For the first time ever, an alternative asset manager -- Fortress Investment (NYSE: FIG ) -- is going public on the New York Stock Exchange. By purchasing shares of the firm, you are essentially participating in the hot areas of private equity and hedge funds. But at its current valuation, the risks are certainly hefty.
Background
Fortress got its start in May 1998 with three co-founders: Wesley Edens, Robert Kauffman, and Randal Nardone. Before this, the group had deep financial experience with companies like BlackRock (NYSE: BLK ) , Lehman Brothers (NYSE: LEH ) , and UBS AG (NYSE: UBS ) .
From the start, the firm has undergone tremendous growth. For example, assets under management are nearly $30 billion, which compares to just $1.2 billion at the end of 2001.
These assets are spread across three areas. First, there are private equity funds, at $17.5 billion, which involve the buyouts of undervalued companies that have strong cash flows. According to Thomson, annualized returns for private equity funds over the past 10 years have been 12.3%, which compares to 7.3% for the S&P 500.
Next, there are hedge funds, at $9.4 billion. Such vehicles invest in diverse areas (derivatives, illiquid securities, etc.) and employ complex strategies such as arbitrage and short sales. For the past five years, the HFRI Fund Weighted Composite, which measures overall hedge fund performance, showed a 9.7% return, which compares to a return of 7% for the S&P.
Finally, there are real estate funds. These include two publicly traded companies, Newcastle Investment (NYSE: NCT ) , which invests in real estate securities in the U.S., and Eurocastle Investment Group LLC, which is listed on the Euronext and focuses on investments in Germany.
It's all about returns
The compensation for Fortress is primarily based on the performance of its portfolios. The fees generally range from 20% to 25% of the quarterly or annual profits. What's more, the investment managers must put their own capital in the funds.
The goal is to achieve absolute returns. This means that the return should be positive despite what the overall markets do. And it's worked quite well -- in the first nine months of 2006, net income was $158.7 million, up from $32.7 million during the same period in 2005.
Takeaway
The portfolio managers at Fortress have a stellar performance record, especially with the private equity funds, which have realized an average annual return of 39.7% since 1999. However, even legendary money managers stumble; last year, Goldman Sachs' (NYSE: GS ) flagship hedge fund, Global Alpha, sustained a loss of 6%.
With the Fortress IPO, you are betting that its team will continue to post above-market returns. If the team loses its momentum, the Fortress could crumble.
Investing in Fortress is not the same as investing in a hedge fund or private equity fund -- here, you are investing in the fees of Fortress. For example, suppose Fortress has a year in which its portfolio does not increase. In this case, the incentive fees will be zero, which would be a massive hit to the bottom line.
There is also the problem with the "high-water mark." Let's say the fund falls 10% for the year. It will need to make up for all its losses before it will start generating incentive fees, which could easily take a couple of years. This is a reason why some hedge funds close down.
The Fortress IPO may lead to other public offerings of alternative asset managers, especially if the stock performs well for a couple of quarters. This is what happened when U.S. stock exchanges started to go public a few years ago. Some IPO prospects include the Tier 1 players, such as KKR, Blackstone, Bain Capital, and Texas Pacific Group.
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Fool contributor Tom Taulli does not own shares of any company mentioned in this article. The Fool's disclosure policy never hedges.
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