Executives
Lilly H. Donohue – Investor Relations
Wesley Robert Eden – Chairman of the Board & Chief Executive Officer
Daniel N. Bass – Chief Financial Officer
Peter L. Briger, Jr. – President & Director
Michael E. Novogratz – President & Director
Analysts
Roger A. Freeman – Barclays Capital
Roger Smith – Fox-Pitt Kelton
Marc Irizarry – Goldman Sachs
Craig Siegenthaler - Credit Suisse
Daniel Fannon - Jefferies & Co.
Fortress Investment Group, Inc. (FIG) Q3 2008 Earnings Call November 13, 2008 8:00 AM ET
Operator
My name is Cynthia and I will be your conference operator today. At this time I’d like to welcome everyone to the Fortress third quarter earnings calls. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) I would now like to turn today’s call over to Lilly Donohue.
Lilly H. Donohue
I’d like to welcome everyone to our third quarter earnings conference call. Joining me today is Wes Eden, our Chairman and CEO, Dan Bass, our Chief Financial Officer, Pete Briger, President and Head of our Hybrid Hedge Fund Business and Mike Novogratz, President and Head of our Liquid Markets business.
I want to point out that statements today which are not historical facts may be forward-looking statements. Our actual results may differ materially from the estimates or expectations in any forward-looking statements. These statements represents the company’s beliefs regarding events that by their nature are uncertain and outside of the company’s control.
I would encourage you to review the forward-looking statement disclaimer in our quarterly earnings release including the recommendation to review the risk factors that are contained in our annual and quarterly reports that are filed with the SEC. Another thing that I would like to just point out is that we actually put up a slide deck on our website. You should be able to access it just by going to the investor relations site.
With that, I’ll turn it over to Wes Eden.
Wesley Robert Eden
Welcome to our 2008 third quarter earnings call. The markets have obviously continued to be incredibly volatile and while the third quarter that was just completed was a very difficult one, the month of October that followed it was among the most volatile on record. I know that you know lots of statistics and thoughts about this but just as one measure how volatile it was, if you look back at the five year period from 2003 to 2007, the S&P only had two days of more than a 4% move in one day.
The month of October along, 20 of the 23 days had intraday moves greater than 4% with one day as high as 10% so really incredible volatility in the equity markets. In addition to that, the credit markets are for the most part completely dysfunctional right now. To the extent that you have a debt maturity of any real consequence in this market, you have a serious problem. This is something of course the TARP and the government is very focused on and while we do believe the government and its actions will have positive results eventually, for the moment the credit markets are basically shut.
Now, this is the type of environment that will eventually create tremendous opportunity. It’s also quite demanding with respect to the liquidity and performance of our existing investments. As a firm, at Fortress we’re very fortunate to have a high-diversified group of private equity and hedge funds and are positioned to weather these volatile times and profit from the opportunities we believe are likely to come.
Now, before I talk about the earnings for the quarter, I’d like to run through a few topics that I know people are interested in hearing about. In a market as difficult as this, of course the liquidity and financing both for Fortress as well as our various funds, are at the top of everyone’s list. In addition, looking ahead key questions for investors are the stability and the sustainability of our earnings base during a period when there may be limited private equity realizations as well as zero or limited hedge fund profits.
Lastly, I want to bring you all up to speed on capital formation here in the businesses and what we expect in the coming months and quarters. As Lilly mentioned, if you have access to our website, I’ve posted a couple of summary pages I hope you’ll find helpful and I’ll step through those now.
Let’s start with liquidity; the firm has very good liquidity and our company is highly, highly cash flow positive. If you look at slide #2 in the presentation entitled liquidity of Fortress, we currently have a total of $675 million in debt and $225 million in cash for net debt of $450 million. Our total credit facility current s now $800 million so in addition to the cash on hand we have about another $100 million available under the lines when you take in to account letters of credit, etc.
So, lots and lots of current liquidity. We also just completed this week an amendment to our debt facility which Dan will walk through the details in a few minutes which gives us added flexibility. So, with the respect of our current liquidity combined with our internally generated cash flow, we believe we have sufficient cash flows to significantly amortize or pay off the debt over the next couple of years just based on our core management fees and are very well positioned to pursue the myriad of opportunities that we see from investment perspective.
The private equity funds, we still have several billion of uninvested capital and we’re actively pursuing and looking at a number of very compelling investments. In a market like this, you can never have too much liquidity but we feel fortunate to be as well funded and as liquid as we are. Specifically with regard to the portfolio companies in our private equity business which is the next slide, we’ve had a tremendous amount of productivity in extending or refinancing the debt of these companies over the past 18 months.
As a firm, we used modest amounts of leverage, on average it’s about 55% at acquisition and controlled private equity transactions and the bulk of the private equity debt that is due, you can see is due in 2012 and beyond. In the middle of 2007 when the whole credit crisis started, we had a total of $7.2 billion of debt maturing in the second half of 2007 and the calendar year 2008. That’s $7.2 billion out of a total of $39 billion in total portfolio debt so it’s a modest percentage of our debt.
But basically, we got very, very focused on this very early on knowing that things would get worse. Not necessarily predicting that they would be as bad as they are today but fortunately starting about a year ago we got after all this and we have refinanced all of it with the exception of a couple of hundred million that we expect to get refinanced or paid off in the next couple of weeks. We refinanced it without losing any companies, any shares or any assets.
