0% p.a. on loans; 20.0% p.a. on loans; maturity 0.0% on bonds 0.0% on bonds Reinvestment Price Until deal maturity 100% 100%
Constant Annual Default Rate ("CADR"):
U.S.CLOs: The average CADR applied to U.S. CLOs for 2012 and 2013 was reduced to 1.0x the WARF-implied default rate or approximately 2.2%, down from 1.5x or 3.3% under the previous assumption set. During the course of 2011, multiple research sources expressed the view that near-term defaults would remain at levels well-below the long-term average. In light of these market expectations, as well as low realized 2011 U.S. defaults, we believe that adjusting TFG's default assumptions in 2012-2013 to 1.0x the long-term WARF-implied average was appropriate. Beyond 2013 through 2016, the default assumption of 1.5x the WARF-implied default rate has been applied to reflect, among other factors, continued significant macro-economic and systemic risks as well as the remaining size of the "maturity wall" between 2014 and 2016.
European CLOs: The average CADR applied to European CLOs for 2012-2014 has remained unchanged at 1.5x the WARF-implied default rate or approximately 3.1%. Beyond 2014, the default assumption has also remained unchanged at a reduced rate of 1.0x the WARF-implied default rate. These levels reflect, among other things, observable market data regarding the significant level of near-term uncertainty surrounding Euro-zone economies.
FORWARD-LOOKING CASH FLOW MODELING ASSUMPTIONS (continued)
- Recovery Rate: The U.S. and European average recovery rates remain unchanged at their long-term average for the life of each CLO transaction. (35)
- Prepayment Rate: While observable loan prepayment rates remained elevated during 2011, the pace of repayments decelerated during the second half of 2011, as described earlier in this letter. In light of the significant inter-period volatility of observed quarterly prepayment rates, we have therefore maintained our long-term assumption of a 20% p.a. prepayment rate on loans and 0% p.a. on bonds throughout the life of each transaction.
- Reinvestment Price and Spread: In order to better reflect recently observable reinvestment prices the assumed reinvestment price for U.S. CLOs in 2012 has been reduced to 98%, a level that generates an effective spread over LIBOR of approximately 343 bps on broadly syndicated U.S. loans, and 417 bps on middle market loans. From 2013, the reinvestment price assumption remains at par until the maturity of the investment. For European CLOs an assumed reinvestment price of 100% has been maintained for the life of each of these deals.
- Effect of Assumption Changes on Fair Value: The input assumption recalibrations for U.S. CLO equity investments outlined above, had the impact of increasing future projected cash flows on an aggregate portfolio level, which when discounted at TFG's applicable discount rates (see below), resulted in an increase in fair value of approximately $39.4 million or 4.0% relative to the immediately preceding assumptions utilized.
APPLICATION OF DISCOUNT RATE TO PROJECTED CASH FLOWS AND ALR
In determining the applicable discount rates to use, an analysis of observable risk premium data is undertaken. Over the course of the second half of 2010 and beginning of 2011, certain observable data and research, covering both CLO equity and more senior tranches (including BB and BBB-rated debt tranches), suggested that the risk premium for CLOs in general and CLO equity in particular had been declining. The remainder of Q1 2011 witnessed further reductions in CLO risk premia as evidenced by, among other things, the reduction in spreads on originally BB and BBB-rated CLO tranches and further spread compression between such tranches. There was also market evidence that CLO equity was trading at yields in the mid-to-high teens during this period. Given the magnitude of those reductions and the developments over the preceding six months, at the end of Q1 2011 the discount rates applied to TFG's future cash flows were reduced from 23% to 20% for the stronger deals and from 30% to 25% for the remainder of the CLO portfolio.
The second half of 2011 saw a notable divergence in the way that spreads on BB and BBB originally rated tranches performed, depending on whether they referenced U.S. or European CLOs. For example, U.S. BBs as reflected by Citibank research, tightened during Q4 2011 to end the year at a yield to maturity of approximately 11.5%. By contrast, European BBs moved significantly wider to a yield to maturity of 23.5%, ending the year approximately 10.0% wider than where they had been six months earlier.
