Fortress Investment Group (NYSE:FIG)

Transcription

1 1455 de Maisonneuve West H3G 1M8 (514) ext November 26 th, 2013 Recommendation: BUY Stock Rating: Sector Outperformer Sector Weighting: Overweight 12-month Price Target $10.00 Current Price $ week Range $4.10-$9.10 Shares Outstanding 239.6M Float 212.2M Avg. Daily Trading Volume 17.32M Beta Market Capitalization $3.91B Dividend / Div. Yield $0.20/2.53% Fiscal Year Ends Dec. 31st Book Value $ ROE 23.42% L-T Debt None Forward P/E Earnings Per Share 2012 $ E $ E $0.73 P/E Current Dividend Per Share / Yield 2012 $ E $ E $0.20 Company Description FIG is an alternative asset manager. The Company raises, invests and manages private equity funds, hedge funds and publicly traded alternative investment vehicles. Alternative Asset Manager Fortress Investment Group (NYSE:FIG) A Diamond In The Rough Attractive Valuation: Although FIG has increased by more than 92.0% year-to-date, we believe that it is still attractively valued. Based on our conservative assumptions, the alternative asset manager has an intrinsic value of $ % above it current price of $7.99/share. This valuation is based on 2014 management fee income of $0.30/share and 2014 incentive income of $0.21/share. By applying a P/E multiple of 16.0x (average among traditional asset managers) to fee based earnings and a multiple of 8.0x to incentive income, and adding the company s $3.14/share in cash and investments and its $0.41/share in undistributed incentive income, we arrive at our price target of $10.00/share. At $7.99, investors are paying for the company s stable feebased earnings and its cash and investments and are essentially getting the firm s growing traditional asset management segment (Logan), as well as existing and future incentive income free of charge. The Recovery Private Equity: Although FIG s PE funds have underperformed the market in recent years (due primarily to their exposure to the U.S. financial and housing markets during the crisis) it has been a major catalyst behind the stock s upswing over the past 12 months. In fact, three of the company s PE funds are nearing their high-water mark and could start earning incentive income as soon as The company has also announced that they will be raising 2 new PE funds by the end of 2013 with a combined AUM of $5.0B. Logan Circle Partners as a L-T Catalyst: Since it acquired Logan in 2010, FIG has more than doubled its AUM and has added equity funds to its product offering. Continued AUM growth and higher management fees could make this a major driver for the stock. Stock Price Performance David Hemmings 1 (514) dav_hem@hotmail.com Alexandre Morin-Innes 1 (514) alex_innes@icloud.com

2 Investment Thesis Generally speaking, alternative asset managers are deeply discounted compared to traditional asset managers. Among these alternative asset managers, Fortress Investment Group (FIG) appears to be the most undervalued. Assuming 2014 base management fee earnings of $0.30/share and 2014 incentive income of $0.21/share and applying a P/E multiple of 16.0x to management fees and a multiple of 8.0x to incentive fees, we arrive at a basic a value per share of at least $6.48/per share. In addition, the company has $3.14/share in cash and investments as well as $0.41/share in undistributed incentive income, which gives us an implicit value per share of $ At current levels, investors are paying for the stable management fee income, as well as the cash and investments on the balance sheet, but are also getting the optionality of existing and future incentive income, the firm s growing traditional asset manager (Logan) as well as its PE segment which is being heavily discounted by the market. FIG has $10.00/share of hard, tangible value. Potential Catalysts Restructuring of Newcastle and Eurocastle has reset their respective high-water marks, allowing FIG to generate incentive income as soon of Q Strong credit franchise should continue to perform well despite shrinking opportunities in credit markets. The segment has more than $650M in undistributed and unrecognized incentive income, which should bolster end of year earnings as more and more funds are realized. Logan Circle Partners has grown its AUM tremendously over t6he past 12 months, and should continue to do so. Assuming the traditional asset manager can grow its asset under management to $27.2B by year end; this should push the stock higher. Three PE funds FHIF, Fund III and Fund IV are nearing their high-water mark and will likely start generating promote as soon as Q AUM growth, as FIG continues to raise money for private equity, credit hedge funds, liquid hedge funds and Logan. We expect total AUM to increase to $70.2B by the end of 2014 (from $58.7B). Potential Risks Weaker than expected performance from credit franchise. Although FIG has one of the most successful credit franchises in the world, management has warned that they are facing limited opportunities. This could weight on the stock. Continued weakness in private equity funds. Now that 46.0% of the company s PE holdings are public companies, it is easier to track PE fund performance. Notable public holdings include GAGFAH, Brookdale Senior Living Inc., Penn National Gaming Inc., and Nationstar Mortgage Holdings, Spingleaf Holdings Inc. as well as Walker Dunlop. A weakening U.S. housing market would exert considerable pressure on the company s PE funds, and could prevent incentive income and even affect the FIG s ability to raise money going forward. Higher interest rates could also have an adverse effect on the company stock moving forward. With up to 25.0% of its PE funds invested in mortgage-related companies (Nationstar, Springleaf and Walker & Dunlop) a weaker origination and loan servicing outlook would certainly have an adverse effect on the funds performances. Lack of liquidity and float could keep institutional investors from taking a stake in FIG. Page 2