With the exception of the last big financing that was completed a couple of weeks ago, it was all done in the ordinary course of business. The average cost of our debt that we refinanced was about 6.5%. In our controlled private equity business we also have fund level margin debt of a couple of hundred million which we expect to fully pay off certainly before the end of the year, hopefully in the next week or so.
Refinancing debt has been a major focus for us over the past year and by being ahead of this we were able to finance our companies without mishap and avoid any major problems thus far. The debt map that I provide in the slides shows how well financed the companies are in general. We still have some work to do for next year.
When you look at the next page that’s basically two companies that represent about 75% of the debt maturing. These companies on average were about 50% financed at the time of acquisition so they’re actually companies that have lots of assets, lots of cash flows, we feel very good about those two companies. When you get out pass them, the bulk of the debt begins to mature in 2012 and beyond when hopefully the markets will have returned to some normality.
The credit business under [PEC] are very well financed. Our average debt to equity is approximately one-to-one and it’s all term non-callable debt for the most part. In short, we do not have any significant financing needs in this business at all.
Now, I’d like to spend a couple of minutes on the nature of the money that we manage. As you can see from our next slide, about 73% of our capital is private equity styled capital which essentially means that for the most part the bulk of our capital is long term locked up capital. The specifics on our lockups for the various funds are all detailed in the public filings if you want scroll through them.
Only our liquid hedge funds have short-term liquidity and while we do expect that we, along with the rest of the hedge fund community, will experience some increased redemptions at year-end, with the bulk of our investment capital in long-term vehicles, we have a high degree of stability in our management fees. In a market as difficult and challenged as this, being able to be patient is obviously key and capital structure becomes critically important.
As you can see, using our September 30th numbers, we generate about $500 million in annualized management fees. Although it’s a little hard to project precisely, we estimate that our pre-tax fund management for the year will be about 50% of that. These are looking forward numbers. So, even if we do have material redemptions in our liquid hedge funds, our core private equity and hybrid hedge funds provides us with an earnings base that we expect to be around for many years to come.
At some point of course, we do expect performance fees will return just as they have in the past and our average 2% on average AUM will be a meaningful guide to our earnings power as much as it has been consistently over the last couple of years. But, in these times having half a billion or so in management fees coming in the door, the vast majority of that coming from locked up long term capital is very comforting to us indeed.
Capital formation is the last of our slides, it’s slide 6. In total this year we’ve raised $8.7 billion in new capital and we had net inflows of $6.4 billion. Our total AUM at September 30th was $34.3 billion, a 10% increase from a year ago. We’ve raised the bulk of our new capital in private equity style funds. In particular we’ve been very active raising capital in the credit space. Pete has raised about $3 billion in the past couple of months and we expect him to continue to do so as that capital is invested.
As I’ve said before we have had some redemptions thus far, they’re all noted on the page there and we expect more at year-end in our liquid hedge funds. In our hybrid hedge funds we’ve set up the funds specifically to function well in this type of market and while we’ve received significant redemption requests, they’ll be paid out as the fund’s assets are resolved in the ordinary course and thus do not create any asset liability mix matches.
In addition, the redeemed assets in the hybrid funds continue to earn management fees. Year-to-date Pete has raised more new capital which includes some of the private equity funds and the hedge funds that we talked about that he’s loss in performance and redemptions give him positive AUM growth in this year which is really extraordinary performance for a credit based business in the middle of this credit crisis.
Now, let’s talk a little bit about the results before I turn the call over to Dan. For the third quarter pre-tax DE was -$20 million. Pre-tax for DE for the third quarter 2007 was $111 million so our quarterly earnings obviously declined substantially year-over-year. It was another slow quarter earnings wise, for the most part we only earned based management fees. But, as expected, even without material incentive income earned this quarter, our fund management business generated $63 million in pre-tax DE.
That is essentially the current version of our half a billion in management fees less expenses kind of manifesting itself in the positive cash flows in an environment like this. That positive result was turned in to a loss with non-cash impairments of some of our assets on balance sheet. Dan will talk a little bit about that and we created a reserve for impairment of private equities incentive income.
Excluding these non-cash charges, our business generated significant free cash flow and we expect it will continue to do so for the future as well. All the major business segments with the exception of our commodities business experienced either write-downs in the case of the private equities business or mark-to-market losses in the hedge funds. Through the end of September, the core liquid markets fund was down 13.5% for the year. It is now down 19.9% through the end of October.
Our commodity hedge fund has had actually quite a good year. It was up 7.2% for the year and it’s 8.5% year-to-date through October. If you consider the extraordinary volatility through the month of October and just the year overall in the commodities business, that is exceptional performance and the special ops fund down 5.7% as of September 30th, estimated to be down 14.9% year-to-date through October.
Again, negative returns but relative to the peers in the credit space where it has been myriad of blow ups and major, major losses, we feel great about that. The performance for the quarter is certainly one that we’re not happy with and the market conditions are certainly very difficult and we’re very focused on making money in every one of these businesses.
On a relative basis, I do believe that when all is said and done, our businesses will stack up very well versus the industry and the competitors but you can’t eat relative performance and while I’m not happy with the market valuations or investments, we still own our assets, we have little in the way of short term debt and feel very good about our ability to benefit when the market becomes a bit more functional.
I know that our focus on liquidity and funding in the private equity business is exactly the right focus and while we still have some work left to do much of our attention is now turned to sorting out how best to benefit from these market conditions in particular those opportunities that are less well financed and capitalized.
