Fortress Investment Group LLC Q2 2009 Earnings Call Transcript

| About: Fortress Investment (FIG)

Fortress Investment Group LLC (NYSE:FIG)

Q2 2009 Earnings Call

August 5, 2009 8:00 am ET


Lilly Donahue – Managing Director, Investor Relations

Wesley Edens – Chairman and Chief Executive Officer

Daniel Bass – Chief Financial Officer

Peter Briger – President and Head of Hybrid Hedge Fund Business

Mike Novogratz – President and Head of Liquid Markets Business


Roger Freeman - Barclays Capital

Marc Irizarry - Goldman Sachs

Craig Siegenthaler - Credit Suisse

Daniel Fannon - Jefferies & Co.

Robert Lee - Keefe, Bruyette & Woods

Roger Smith - Fox-Pitt Kelton


Good morning. My name is [Lori] and I will be your conference operator.

At this time I would like to welcome everyone to the Fortress second quarter earnings conference call. (Operator Instructions)

I will now turn the call over to Lilly Donahue. Please go ahead.

Lilly Donahue

Thanks, [Lori]. Good morning, everyone. I just want to welcome all of you to our second quarter earnings conference call.

Joining me today is Wes Edens, Pete Briger, Mike Novogratz, Dan Bass and also in attendance we have Dan Mudd, our new CEO effective next week.

I just want to quickly 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 statement. These statement represent 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 press release, including the recommendation to review the risk factors that are contained in our annual and quarterly reports that are filed with the SEC.

With that, I'd like to turn it over to Wes Edens.


Wesley Edens

Great. Thanks, Lilly, and good morning, everyone. Thanks for joining our 2009 second quarter earnings call.

The second quarter was an excellent quarter for us. It's our best in the past year and it results in a very solid start for the first half of 2009. Before I turn to the quarter and update you on the businesses, I'd like to take a few minutes to welcome Dan Mudd, our new Chief Executive Officer as of next week.

Bringing in Dan is a great result for us. It's the product of a series of discussions we've had over many months internally. The principals and I have talked about the right management structure for our company and we agree that it's import to separate out the day-to-day management and all the responsibilities of a public company from the actual investing of the capital. Dan is someone Pet and I have known for many years and he has the right experience. Not only is Dan a top tier institutional manager, but we've known him as a partner, operator, investor and as a Board member since our beginning. We're all excited here at Fortress to have Dan in this new role and we strongly believe that he'll be a catalyst to help us achieve our ambitions and our potential as a firm. So welcome, Dan. All good.

Now a few words about the quarter. As I said, we had a very strong second quarter and we've continued to having strong performance in the first month of the third quarter. The highlights are that the funds posted very positive returns across the firm; we closed on a large advisory assignment; we've made progress on several new business initiatives, most notably including a new Asian fund, our first in the region; and we're making headway bringing fresh capital into the firm.

Let me walk through some of the key financial highlights and then detail each business segment, and then I'll turn it over to Dan Bass to review the financial results in more detail. So first the results.

As I said earlier, our second quarter was our strongest quarter in the past year. First, our assets under management ended the quarter at $31 billion. [Break in audio]


Ladies and gentlemen, this is the operator. I apologize, but there will be a slight delay in today's conference call. Please hold and the call will resume momentarily.

Lilly Donahue

Sorry about the technical difficulties. Our line just cut off.

Wes, do you want to continue?

Wesley Edens

In spite of the line - no problem - we actually did have a very good quarter. I'm not sure exactly where this cut off so let me just walk through the operating results for the quarter and if I repeat anything I apologize and we'll kind of go from there.

For the second quarter, it was our strongest quarter in the past year. First of all, our assets under management ended the quarter at $31 billion, up $4.5 billion or 17% from the $26.5 billion that we closed at the end of the first quarter. The increase is primarily a result of positive investment performance across all three businesses and the closing of the management of a large credit hedge fund.

Secondly, we generated $53 million of fund management distributable earnings, which is up from $44 million in the first quarter or 20% higher. We generated $59 million of pre-tax DE, which is the measure that we focus most closely on, which includes our balance sheet investment portfolio here at Fortress. That's up from $9 million generated in same - numbers the first quarter.

This quarter we also earned incentive income of $7 million. Though the fees are modest, it's movement in the right direction. As you know, as our funds continue to produce positive returns and we raise additional capital, our potential to earn significant performance fees will increase in 2010 and beyond.