3 Company Description Fortress Investment Group LLC (NYSE: FIG) is a global alternative asset manager that specializes in asset-based investing. With AUM of $57.97B, the company operates under 6 major segments: (1) Private Equity; (2) Castles; (3) Credit Hedge Funds; (4) Credit Private Equity; (5) Liquid Hedge Funds; and (6) Logan Circle Partners. (See exhibit 1.1 for details). Exhibit 1.1 Overview of Fortress Investment Group Private Equity Credit Liquid Markets Logan Circle Partners Private Equity Castles Private Equity Hedge Funds AUM ($Bn) $11.64 $3.2 $6.9 $5.7 $6.9 $23.6 Strategy Opportunistic lending situations & securities General buyout and sector-specific funds focused on controloriented investments in cash-flow generating assets and asset-based businesses in North America, Western Europe and Asia. Life of Business PE Funds: 10 yrs Perpetual Various (3 to 25 years) Perpetual Perpetual Not Applicable Mortgage Funds: 5 yrs Redemption Rights None None None Annual Redemptions Monthly Redemptions Not Applicable *Castles: Newcastle, Eurocastle and New Residential Publicly traded permanent capital vehicles that invest in a wide variety of real estate related assets including securities, loans, real estate properties and mortgage servicing rights. Distressed and undervalued assets (some with limited current cash flows and long investment horizons) and tangible & integible assets (real estate, capital assets. Natural resources and intellectual property) Invest globally in fixed income, currency, equity and commodity markets, and related derivatives to capitalize on imbalances in financial markets. Actively managed fixed income and growth equity investment strategies. Exhibit 1.2 Segmented Assets Under Management & Redemption Periods 40.7% 20.1% 5.5% Private Equity - PE Private Equity - Castles Credit - Private Equity 10.0% 10.0% 39.0% None Perpetual 3-25 years 11.9% Credit - Hedge Funds 20.0% 5-10 years 11.9% 9.8% Liquid Markets Logan Circle Partners 13.0% 8.0% 1 year Monthly Exhibit 1.3 Revenue Segmentation & Types of Revenue Logan Circle 3.54% Credit Private Equity 22.04% Private Equity 17.23% Castles 7.46% Incentive Income 37.66% Credit Hedge Funds 30.56% Liquid Hedge Funds 19.17% Management Fees 63.33% Page 3

4 Private Equity With $11.64B under management, FIG s private equity operating segment manages a total of funds of 12 active funds with maturities ranging from February 2013 to February These sector-specific funds are focused on control-oriented investments in cash-flow generating assets and asset-based businesses in North America, Western Europe and Asia. Exhibit 2.1 Appreciation Needed to Generate Incentive Income by Fund PE Fund Vintage Maturity NAV (USD, in Thousands) MOIC Estimate Gain to cross HWM Appreciation to generate promote FHIF 2006 Jan-17 2,287, , % Fund III 2004 Jan-15 2,830, , % Fund IV 2006 Jan-17 4,388, , % Fund V 2007 Feb-18 4,387, ,498, % Fund IV Coinv Jan , , % Fund III Coinv Jan , , % FECI 2007 Feb , , % FRID 2005 Apr , , % Fund V Coinv Feb , , % FRIC 2006 May , , % Exhibit 2.2 Major Investments by Fund Private Equity Funds Main Investments NIH Fund I Italfondiaro Fund II GAGFAH Fund III Nationstar, GAGFAH, Eurocastle, Gatehouse Fund III Coinvestment Nationstar, Holiday, Florida East Coast & Flagler, Eurocastle, GAGFAH, Gatehouse Fund IV Florida East Coast & Flagler, Springleaf, Penn National Gaming, CW Financial, Brookdale, Nationstar Fund IV Coinvestment Florida East Coast & Flagler, Springleaf, Penn National Gaming, CW Financial, Brookdale, Nationstar Fund V Penn National Gaming, Walker & Dunlop Fund V Coinvestment Penn National Gaming, Walker & Dunlop GAGACQ Fund GAGFAH FRID GAGFAH FRIC Brookdale Senior Living FICO Intrawest FHIF Holiday Retirement FECI Holiday Retirement Source: Company 10-Q Fortress-A. (2013). 10-Q Q3 201 FHIF Holiday Retirement (exp. Jan-17) Holiday Retirement Stock Symbol NA Initial Investment Date Feb-07 Investment Type Buyout Industry Senior Living / Healthcare Region North America Transaction Size $6.89B Holiday Retirement is the largest private owner and operator of independent living communities for seniors in the United States Page 4

5 With capital invested of $1.54B, FHIF is one of FIG s largest PE funds, and certainly its best performing one. As of September 30 th, 2013 FHIF had a net asset value of $2.29B only 5.73% below its high-water mark. Its growth in NAV is attributable to the success of Holiday Retirement, the largest private owner and operator of independent living communities for seniors in the U.S. Based on their performance over the past twelve months, we expect FHIF to cross its high-water mark before the end of Q and to start generating incentive income as soon as Q Altogether, we expect FHIF to generate a total of $94.1M (after profit sharing) in incentive income before it expires in That being said, given the uncertainty we applied a 50.0% discount on this promote. Fund III Nationstar, GAGFAH, Eurocastle and GateHouse (exp. Jan-15) Nationstar 12 month Price target of $45.00 from $ rebounding from a low of ~$35.00 (*IPO in 2013) Initial investment Date July 2006 Investment Type Buyout & Opportunistic Transaction Size $450M Shares Held Nationstar Mortgage Holdings, Inc is a non-bank residential mortagage servicer and originator. NSM primarily focuses on the "high-touch" servicing of non-prime credit sensitive mortgages, but also has capabilities to service more traditional assets. The originations segment primarily focuses on the re-origination of current loans in the servicing portfolio through the retail channel, but also acquires loans through the wholesale and correspondent channels. (USD, in Thousands) FY 2013 Q Q Q Q FY 2014 FY 2015 Revenue Servicing Fee Income 1,283, , , , ,468 1,932,266 2,398,938 Other Fee Income 267,483 82,794 86,935 91,000 94, , ,719 Gain on Mortgage Loans 902, , , , , , ,000 Total Revenue 2,453, , , , ,708 3,236,984 3,734,657 Net Income 297, , , , , , ,821 Net Margin (%) 12.13% 14.46% 14.56% 15.30% 15.22% 14.90% 15.26% The $53.00 PT is based on a 8.5X of FY'15 estimate of $6.20 9X on servicing and 5X on origination The FY'15 of $6.20 depends heavily on NSM acquiring roughly half of its $400B pipeline Origination Outlook the origination mix is kewing towards retail products Servicing Outlook At the moment, banks are offloading significant amounts of loans for servicing. This is not expected to last, which means that orgination must become more significant Originations Volume $26b Upside Scenario 2015 Originations Profits 69 bps Servicing UPB expanding 2015 Servicing Pre-tax Profit 13 bps Servicing segment profitability reaches 15 bps by FY' Avg UPB $690B Gain -on-sale margins remain elevated Ramp up and spin-off of Solutionstar Page 5

