Marching on the Fortress

Fortress Investment Group (NYSE: FIG  ) has created quite a stir by blazing a trail to U.S. public equity markets for alternative asset managers. Overseas markets have seen similar offerings from Man Group and KKR Private Equity Investors, but Fortress is the first pure play for the U.S. equity markets.

The Fortress storm started as a giddy breeze when the group announced its intention to go public, kicked up into a strong tailwind when it filed its initial S-1 back in November, and turned into bona fide gale-force winds when the company went from pricing to the first day of trading. After pricing at $18.50 per share, the stock hit the NYSE at $35, a quick 89% gain for IPO investors. The 19% drop that followed, though, has sobered everyone up pretty quickly and left questions over what Fortress investors are actually investing in and what the stock is really worth.

What exactly are Fortress investors buying?
Though it's tempting (and easy!) to say that investing in Fortress is investing in a hedge fund, the truth is actually a bit more complex than that. Fortress's description of itself as an "alternative asset manager" is much more accurate, since the company operates a few different types of funds. These are:

1. Private equity. The bulk of Fortress's $30 billion under management ($17.5 billion, to be exact) is in private equity funds, which primarily make control-oriented investments in cash flow-generating businesses. The overall internal rate of return (IRR) for the four main PE funds has been 41% since the inception of Fortress Investment Fund I in 1999. Notable companies churned out of Fortress PE funds include Brookdale Senior Living (NYSE: BKD  ) and Aircastle (NYSE: AYR  ) .

2. Hedge funds. Ahh, the hedge funds. Although they account for a lower percentage of the invested capital at Fortress, these funds make up around 60% of Fortress's total revenue. They come in two broad flavors: liquid and hybrid. The liquid hedge funds invest in vehicles that are (surprise) very liquid, such as equities, currencies, and commodity derivatives. The hybrid funds take on less liquid investments like private loans, asset pools, and receivables. The $9.4 billion in the hedge funds is split almost 50/50 between the two categories, and on an annualized basis they have returned 13.3% and 13.7%, respectively.

3. "Castles." Fortress's "Castles" business segment consists of two publicly held companies with the mandate to make broad investments in the real estate market. The two funds are Newcastle Investment (NYSE: NCT  ) and Eurocastle Investment, and they have returned 33.9% and 69.1%, respectively, on an annual basis. Income from the castles represents about 7% of Fortress' overall revenue.

Investing in Fortress is different from investing in its funds. Public investors have an ownership stake in the company that runs the funds, meaning they are not just relying on the funds' absolute returns. Instead, they have an interest in a) the management fees each fund collects from its investors based on the total funds under management, b) incentive income based on the performance of each fund, and c) returns from the investments that Fortress makes in its own funds.

The upshot of this arrangement is that there are multiple streams of income coming in, including the recurring and somewhat predictable management fees. The other side of the coin, though, is that if fund performance hits a rut, several unpleasant possibilities -- declining management fees as investors pull out their money, loss of incentive income, and poor returns from principal investments -- may come true all at once.

An alpha factory
To many, Fortress's inner workings may seem complicated and opaque. Though there's no physical factory or product to kick the tires on, Fortress manufactures a product called alpha in much the same way that Toyota (NYSE: TM  ) makes cars. Alpha is the risk-adjusted excess return that an investment produces versus a benchmark. So, for example, if a portfolio's benchmark is the S&P, its volatility is equal to the S&P, and it returns 13% versus 9% for the S&P, then the alpha is 4%. That's what's coming off the factory line at Fortress.

Toyota customers want to be sold high-quality cars, and if the company falls down on the job and starts making junk, it's going to lose its customers, plain and simple. Similarly, Fortress's customers -- the fund investors -- expect a certain rate of return on the money they invest, and if they don't get it, they'll pull their money back out and shop at another alternative-investment superstore.

Great investors sell at the top
I've read lately that there's concern that Fortress insiders are cashing out because it's currently at its peak. I figure they wouldn't admit it if that were the case, but I have a hunch that they're hoping Fortress still has good days ahead, since the principals still have a 77% interest in the company after the IPO. Plus, more than half of the 23% they sold went to another savvy investor -- Japanese financial powerhouse Nomura.

In its prospectus, Fortress cites four primary reasons that it is listing on the public markets: to be able to provide equity-based compensation to retain and attract employees; to increase its market presence; for easy access to future capital; and to have an equity currency for strategic acquisitions. I speculate that an unlisted fifth reason may be that the founders thought it might be nice to have a few hundred million extra -- but could you blame them?

So is Fortress worth 40 times net income, where it's currently trading? Man Group has done jolly well for its investors since its debut on the public markets, but it never traded at Fortress's current multiples. With the intellectual horsepower Fortress has behind it, I'd have trouble betting against it long-term, but the stock would have to take more of a breather before I'd consider calling myself an investor.

I'd cap this off with a pun having to do with fortresses or castles or medieval warfare of some sort, but I'm pretty sure I've been beaten to the punch on just about every one out there.

More Foolish fun with Fortress:

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Fool contributor Matt Koppenheffer doesn't run a hedge fund, and he appreciates his ulcer-free existence, thank you very much. He does not own shares of any of the companies mentioned, but encourages readers to email him any Fortress-related puns that he may have missed. The Fool's disclosure policy protects loyal readers like, well, a fortress, I guess.


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