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Thursday 31 January, 2013

Tetragon Financial Group Limit

Tetragon Financial Group Limited (TFG):


    Tetragon Financial Group Limited (TFG) is a Guernsey closed-ended investment
company
        traded on the NYSE Euronext in Amsterdam under the ticker symbol "TFG".

        In this update, unless otherwise stated, we report on the consolidated 
business
    incorporating TFG and Tetragon Financial Group Master Fund Limited.[1]

        In this update, we provide additional information on "U.S. GAAP NAV per
Share" and
         a
    new metric, "Pro forma fully diluted NAV per Share". We believe this new 
metric
     (described
    below in section 1.2) may be helpful in illustrating the potential impact of
various
     share
    changes on Net Asset Value ("NAV") per Share and we intend to include the 
item in
     future
    reporting. We also explain the recalibration of certain inputs used in the
     determination
    of the fair value of TFG's CLO equity investments.

        1. NAV per Share movements

        The figure below shows how U.S. GAAP NAV per Share and pro forma fully 
diluted NAV
         per
    Share metrics have evolved over the last four quarters.

    <start_table>

                                              Q1 2012 Q2 2012 Q3 2012 Q4 2012
        US GAAP NAV per Share                   13.12   13.75   14.29   16.41
        Pro Forma Fully Diluted NAV per Share   13.12   13.75   14.29   14.91

    <end_table>

        1.1 U.S. GAAP NAV per Share movements:

        NAV per Share calculated under U.S. Generally Accepted Accounting 
Principles ("U.S.
    GAAP") for TFG as at December 31, 2012 was $16.41, up from $14.91 as at 
November 30,
     2012.
    Two events significantly contributed to the increase in U.S. GAAP NAV per 
Share in
    December. Firstly, as announced on December 7, 2012, in conjunction with a 
"modified
     Dutch
    auction" tender offer (the "Offer"), TFG purchased 15,384,615 TFG non-voting
shares at
     a
    price of $9.75 for $150 million. As the purchase price of the Offer was 
significantly
    below the prevailing U.S. GAAP NAV per Share this had the impact of 
increasing U.S.
     GAAP
    NAV per Share by $0.85.

        Secondly, as at December 31, 2012, certain inputs into the CLO valuation
model were
    recalibrated, including forward-looking default assumptions and discount 
rates utilized
     in
    the determination of the applicable fair value of each deal. The net impact
of these
    changes was to increase fair value and thus to increase the U.S. GAAP NAV 
per Share by
    $0.50 on a net basis. A description of these changes is set forth below in 
section 2.

    <start_table>

        Gross Impact on Fair Value           U.S. CLOs    EUR CLOs     Total
                                             $ (millions) $ (millions) $ 
(millions)
        Recalibration of Default Assumptions         20.1         -1.1         
 19
        Recalibration of Discount Rates              45.3          7.1         
52.4
        Total                                        65.4            6         
71.4

    <end_table>

        1.2 Pro Forma Fully Diluted NAV per Share:

        We have also included in the December 2012 monthly update the 
calculation of a "Pro
    forma fully diluted NAV per Share" to seek to reflect certain potential 
changes to the
    total non-voting shares over the next few years, which may be utilized in 
the
     calculation
    of NAV per Share. Specifically, the number of shares used to calculate U.S.
GAAP NAV
     per
    Share has been adjusted to incorporate:

<pre>    
    - Shares which have been used as consideration for the acquisition of
      Polygon Management L.P. and applicable stock dividends relating thereto, 
and which
         are
      held in escrow and are expected to be released and incorporated into the 
U.S. GAAP
         NAV
      per Share over a five year period.[2]
</pre><pre>    
    - The number of shares corresponding to the applicable intrinsic value of
      the options issued to the Investment Manager at the time of the company's
IPO with
         a
      strike price of $10.00, to the extent such options are in the money at 
period end.
         As
      of December 31, 2012, the TFG share price was $9.67 and therefore such 
options were
      out of the money.[3]
</pre>        The Pro forma fully diluted NAV per Share was $14.65 at 2012 
year-end based on
         110.64
    million shares outstanding in respect of such calculation as outlined in the
table
     below.
    As at December 31, 2012, the U.S. GAAP NAV per Share is $16.41 based on 
98.80 million
    shares outstanding. As of December 31, 2012 TFG had approximately 133.75 
million shares
    legally issued and outstanding.

        The table below illustrates the three measures of shares described above
- legal
    shares issued and outstanding, U.S. GAAP shares outstanding and pro forma 
fully diluted
    shares. Legal shares issued and outstanding is used, for example, in TFG's 
monthly
    reporting, including to applicable regulatory authorities.