6 GAGFAH Stock Symbol GFJ (FSE) Initial Investment Date Sep-04 Investment Type Platform Buildup & Government Privatization Industry Real Estate Region Western Europe Transaction Size $8.59B CW Financial Services is a vertically integrated commercial real estate debt platform offering a full range of products and services including multifamily lending, primary servicing, special servicing, consulting and investment management. The special servicing unit is the second largest special servicer of commercial real estate loans inthe U.S.. Fortress acquired the Company in 2010 from a major Canadian institutional fund manager who was seeking to exit the U.S. commercial real estate debt markets. GateHouse Media Inc. Stock Symbol GHSE.PK (OTC) Initial Investment Date Jun-05 Investment Type Buyout & Platform Buildup Industry Media & Telecomm Region North America Transaction Size $530M GateHouse Media, Inc.is oneof the nation s largest local media companies as measured by its daily publications. Fortress Funds acquired GateHouse (formerly Liberty Group Publishing) in June 2005 and took the Company public in October Eurocastle Investment Ltd. Stock Symbol ECT (Euronext Amsterdam) Initial Investment Date Feb-06 Investment Type Growth Equity Industry Real Estate Region Western Europe Transaction Size $2.40B Eurocastle Investment Ltd. is a closed-end investment company that invests primarily in German commercial real estate. Source: Company Website & Bloomberg Penn National Gaming Inc. Stock Symbol PENN Initial Investment Date Jun-08 Investment Type Growth Equity Industry Leisure Region North America Transaction Size $980M Preferred equity investment in Penn National Gaming, Inc., a leading owner and operator of regional gaming assets throughout the United States and Canada. With $2.76B of invested capital, Fund III is also very significant and given its performance over the past 12 months, we expect it to exceed its high-water mark by the end of Q and to start generating promote as early as Q All-in-all, we are forecasting incentive income of $244.5M (after profit sharing). As with FHIF, we applied a 50.0% discount to this forecast in order to remain conservative. Fund IV Florida East Coast Railway, Flagler, Springleaf, etc. (exp. Jan-17) Page 6

7 Florida East Coast Railway Stock Symbol NA Initial Investment Date Jul-07 Investment Type Buyout Industry Transportation Region North America Transaction Size $850M Florida East Coast Railway is a major regional freight railroad, operating mainline track along the east coast of Florida between Jacksonville and Miami. Flagler Stock Symbol NA Initial Investment Date Jul-07 Investment Type Buyout Industry Real Estate Region North America Transaction Size $3.11B Flagler is Florida's top commercial real estate operator and developer. The Company owns, manages, leases and develops office and industrial space throughout Florida. CW Financial Services Stock Symbol NA Initial Investment Date Sep-10 Investment Type Buyout Industry Financials Region North America Transaction Size $292M CW Financial Services is a vertically integrated commercial real estate debt platform offering a full range of products and services including multifamily lending, primary servicing, special servicing, consulting and investment management. The special servicing unit is the second largest special servicer of commercial real estate loans inthe U.S.. Fortress acquired the Company in 2010 from a major Canadian institutional fund manager who was seeking to exit the U.S. commercial real estate debt markets. Brookdale Senior Living Inc. Stock Symbol BKD Initial Investment Date May-00 Investment Type Buyout & Platform Buildup Industry Senior Living / Healthcare Region North America Transaction Size $1.55B Brookdale Senior Living is the largest owner and operator of senior living communities throughout the United States and a leading national provider of senior-related services. Fortress took Brookdale public in November Source: Company Website Page 7

8 With $3.64B in invested capital, Fund IV is FIG s second largest PE fund, and as of September 2013 its NAV was 20.30% below its high-water mark. Although this may seem sizable, it should be noted that Fund IV s NAV is expected to grow by roughly 15.0% in 2013 due primarily to the success of Springleaf and Penn National Gaming. We expect Fund IV to exceed its high-water mark in 2014, and generate cumulative incentive income of $217.4M before it expires in As with previous funds, we applied a 50.0% discount to this forecast in order to remain conservative. The Bottom Line Although we expect the private equity segment to start generating incentive income as soon as 2014, base management fees are still the mainstay of this business. On average, FIG earns 116 bps of AUM in management fees. That being said, the recovery of its PE holdings has been a major driver for the stock over the past year, with the IPOs of Nationstar and Springleaf as major catalysts. As it stands today, roughly 46.0% of the PE portfolio is publicly traded and that percentage is expected to increase as FIG begins to unwind its funds expiring in late 2013 and early There have also been rumors that FIG may take Intrawest (FICO) public as the demand for U.S. commercial real estate continues to grow. Despite weak historical performance, FIG remains highly adept at raising money. Recent successes such as Springleaf and Aircastle have allowed FIG to raise $5.0B for two new PE funds. One will focus on infrastructure investments, while the other will be dedicated to non-performing loans in Italy. As a result of the growth in AUM and the potential for upcoming incentive income, we expect private equity funds to earn $199.2M in revenue and generate pre-tax distributable earnings of $127.8M in Castles Fortress manages three permanent capital vehicles called Castles (New castle, Eurocastle and New Residential). These are public REIT-type structures with aggregate AUM of about $3.65 billion. In addition to providing comfort about reliability of future management fees, permanent capital vehicles allow the firm to raise capital quickly when opportunities arise. As the exhibit below shows, it takes about 18 months to achieve a final close for a traditional private equity fund. Thus, being able to raise and put it to work quickly could allow the company to capitalize on opportunities it might miss otherwise. In an effort to increase the pace of realizations, Fortress has carved out all of Newcastle s residential assets into a new publicly traded company called New Residential (NRZ). These assets include excess mortgage-servicing rights, residential mortgage-backed securities, nonperforming loans and other residential real estate. The carve-out reset any high-water marks and allows Fortress to earn incentive income once the performance hurdle rate has been passed. Thus, Fortress is now more likely to earn incentive income and earn it sooner than it would have been absent of any restructuring. Newcastle (NCT), the original permanent capital vehicle, will now focus on commercial real estate investments, along with senior housing and other real estate debt. As for Eurocastle (ECT), the company s third permanent capital vehicle, Fortress has restructured the balance sheet and lowered management fees expenses it charges for its services. Whereas it used to charge management fees of 1.5% on equity capital of roughly $1.9 billion, it now charges management fees of 1.5% on equity capital of about $.5 billion. We believe lower fees could make the fund more attractive and lead to capital contributions as management fees declined from about $7 million to $2 million per quarter. The company disclosed that it raised $140 million (which is part of the $0.5b) since restructuring the balance sheet. No doubt, the recapitalization has lowered management fee revenues to the tune of $5 million per quarter. However, we believe that Fortress could offset the decline in revenues by raising additional capital over time. With the restructuring, ECT has also reset the capital base upon which its Page 8