Private equity funds have better and worse vantages, largely as a function of the state of the markets. The worse the market is usually means the best of time for the investments in particular after a market blow up like this and if indeed the past is precedent to the investments made now in the next couple of years should be fabulous.
The debt markets to me in particular and to us in particular seem very, very underpriced right now. It is true that just about anything you have bought in credit this year is worth less than what you paid for it as the credit markets have had a full year slide.
I think many of these markets are now priced far beyond what the worst case scenario is and actually offer a lot of upside from these current prices but there are some that are not yet fully priced and we think the market’s overall are probably going to continue to be negative on the debt side but do offer some very compelling opportunities if you can own them on either an unleveraged basis or won then with actually term financing so you’re not subject to the vagaries of the financing markets.
The hedge funds had a tough quarter. It’s been by far the toughest period in the industry in its history and we’ve been impacted as have most others. We’ve been through many tough markets before and we know what it takes to survive and prosper. There are very few groups in the world that have had as much collective distressed investment expertise and experience as we have here at Fortress and we expect that to serve us well in these times.
While the current market is grim and prospects for economic growth seem very limited in the near term, I do believe that the level of government intervention we have seen as well as that which is likely to come will rest the slide the markets are in and lead to more stable and functional markets for us in the future. Investors have had a very tough year in virtually regard and while new investment capital will be very dear to come by, the recognize, as do we, that these are the times to be making new investments in particularly in those sectors that have been the hardest hit.
To date, as testimony to that, we have raised several billion of new capital for distressed investments in the past couple of months and expect after year-end we’ll see incremental capital formation in all of our businesses. Year-to-date the primary investment opportunities have been for us in the asset and loan stuff. We haven’t bought a company in the private equity business in over a year. It just has not made sense. I’ve looked at lots and lots of things but it just hasn’t made sense to us on an evaluation basis.
But, looking ahead there’s no question there will be tremendous financial services opportunities in banking and insurance and then of course in the more traditional classic distressed corporate [taxes] opportunities. It’s going to be a very busy six weeks through the end of the year and then my guess is the next year is going to be a very interesting one indeed.
With that, let me turn the call over to Dan to review the firm’s results.
Daniel N. Bass
Let me now provide you with information on the third quarter financial results. Assets under management ended the third quarter at $34.3 billion. This is down 2% from the previous quarter but is up 3% since year-end and up 10% from a year ago. The growth in AUM from year-end includes $4.2 billion of fee-paying capital raised on our hedge funds plus $3.4 billion or fee-paying capital raised or deployed by our PE funds.
This growth offsets $1.1 billion of redemptions in our hedge funds and $4.6 billion of negative NAB changes in our hedge funds or marks below costs in our private equity funds. Fee-paying capital raised for the third quarter was $2.6 billion bringing our total for the year to $8.2 billion through September 30th and we have subsequently raised another $400 million in the fourth quarter through today as Wes mentioned.
During the third quarter our private equity funds raised approximately $1.4 billion which included $945 million of commitments to our credit focused funds. Also our liquid and hybrid hedge funds collectively raised $1.1 billion during the quarter. It is important to clarify that these capital raises, in particular our private equity funds, do not immediately become AUM because in most cases they do not generate management fees until the capital is deployed.
As of September 30th we have $2.8 billion of such uncalled fee paying capital. Further, we had redemptions in the third quarter of $183 million through September 30th to $1.1 billion. This does not include another $1.1 billion of fee-paying redemptions paid out subsequently to September 30 for a total of $2.2 billion of redemptions through today.
As previously mentioned, DE is the way we measure our performance. With that being said, we had a difficult third quarter recognizing a DE loss of $20 million which is down $58 million from last quarter and $111 from the third quarter last year. Pre-tax DE per share was a loss of $0.04 for the quarter. Pre-tax DE is the sum of fund management DE and DE from principal investments.
First I will discuss fund management DE which consists of segment revenues including management fees and incentive income net of segment expenses. Fund management DE for the quarter was $63 million versus $75 million in the second quarter last year. For reconciliation of DE fund management to our GAAP earnings please refer to our press release and other filed reports.
Management fees for the third quarter were $156 million up 4% from the second quarter and up 25% from $125 at third quarter last year. Incentive income for the third quarter was a loss of $3 million compared with $15 million of income in the second quarter and $94 million of income third quarter last year. This is a result of limited realization events, our hedge funds being under their high water mark and a $10 million net impairment reserve taken on previously reported fee incentive income.
Segment expense for the quarter were $90 million as compared to $104 million in the second quarter this year. While operating expenses have grown modestly since last year due to high average headcount profit sharing expenses have declined significantly since they are generally aligned with our net revenues. Operating margin from fund management activities for the quarter was 41% versus 45% in the second quarter this year.
As for fund management fee results on a segment basis, our private equity segment generated fund management fees of $22 million for the quarter, down $36 million in the second quarter this year. Management fees for the third quarter was $57 million which was consistent with the second quarter and an increase of 21% versus third quarter last year. The growth and stability of private equity management fees is reflective of the long-term nature of these funds.
Liquid hedge fund segment generated DE of $26 million for the third quarter versus $24 million in the same period last year. Management fees for the same period were $60 million, up 5% from the second quarter and up 33% year-on-year. In addition, the liquid hedge fund expenses were $34 million down 17% from the second quarter.
