Tetragon Financial Group Limited (TFG): Supplemental Information To The Monthly Update For December 2012
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. 
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.
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