9 Credit Franchise entitlement to incentive income is calculated and any high water marks. Unlike NCT and NRZ, ECT has an 8% preferred return threshold. The Bottom Line Much like PE funds, the Castles posted lackluster performance following the financial crisis earning no incentive income from 2010 to However, with the restructuring of Newcastle (which has reset its high-water mark), we expect both Newcastle and New Residential to start generating incentive income as soon as Not unlike PE funds, base management fees are the most significant source of revenue Given the recovery of Newcastle and the growing demand for exposure to the U.S. real estate market, we expect FIG to grow Castles AUM to $11.6B by 2018 as it raises new funds. On average, they earn 150 bps of AUM in base management fees. We expect $100.33M in revenue in 2014, and $45.15M in pre-tax distributable earnings. While FIG s PE funds suffered from the financial crisis, its credit franchise (credit private equity and credit hedge fund). With the majority of investments made in 2008 and 2009, the company s credit funds have posted strong returns. In fact, it has the highest IRR (%) among all its peers. Exhibit 4.1 Major Investments by Fund 25.00% 22.00% IRR (%) 20.00% 15.00% 10.00% 15.00% 18.00% 11.00% 9.00% 5.00% 0.00% APO BX CG KKR FIG Source: Fortress Investment Group LLC Initiating Coverage - RBC Moreover, during the Q conference call management disclosed that it had more than $700M in undistributed, unrealized incentive income embedded in its credit franchise. These fees will be distributed as the funds are realized. With hurdle rates of 20.0% for credit private equity and 10.0% for credit hedge funds, it is increasingly difficult for these funds to find worthwhile investment opportunities. In addition to interest rates and financing costs increasing, the market has become increasingly competitive making it harder to allocate capital. However, this should not be a major source of concern, as there are some opportunities arising. Namely in Italy, where banks (in compliance with Basel III) are entering a long de-levering process. The Bottom Line Because of its lower hurdle rate, we expect Credit Hedge Funds to continue to grow AUM over the next few years from $5.820B to $12.0B by Credit PE is another story entirely. Because of its hurdle rate of 20.0%, we expect AUM to decrease from $7.2B to $4.0B by Given these changes, we are forecasting 2014 revenue and Page 9

10 pre-tax distributable earnings of $227.2M and $79,5M for Credit Hedge Funds, and $117.4M and $35.0M for Credit Private Equity respectively. Liquid Hedge Funds The liquid hedge funds accounted for $6.9 billion of assets under management at the end of the third quarter (Fortress-A, 2013). Fortress offers four different investment strategies: Macro, Asia Macro, Convex Asia, and Partners Funds (Fortress-B, 2012). Its liquid hedge funds trade currencies, interest rates, equities, commodities and derivatives to play global opportunities. The Macro and Asia Macro hedge funds are by far the most important for performance fees with $1.8 billion and $1.6 billion of AUM eligible for incentive income (Fortress-A, 2013). The remaining AUM is spread over the Partners Funds and the Convex Asia macro funds. Here is a quick description of each strategy: 1. Macro: exploit global imbalances with relative value and directional strategies based on a top-down approach. The fund has no limitations in terms of strategy and geography (Fortress-B, 2012, p. 4). 2. Asia Macro: exploit trading and capital flows that affect the Asia-Pacific region based on a fundamental macroeconomic strategy using liquid investments (Fortress-B, 2012, p. 4). 3. Asia Convex: exploit a convex investment strategy focused on the Asia-Pacific region, usually resulting in small returns in good markets, but outsized returns in poor markets (Fortress-B, 2012, p. 4). 4. Partners Funds: essentially a fund of funds, it makes investments in both Fortress hedge funds and other managers hedge funds (Fortress-B, 2012, p. 4). Exhibit AUM & Returns by Liquid Hedge Fund AUM Returns Inception September 30, Inception 9 months ended Sept. 30, Liquid Hedge Funds Date Date Drawbridge Global Macro Funds Jun % 8.60% 10.20% Fortress Macro Funds May-09 1,425 1, % 9.80% 11.10% Fortress Macro MA1 Nov % 10.30% N/A Fortress Partners Fund LP Jul % 4.20% 6.90% Fortress Partners Offshore Fund LP Nov % 7.20% 7.90% Fortress Asia Macro Funds Mar-11 1, % 11.70% 10.70% Fortress Convex Asia Funds May % -1.50% N/A Fortress Redwood Fund LTD Aug N/A N/A N/A N/A Source: (Fortress-A, 2013, p. 63) Year-to-date both the Macro and Asia Macro earned strong returns of 9.8% and 11.7% respectively, pointing toward another good year for performance. In fact, both of them were up more significantly in the second quarter, with year-to-date returns of 13.2% and 12.9% respectively (Fortress-E, 2013, p. 62). The decline in year-to-date performance from Q2 to Q3 explains why it incurred a clawback in incentive income for the quarter. While performance declined quarter-over-quarter, management indicated on the conference call that performance bounced back up at the beginning of the fourth quarter. As of October 25, the Macro and Asia Macro were up 20 bps and 90 bps Page 10