Our hybrid hedge fund segment generated $15 million of fund management fee in the third quarter, up 67% from the second quarter and up 114% compared to last year. Management fees for the quarter were $39 million up 8% from the second quarter and up 18% versus last year mainly due to an 11% growth in AUM to $8.2 billion. In addition, expenses for the third quarter were up modestly compared to last year.
With respect to our principal investment segments which houses our principal investment portfolio, we had a DE loss of $83 million for the third quarter. The majority of this loss relates to $50 million of impairments taken investments in our [PE] funds. Marks of $23 million on our investments in hedge funds and $10 million of net interest expenses. With respect to our balance sheet, as of September 30th we have $259 million in cash and as of today we have approximately $225 million.
In the third quarter we paid down $50 million on our term loan brining our debt as of September 30th down to $750 million and as well as in the fourth quarter we paid down another $75 million further reducing our outstanding debt to $675 million as the slide represents. Regarding our credit facility, as Wes mentioned, we recently amended our agreement to modify our leverage test to exclude certain non-cash charges and modify our asset coverage test to encourage pay downs on our debt rather than cash collateralizations.
This amendment represents a modest change to our facility and the covenants therein and gives us significant operating flexibility to manage our level of financing and make future pay downs accordingly. After the amendment our credit facility is $800 million made up of $670 million term loan and $125 million revolver and carries and interest rate of LIBOR plus 200 basis points.
We think this amendment makes a lot of sense in this market environment and we have a great relationship with our banks and this transaction was incredibly smooth especially with all the market turmoil going on in the financing sector.
Further, we generally commit to invest in our funds up to 5% of their capital. These investments make up our principal investment portfolio. As of September we had segment investment assets of $981 million of which $749 million are private equity and $232 are in our hedge funds. In addition, we have remaining $142 million of commitment to these funds which we anticipate to be funded over the next couple of year as Wes mention we deploy the existing capital that we have.
As it relates to taxes on a DE basis, as of now we expect our tax rate to be within a range of 20% to 25%. This reflects our lower level of incentive income this year than in previous years as well as impairments of investments to date. To reiterate what Wes mentioned earlier, the longevity of many of our funds investment strategies and structure provide us with a degree of stability in our cash flows to manage our business during these challenging markets and time.
Now, we’ll open it up to Q&A.
Question-and-Answer Session
Operator
(Operator Instructions) Our first question comes from Roger A. Freeman – Barclays Capital.
Roger A. Freeman – Barclays Capital
Dan, actually just to come right back to the covenants on the credit facility, can you just run through exactly what those covenants are right now?
Daniel N. Bass
Right now we have a leverage test which is debt over EBITDA of 2.75 times. The debt is debt less a maximum of $50 million of cash on the balance sheet, so debt less the $50 million over EBTIDA, 2.75 times is the covenant.
Roger A. Freeman – Barclays Capital
The trailing EBTIDA?
Daniel N. Bass
That’s four quarter trailing EBITDA which essentially aligns with fund management fees.
Roger A. Freeman – Barclays Capital
So where does that ratio come in for the third quarter here?
Daniel N. Bass
The third quarter we’re right now at the 6.75, the third quarter is around 2.0, 1.99 times.
Roger A. Freeman – Barclays Capital
And what else? Was there another one?
Daniel N. Bass
Investment asset test is $975 million and that includes the principal investments as I laid out of $900 million plus the cash on balance sheet and so that is $975 million and that steps down dollar for dollar for future pay downs in the debt. Then, there’s an assets under management covenant which is about $23 billion.
Wesley Robert Eden
The primary thing that we are focused on in the debt covenant was just taking all the non-cash charges out of the calculation of EBTIDA. It’s fine to be measure by our cash flow of the company, we have a lot of cash flows as I went through. We’ve got half a billion in management fees and we feel very good about having very stable income even with no performance fees for a very long time. We want to take out all the non-cash stuff that gave us volatility, it cost us a modest amount to do.
Again, if you think about if it’s an impaired issue, in this market it would have been a very difficult thing to get done. This was not an impaired issue, it was a very simple thing to get done. It gave us great flexibility and as Dan said, we have great relationships at the bank and we’re happy about that. The total cost of the debt now is LIBOR plus 200 so LIBOR plus 200 debt that goes out to 2012 we feel actually really good about especially with the changes.
Roger A. Freeman – Barclays Capital
Then on the upcoming refinancing, I guess you said 75% of next year’s refinancing are in two companies. I guess first, when during the year are those, are they first or second half of the year?
Daniel N. Bass
They’re both second half of the year and one of them was an investment we made that at the time we made the investment it was about 42% or 43% I think was the average LTV. It’s a myriad of a bunch of different assets and companies. We’re actually in the process we think of refinancing a good chunk of that here in the next 60 to 90 days so I think long before we get there that think will be paid off.
The other is a financing which is due now at the end of the year, in the fourth quarter of next year. Also, things that we’re in the process of getting it down. It really is just those two things. The key to both of those financing and I think the key to financing markets right now, we’ve had a lot of success in taking big financings that were needed and breaking them in to small financings.
Even in a very difficult market that we’ve had we’ve had a lot of success in being able to roll and refinance ships and airplanes and real estate and all kinds of the assets that we own. We think we’ll continue to have success with that even in tough markets. If it was a single big corporate transaction of $1 billion, $1.5 billion, I think that is a very, very challenging thing to get done and fortunately that’s not the case with either one of these two. Then our next real major debt maturities actually happen in 2012.