As for our direct investment portfolio at Fortress, it's up approximately 8% since the last quarter, primarily due to positive hedge fund performance and increased valuations in our private equity funds and associated investments.

Lastly, as you know, back in May we raised $220 million of net equity capital through a common stock offering, half of the proceeds of which we used to pay down our credit facility. As of today we have approximately $410 million in outstanding debt and approximately $100 million in cash, so net debt just a shade over $300 million, which puts our balance sheet liquidity in a real place of strength.

So at the corporate level I'd summarize by saying we're seeing positive, albeit early, momentum on key indicators. We structured our management responsibilities to increase focus in this environment and we've once again been to successfully access the public capital market.

Now let me just spend a few minutes on the performance of each of the businesses, starting with the liquid hedge funds.

In liquid hedge funds at Fortress we have a total of $4.6 billion in capital. That's approximately $3.7 billion in a macro fund and then approximately $900 million in our commodities fund. During the second quarter and up through the end of July we've raised several hundred million dollars across these funds in new capital. Mike and Adam have been very focused on rebuilding and restructuring the global macro fund since the beginning of this year, and we're very pleased that we've made significant progress on earning back [inaudible] high water mark and returning capital from the SPV that we set up back in January.

For the second quarter the Drawbridge Global Macro Fund was up 5.8% net, up 11.3% net through the end of June and through the end of July it was up to 14.8%, so just under 15%. So approximately two-thirds of the way back to the high water mark. In addition, as part of the restructuring we launched a new Fortress macro fund in May, and that fund was up 3.2% through June 30th and at the end of July it was up 5.5% net.

The credit and hybrid funds had a very, very significant quarter. For the quarter, our credit funds ended with $12.7 billion of assets under management, up from $8.5 billion at the end of the first quarter. The increase in assets under management was primarily driven by the closing of the management of the Zwirn funds as well as increased investment of our initial private equity credit fund and our new fund in Japan, so a lot going on in the credit business this year.

Today our hybrid businesses have a team of over 350 professionals, which includes over 100 professionals recently integrated to focus on the management and liquidation of the Zwirn funds. In addition to the people, we've added approximately 80 new investors from this assignment.

The main fund had a good quarter. It was up 7.3% net. That brings the total return for the fund to 10.7% net to date through the end of June, and although we've not finalized numbers the fund's positive performance trend continued through the month of July, having another excellent month.

As I mentioned in our last earnings call, we started to develop a few new capital formation initiatives.

In June we launched our Asia fund and have already had several closings. In these tough markets where capital is scarce, being able to start a new business in a new region for us is something we're very proud of. This fund is the first that we have raised and will invest purely in Asia and will be the cornerstone of what we believe will be a very important focus of the firm in the coming months and years. Tom Pulley, who's based in Tokyo, heads up our investment team there, working for Pete and his group here. We're particularly excited about this opportunity but it has leveraged our strategic relationships with [Imera], our largest investor at Fortress. They were very helpful in the capital formation for the fund.

The fund has already closed on its first investment. We purchased a portfolio of 1,200 [home] loans in Japan that we bought as part of the bankruptcy process of the Lehman Brothers' subsidiaries. We expect to continue to grow this business and look forward to updating you on our progress in Asia. We don't know the size of the fund, the final size of the fund, as we do anticipate future closings.

We've also had a first closing for our successful credit fund, FCO 2, in July. We pushed forward the first closing as we were funding on the acquisition of a portfolio of loans and a servicing platform in Spain. Similar to FCO 1, this fund will be used to make opportunistic investments in distressed undervalued credits around the world. We expect to have a number of closings in the fund as is typical of these type of private equity funds, with the final closing some time in the next year or so. As we expect multiple closings we don't yet know the final size of the fund, but we expect it to be significant.

Private equity. Our private equity business has also experienced a strong quarter, one of the best in the last two years. Assets under management was $13.8 billion at quarter end. During the quarter we had excellent operating results from a number of our largest investments, in particular in senior living and our apartment company in Germany.

In addition, we have successfully refinanced and/or extended the maturities of debt in a number of our companies. Two notable financings to point you towards were the issuance of $740 million in high yield from our railroad company in May and the refinancing of Florida East Coast, a financing which we completed right at the end of July.

The high yield and equity public markets were very active in the second quarter and we took full advantage of that to raise capital for several of our companies. In addition, we recently filed for an IPO for Rail America, which is the short line railroad company that we own. If the IPO comes off as we anticipate later this year it'll be the first from one of our portfolio companies in several years, further signs of healing in the capital markets.

