Craig Nerenberg from Brenner West Capital pitched Tetragon Financial Group (TFG) at the Harbor Investment Conference on February 3rd as a top idea for 2011. TFG is a classic discount to net asset value (NAV) idea coupled with tailwinds that will continue to grow NAV, at least in the near term.
TFG is a closed-end investment management company that buys the equity tranches of collateralized loan obligations ((CLOs)), i.e., it invests in CLO residuals. TFG has invested in $1.4bn of CLO equities, which have been written down to $1.0bn, and it charges investors a 1.5% management fee and 25% incentive fee over a LIBOR + spread hurdle.
After a dislocation in the financial markets, CLOs (and TFG) can deliver higher return on equity (ROE) because they have fixed liabilities that can't be pulled off and they can generate outsized returns by locking in wider spreads.
The key risk for TFG is deterioration in the health of the capital markets, which would lead to higher credit spreads and defaults, and consequently lower asset prices and cash - trapping in the CLOs. Even though TFG has no debt and its cashflows would not be impacted, its NAV would go down and with it, its price (it doesn't trade above NAV because of the high volatility and low/mid-teens planned ROE).
Bull Versus Bear
The bull thesis is that CLO equity has been growing rapidly due to spread compression in the institutional loan and high-yield markets, a trend that has continued in January 2011. The bear thesis is predicated on the loan-refinancing cliff that the market is facing in 2013-14 as CLOs enter their "end of reinvestment" period, which eventually takes out 40% of the refinancing supply.
TFG trades at 75% of reported January 2011 NAV of $9.82 versus a 20% premium-to-NAV valuation for its closest comp, KKR Financial (KFN). This NAV excludes an additional $1.60 of value that will accrete into NAV from the reversal of its accelerated loss reserve (ALR), net of incentive fees. TFG's management has indicated that the NAV is projected to grow at a 15% IRR, based on assumptions that are more conservative than current market indications. Net of the 25% incentive fee, TFG's NAV will grow at a rate of 11.25%, so by year-end 2011 it could be $12.50 (inclusive of the ALR).
If it continues to narrow the discount to KFN and trades at 80% of NAV, the stock should be at $10, which is (now) around 40% upside from where it's been trading recently. Assuming KFN's 20% premium to NAV valuation, TFG could be a $15 stock, though there are reasons for a discount to KFN to persist: low liquidity, listed outside of the U.S., and investors feeling sour about management capturing 25% incentive from the ALR. Nerenberg's hedge fund Brenner West Capital has hedged its long position in TFG with a short of KFN.