Roger A. Freeman – Barclays Capital
But these two companies are they older portfolio company investments or more recent ones?
Daniel N. Bass
They’re more recent, the last couple of years. I’m not relaxed about any piece of financing in this market. But of the things that we have had to deal with and get through and where the markets are today if you had told me a year ago that we would have gotten everything rolled as we did and be in the position we are in today I’d be extremely happy about it. I feel good about this and I feel good about those.
I think when you compare, if you could take a similar debt map from all the other private equity firms and lay out all the equity firms and lay out everything that they’ve got which I think by the way, would be a great exercise to go through both for LPs and investors is go look at what the debt maturing schedule is for all these, it would be a fruitful thing to look at because as I’ve said at the beginning , the debt markets right now are 100% shut.
There is no new debt in the world that is being done right now. We think that is a temporary condition and hopefully it will abate coming forward. But, in any significant corporate financing that has to get refinanced right now is going to end up being a restructuring or a default. That’s pretty much where the world is.
Roger A. Freeman – Barclays Capital
Then in your private equity business you had I guess you talked about this impairment reserve. Can you talk about is that a reserve for potential claw back?
Daniel N. Bass
The $10 million yes, is a reserve on one of our funds which is a single investment reserve for the claw back.
Wesley Robert Eden
Our total liability for all claw backs across all funds Dan is what?
Daniel N. Bass
September 30th is $55 million. This is a fund that the claw back, the maturity of the fund is in 2014 so it’s six years out but we’re making a reserve today.
Roger A. Freeman – Barclays Capital
That’s why I was just curious why would you have to take a reserve now if it’s that far out?
Daniel N. Bass
It’s a function of the time it’s been under water and the magnitude of the recovery of that investment, that’s why. So, it’s not a mark-to-market but it’s essentially like a permanent impairment analysis that you would do on an investment.
Wesley Robert Eden
It’s just an accounting policy this mandated to us.
Roger A. Freeman – Barclays Capital
Presumably, if that investment performs drier to that, obviously that could get reversed?
Daniel N. Bass
We could reverse that reserve in the future.
Wesley Robert Eden
Again, in the context of claw back reserves, $50 million in the aggregate is kind of where our number is compared to billions of dollars at lots of other balances so it’s something that’s not a problem but it is a $50 million issue prospectively years in the future.
Roger A. Freeman – Barclays Capital
Just lastly and I’ll jump back in the queue, maybe Mike could you talk a little bit about the macro strategy during the quarter? Obviously, tough conditions but how were you positioned there and how are you positioned now? What asset classes you think you’ll be concentrated in and what percent cash are you in?
Michael E. Novogratz
Listen, we had a very disappointing quarter as the returns show. Part of that was getting caught long assets in a market where liquidity disappeared. We had really built in to a multi strategy type of approach over the previous three to four years and we have been quickly dismantling the multi strategy approach and refocusing on core macro, liquefying our portfolio. We’re currently about 80% liquid, 20% illiquid with risk very low waiting for more clarity in the markets.
Operator
Our next question comes from Roger Smith – Fox-Pitt Kelton.
Roger Smith – Fox-Pitt Kelton
I just wanted to go over a couple of things in the private equity, if you look at the change in the value on the roll forward can you give us an idea of what was really due to the public market companies versus the private market companies and what was really the foreign currency component.
Wesley Robert Eden
I think 86% is the number that comes to mind but I think 86% of the right downs to the private equity portfolio were from the public companies which is obviously the bad news. On the other hand we had just done this calculation for our private equity conference a couple of weeks ago. I think by our estimate the private equity companies are now valued at a discount value of our estimate of NAV of about $10 billion. It’s probably more than that since then because that was as of a few weeks ago and the markets have gone down.
The bad news is we’ve had big write-downs, that’s been almost the sole source of write-downs across the private equity portfolio. When you look at the public valuations of these companies, I think, we think, they are a far cry from what they will eventually perform at and it’s a major focus of ours. They’re public companies so there isn’t a lot I can say about that other than to say that it is something that we’re very focused on and we think there’s a lot of upside from looking at different ways to take advantage of what the price in the marketplace are.
The foreign exchange component of it, we hedge what we think our exposures are and over time have done a pretty good job of trying to match up what the exchange valuations are versus our investments. It’s not a perfect science but that has not been a meaningful aspect of the write down.
Roger Smith – Fox-Pitt Kelton
Then just on the fund level debt, there I think you said in the comments that it was just a couple of hundred million, has that declined significant in the last quarter or two?
Wesley Robert Eden
If you look at the fund level debt at the peak, margin loans against public securities, etc., the peak I think it was probably around a couple of billion a couple of years ago. The tip top was $2.1 or $2.2 billion, that’s down to a couple of hundred million now and it is the process of actually all getting paid off as I said. There’s no real issues there, that will actually happen in the ordinary course.
In this market obviously there’s lots of conjecture, people get speculative of a lot of stuff but at this level those loans are modest in size and something that as we speak are in the process of being handled so it’s not something we’re very worried about now.
Roger Smith – Fox-Pitt Kelton
Then on the hedge fund business, particularly the liquid hedge fund business, I guess you did say you were 80% liquid now which makes me think that you’re more than adequately prepared for any of these redemptions that we’re thinking about coming. When did you guys get that liquid because I just want to understand from the performance point of view is that performance really on more like 20% in those assets or more like 80% of the assets through that quarter?
