As something of a contrarian, I’m always in search of a bargain, especially in the investment trust space. That usually means perusing the list of funds (and stocks) hitting their 52 week low. In truth though, this is usually a fairly miserable, counterproductive pursuit as the vast majority of stocks on the said list are a complete and utter waste of time. Next up on my regular scan is the list of funds trading at cavernous discounts to NAV. This is usually a slightly more productive exercise although the usual candidates always keep popping up (usually involving regulars in this blog such as Ranger and EPE). Tetragon also regularly features on this latter list and if I’m honest it’s one that I’ve only known the basics about. On paper, it’s a listed hedge fund which features all manner of equity/credit strategies, bank loans and real estate investments – with all the to-be-expected high charges and performance fees. This is usually enough to make me skip straight on to the next fund in the list but Matt Hose, investment trust analyst at Jefferies reckons I should linger a bit longer. He thinks it’s a buy – I’ve pasted in his most recent note below – and I think he might just be on to something.
It has to be said that Tetagron isn’t likely to feature highly in many analysts or investors buy lists. It has lots of things going against it. A big and persistent discount to NAV (currently at 35% and averaging just under 40% over the last five years) which has hit as high as 55% (in 2016). It’s well-rewarded managers have also been using their generous fees to buy up more of the fund, to the point where they now own 27% of the stock. All of this might be justified if relative returns from the various funds and strategies had blown the lights out – but they haven’t. In truth, recent returns have been fine but not spectacular.
So, what might make us reconsider? In structural terms, the fund is doing its best to make itself more attractive. There have been regular share buybacks and tenders. The fund is also very active in paying out a regular and progressive dividend, which currently amounts to a yield of 5% – which isn’t bad all things considered. It’s also brought in specialist research outfits such as Edison to help explain its business model better. The link to their last (paid for) research report is online at –
Crucially Tetragon is very far being a conventional hedge fund. A good chunk of the fund’s balance sheet is invested in the actual fund managers – TFG Asset Management includes stakes in Equitix (infra), LCM (CLO), GreenOak Real estate, and Polygon itself. I have no idea how good these fund managers are but it does establish clear alignment of interests – as does that stake in the fund itself by the main managers. Cash also represents around 25% of the value of the fund, though that’ll obviously decline over time as the tenders and buybacks cut in. So, presumably, the beta of this fund should be relatively low when compared to the wider stockmarket – all that cash, stakes in private businesses and in log/short strategies will help. Last by no means least we come to the core positive articulated by Matt Hose – that we’ve reached a key tipping point where the interests of the managers are now aligned with increasing the share price rather than just buying back shares or paying out dividends. As I said above I’ve pasted in the main core of the recent note from Matt below. The discount of Tetragon has been as low as 20% in recent years (in 2013), so it’s not entirely impossible that Tetragon could re-rate higher. And you still get that regular dividend? Might this be a new contrarian bet?
Matt Hose note on Tetragon
Alignment: We see TFG’s onerous fee structure as one of the drivers behind its wide discount to NAV, of currently an estimated 33%. These arrangements consist of a 1.5% of NAV management fee, and a 25% performance fee over a 3m U.S. LIBOR plus 2.65% hurdle (so currently 4.37%), subject to a high water mark, which is reset every quarter with a six-month ‘look back’. Such performance fee arrangements can understandably be costly in terms of return leakage and represent an asymmetric alignment of interests. However, an ameliorating factor here is TFG’s high degree of alignment via its partner and employee share ownership. If we adjust the last reported figure of TFG’s insider ownership for December’s tender, it represents 27.2% of TFG’s diluted shares in issue, with the level of insider ownership having steadily increased for a number of years now.
The crossover: Our observation is that at this level of partner and employee share ownership TFG is approaching a subtle crossover point at which the group, as a whole, will arguably be more incentivised from share price appreciation than from the performance fee. If we take the scenario of a 10% increase in the NAV (TFG targets a 10-15% RoE), in turn translating to a 10% share price return, assuming no change in the rating, this would result in $35.3m of accrued value. Against this, based on the current level of hurdle and assuming the HWM has been surpassed, a 10% increase in the NAV implies the payment of $36.4m of performance fees.
A number of caveats: There are of course certain caveats to this. Chiefly that TFG’s external manager levying the performance fee – Tetragon Financial Management (TFM) – is ultimately controlled by Reade Griffith and Paddy Dear, whereas the insider share ownership is distributed more widely, albeit still with these two principals owning material stakes. Elsewhere, higher levels of assumed NAV return (say 15% or 20% p.a.) will entail performance fee incentivisation outweighs the share appreciation benefits as there is more headroom over the hurdle. To this end, the recent increase in U.S. LIBOR has served to raise the hurdle, but ceteris paribus this higher risk-free rate should also flow through the portfolio (both directly and indirectly) resulting in higher NAV returns. We are also not forgetting the management fee still equates to sizeable payment to the managers that will naturally increase as the NAV increases.
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