In May, I published a series on alternative asset managers, which culminated in a write-up of my latest purchase (at the time), Fortress Investment Group (FIG). Based on its net cash/investments per share, plus a fund management valuation of 6.3% * $46.4 billion of Assets under Management (AUM), I pegged FIG at a Fair Value of $7.80 per share. Based on FIG's $3.11 share price at that point, this offered substantial upside potential of 151%. This turned out to be very fortunate timing, as I caught the 2012 bottom (in fact, pretty much the three-year low) for FIG.
On Thursday, the share price again traded down to and held the key $4.08-19 support zone (for the past five months), and then rallied strongly to close at $4.38. That's a 41% gain compared with my write-up price seven months ago. And a 53% gain versus my own net entry price (which also includes the impact of dividends). I'm sure many readers (new and old) who were interested, but perhaps missed the boat on buying FIG, are now ready to give up and move on to the next idea... but why? First, my $7.80 fair value still offers a 78% upside potential -- pretty damn excellent for a U.S. mid/large cap stock with zero debt. Second, fair value's a moving target, so we need to take a closer look at what's been happening with Fortress since.
As with all asset managers, we first look at AUM: Fortress is definitely firing on all cylinders here. End-September, AUM stood at $51.5 billion, which compares to $43.7 billion at the beginning of the year, and is up +18% year-on-year. And this actually downplays its actual fund-raising success in the past year. Unlike some of its peers (bear in mind if you're doing any comparative analysis), Fortress doesn't include uncalled/non-fee earning commitments ("dry powder") within its total AUM. This dry powder was $3.2 billion last year, but has since more than doubled to $7.2 billion. I don't include this dry powder figure in my valuation, but obviously, it's a significant and reassuring source of new AUM to come.
Next comes Performance: Considering the average hedge fund's up just +3% year-to-date in 2012, Fortress has blown the lights out. Virtually all of its hedge/credit funds are, by comparison, reporting double digit returns this year (with some of its private equity funds earning 20%+). Logan Circle Partners, its fixed income manager, also continues to outperform benchmarks in virtually all strategies. Fortress has also won awards left, right and center this year. And since quarter-end, they've reported a very successful divestment of a private equity holding, RailAmerica (RA), to Genesee & Wyoming (GWR) for $1.4 billion.
And next, we look at Financial Stability: As of end-September, FIG cash was $254 million, investments were $1,200 million, and debt was $181 million. This equates to $1,273 million of net cash/investments. Clearly, FIG's outstanding commitment of $154 million to its funds (in the years to come) poses no threat to liquidity. However, we need to make a couple of subsequent adjustments. First, Fortress repaid all debt in October. This doesn't affect net cash, but it removes a minor risk from the balance sheet, grants some additional flexibility, and has an incrementally positive impact on earnings.
Second, the divestment of RailAmerica resulted in Fortress receiving aggregate proceeds of $182 million. Only $17 million was carried as an investment, the balance was classified as a receivable and/or was simply a previously unrecorded gain. This increases net cash/investments by a net $165 million to $1,438 million.
Finally, we've just heard news of Co-Founder and Principal Robert Kauffman's retirement. This prompted the buy-back of his entire 51.3 million share stake, at a discounted $3.50 share price. Of course, the real benefit here is the buyback of approximately 10% of the company's outstanding shares at a far more substantial discount to intrinsic value. The total cost was $179 million, mostly funded through the issuance of promissory notes -- which will presumably be retired with cash on hand in 2014. This reduces my most up-to-date estimate of net cash/investments to $1,258 million.
Now, let's revisit my valuation of the asset management business itself. I recommend you read my previous write-up, but to briefly summarize: In the last two financial years, management fees averaged 1.20% of AUM. Incentive fees were far more volatile, of course, so I considered a five-year average of 0.74% of AUM the most useful metric to reference. Fund management DE (distributable earnings -- broadly equivalent to operating profit) was 36% of total fees, which I thought deserved a 3.25 Price/Sales (P/S) multiple. This produced an (ex-cash) fund management valuation of 6.3% of AUM (i.e., 1.94% of AUM in total average fees * 3.25 P/S).