Daniel N. Bass
During the month of October we were in the process of both selling out illiquid investments and a lot of the losses came from just price deterioration on the illiquid assets. Some of the less liquid asset classes have dropped 60%, 70%, 80% and so part of the having a smaller percentage of illiquid is that is where a lot of the losses came from. Not 100% of the losses but a decent bit of them.
Roger Smith – Fox-Pitt Kelton
Just so I understand what you’re definition of liquid versus illiquid, equity stocks, like stock market be considered illiquid assets?
Daniel N. Bass
It’s interesting, it’s a shifting bar right now. Outside of really almost S&P futures and G3 currencies, everything varies to degrees of illiquidity. I mean markets are almost functionally shut in anything small cap or anything credit related. We look at it as a five day or a two week test and if we think we can exit a position in one or two weeks we’ll consider that liquid and if we think we can’t exit a position in one or two weeks at a reasonable price we’ll consider it illiquid.
Roger Smith – Fox-Pitt Kelton
Then on the redemption levels, it looks like it’s about a quarter of the assets that you’re looking to be redeemed and when you listen to commentary across the industry that doesn’t seem to be so unreasonable relative to what people are talking about from hedge fund redemptions. But, can you give us any kind of color of really what or the reason people are redeeming these assets. I mean when you do look at these performance numbers relative to equities in general it’s much better so what are they really telling you and what do you think people are going to end up doing with this capital? Is there any kind of rebalancing that you might expect sometime in the back half of 2009 or 2010?
Peter L. Briger, Jr.
First of all, I think what you’re seeing right now, and this is just one piece of evidence is deleveraging in general so hedge funds are one form of that. People actually need their cash, that’s really the main point right now is that there is a big restructuring that is going on in the hedge fund industry. Actually, funds that have greater liquidity are receiving more redemptions because people can’t get their cash out of so many different places.
So, they hybrid hedge funds come up for redemptions once a year, you have a private equity payout as opposed to a more of cash payout structure in those funds when situations like the current environment arise. But, what we’re expecting is to see much higher levels of redemptions in the industry for the next year or so as this deleveraging in every part of the financial industry and every part of the real economy and we think that that process is accelerating not decelerating.
Roger Smith – Fox-Pitt Kelton
So 2009 you’d expect these redemption levels to really be up from where we’re seeing in the fourth quarter.
Peter L. Briger, Jr.
Yes.
Operator
Our next question comes from the line of Marc Irizarry – Goldman Sachs.
Marc Irizarry – Goldman Sachs
Just following along on the redemption, can you just clarify again through October what you’ve seen in terms of redemptions notices? And then, I guess is the expectation such that the ’09 redemption you’ll see more increases for redemptions or more notices heading in to ’09? Then also, can you talk about any gates that you have that you can lower?
Peter L. Briger, Jr.
First of all, if you turn to page 6 in our presentation Marc, you see it laid out pretty specifically as to what redemptions we’ve seen of late. With respect to hybrid hedge funds we’re investing in illiquid assets and so we have taken account of that and our redemption provisions are more private equity like. We have options for investors to redeem once a year so from our perspective we’re assuming that this deleveraging process broadly speaking will continue and accelerate just as the debt markets and the equity markets are deleveraging. So from our perspective we do expect this to continue.
Wesley Robert Eden
The context of course is that we start at the beginning of this with 73% of our assets in funds that can’t be redeemed so as I said at the beginning the only material liquidations that we can have are in the liquid hedge funds either in the commodities business or in Mike’s business. The redemptions that we show you are everything that we know at this point and I agree with Pete, I think one of the real cornerstones of the hedge fund industry was the notion that you could get liquidity in these liquid strategies and so people put their money in to different funds and they said, “Geez, if times are bad I can take my money out and redeploy.”
I think with the credit markets locked up and with the crisis of confidence that is out there I think people are voting to have more money in the sidelines. It’s something that can reverse itself, I think if confidence returns and obviously that’s the focus of the government and the administration and we’re all rooting for that but I view the redemptions that you’re hearing about around the industry and certainly as it pertains to us are at some level a real vote of lack of confidence about the financial system more so they are about any specific strategy because I think as was said earlier, the fund returns on this compare very favorable to market indices and stock markets overall, credit markets overall, etc.
That’s not to say our funds are the best across every sector that they’re in but there’s nothing to really distinguish them one-way or the other. It’s more the industry itself is going through a real rebalancing in terms of its liquidity positions.
Peter L. Briger, Jr.
And, a lot of what we saw in September and October and what we’re continuing to see in November is funds under pressure to sell assets and lots of folks who have got assets that are financed with bad asset liability matches being taken out of their positions. In particular, the number of total rates of return swap positions that are being liquidate by the investment banking and commercial banking community, is at an all time high by some multiple and the structure finance world where people finance assets and CLOs and CDOs that had market value triggers, even the most conservative of those market value triggers are now coming under pressure and assets are being liquidated and funds are being forced to either recapitalized by calling new capital from their investors at much lower prices or liquidating out entirely and losing all of their investors’ money.
Wesley Robert Eden
And the investors themselves of course are having real asset liability mismatches. So, there’s been some more publicized cases of that in the newspapers but the LPs themselves will probably after all this is said and done really relook at how they allocate capital and how they look at liquidity in addition to asset allocations and returns.