This growing disparity between U.S. and European mezzanine CLO spreads was also reflected, we believe, in the risk premium attached by investors to U.S. and European CLO equity. Various investment bank research reports, for example, indicated that for the United States, strong current cash flows provided support for CLO equity prices and we believe that the previous discount rates of 20% for strong deals, and 25% for the rest of the U.S. CLO portfolio, remained appropriate as of year-end 2011. By contrast, for European deals we believe that the widening of mezzanine spreads was also indicative of changing attitudes to the European risk premium in general and in particular, higher discount rates and lower carrying values on European CLO equity. In order to better reflect this, the discount rate for all European deals was increased to 30%, which restored a reasonable spread over European BB CLO spreads and reflected the divergence from the risk premium on U.S. deals.
The impact of the changes to the discount rates were separately disclosed in the Q1 2001 and Q4 2011 financial results, but taken together increased the fair value of the CLO portfolio by approximately $67.0 million. Through the process described above, as of the end of Q4 2011, the total ALR stands at $128.7 million, consisting of $20.4 million for U.S. deals and $108.3 million for European deals, as compared to $258.0 million at the end of Q4 2010 (split $150.1 million for U.S. deals and $107.9 million for European deals).
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, equity, interest rate and real estate 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 credit, equity, interest rate and real estate 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.
The Company maintains two key business segments: an investment portfolio and an asset-management platform.
The Company seeks to invest in a variety of assets and asset classes (potentially with different investment durations) across multiple geographies.
To date, senior secured bank loans represent the substantial majority of assets of the Company with such assets underlying the Company's CLO equity 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").
From inception through 31 December 2011, the Master Fund (company number 43322) has acquired investments with an end-of-year fair value of approximately $1,264.6 million.
The Company currently invests in a broad range of CLO products, utilizing 27 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).
Asset Management Platform:
The Company remains committed to expanding its asset management platform and its efforts to become more of a broad-based financial services firm that owns interests in multiple operating businesses.
The Company owns a 75% interest in LCM, an asset manager with approximately $3.4 billion of loan assets under management as of year-end 2011 that yielded positive results for the Company's investment performance.
The Company also owns a 10% an equity interest in GreenOak, a real estate asset manager.
The Company is seeking to realize the benefits of building and integrating existing and potentially new asset management businesses into the platform. In turn, the Company will continue to advance this effort throughout 2012, including by evaluating other asset managers for acquisition.
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. Jacksonwas given notice to vacate office as a director on 24 January 2011.(36)
On 12 July 2011, a shareholder derivative action was filed against the current and former directors of the Company and the Master Fund, the Investment Manager, the principals of the Investment Manager (each being an indirect equity holder of the Investment Manager) and an affiliated entity (the "Action"). (37) On 14 February 2012, Judge Jed S. Rakoff of the United States District Court for the Southern District of New York rendered his decision, agreeing with defendants that the purported shareholder who brought the lawsuit failed to satisfy basic pleading requirements of derivative actions. The Court ordered the case dismissed in its entirety with prejudice.
CERTAIN CORPORATE BACKGROUND
Shares of TFG (the "Shares") are publicly traded solely on the NYSE Euronext in Amsterdam under the ticker symbol "TFG". The Shares do not carry any voting rights other than limited voting rights in respect of variation of their class rights. The voting shares of TFG are owned by Polygon Credit Holdings II Limited, which is a non-U.S. affiliate of the Investment Manager 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. Mr. Griffith acts as the authorized representative of the General Partner and the Investment Manager.
In February 2012, the Investment Manager filed the relevant materials with the U.S. Securities and Exchange Commission to become registered as an investment adviser under the U.S. Investment Advisers Act of 1940.
The investment committee of the Investment Manager (the "Investment Committee") currently consists of Jeffrey Herlyn, Michael Rosenberg, David Wishnow, Reade Griffith and Paddy Dear and is responsible for the investment management of the portfolio and the business. The Investment Committee currently sets forth the investment strategy and approves each significant investment by the Master Fund.
The risk committee of the Investment Manager (the "Risk Committee") has the same composition as the Investment Committee. The Risk Committee is currently responsible for the risk management of the portfolio and the business and performs active and regular oversight and risk monitoring.