So, how do the numbers compare in 2012?
Well, as of end-September, Fortress has earned $348 million and $164 million in management and incentive fees, respectively. On an average $47.4 billion of AUM, this equates to 0.98% of AUM for management fees, and 0.46% of AUM for incentive fees. No need for alarm at the drop in the management fee rate -- it simply reflects Logan Circle's increasing slice of the AUM pie (Logan has a much lower fee structure). Logan has actually proved to be a marvelous acquisition/integration for Fortress -- AUM has almost doubled from $12 to $21 billion since it was acquired in 2010. This may bode well for possible future acquisitions.
This lower management fee rate may well prove permanent, so let's now adopt it. On the other hand, I think it's quite reasonable to continue assuming an average 0.74% of AUM for incentive fees over time. With fund management DE of $172 million this year at 34% of total fees, I'll also continue to assume a 3.25 P/S multiple. This lowers my fund management valuation to 5.6% of AUM (1.72% of AUM * 3.25 P/S). Depending on your perspective, you may consider this to be an aggressive (or conservative) valuation… I'd argue it might prove to be relatively conservative, in due course:
- Post-financial crisis, I think Fortress has done a marvelous job maintaining and increasing AUM. Noting this, and its success in 2012, certainly bodes well for its continued progress in fund-raising/AUM.
- My valuation incorporates none of Fortress' $7.2 billion of dry powder.
- Fortress just announced the successful close of Fortress Japan Opportunity Fund II with $1.65 billion in assets. Some/all of this total will be a fresh addition to the next AUM/dry powder figures.
- As we've seen with some of its peers, Fortress' increasing scale and superior relative performance (particularly in 2012) are likely to attract an increasing/disproportionate share of inflows from investors and institutions.
- Fortress currently has $651 million of embedded incentive income in its funds, of which the vast majority remains unrecorded in DE.
- Current FIG results are dragged down by Logan Circle, which appears to have been run on a low-fee/break-even basis since acquisition. This has allowed it to focus very successfully on an accelerated increase in AUM. It's reasonable to expect a significant increase in Logan's fee rates and profit margins in due course.
- FIG's current annual dividend is $0.20 -- an attractive 4.6% yield. However, current (annualized) pre-tax DE is $0.48, and FIG's committed to a top-up dividend for year-end. If we assume, say, about one third of the incremental earnings are paid out, we could see a $0.10 top-up payment. This would, of course, re-base investors' expectations to a $0.30+ annual dividend, and a 6.8% yield would provide strong support for the share price.
- The asset management industry has well established market/M&A multiples. On average, a high quality fixed income manager might attract a 0.67%-1.0% of AUM valuation, while a top-class alternative asset manager could command anything from 7.5%-10% of AUM, or even higher. Using mid-points of these metrics, and noting a 21:31 split in favor of alternative assets, this is further confirmation of a potential 5.6% of AUM valuation for FIG.
So, putting all this together:
$51.5 billion AUM * 1.72% Total Fees * 3.25 P/S + $1,258 million Net Cash/Investments = $4,136 million/ (519.1 - 51.3) million shares = $8.84 Fair Value per share
This offers fresh upside potential of 102%. I've now added to my FIG holding, increasing my portfolio stake to 4.9%.
- Fortress Investment Group
- Market Price: $4.38
- Market Cap: $2,049 million
- Dividend Yield: 4.6%-6.8% (based on a $0.20-0.30 dividend)
- Price/Cash: 1.63
- Ex-Cash % of AUM: 1.5% of AUM
- Target Market Cap: $4,136 million
- Target Dividend Yield: 2.3%-3.4%
- Target Price/Cash: 3.3
- Target Ex-Cash % of AUM: 5.6%
- Target Price: $8.84
- Upside Potential: 102%
Disclosure: I am long FIG.