11 respectively (Fortress-G, 2013, p. 7). It is important to note that performance as of the second quarter was outstanding, generating $92.5 million in incentive income. Therefore, even after accounting for the $27 million in clawback, Fortress is still largely ahead compared to last year (Fortress-A, 2013, p. 75). If the bounce back observed earlier in the quarter continues, it may earn back all or part of the clawback. More importantly, performance has been strong over time. As of Q3, the Macro and Asia Macro funds had annualized returns of 8.9% and 13.9% since inception (Fortress- A, 2013, p. 63). In fact, the Asia Macro fund was named Fund of the Year by the AsiaHedge Awards earlier this month for best risk-adjusted returns (Fortress-H, 2013). As a reminder, the strength of the track record is best determinant of an asset manager s ability to attract AUM. Unsurprisingly, Fortress was able to raise a whopping $2.3 billion year-to-date for its liquid hedge funds alone (Fortress-A, 2013, p. 56). The fee structure on Fortress hedge funds is attractive. First, it earns a healthy base management fee of 1.0% to 2.0% on AUM. The management fee as a percentage of AUM has been stable over time. In addition, it earns between 18% and 25% of any positive performance when NAV is above the higher water mark, which is set at the performance achieved at the last incentive income earned. Exhibit Fee Structure Fees Structure Management Fees Incentive Income Low High Average Low High Average Fortress Macro Funds 1.50% 2.00% 1.75% 15.00% 25.00% 20.00% Fortress Asia Macro Funds 1.50% 2.00% 1.75% 20.00% 25.00% 22.50% Fortress Partners Funds 1.00% 1.50% 1.25% 20.00% 20.00% 20.00% Convex Asia Funds 1.25% 1.25% 1.25% 18.00% 18.00% 18.00% Source: (Fortress-B, 2012, p. 4) Exhibit Incentive Income Threshold Q3/2013 Incentive Income Eligible NAV Gain to Cross Incentive Income Percentage of Incentive Income Undistribute d Incentive Income Year to Date Incentive Income Macro Funds Main fund investments 1,497,640 9, % 24,875 15,719 Single investor funds 918,685 4, % 5, Sidepocket investments 17,977 16,278 N/A 304 Sidepocket investments - redeemers 173, ,105 N/A 2,951 Managed accounts 1,147, % 22,054 3,725 Asia Macro Funds Main fund investments 1,556,613 5, % 21,212 1,375 Managed accounts 191, % 3,027 Fortress Convex Asia Funds Main fund Investments 106,210 3, % Fortress Partners Funds Main fund investments 55,680 33, % 1 Sidepocket investments 132,251 24,848 N/A 2,477 Source: (Fortress-A, 2013, p. 15) 5,797,082 82,291 20,910 Page 11

12 As of Q3 2013, 82.5% of the Macro main fund investments, 28.9% of the Macro single investor funds, and 66.1% of the Asia Macro main fund investments were above their high water mark. However, each of them is less than 1% away from having 100% of its NAV above the high water mark. In fact, if the performance kept bouncing back, the Asia Macro fund is probably already 100% above high water mark, earning incentive income. That s the reason why we believe Fortress has a decent probability of recouping part of the clawback from Q3. Interestingly, despite the strong performance since inception and year-to-date, we calculate that investors are assigning no value to potential future incentive income, some of which could be earned as soon as the end of the year. While we acknowledge the rather uncertain nature of performance fees, we do not believe it justifies denying its existence. To value both the contribution of the management fees and the performance fees from liquid hedge funds, we made conservative assumptions. First, we assume that asset inflows over the next five years will total $2 billion. This impacts both the amount of management fees and performance fees earned as it increases the size of the pool of asset upon which they are calculated. Considering that it raised $1.7 billion in 2010, $1.3 billion in 2011, $1.0 billion in 2012, and $2.3 billion year to date, we are convinced it can achieve $2 billion within 5 years (Fortress-B, 2012, p. 51). Assets under management also grow or shrink with positive or negative performance. For performance, we looked at the historical quarterly returns on both the Macro and Asia Macro funds back to On a quarterly basis, they returned 2.42% and 3.76% respectively. In our valuation we assume that it can reach 2% per quarter, clearly below past performance. This is much more conservative than RBC Capital Markets that applies a quarterly performance of 3.5% in its base case and 2.8% in its bear case (Ozcan, 2013, p. 2). However, despite being below the historical average, we feel that assuming a 2% return with certainty remains a strong statement. Consequently, we decided to apply a 50% probability to incentive income. In effect, we are saying it will earn a below average rate of return half of the time. Despite the uncertainty in future performance, we are comfortable with this assumption. As for the actual fees earned, we expect management fees to remain in line with the historical average at 1.7% of average AUM as it remains constant over time. As for performance fees, we used 20%, which represents the lower bound for the Macro found. While the lower bound for the Asia Convex fund is even lower, there is so little AUM behind it that it would make no sense to apply it to total AUM. Overall, we expect AUM to grow from $6.9 billion at the end of Q3/13 to $10.4 billion at the end of This represents an increase in AUM of $3.5 billion, of which $2 billion will come from asset inflows and $1.5 billion from performance. According to our estimates, incentive income could amount to $58 million in 2014 and gradually increase to $81 million in However, even if Fortress realizes only half of what we project from our conservative estimates, there is still a significant amount of incentive income not being priced in by investors. The Bottom Line Fortress liquid hedge funds registered strong performance since inception and year-todate. While performance came down a little bit in the third quarter, it should be able to Page 12

