Description

Fortress Investment Group (FIG, $5.40) was written up over a year ago by nha885 and I encourage you to read that write-up for additional background on the company and a more detailed valuation framework.  In that time, the company has raised more capital, much of it permanent capital, and yet the valuation has gotten cheaper.  While we recognize the risk of owning an alternatives business in volatile markets, we think the risk/reward is especially interesting here.

Elevator pitch:

Fortress Investment Group has $2.70 cents in cash and investments on its balance sheet.  The company as of the last quarter end (June 30^th) had another approximately $1.10 per share in net embedded gains (after comp paid out) - so just under $4 in cash, investment, and net embedded gains on the balance sheet. The company has spoken about returning a large portion of its excess capital (see most recent slide deck), or just under $3 tax affected and allowing for retained cash.  The stock trades at $5.40 – so there is a ~$2.60 stub net of the probable return of cash and investments.  The run rate distributable earnings are 84 cents and consensus is around 80 cents, so the stub is trading for somewhere around 3 times distributable earnings. We see fair value closer to $10 barring a prolonged downturn. In the meantime, you get paid to wait – the base dividend is 32c, supported by net management fees alone, with extra dividends based on realizations.

The business of asset management is a good one – asset-light and scalable. The company continues to launch new products and increase capacity in existing ones, leveraging existing relationships with institutional funding and public markets. FIG has been focusing its fundraising efforts on long-term and permanent capital vehicles, giving a far more stable base of income for the business. There are definitely some risks and potential headwinds but we think you’re getting paid to deal with them at these prices.

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Business description:

Fortress Investment Group is a global investment management firm, specializing in alternative investments such as private equity funds and hedge funds, but with a significant fixed income business. The funds are divided into several lines:

·         Private Equity: These are buyout funds some of which are closed and in runoff. The bulk of the funds (by AUM) hit maturity in 2017/18 (see detail in 10-K), though they should continue to earn management fees for several years.

·         Permanent Capital Vehicles (PCVs). The PCVs are publicly traded and have been growing capital through public offerings. NRZ, NCT, SNR, NEWM, ECT, FTAI. This is an exciting long term growth opportunity for the firm, typically earning 1.5% management fees, and 25% incentive fee subject to a hurdle of 10%. New assets are being raised through follow-on offerings and by launching new vehicles. So far this year they have raised $2.4B.

·         Liquid Hedge Funds —includes Fortress Macro Funds, and Affiliated Managers which is primarily Fortress Asia Macro Funds. This segment has had poor recent performance, has been losing AUM and has been restructured.

·         Credit hedge funds. Investments in direct lending, corporate debt and securities, real estate and structured finance.

·         Credit private equity (“PE”) funds: Global credit and real estate opportunities funds.

·         Logan Circle — a traditional institutional fixed income management business. AUM has been growing steadily and the business is now operating around breakeven. Further AUM growth should lead to meaningful growth in profits.

From the most recent 10-K, here is the breakdown of revenues from Management and Incentive fees across each of the lines.

The business is built on performance fees and management fees, with management fees obviously the more stable of the two streams.  The good news is that the company has been growing AUM at a steady pace and ended the second quarter with $72B in AUM with another $10B in uncalled “dry powder”.  They have raised $3.2 billion of capital across alternative investment businesses during the second quarter and $8.6 billion in the first half of 2015.  This is a healthy business that is not going away anytime soon. 

Permanent capital vehicles (PCVs) are a major focus of Fortress and a bright spot for the business as they have been growing these funds rapidly in the last couple of years.  Fortress is expecting to collect management fees of 1.3% to 1.5% on these vehicles in perpetuity and is also eligible for performance fees up to 25% of profits above a hurdle.   The Permanent Capital Vehicles have raised $2.4 billion of capital year-to-date through June 30, 2015 and stand at just under $7B in AUM.   The PCVs are focused on large markets including residential, senior living, transportation and infrastructure, and new media.  The company has indicated they could ultimately be in the $10B to $15B AUM range, depending on investor demand.

Qualitative Factors: 

Fortress has several attributes of an attractive business including aligned management team, recurring revenues, expanding margins, and a reasonable valuation. 

·         Aligned Management:  Fortress management is very well aligned with common shareholders.  Over 50% of the company is owned by insiders and their compensation is tied to the performance of the funds that they manage.  Strong performance leads to AUM, management fee and performance fee growth.   

·         Recurring Revenues: The performance fees will come and go with investment performance, but in the first half of 2015, over 50% of revenues were from management fees ($283M) for a run rate of $560M a year in management fee revenue..

