Navigating Through the Fortress

Reading the recent Fortress Investment (NYSE: FIG  ) earnings announcement, my initial reaction was "huh?"

The alternative assets manager, which went public earlier this year, reported "pre-tax distributable earnings" of $143 million on segment revenue that was up 50% from the second quarter of last year. Under GAAP accounting rules, though, the company reported a $55 million loss. So what gives?

Deciphering the results
For most companies, completing an IPO is a fairly straightforward process. The company sells a chunk of its ownership on the public markets and voila! they're now a publicly traded company. OK, so that's a bit of oversimplification; with SarbOx in effect, becoming a public company is a bit more challenging, but it's still a relatively vanilla transition.

The IPOs of alternative asset managers like Fortress and Blackstone (NYSE: BX  ) , though, have been another story. These firms underwent significant structural changes to how their businesses report prior to entering the public markets. In the case of Fortress, it deconsolidated the funds that it manages so the operations of the funds are a bit more opaque and its reports focus on the results of the holding company. This can be seen, for example, on the balance via the disappearance of the fair value of investment company holdings.

Additionally, Fortress structured some interesting compensation and retention plans. One such plan stipulates that any principal of the firm who leaves voluntarily before the fifth anniversary of the firm's IPO must forfeit a portion of his Fortress stake. According to Fortress' filings, $4.8 billion of the principals' ownership as of the IPO date was subject to this forfeiture and it is being recognized proportionately as an expense over the next five years. This can be found on the income statement under the heading "Principals' agreement compensation" and amounted to a $243 million expense for the June quarter.

So, in short, it is going to be tough to get a good picture of Fortress' financial performance by simply looking at the bottom-line GAAP profit and comparing it to prior years. To address this, the company reports the pre-tax distributable earnings number, a number which it, and apparently Wall Street, believes is more indicative of the firm's performance. To get to this number, Fortress takes GAAP profit and adds back the principals' agreement compensation, as well as a number of other incentive income and equity compensation expenses.

The numbers are good ... but what's ahead?
On that basis, it was a nice quarter for Fortress. Pre-tax distributable earnings were up 86% on a year-over-year basis and total assets under management (AUM) increased a heady 68%. It also issued a $0.225 dividend for the quarter and closed a new $5 billion private equity fund after the quarter ended.

While the results, particularly the growth in AUM, are encouraging, they do need to be taken in light of the time period. In the second quarter, the mood on the market was relatively positive and the S&P gained almost 8%. Since the close of the second quarter, though, Mr. Market has put on a bit of the Mr. Hyde routine. Investors are decidedly less bullish, hedge funds at quality firms like Bear Stearns (NYSE: BSC  ) and Goldman Sachs (NYSE: GS  ) are huffing and puffing, some parts of the debt markets have ground to a near halt, and the S&P is back down nearly 10%.

Though Fortress' Newcastle (NYSE: NCT  ) investment fund has been caught in the middle of the real estate mess and is down around 43% since the close of the second quarter, choppy markets don't have to mean poor performance for the firm's hedge funds. The performance of the hedge funds, which generate the lion's share of Fortress' income, will make or break their results for the next quarter. If its managers are able to successfully navigate the choppy markets, the incentive income will come rolling in and investors that have been burned by other funds could end up throwing more money its way. On the other hand, if the managers blow it -- well, you know what happens then.

The one thing that's for sure right now is that the idea of Fortress is not what it was a few months back. The firm's IPO priced at $18.50 per share, but amid extreme excitement for alternative asset managers, didn't make it to the public markets before clearing $30. Today the shares trade at just over $17.00 per share, and even at this price investors seem wary about taking a chance.

More financial Foolishness:

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy would like to lock Mr. Market inside the Fortress' dungeon when he starts acting like this.


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