Also in the second quarter the market values on our public portfolio companies are up significantly, increasing approximately 53% compared to the end of the first quarter. In addition, since June 30th through the closing yesterday our public portfolio companies are up another 13%, so a very substantial increase in valuations in the public companies.

While we're pleased with this positive movement in stock prices, we continue to remain focused on the underlying performance of the companies. With strengthened balance sheets we began to look closely at growing these businesses opportunistically through acquisitions and are very engaged in a number of initiatives. I look forward to be able to report to you more on this in the coming quarters.

Just a few words on the market overall. For the second quarter the S&P Index was up 15.2%, the best quarterly performance in the last 10 years. And even with the gains in the month of July, the Dow is still down 36% from its peak in October of 2007. While some economic data continues to show weakness, the rate of economic contraction has clearly slowed and a number of indicators have begun to turn positive. There are even signs that the housing market may finally be bottoming out.

Credit markets are starting to function again as creditworthy companies are now able to borrow at reasonable rates. And while that's not to say that we're clearly on the way to a material recovery in the economy, but the equity and debt markets are beginning to stabilize and become functional again.

One sector that we have been and continue to be very focused on is the banking sector, which although in much better shape than it was just a few months ago, in our view it still has much recapitalization and restructuring ahead of it. There's been approximately $56 billion in capital raised for the banking sector in equity this year, but of that 97% of the capital was raised for only 15 institutions. So with approximately 8,300 banks in the United States, there are still many hundreds if not thousands that need capital that have not been able yet to access it.

And being a solution provider in this sector is something that we are very interested in and continue to work hard on, although, until some of the rules regarding the investments in banks are clarified, it's difficult to commit capital given the uncertainty. Hopefully, there will be a constructive resolution of the parameters which govern investment in banks soon and this will be a significant area of activity for us in the future.

So in summary, looking ahead, it's never been more important to single-mindedly focus on existing investments and position the firm for unprecedented investment opportunities over the next five years - the Great Liquidation, as we call it here. Pete and I and others collectively have made a career out of investing in distressed markets and this market aligns with the key area of our expertise and we hope to capitalize on our past experiences in the future for our investors.

We look forward to updating you on progress in the coming quarters and, with that, let me turn it over to Dan Bass.


Daniel Bass

Thanks, Wes, and good morning, everybody.

During the second quarter we saw a return to the positive trend for AUM as we were able to capitalize on the renewed interest of investors based on the performance of our funds and our investment expertise as it relates to the opportunities were seeing in the marketplace. We had very strong performance virtually across the board and we had positive quarterly financial results. In addition, we successfully raise common equity, as Wes mentioned, at the Fig level with the effect of continuing the leveraging process of our balance sheet.

Let me discuss each of the following highlights in more detail - assets under management, fund performance, distributable earnings, and activity on our balance sheet.

Assets under management increased $4.5 billion during the quarter at $31 billion at the end of the quarter. This increase was driven by two primary sources - new capital raises net of redemptions, which includes the D.B. Zwirn transaction and asset growth within our funds due to performance. As I mentioned in my introduction, we see renewed momentum on many fronts for capital formation and are benefiting from our global reach and relationships.

Within our liquid hedge funds we started our new Fortress macro fund in May and had new capital inflows in excess of $200 million during the last four months, of which $100 million was raised during the quarter.

Through the end of July our hybrid business has raised approximately $275 million in newly created funds focusing on Asia real estate and credit, of which $135 million was raised during the second quarter.

Additionally, as you're aware, on June 1st we took over management of the Value Recovery funds, formerly called the D.B. Zwirn Special Opportunities Funds. The Value Recovery funds and managed assets added $3.1 billion of capital to our AUM. The terms of the management agreement include that we are reimbursed for all costs related to the management of the funds, we receive management fees equal to 1% of the gross collections and a fee on certain managed assets, and we also may receive limited incentive income if aggregate realizations exceed an agreed threshold.

Another contributor to AUM growth was positive performance within virtually all of our funds. NAV growth added $1.6 billion of AUM to our AUM. The contribution by segment was a $900 million increase related to the hybrid funds, a $300 million increase related to private equity, and a $400 million increase related to our liquid hedge funds.