13 Logan Circle bring back most of the AUM above the high water mark with the bounce back in October. Fortress continues to enjoy a strong track record, which is reflected in its ability to raise considerable amounts of capital year after year. Most importantly, we believe investors are wrong in assigning no value to potential future incentive income, as its ability to generate good performance remains intact. Fortress acquired Logan Circle, a traditional asset manager, in Logan offers core based, sector based, short duration and high yield fixed income strategies to institutional client. Its assets under management jumped to $23.6 billion at the end of Q3/13 from $11.7 billion at acquisition, representing an increase of 102% in less than 4 years (Fortress-A, 2013, p. 48). Overall, it is the segment with the most AUM, accounting for 40% of the total. Exhibit 6.1- AUM by Strategy (LHS) and by Client Type (RHS) Source: The rapid growth in AUM can be attributed to Logan Circle s outstanding performance combined with Fortress strong distribution capabilities. On the performance side, Logan Circle is outperforming in 13 of its 15 fixed income strategies on an annualized basis since inception. All strategies have been set up prior to 2010, indicating sustained long-term performance. Obviously, an asset manager s track record is the first determinant of its ability to attract asset under management on the long-term. Exhibit Return vs Benchmarks of Fixed Income Strategies Strategy Inception Return Since Inception Minimum Benchmark 1 Benchmark 2 Year (Net of Fees) Outperformance Core Plus Fixed Income % 5.58% N/A 0.92% Core Fixed Income % 5.58% N/A -0.15% Cash Plus % 2.87% 2.54% 0.95% STAMP 1-3 Year % 3.93% 4.24% 0.37% STAMP 1-5 Year % 3.08% 3.52% 0.69% Intermediate Gov't/Credit % 5.39% N/A 0.24% STAMP Municipal % 1.88% 0.88% 0.09% Corporate Fixed Income % 6.41% N/A 1.33% Emerging Market Debt % 7.51% 7.61% 3.93% Long Duration Fixed Income % 7.84% N/A 2.07% Long Credit Fixed % 14.01% N/A 3.43% Multi-Sector Fixed Income % 5.12% N/A 2.18% High Yield Fixed Income % 8.11% 8.09% 0.06% High Yield Mid-Grade % 7.52% 8.00% 0.49% Global High Yield % 10.86% 0.00% -1.23% Page 13

14 Source: With strong returns, it is not surprising that it was able to double the amount of assets under management. As long as the current performance continues, Logan has a strong base for future growth. It also makes it easier for Fortress, which has always excelled at raising money for its alternative asset management business, to distribute Logan s funds to a larger pool of institutional investors. This can be seen in the amount of capital raised over the past three years by Fortress. Indeed, excluding Logan, Fortress was able to raise $2.6 billion in 2010, $2.0 billion in 2011, $2.7 billion in 2012, and $3.7 billion in 2013 (Fortress-A, 2013, p. 60) (Fortress-B, 2012, p. 76). It is interesting to note it includes $2.3 billion for private equity, where performance has been less than stellar. Therefore, we are convinced that it will be able to continue distributing Logan s funds at a good pace. For now, investors seem to assign little to no value to Logan. The most probable reason is that it is not profitable yet. The distributable earnings have improved gradually since the acquisition in Indeed, the loss shrunk to $1.0 million in Q1/13, essentially breaking-even, from a loss of $4.8 million in Q1/11 (Fortress-C, 2013, p. 70) (Fortress-D, 2012, p. 60). In Q2/13 and Q3/13, losses totaled $3.2 million and 3.3 million respectively (Fortress-A, 2013, p. 75) (Fortress-E, 2013, p. 73). At first glance, Logan Circle would appear to be a poorly performing business and a bad investment from Fortress. However, Fortress acknowledged the potential to grow assets under management and decided to maintain the platform intact after the acquisition. We view this as a good decision. Indeed, human capital is an asset manager s most important asset. Talent drives performance and AUM growth, both essential to profitability. This is especially true when dealing with institutional investors who seek continuity in management. Downsizing at the acquisition and scaling up the business as AUM grows could have made the operations profitable immediately, but this may have permanently damaged its ability to grow. At current expense levels, Fortress believes Logan is highly scalable and that it can grow AUM significantly. The recent decline in distributable earnings is attributable to the introduction of growth equity strategies in April. Indeed, Fortress hired David Shell, Joseph Hudepohl, Scott Kolar, Warren Fisher and Gregory Frasca, which, together, managed growth equity strategies with $20 billion of AUM at Goldman Sachs Asset Management. Therefore, it is important to note that the increase in expenses is related to this growth initiative, and not in poor cost control. While this pushes back the break-even point, it is good strategy to accelerate AUM growth. For now, Fortress plans to introduce four concentrated growth equity strategies focused on US equities. Each investment strategy will vary in concentration and market capitalization (Fortress-F, 2013). In the third quarter conference call management said that the funds are seeded and that they are now in the marketing and raising capital. They expect to start accumulating AUM as soon as Q4/13 or Q1/14 (Fortress-G, 2013, pp. 4,12). Usually it takes more time for a fund to accumulate assets, as investors require a certain track record. However, with Logan s reputation and Fortress distribution capabilities, we believe it is achievable. Not only will the growth equity strategies help maintain or accelerate AUM growth, but they typically yield much higher base management fees. This will make the overall fund portfolio much more profitable. Page 14