    &lt;start_table&gt;

                                            Dec 31 2012
        Shares Reconciliation               Shares (millions)

        Legal Shares Issued and Outstanding            133.75 
        Less: Shares Held In Subsidiary                 16.60 
        Less: Shares Held In Treasury                    6.50 
        Less: Escrow Shares                             11.84 
        U.S. GAAP Shares Outstanding                    98.80 
        Add: Manager (IPO) Share Options                    0 
        Add: Escrow Shares                              11.84 
        Pro Forma Fully Diluted Shares                 110.64

    &lt;end_table&gt;

        2. Fair Value Determination for TFG's CLO Equity Investments:

        In accordance with the valuation policies set forth on the company's 
website, the
    values of TFG's CLO equity investments are determined using a third-party 
cash flow
    modeling tool. The model contains certain assumption inputs that are 
reviewed and
     adjusted
    as appropriate to factor in how historic, current and potential market 
developments
    (examined through, for example, forward-looking observable data) might 
potentially
     impact
    the performance of TFG's CLO equity investments. Since this involves 
modeling, among
     other
    things, forward projections over multiple years, this is not an exercise in
     recalibrating
    future assumptions to the latest quarter's historical data.

        Subject to the foregoing, when determining the U.S. GAAP-compliant fair
value of
         TFG's
    portfolio, the company seeks to derive a value at which market participants
could
     transact
    in an orderly market and also seeks to benchmark the model inputs and 
resulting outputs
     to
    observable market data when available and appropriate. Please refer to the 
2011 Annual
    Report for a more detailed description of the cash flow projection and 
discounting
    process.

        2.1 Forward-looking CLO Equity Cash Flow Modeling Assumptions 
Recalibrated in Q4
         2012:

        The Investment Manager reviews and, when appropriate, adjusts in 
consultation with
    TFG's audit committee, the CLO equity investment portfolio's modeling 
assumptions as
    described above. At the end of Q4 2012, certain key assumptions relating to
defaults
     were
    recalibrated. Those relating to recoveries, prepayments and reinvestment 
prices were
    unchanged from the previous quarter.

        U.S. CLOs - default assumptions recalibrated

        For the U.S. deals, near-term default assumptions were unchanged but 
medium-term
    default multiples were reduced to reflect, among other things, the perceived
decline in
    concern over the so-called "maturity wall". These changes, which are 
detailed in the
     table
    below, had a positive impact on the undiscounted future projected cash flows
of the
     U.S.
    deals.

    &lt;start_table&gt;

        Variable        Year          Current Assumptions      Prior Assumptions
        CADR
                                    1.0x WARF-implied        1.0x WARF-implied
                 2013               default rate (2.2%)      default rate (2.2%)
                                    1.0x WARF-implied        1.5x WARF-implied
                 2014               default rate (2.2%)      default rate (3.3%)
                                    1.25x WARF-implied       1.5x WARF-implied
                 2015-2016          default rate (2.7%)      default rate (3.3%)
                                    1.25x WARF-implied       1.0x WARF-implied
                 2017               default rate (2.7%)      default rate (2.2%)
                                    1.0x WARF-implied        1.0x WARF-implied
                 Thereafter         default rate (2.2%)      default rate (2.2%)
        Recovery Rate
                 Until deal
                 maturity           73%                      73%
        Prepayment Rate
                 Until deal         20.0% p.a. on loans;     20.0% p.a. on 
loans;
                 maturity           0.0% on bonds            0.0% on bonds
        Reinvestment Price
                 Until deal
                 maturity           100%                     100%

    &lt;end_table&gt;

        European CLOs - default assumptions recalibrated

        For the European deals, an elevated default multiple was maintained in 
the near
         term,
    but the medium term multiple was recalibrated higher bringing it in line 
with the U.S.
    deals, and reflecting some of the enhanced risks during that period, 
including the
    percentage of loans maturing. For European deals, this change resulted in a
reduction
     in
    future undiscounted projected cash flows.

    &lt;start_table&gt;

        Variable        Year          Current Assumptions      Prior Assumptions
        CADR
                                    1.5x WARF-implied        1.5x WARF-implied
                 2013-2014          default rate (3.1%)      default rate (3.1%)
                                    1.25x WARF-implied       1.0x WARF-implied
                 2015-2017          default rate (2.6%)      default rate (2.1%)
                                    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%

    &lt;end_table&gt;

        These key average assumption variables include the modeling assumptions
disclosed
         as a
    weighted average (by U.S. dollar amount) of the individual deal assumptions,
aggregated
     by
    geography (i.e. U.S. and European). Such weighted averages may change from 
month to
     month
    due to movements in the amortized costs of the deals, even without changes 
to the
    underlying assumptions. Each individual deal's assumptions may differ from 
this
    geographical average and vary across the portfolio.