Marc Irizarry – Goldman Sachs
With that in mind and rebalancing of liquidity positions by LPs what’s sort of the appetite out there for additional capital formation and private equity? Maybe you can give an update on the latest vintage fortress fund that you’re raising? Then also Wes can you talk a little bit about the performance of the underlying portfolio companies from an operational perspective?
Wesley Robert Eden
The investors, I think I tried to say this earlier Marc, the investors I think are in a place where their endowments or their funds are worth less month, their asset allocation balances are all out of whack because they’ve had big underperformance in terms of the equity markets and then the percentage they end up in alternatives in many cases is now out of whack so you’re seeing a lot of rebalancing that is going on right now.
I think as difficult of a time as it is from a liquidity standpoint people do recognize as we do that the dollars that are invested in this environment can really go a long ways towards closing the gap between the losses that they’ve had. I think there will be capital formation in the industry, I think it will be selective, it will be focused on people that have specific strategies and experience at executing those strategies.
I can’t comment specifically about the funds that we’re raising as we’re a public company we can’t make specific comment about that. We have not, in the private equity business, I haven’t made a corporate investment in really the last year and a half or year and three months or so. We’ve made a couple asset purchases. I think that we’re getting closer to the point where some of the distressed opportunities are looking very interesting. There’s one in particular that we are in the throes of pursuing right now.
On the performance of the underlying companies it’s a tale of two cities versus what the performance of the public markets have been. We made an attempt at our investor conference a couple weeks ago to try to look at whatever the relative metric is that pertains to a company, be it cash flow or NAV or whatnot and look at how it had done year-over-year and weight that by the amount of capital that we had in those businesses. We ended up with a net positive result of about a 5% year-over-year increase across the entire portfolio.
So it’s a little hard to compare because it is apples and oranges in some cases but by and large we’ve had kind of flat to increasing performance, modest as it was, and when you contrast that to what’s happened in the overall market we feel very good about that.
Having said that, since Lehman went out of business in the middle of September and the world kind of blew apart I think people are really wondering what next year’s going to bring. A lot of our investments have very long-term cash flow, very stable cash flows so they’ll be well protected almost irrespective of what happens. Some of them have got more exposure to it. Those are the kinds of things where you’re actively cutting costs and trying to manage yourself to be well positioned for.
That’s where liquidity plays such a major role in these companies is that to the extent that you can manage your balance sheet and not have any short-term liquidity events, then you can make it through these tough times and when you get to the other side you’re in better shape than competitors and you can actually make some real hay of it. That’s exactly what we are preparing to do.
Marc Irizarry – Goldman Sachs
Mike, just one quick one for you and for Dan as well. What are the high water marks on the liquid fronts?
Michael E. Novogratz
The macro currently is down about 18.5% and that is the high water mark. On new capital of course there’ll be no high water mark but right now new capital is tough to come by. We actually think though come the beginning of the year macro will probably be the favored allocation of fund-to-fund allocators. Most likely people will use a barbell strategy either investing long-term in credit funds or short term in very liquid macro funds. So we’re repositioning the fund to really go back to its core roots as a purely liquid macro fund.
Marc Irizarry – Goldman Sachs
What’s our leverage you think you’ll be running with going forward?
Michael E. Novogratz
Leverage is always a tough question in a macro fund because you can buy a 30-year bond or a lot of three-month T-bills and have the same amount of risk and 10 times the leverage. Roughly about five times leverage in the real liquid stuff but that’s a formula we come up with in 10-year equivalents and S&P equivalents. If you want to think about it in terms of percent net long equities or percent net long currencies, in the current volatility a 15% net long equity position is a ton of risk. So right now you don’t need almost any leverage to generate returns. That’s a changing bar.
Operator
Our next question comes from Craig Siegenthaler - Credit Suisse.
Craig Siegenthaler - Credit Suisse
When you look across your channels and I’m mainly looking at a few buckets; institutional direct, high net worth, fund-to-fund; which buckets are driving the majority of the $3 billion of hybrid and liquid hedge and redemption notices that you disclosed in your slide deck?
Peter L. Briger, Jr.
It’s really across the board. The redemptions were for the most part partial redemptions meaning that people from my perspective were redeeming because we had redemptions that were once a year so people from a defensive perspective were redeeming in many cases because they themselves might be subject to cash needs. I don’t think there was any particular investor type that was notable. I think it was across the board and I think that it was by far and away partial redemptions as opposed to full redemptions.
Michael E. Novogratz
In liquid markets the bulk of the redemptions are coming from the fund-to-fund community.
Craig Siegenthaler - Credit Suisse
Is there some floor on that $3 billion because we’re at the point now where we’re pretty far into the fourth quarter or could we see further redemption notices and that number kind of pick up over the next month and a half?
Peter L. Briger, Jr.
There are sort of two different businesses you’re dealing with. In terms of hybrids the redemption potential is once a year and we’ve seen that come and go in September, and macro has greater liquidity on a quarterly basis.
I think that we are accelerating into a deleveraging process and hedge funds are no exception of that. If you look at the endowment community, if you look at the pension fund community, and if you look at the private equity community in general, there’s been a tremendous value loss that has gone on there.
In particular I think there’s a topic in the private equity investor community which is really unfunded commitments. Those unfunded commitments are an issue because that creates an asset liability mismatch at the investor level that has to be dealt with because realizations in the private equity business are much lower. So in order to raise the funds and make those commitments all across the board, you’re selling your more liquid assets. There is a vicious cycle effect of this.