Polygon 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.
In recognition of the work performed by the Investment Manager in successfully arranging the global offering and the associated raising of new capital for the Company, TFG granted to the Investment Manager options (the "Investment Management Options") to purchase 12,545,330 of TFG's Non-Voting Shares at an exercise price per share equal to the IPO offer price (U.S. $10). The Investment Management Options are fully vested and immediately exercisable on the date of admission to the NYSE Euronext in Amsterdam and will remain exercisable until the 10th anniversary of that date.
For more information on TFG's investment manager, including a summary of key terms of the Investment Management Agreement, please refer to TFG's website at http://www.tetragoninv.com.
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 investment portfolio is composed mainly of substantial positions in the Residual Tranches of a broad range of CLO products and direct loan investments as well as cash and certain real estate investments.
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. Residual Tranches will in most cases be unrated and represent the "equity" or "first loss" position of a 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.
As previously described, the asset class primarily represented in the Company's current CLO equity 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 primary focus to date on the leveraged loan asset class (whether accessed through Securitization Vehicles or via direct loan investments), 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 (including, for example, real estate investments).
ASSET MANAGER SELECTION
In selecting asset managers (whether to acquire, or invest in or with, or to partner), the Investment Manager has sought to take advantage of the significant experience of the members of the Investment Committee. 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.
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.
The Company believes that, as a result of (among other things) the reduction in CLO issuance volumes in recent years, 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 2011.
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 investment portfolio, including across asset classes, industry sectors, geographies, investment horizons and asset managers. The Investment Manager may dispose of investment portfolio positions from time to time and may reallocate investments in the portfolio within and among asset classes on a discretionary basis.
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. For example, 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 current investments are in CLOs. Notwithstanding the efforts of the Investment Manager to diversify its CLO investments 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 current CLO investment strategy for the Company has been on the selection and structuring of investment positions that are then intended to be held for returns based on cash flows and other revenues to provide a stable stream of income for the Company. The Investment Manager believes, for example, that its buy-and-hold strategy has allowed the Company to take a long-term view on the expected cash flows from a CLO or other Securitization Vehicle. Market developments, however, have and may continue to, impact the fair value of a Securitization Vehicle and/or its underlying assets.
The Company believes the Investment Manager's asset liability management and its strategy of taking majority (or substantial) positions in its CLO investments has made a CLO buy-and-hold strategy more attractive, as the Investment Manager may in certain cases influence the performance of a CLO investment through, among other things, the support of amendments to the CLO structure or the collateral management agreement.
State Street (Guernsey) Limited serves as the Company's independent administrator and values the investments of the Master Fund on an ongoing basis. The NAV per Share is expected to fluctuate over time with the performance of TFG's investments. The NAV of TFG and the Master Fund and the NAV per Share are determined as at the close of business on the last business day of each fiscal quarter for purposes of calculating incentive fees. As TFG makes all of its investments through the Master Fund, TFG's NAV will equal the NAV of the Master Fund before incentive fees. The Company's valuation policies are set forth on the Company's website at http://www.tetragoninv.com. The information on the "Valuation" page of the website supersedes any other disclosure by the Company with respect to such information. Subject to the foregoing, additional information with respect to TFG's or the Master Fund's valuation policies may be found in each company's annual audited financial statements accompanying this Annual Report.
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.
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 NYSE Euronext in Amsterdam and applicable regulations under Dutch law, TFG provides annual and semi-annual reports to its shareholders, including year-end financial statements, which in the case of the financial statements provided in its annual reports, will be reported in accordance with U.S. GAAP and audited in accordance with international auditing standards. 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 2011 and contains a fair review of that period and (ii) the 2011 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.