        The reinvestment price, assumptions about reinvestment spread and 
reinvestment life
    are also input into the model to generate an effective spread over LIBOR. 
Newer vintage
    CLOs may have a higher weighted-average reinvestment spread over LIBOR or 
shorter
    reinvestment life assumptions than older deals. Across the entire CLO 
portfolio, the
    reinvestment price assumption of 100% for U.S. deals and European deals with
their
    respective assumed weighted-average reinvestment spreads, generates an 
effective spread
    over LIBOR of approximately 284 bps on broadly syndicated U.S. loans, 272 
bps on
     European
    loans, and 328 bps on middle market loans.

        2.2 Application of Discount Rate to Projected CLO Equity Cash Flows: 
2005 - 2007
    vintage deals:

        In determining the applicable rates to use to discount projected cash 
flows, an
    analysis of observable risk premium data is undertaken. Observable risk 
premia such as
     BB
    and BBB CLO tranche spreads decreased late in Q3 2012 and we noted in TFG's
Q3 2012
    performance report that we would continue to monitor closely over the course
of Q4 2012
    whether these reductions were sustained, before considering a reduction in 
applicable
    discount rates. In Q4 2012 observable data has confirmed the re-rating of 
CLO risk,
     albeit
    the trend has continued at a slower pace. For example, according to Citibank
research,
     the
    spread on originally BB-rated U.S. CLO tranches decreased from approximately
11% at the
    end of Q2 2012 to 8% as of the end of September 2012 and further reduced to
     approximately
    7% at the end of December.[4]

        As a result of the observed continued tightening of these spreads and 
overall
    reduction in risk premia, the discount rates for the U.S. deals have been 
reduced to
     17.5%
    for strong deals and to 22.5% for other deals.

        Per Citibank research, European originally BB-rated tranche yields have
followed a
    similar trajectory to U.S. spreads over the last two quarters, reducing from
22% at the
    end of Q2 2012 to 16% at the end of Q3 2012 before a further reduction to 
14% in Q4
     2012.
    As a result of this reduction in risk premia, the discount rates for 
European deals
     have
    been reduced to 27.5%, which are still significantly above the U.S. deal 
discount
     rates,
    reflecting in part the ongoing uncertainty surrounding Europe.

        Previously on average, the discount rate being applied to the future 
cash flows was
    greater than the weighted-average IRR on pre-crisis deals, so the aggregate
fair value
     for
    both U.S. and European deals was lower than its amortized cost. The 
difference between
    these two figures was characterized as the "ALR Fair Value Adjustment" or 
"ALR". Post
     this
    recalibration this is no longer the case for U.S. deals so there is no ALR 
to report in
    respect of such deals. For European deals at the end of Q4 the ALR stands at
$86.6
     million
    compared to $97.9 million at the end of Q3.

        2.3 2010-2012 vintage deals

        The applicable discount rate for newer vintage deals is determined with
reference
         to
    each deal's specific IRR, which, in the absence of other observable data 
points, is
     deemed
    to be the most appropriate indication of the current risk premium on these 
structures.
     At
    the end of Q4 2012, the weighted-average discount rate (and IRR) on these 
deals was
     12.4%.
    Such deals represented approximately 14.3% of the CLO equity portfolio by 
fair value
     (up
    from 12.8% at the end of Q3 2012). We will continue to monitor observable 
data on these
    newer vintage transactions to determine whether the IRR remains the 
appropriate
     discount
    rate.

        2.4 Effect on fair value and net income of recalibration of certain 
inputs into the
    CLO model

        Overall, the net impact of the recalibration of certain forward-looking
default
    assumptions and discount rates described above led to an overall increase in
fair value
     of
    the total CLO equity portfolio of approximately $71.4 million, or $53.6 
million in
     bottom
    line net income.

        [1] TFG invests substantially all its capital through a master fund, 
Tetragon
    Financial Group Master Fund Limited ("TFGMF") in which it holds a 100% 
share.

        [2] Please see the press release of October 29, 2012 noting TFG's 
acquisition of
    Polygon Management L.P. and certain of its affiliates.

        [3] The intrinsic value of the options will be calculated as the excess
of (x) the
    closing price of the shares as of the final trading day in the relevant 
period over (y)
    $10.00 (being the exercise price per share) times (z) 12,545,330 (being a 
number of
     shares
    subject to the options before the application of potential anti-dilution). 
The terms of
    exercise under the options allow for exercise using cash, as well as, with 
the consent
     of
    the board of the Company, certain forms of cashless exercise. Each of these
prescribed
    methods of exercise may give rise to the issuance of a different number of 
shares than
     the
    approach described herein. If the options were to be surrendered for their 
intrinsic
     value
    with the board's consent, rather than exercised, the number of shares issued
would
     equal
    the intrinsic value divided by the closing price of the shares as of the 
final trading
     day
    in the relevant period. This approach has been selected because we currently
believe it
     is
    more reasonably illustrative of a likely outcome if the options are 
exercised. The
     options
    are exercisable until April 26, 2017.

        [4] Citi Global Structured Credit Strategy 22 January 2013



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