15 Both management and RBC Capital Market forecast about $40 billion of AUM within a few years for fixed income strategies alone, and about $20 billion in AUM for growth equity strategies, similar to what the ex-goldman managers were handling (Fortress- G, 2013, p. 12) (Ozcan, 2013, p. 22). While we most certainly believe that they can achieve those targets, as they have repeatedly proven their ability to raise money in the past, our estimates are more conservative. We forecast $40 billion of AUM within five years for fixed income and equity strategies combined, with a split of roughly 75% in fixed income and 25% in equity. This split is below RBC s estimates, which assume an allocation to equity of 30% to 40% (Ozcan, 2013, p. 22). Following our estimates, they would have $30 billion of AUM for fixed income and $10 billion of AUM for equities by the end of Considering that they are currently at $23.6 billion of AUM for fixed income, it means they most raise $6.4 billion over 5 years. This is about 53% of what they raised in less than 4 years. As for equities, while we are encouraged to hear assets may start flowing in as soon as this quarter, we begin asset accumulation in Q1/14 and cap the total weight of equity at 2.5% for the first year, reflecting the time usually required to ramp up a new fund. Exhibit AUM by Asset Class and Management Fees $45B $40B $35B $30B $25B $20B $15B $10B $5B $0B A 2011A 2012A 2013E 2014E 2015E 2016E 2017E 2018E Fixed Income Equity Management Fees 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% Source: 10-Qs, 10-Ks, Kenneth Woods Portfolio Management Program In terms of management fees, Logan Circle charges 16 basis points on all its fixed income strategies. It has been extremely stable overtime, so we kept it at that level going forward. As for equities, management expects to earn about 60 bps, while RBC estimates that equity strategies earn 75 bps in management fees on average in the industry (Fortress-G, 2013, p. 12) (Ozcan, 2013, p. 22). While we acknowledge that management may be guiding below average, we opted for 60 bps of base management fees for the four equity strategies going forward. In terms of operating expenses, consisting principally of compensation expenses as well general and administrative expenses, we assume a long-term target operating margin of 40%, which they should reach by Therefore, over the coming years, we expect operating expenses to decline as a percentage of revenues. This reflects the Page 15

16 Valuation scalability of the business, as increases in general and administrative expenses going forward will be less than proportional to increases in revenues. Overall, we expect Logan to break-even by the end of 2015, reflecting an average AUM of $28.8 billion and an average split of 94.7% in fixed income and 5.3% in growth equity. Afterward, we expect it to become a net contributor to distributable earnings with an operating income of $12.2 million in 2016, $25 million in 2017 and $39 million in While this may seem a relatively small contribution relative to Fortress other business segments, Logan will be incremental to the company s overall distributable earnings from base management fees. Considering that at the current stock price investors are assigning little to no value to it, we see upside potential in the share price from Logan as investors begin to factor it in. Also, we believe we are conservative in our estimates, such that AUM growth may be bigger and may come sooner than currently projected. Finally, we want to highlight another potential contributor. Logan s fixed income funds currently do not earn any performance fees. While there has been no mention of it, equity strategies usually earn performance fees when returns exceed a certain threshold. Therefore, we may see a contribution to incentive income from Logan in the future. The Bottom Line We expect continued rapid growth in AUM driven by Logan s performance and Fortress distribution capabilities. More specifically, we assume $40 billion of AUM within five years, with a split of 75% in fixed income and 25% in equity. Equity strategies yield higher base management fees. We expect the overall portfolio to go from an average yield of 16 bps to 26 bps within five years. Logan should be incremental to distributable earnings by 2015, with a long-term operating margin of 40%. We value Fortress Investment Group at $10.00 per share, implying a 25% return, justifying a BUY recommendation. We base our valuation on a sum of the part methodology: Management Fees Average P/E 16x DE/Share $0.30 Incentive Income Average P/E DE/Share $0.21 Cash & Investments Undistributed, Unrecognized Incentive Income Total SOTP 8x $3.14/Share $0.41/Share $10.03/Share Page 16

17 We apply a P/E multiple of 16 to our 2014 after-tax distributable earnings per share from management fees. We derive our multiple from the average 2014 P/E at which comparable US traditional asset managers. We do not see any reason why investors should pay less for the management fees from Fortress Investment Group. Distributable Earnings LTM Management Fee - ATDE -168, ,672 67, , , , , , , ,479 Management Fee - ATDE/Share (Diluted) Incentive Income - ATDE -116, ,348 51, , , , , , , ,475 Incentive Income - ATDE/Share (Diluted) Source: (Fortress 10-Ks & 10-Qs), Kenneth Woods Portfolio Management Program Traditional Asset Managers - Comparables Name Ticker Mkt Cap ($M) Forward P/E BLACKROCK INC BLK 51, x LEGG MASON INC LM 4, x WADDELL & REED FINANCIAL-A WDR 5, x FEDERATED INVESTORS INC-CL B FII 2, x T ROWE PRICE GROUP INC TROW 21, x FRANKLIN RESOURCES INC BEN 34, x INVESCO LTD IVZ 15, x JANUS CAPITAL GROUP INC JNS 2, x EATON VANCE CORP EV 5, x COHEN & STEERS INC CNS 1, x AFFILIATED MANAGERS GROUP AMG 10, x ARTISAN PARTNERS ASSET MA -A APAM 4, x Average 17.1x Source: (Bloomberg) Then, we apply a P/E multiple of 8 to our 2014 after-tax distributable earnings per share from incentive income. While we already assigned a 50% probability to any incentive income across the business segments, we feel it is necessary to take one step further to ensure that we are not overpaying for earnings that are usually much more volatile. We also account for the average 2014 P/E at which comparable US alternative asset managers are trading. Alternative Asset Managers - Comparables Name Ticker Mkt Cap ($M) Forward P/E APOLLO GLOBLA MANAGEMENT APO US 11, x KKR & CO LP KKR US 16, x CARLYLE GROUP CG US 10, x BLACKSTONE GROUP LP BX US 31, x Average 9.9x Source: (Bloomberg) Page 17