·         Operating Leverage/Expanding Margins:  Like virtually all asset managers, incremental volume tends to be very profitable as there are limited additional fixed costs.  The benefits of growth are obvious as typically there are only variable costs associated (incentive compensation) associated with increased assets.  Of course, the operating leverage is only favorable as AUM increases.

Why is it cheap?

You can fill out your own list of concerns here but a few include:

·         General pullback from the publicly traded alternatives sector over the last year

·         Concern over impact of recession and/or rising rates on value of assets in real estate, fixed income etc

·         Perception of exposure to volatile incentive fees (see discussion below)

·         FIG performed poorly in the last downturn

Valuation: 

The truth is, the value of FIG is hard to nail down, with so many variables around AUM, return profiles etc. We see reasonable estimates in the $6-$10 range. One of the big pushbacks is the volatility of incentive fees, so we focus on the management fee portion of income, and let the reader decide what value to put on the incentive fees. nha885’s write-up has several compelling valuation metrics, here are a few ways we look at it:

1)   Base dividend of $0.32 (which FIG claims represents sustainable after-tax net management fees); put a 15x on that and you get ~$4.80 + cash, investments and embedded gains of ~$3.80 = $8.60.  Then add to that the value of performance fees on $38 billion AUM (ex-Logan Circle) of which $16B was incentive eligible at the end of last quarter. Just using a mid single digit multiple on that would get you to ~$11 overall

2)     Fortress paid out an LTM dividend of $0.62 which is a yield of about 11% right now.  A 6% yield puts you at over $10.  If you believe the business is not permanently impaired and they continue to make money and pay it out – something should give.

3) Crude SOTP.  

$1.80   haircut the cash and investments to ~$1.80/share for taxes and cash retained.

$1.00   unrecognized incentive income, after tax and profit share.

$0.50   Logan Circle, which has just hit breakeven, at about 0.7% of AUM.

$0.30   3 more years of net management fees on the traditional PE funds (conservative)

$2.70   15x 18c of taxed management fees net of expenses on Credit HF & PE and PCVs.

$6.30

++Plus++

$?? Future incentive fees on all funds

$?? Future AUM growth / New products

$?? Value of the liquid HF business.

Plug in your own values for the question marks it’s not hard to make a case for a double from here.  

Fortress should have limited downside with cash, investments, embedded incentive fees, uncalled capital, and earnings from management fees.  There is significant optionality from multiple expansion, incentive fees, and continued fundraising, hopefully creating an asymmetric heads I lose a little - tails I make a lot situation. 

Catalyst

·        Dividend increases / recurring special dividends

·       Sentiment Shift: The company may “snap back” nicely if more positive overall market sentiment emerges. 

 ·      Insider buying/Tender Offer:  Insiders worry about float, but given the valuation, we would not be surprised to see action taken by management.  They are professional capital allocators, and FIG has bought back blocks in the past.

 ·      Launch of new products. FIG continues to look at new growth vehicles in PCVs and funds, tied to specific asset classes or geographies.

Risks: 

·        If you believe we are about to enter into a multi-year correction and deflation of asset values, this is clearly not the investment for you. Performance fees, AUM and fundraising would be significantly impacted.  This is modestly offset by $10B in callable capital that the company is not collecting management fees on. In the event of a severe correction, some of this capital could be called to take advantage of asset prices.

·      Institutional preference: The “bigger is better” mentality has favored the likes of Fortress when raising assets.  It does not mean they always have the best returns.

·        Poor investment performance – the Macro hedge fund performance has been terrible.  The business never seems to fire on all cylinders, there is usually a “problem child” but typically credit hedge fund or private equity has driven performance fees. 

·        Key man risk. Departure of one of the business heads could have a significant impact

·        Decline in value of the Balance Sheet (Cash + Investments + Embedded Incentive) – There is limited clarity into the investments and embedded incentive.  Presumably the value of most of the investments will decline in value if there is broad based multiple compression.  The largest investments are in Florida real estate (not public) and Springleaf (LEAF).  The majority of the embedded gains are from the credit funds and the diversified mix of cash, credit based instruments, and private real estate holdings may somewhat mute swings in the value of the Investments + Embedded incentive) 

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. Please do your own work.

Catalyst

·        Dividend increases / recurring special dividends

·       Sentiment Shift: The company may “snap back” nicely if more positive overall market sentiment emerges. 

 ·      Insider buying/Tender Offer:  Insiders worry about float, but given the valuation, we would not be surprised to see action taken by management.  They are professional capital allocators, and FIG has bought back blocks in the past.

 ·      Launch of new products. FIG continues to look at new growth vehicles in PCVs and funds, tied to specific asset classes or geographies.