Now focusing on performance, we saw positive performance returns across the board in our hedge funds. As Wes mentioned, with our Drawbridge Special Ops fund up 10.7% for the year through June and macro up 11.3%, we've made considerable progress towards reaching the funds' respective high water marks established in 2008.

Finally, as Wes also mentioned, both funds had significant positive performance in July.

On the distributable earnings front, the previously mentioned AUM growth and performance results are starting to have a positive impact. For the quarter pre-tax distributable earnings was $59 million or $0.12 per dividend-paying share, which was an improvement of $1 million from the second quarter last year and $50 million over the first quarter of this year. Fund management DE, which is a measure of our fund net fee-based operating results, was $53 million for the quarter and our principal investments, which reflects earnings from our balance sheet, was a positive $6 million for the quarter.

Fund management DE increased $9 million from the first quarter. This is primarily due to improved margins, which increased from 41% in Q1 to 45% as revenues were 9% higher and operating expenses were 5% lower based on ongoing expense management efforts within and across the businesses.

Principal finance increased $41 million from a loss of $35 million in the first quarter to a gain of $6 million in the second quarter. This was primarily related to marked-to-market gains in our hedge fund investments and the fact that we had no impairment charges on any of our balance sheet investments in the second quarter versus $32 million in impairments in the first quarter.

Finally, as I touched on earlier, we had significant developments with regard to our balance sheet during the quarter. The main highlight during the quarter was successful completion of a $220 million net capital raise in May. $110 million of the proceeds were used to pay down our term bank debt. In total this year we have paid down approximately $320 million of debt, bringing our outstanding balance to approximately $410 million. We believe that this lower leverage, including cash on the balance sheet, and the low cost of the remaining debt is a significant benefit to the company.

Our investment portfolio ended the quarter on $768 million which consisted of $601 million in private equity assets, $116 million in hedge fund assets, and $51 million of publicly traded securities. The value of our assets increased $68 million during the quarter. The increase was primarily comprised of a $54 million increase in the private equity investments and publicly traded securities; however, this value change does not affect DE on a current basis but rather only upon a realization event or if we incur an impairment. The remainder of the value increase of the assets related to marked-to-market gains on our hedge fund investments, which in this case does flow through our DE results on a current basis.

As it relates to taxes for DE purposes, as of now we are estimating that our 2009 effective tax rate will be between 21% and 27%, but as you know this estimate is sensitive to change in our income for the year.

In closing, we had a number of positive results in the quarter. We are staying intensely focused on managing our fund investments and operations and evaluating our organization to optimize our results for all stakeholders.

Now we will open it up for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Roger Freeman - Barclays Capital.

Roger Freeman - Barclays Capital

Wes, can you just sort of clarify some of the questions that have been out there about any potential change in strategy for the company with Dan coming on board? There was that FT article that seemed to have been leaked by somebody that was at an employee meeting. Can you just sort of talk about any changes with respect to acquisition strategy, etc.?

Wesley Edens

Roger, it's not so much a change in strategy per se. It is something we've talked about internally for a long time, which is the need to focus on the day-to-day operations and management of the company as a full-time job and then focus on the investing of the capital separate and apart from that. So myself, Randy, Rob running the private equity business, that's what we're focused on; Pete and Dean and others running the credit businesses, Mike, Adam and others running the macro businesses, we're very focused on the day-to-day management of our investors' capital.

And it's not to say that the strategy is going to shift per se, but we do think that there are many, many other things we could be doing as a firm and doing them on a part-time basis was just simply something we knew in the long run was not the right answer. And while we knew it was not the right answer, it's a difficult thing to find the right person to do this. Dan is a guy that's got a tremendous amount of substance and has had lots and lots of experience being a CEO of, obviously, a very substantial financial institution before. He'll focus on the day-to-day management of the company.

I do think that in the ordinary course of our activities we will be very focused on other kinds of things that are out there in the world and there are lots and lots of opportunities. And so just like we have lots of opportunities in our investment businesses that the three groups are focused on, we think there's lots of opportunities as a firm that we can be focused on as well, to both allow us to realize our ambitions and our potential as a firm. So the right thing to do was to make the appropriate changes to put somebody in charge of that, and that's why we're very excited to have Dan here.

Roger Freeman - Barclays Capital

Well let me maybe ask it this way. That was a helpful answer but, as you look at how you had been spending your time, I guess two questions. One is: How much of your time was spent on the investment process previously versus the administrative responsibilities of running the company? And secondly, in that sort of balance of time you had to figure out, what kinds of opportunities did you not get to pursue as much as you would have liked to or maybe that even passed the company by because you couldn't put the effort into it?