I think if you look at pension fund mark-to-markets across the board, if you look at endowment fund mark-to-markets across the board, and these are just going to start coming out in the near future, the numbers are very, very, very significant and again that will only cause more deleveraging of those asset categories where funds can in fact be withdrawn.
Craig Siegenthaler - Credit Suisse
Just another question on the hedge funds. I heard a great explanation, great color on addressing liquidity concerns in the private equity business and for the corporate entity of Fortress but I didn’t hear a lot of color on the hedge fund businesses. I’m just wondering, has there been any changes made to any strategies due to deleveraging or maybe higher borrowing costs at some of the prime brokers or have the strategies largely remained intact because of your lower levels of leverage?
Peter L. Briger, Jr.
Again there are two significantly different businesses in hybrids and in liquids so I’ll speak to hybrids and pass it over to Mike for liquids.
In hybrids we run our business, and this is really talking about the special opportunities fund, about 1 to 1 levered. We actually before the crisis began issued upwards of $8 billion of term financing, meaning longer than 10 years, with a revolving feature to it with no mark-to-market triggers. That is the foundation for the leverage in our business and that business has no margin capability. It’s term debt, it’s reusable, etc. We do have a small amount of margin debt or repo debt but we have cash on hand to pay that debt off.
So I think from our perspective the strategy continues to be in place. We have lots and lots of debt at yesterday’s prices. We do find that the market has changed tremendously as a result of the fact that debt terms across the board are much, much tougher and debt financing much harder to come by, and in fact the deleveraging caused by other people’s mark-to-market triggers has caused asset prices to fall precipitously.
That’s not to say that there aren’t substantive concerns in terms of the top line of every single asset class that’s cash flow producing but what you saw in September and October was really spectacular in terms of the vicious cycle effect of price degradation causing price degradation, causing re-margining, causing recapitalization, causing asset sales, causing losses; and just to take as one metric a business that I’m intimately familiar with, the lending business, is down about 20% on the year. The indexes are down about 20% on the year and even though they’ve been volatile, 20% of that degradation was caused in September and October.
So there were other points where the index was down and up but really the majority of loss was taken in those two months. I think there isn’t anything close in the recorded history of the loan market to that. Not in 1998, not in 2002, etc. Those two months were really the cat’s meow.
Financing is much tougher and it’s getting actually tougher. There are going to be lots and lots of financial institution deleveraging; there are going to be continued failures; and all of that even despite the Feds efforts is causing this to accelerate.
Craig Siegenthaler - Credit Suisse
One question on that. If the average index is let’s say down 20%, with 2 to 1 leverage wouldn’t that assume that you’re looking at 40% reductions in the average fund out there holding loans?
Peter L. Briger, Jr.
Well, assuming that you were long only in assuming that your loans were the index assuming lots and lots of things, yes. You have seen lots and lots of long only funds without term leverage, etc. down full year 50% in the last month.
Michael E. Novogratz
In the macro or liquid markets space we’ve seen larger haircuts, more aggressive margin enforcement across the board. We’ve been moving to one, decrease the number of counterparties that we use. We’ve been getting more liquid; not less liquid. We’ve shut down businesses; we’ve moved away from the RV space and away from the [inaudible] space, away from a lot of our long/short equity strategies really into the core macro space. When I think about the future, the CTA model or a very liquid business where you can run on 20% or 25% of your fund and the rest in cash, it’s probably the future of what most macro funds will look like.
Operator
Our next question comes from Daniel Fannon - Jefferies & Co..
Daniel Fannon - Jefferies & Co.
I wanted to talk about fees, if there’s any discussions this year as you guys have raised capital, if any changes in terms of the fees that you guys are charging for this capital? And as you look out into 2009 will you be looking to get more long-term private equity capital across your businesses like your liquid funds and would that potentially result in lower management fees or incentive fees being charged?
Wesley Robert Eden
There’s really been no discussion of fee changes but it’s a changing landscape. It’ll be interesting to see how the world looks by this time next year. I do think that Pete’s assessments of the liquidity problems in the industry are similar to mine.
Having said that, I do think that there will be a very robust hedge fund industry at the end of the day and people will pay full fees and there are people who over many, many years have been able to demonstrate that they can outperform indices and markets and those people will have no problem attracting capital and no problem getting paid full fees to do it. I think you’ve got 10,000 hedge funds or whatever it is in the world, there’s going to be a lot fewer of them probably when this is all said and done, and the fees will address that. But I don’t think at the end of the day it’ll be a fee issue. I think it’ll be a performance issue.
Peter L. Briger, Jr.
Just as an example, we raised $3+ billion for private equity this year to invest in credit and there really was not a fee discussion to be had. People want the returns.
Daniel Fannon - Jefferies & Co.
In those funds for this year, could you just remind us how long that capital is tied up for?
Peter L. Briger, Jr.
About 10 years. That’s capital raised for the most part in the second half of the year into kind of a tougher environment. I think that capital will be dear but people recognize as we do that those sectors that have been hit the hardest are the ones that have the best opportunities.
Operator
Ladies and Gentlemen, we have reached the end of the allotted time for the question and answer session. I would like to turn the call back over to management for closing remarks.
Lilly H. Donohue
Thanks everyone for participating. If you have any follow up questions, don’t hesitate to call my office. Again thanks everyone.
Operator
Ladies and Gentlemen, this concludes today’s Fortress third quarter earnings call. You may now disconnect.
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