18 Further, we add the amount of cash and investments per share on balance sheet. Cash & Investment (in $000) Sept-13 Cash & Cash Equivalent 311,114 Private equity funds, 806,875 Publicly traded portfolio companies 64,176 Newcastle 5,828 New Residential 6,866 Eurocastle 2,606 Total private equity 886,351 Liquid hedge funds 166,460 Credit hedge funds 57,101 Credit PE funds 145,274 Other 8,206 Total investments 1,574,506 Diluted Number of Shares 502,091,166 Cash & Investments per Share $3.14 Using 502 million diluted class A shares, we arrive at a value per share of $3.14. While some investments listed above are relatively illiquid, we do not expect the company to proceed to a disorderly liquidation. Instead, Fortress expect to allow investments like private equity to realize and liquefy naturally. As the investments liquefy, the company expects to distribute the excess liquidity to investors, mainly as share buybacks. On conference call, management said that share buybacks could come in as soon as the end of the year. Finally, we add the value of undistributed & unrecognized incentive fees, net of clawback. Distributed- Gross Distributed- Recognized Distributed- Unrecognized Undistributed net of intrinsic clawback Deferred incentive income as of December 31, , , , ,432 Fortress Funds which matured (no longer subjectto clawback) -2,180 2,180 N/A N/A Share of income (loss) of Fortress Funds N/A N/A N/A 397,018 Distribution of private equity incentive income 106,709 N/A 106, ,709 Recognition of previously deferred incentive income N/A -50,262-50,262 N/A Changes in foreign exchange rates -1,111-1,111 N/A Deferred incentive income as of September 30, , , , ,741 Deferred incentive income including Fortress Funds which matured 1,051, ,170 Page 18

19 These represent crystallized incentive income not yet earned, as Fortress must wait for the realization of the underlying investment. As of the third quarter, this represented $818 million. This is a gross amount. Therefore Overall, when we add the value per share from distributable earnings on management fees, the cash and investments per share, and the undistributed and unrecognized incentive income per share, we get a value of $8.35 per share before adding the value of potential incentive income. Therefore, we are convinced that there is certain margin of safety on the stock. Page 19

20 Works Cited Fortress-A. (2013). 10-Q Q New York: Fortress Investment Group LLC. Fortress-B. (2012). 10-K New York: Fortress Investment Group LLC. Fortress-C. (2013). 10-Q Q New York: Fortress Investment Group LLC. Fortress-D. (2012). 10-Q Q New Yrok: Fortress Investment Group LLC. Fortress-E. (2013). 10-Q Q New York: Fortress Investment Group LLC. Fortress-F. (2013). Logan Circle Partners Announces Launch of Growth Equities Business and Formation of Senior Portfolio Management and Research Team. New York : Fortress Investment Group LLC. Fortress-G. (2013). Conference Call Transcript Q New York: Fortress Investment Group LLC. Fortress-H. (2013). Fortress Asia Macro Fund Named Fund of the Year in the 2013 AsiaHedge Awards. New York: Fortress Investment Group LLC. Ozcan, B. (2013). Fortress Investment Group LLC Initiating Coverage: With Catalysts Abundant, Valuation Seems Compelling. Toronto: RBC Capital Markets. Page 20

21 Appendices Income Statement Historical Projected (USD, in Thousands) LTM Segmented Revenue Private Equity Management Fees 138, , , , , , , , , ,440 Incentive Income 41,649-1,748 10,993 11,923 11, , ,731 - Total Revenue 179, , , , , , , , , ,440 YoY Change (%) % 0.26% 9.69% 6.20% 31.40% 66.21% % 80.72% % Pre-Tax Distributable Earnings -7,424 92,813 85,389 91, , , , , , ,522 YoY Change (%) % -8.00% 7.34% 10.45% 26.26% % % % % % of Revenue -4.13% 71.31% 65.44% 64.04% 66.61% 64.00% 77.26% 64.00% 78.09% 64.00% DE/Revenue -4.13% 71.31% 65.44% 64.04% 66.61% 64.00% 77.26% 64.00% 78.09% 64.00% Expenses 187,111 37,337 45,096 51,474 50,760 71,902 75,497 79,271 87,199 95,918 11,923 9,285 10,611 11,636 12,218 17,218 18,079 18,983 20,881 22,969 Assets Under Management (USD, Millions) 11,923,000 9,285,000 10,611,000 11,636,000 12,217,800 17,217,800 18,078,690 18,982,625 20,880,887 22,968,976 YoY Change (%) % 14.28% 9.66% 5.00% 40.92% 5.00% 5.00% 10.00% 10.00% Management Fees as a Percentage of AUM (%) 1.16% 1.42% 1.13% 1.13% 1.16% 1.16% 1.16% 1.16% 1.16% 1.16% Expenses Interest Expense 6,081 1,213 1,466 1,673 1,650 2,337 2,454 2,576 2,834 3,117 % of Expenses 3.25% 3.25% 3.25% 3.25% 3.25% 3.25% 3.25% 3.25% 3.25% 3.25% Compensation & Benefits 149,689 29,870 36,077 41,179 40,608 57,521 60,397 63,417 69,759 76,735 % of Expenses 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% 80.00% SG&A 23,389 4,667 5,637 6,434 6,345 8,988 9,437 9,909 10,900 11,990 % of Expenses 12.50% 12.50% 12.50% 12.50% 12.50% 12.50% 12.50% 12.50% 12.50% 12.50% D&A (incl. Impairements) 3, ,258 1,321 1,387 1,526 1,679 % of Expenses 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% 1.75% Total Expenses 187,111 37,337 45,096 51,474 50,760 71,902 75,497 79,271 87,199 95,918 % of Revenue % 28.69% 34.56% 35.96% 33.39% 36.00% 22.74% 36.00% 21.91% 36.00% Page 21