RISK FACTORS (continued) - 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. Additional information on the organizational structure and corporate governance of TFG may be found on TFG's website at http://www.tetragoninv.com. - The performance of many of the Company's investments may depend to a significant extent upon the performance of its asset managers (internal and external). - The Company is subject to concentration risk in its investment portfolio, which may increase the risk of an investment in TFG. - The Company's CLO investments are subject to (i) interest rate risk, which could cause the Company's cash flow, fair value of its assets and operating results to decrease and (ii) currency risk, which could cause the value of the Company's CLO investments in U.S. Dollars to decrease regardless of the inherent value of the underlying investments. - TFG's principal source of cash will be the investments that it makes through the Master Fund. TFG's ability to pay dividends will depend on it receiving distributions from the Master Fund. - The ability of Securitization Vehicles in which the Company invests to sell assets and reinvest the proceeds may be restricted, which may reduce the yield from the Company's investment in those Securitization Vehicles. - The shares of TFG may continue to trade below NAV. The NAV per Share will change over time with the performance of the Company's investments and will be determined by the Company's valuation principles. The fees payable to the Investment Manager will be based on NAV and changes in NAV, which will not necessarily correlate to changes in the market value of the shares of TFG. - TFG and the Master Fund have approved a very broad investment objective and the Investment Manager will have substantial discretion when making investment decisions. In addition, the Investment Manager's strategies may not achieve the Company's investment objective. RISK FACTORS (continued) - Shareholders will not be able to terminate the Company's investment management agreement. None of the Investment Manager or the Service Providers owe fiduciary duties to the shareholders of TFG. - The Company may become involved in litigation that adversely affects the Company's business, investments and results of operations. - If the Company's relationship with the Investment Manager and its principals were to end or such principals or other key professionals were to depart, it could have a material adverse effect on the Company. - The Investment Manager's compensation structure may encourage the Investment Manager to invest in high-risk investments. - The liability of the Investment Manager to the Company is limited and the Company's indemnity of the Investment Manager may lead the Investment Manager to assume greater risks when making investment related decisions than it otherwise would. - The Shares are subject to legal and other restrictions on resale and the NYSE Euronext in Amsterdam trading market is less liquid than other major exchanges, which could affect the price of the Shares. TFG may decide in the future to list the Shares on a stock exchange other than NYSE Euronext in Amsterdam. There can be no assurance that an active trading market would develop on such an exchange. - The performance of LCM and, in turn, the Company's operating results, may be negatively influenced by various factors, including the (i) performance of LCM-managed CLOs, which in general are subject to the same risks as the Company's CLO investments and are currently the primary source of LCM's revenues and (ii) ability of LCM to retain key personnel, the loss of whom may negatively affect LCM's ability to provide asset and collateral management services in a fashion, and of a quality, consistent with its prior practice. Furthermore, the Company's ownership of LCM may negatively impact certain aspects of the Company's CLO investment strategy and as a result the Company's performance as well as the Company's ability to diversify its investments across multiple asset managers. - 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 as a company that owns operating companies, it may face difficulties as it invests in asset classes in which it does not have substantial experience. - Direct investments in asset managers will expose the Company's business to additional risks, including: a decline in the price of securities, a more complex regulatory environment and competition. - The Company may 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. ENDNOTES (1) Please note that the TFG portfolio-wide statistics presented in this report do not reflect the purchase of this mezzanine tranche as it was acquired after 31 December 2011. (2) The LCM I, LCM II, LCM III, LCM IV, LCM V, LCM VI, LCM VIII, and LCM IX 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. (3) Throughout this report, except within the Letter to Shareholders, references to "we" are to Tetragon Financial Management LP, TFG's investment manager. (4) Based on a weighted-average share count, excluding treasury shares, of 116.0 million for 2011 and 120.1 million for 2010. (5) The calculation of TFG's lagging 12-month corporate loan default rate does not include certain underlying investment collateral that was assigned a "Selective Default" rating by one or more of the applicable rating agencies. Such Selected Defaults are included the S&P/LCD lagging 12-month U.S. institutional loan default rate discussed above. Furthermore, TFG's CLO equity investment portfolio includes approximately 10.8% CLOs with primary exposure to European senior secured loans and such loans are included in the calculation of TFG's corporate default rate. (6) 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. (7) Based on the most recent trustee reports available for both our U.S. and European CLO investments as of December 31, 2011. (8) Excess Caa/CCC+ or below rated assets above transaction-specific permitted maximum holding levels are generally haircut in our transactions at market value in U.S. CLOs and recovery rate in European CLOs for purposes of the O/C or interest reinvestment test ratios. (9) Morgan Stanley CDO Market Tracker, 9January 2012; based on the lower of Moody's and S&P rating. Furthermore, TFG's CLO equity investment portfolio includes approximately 10.8% of CLOs with primary exposure to European senior secured loans and such loans are included in the calculation of TFG's average CCC asset holdings. (10) The net cash position is calculated as total cash less net liabilities. (11) The LCM I, LCM II, LCM III, LCM IV, LCM V, LCM VI, LCM VIII and LCM IX CLOs are referred to as the "LCM Cash Flow CLOs". The LCM VII CLO was a market-value CLO previously managed by LCM, which CLO 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. (12) The hurdle rate is reset each quarter using three-month USD LIBOR plus a spread of 2.647858% in accordance with TFG's investment management agreement. Please see the TFG website, http://www.tetragoninv.com, for more details. (13) 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. (14) As of the end of 2011, TFG continued to hold three 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. (15) S&P/LCD Quarterly Review, Q4 2011 (16) S&P/LCD Quarterly Review, Q4 2011 (17) S&P/LCD Quarterly Review, Q4 2011 (18) S&P/LCD Quarterly Review, Q4 2011 (19) S&P/LCD Quarterly Review, Q4 2011 (20) S&P/LCD Quarterly Review, Q4 2011 (21) S&P/LCD Quarterly Review, Q4 2011 (22) S&P/LCD Quarterly Review, Q4 2011 (23) LCD News, "(EUR) S&P ELLI: 2011 - The good, the bad and the flat," 10 January 2012. (24) LCD News, "(EUR) S&P ELLI: Default rate rises to 4.1% in December,"6 January 2012. (25) 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. (26) Morgan Stanley CDO Market Tracker, 9 January 2012; based on a sample of 461 U.S. CLO transactions. (27) Morgan Stanley CDO Market Tracker, 9 January 2012; based on a sample of 195 U.S. CLO transactions. (28) Morgan Stanley CDO Market Tracker, 9 January 2012; based on a sample of 195 U.S. CLO transactions. (29) S&P/LCD Leveraged Lending Review, Q4 2011. (30) For additional information, please refer to the Company's website at http://www.tetragoninv.com. (31) 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. (32) Gross cash receipts from CLO portfolio. (33) 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. (34) Please note that TFG undertakes no obligation to update public disclosure with respect to these or other modeling assumptions, except as required by law. (35) 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. (36) 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. (37) The Action made a series of allegations with respect to performance fees charged by the Investment Manager. TFG and its Board of Directors believed, and continue to believe, that the Action was factually and legally without merit.
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 Issuing Agent, Dutch Paying and Master Fund Transfer Agent Tetragon Financial Group Limited Kas Bank N.V. Tetragon Financial Group Master Fund Spuistraat 172 Limited 1012 VT Amsterdam 1st Floor Dorey Court The Netherlands Admiral Park St. Peter Port, Guernsey Legal Advisor (as to U.S. law) Channel Islands GYI 6HJ Cravath, Swaine & Moore LLP One Ropemaker Street Investment Manager London EC2Y 9HR Tetragon Financial Management LP United Kingdom 399 Park Avenue, 22nd Floor New York, NY 10022 Legal Advisor (as to Guernsey United States of America law) Ogier General Partner of Investment Manager Ogier House Tetragon Financial Management GP LLC St. Julian's Avenue 399 Park Avenue, 22nd Floor St. Peter Port, Guernsey New York, NY 10022 Channel Islands GY1 1WA United States of America Legal Advisor (as to Dutch law) De Brauw Blackstone Westbroek N.V. Claude Debussylaan 80 1082 MD Amsterdam The Netherlands Stock Listing NYSE Euronext in Amsterdam Administrator and Registrar State Street (Guernsey) Limited 1st Floor Dorey Court Admiral Park St. Peter Port, Guernsey Channel Islands GYI 6HJ Auditors KPMG Channel Islands Limited 20 New Street St. Peter Port, Guernsey Channel Islands GY1 4AN Sub-Registrar and Transfer Agent Computershare One Wall Street New York, NY 10286 United States of America
David Wishnow/Yuko Thomas
Andrew Garfield / Gill Ackers / Pip Green