Wesley Edens

It's hard to put a number on it. I'd say that specifically I obviously spent the bulk of my time on the businesses that we're investing in, so the private equity business in particular. And, of course, the demands of those businesses in the last couple of years, just given the sorry state of affairs in the credit markets and the economy overall, have increased. So a modest percentage of the time was spent on strategic focus of the company, which we really have run collectively as a partnership between myself, Pete, Mike, others.

And so I think that today where we sit we see a tremendous array of things that we could be doing as a firm and try to formulate exactly what the company, we want it to look like and to be shaped like 12 months from now, 24 months from now, etc. And simply doing that on a part-time basis collectively among all of us is a much less satisfactory result than having a person in charge of the whole thing.

Roger Freeman - Barclays Capital

As we look at some of the investment opportunities, you're obviously engaged in the distressed area. You're bringing Dan on as somebody who has a lot of experience obviously in the mortgage business. What kind of doors in distressed mortgages do you think he can open up for you?

Wesley Edens

Well, we are very engaged in the distressed businesses right now. As I said, the hybrid business has had a big quarter in terms of the investment stuff. I'll turn it over to Pete to comment on that.

Private equity, we think that there are a myriad of opportunities for our companies with the balance sheets in great shape, which by and large they are. We think there's a lot of things we can do there.

And just to try and put a final point to this, Roger, because I'm not trying to be evasive about it or not give a direct answer, we think as a firm there's lots and lots of different things to do. The world is going to consolidate, I think, in the financial services space and there's going to be winners and there's going to be losers, and we fully intend to be one of the winners. And so we're very focused on that and I think bringing Dan in and his capabilities gives us a real focus on that.

In addition to Dan being a terrific manager and a leader of people, Pete and he actually originally met when Dan was working for General Electric working in Asia. Pete was over with Goldman running the distressed business in Asia. So there's been a lot of direct investment as investors as well.

Peter Briger

Just to echo what Wes said about my introduction to Dan, he was running GE Capital in Asia during the Asia crisis. I was running the distressed debt business for Goldman in Asia. I actually started that business for Goldman in Asia and got to work with Dan as a partner on multiple transactions, but more so got to see what Dan accomplished in Asia.

And so just to your point about the mortgage business, I don't know if Dan will add anything to the mortgage business; certainly he will if there are opportunities out there for his judgment to help us. But in particular if you look at the number of businesses that Dan was responsible for buying for GE Capital during that period it was simply phenomenonal. And what I was so impressed by, which really kicked off our relationship, was Dan's ability to analyze situations and to end up in the driver's seat buying significant companies all over Asia. So I think that certainly there's a track record there in Asia that was really unequalled in that period of time, and certainly what he's gone on to do at Fannie Mae, etc., will provide I think lots of opportunities for us.

But I really think that if you look at Dan's background as a manager of financial businesses and the diversity of what he's been involved in, it's exactly what we thought we needed at Fortress.

Roger Freeman - Barclays Capital

The hybrid private equity, the $7 million incentive fees this quarter, it looks like if you do the math on that versus the $79 million of capital return, that those initial investments have generated gains of over 100%. Is that right?

Peter Briger

No, it's not that they've generated - we returned some capital that was not related to gains and so it was just a subset of that that generated the $7 million.

Wesley Edens

Roger, I would say, though, that the credit investing business outside of DBSO, which has done well this half of the year and continues to do well, the private equity business that we raised last year has done extremely well this year both on an absolute and a relative basis relative to where the capital was invested and relative to what it's done this year.


Your next question comes from Marc Irizarry - Goldman Sachs.

Marc Irizarry - Goldman Sachs

Wes, just a couple questions on LPs and capital formation. I guess in the beginning of the year and the end of last year investors were really frozen and looking to increase liquidity and probably found themselves very overcommitted to private equity. Over the last couple of weeks or maybe months can you comment on any discernable change in attitude towards formation of capital on the private investment side?

Wesley Edens

It doesn't change on a daily or weekly basis, obviously, Marc, but I think that when you look at where the world was at the end of the year, in kind of great distress across all markets and a lot of uncertainty, clearly we're in a much, much better place today than we were the first of March, and I think the investors feel that as well.

So I've had many conversations with LPs in the last number of months and I think that as we see lessons certainly in our investment portfolios, they see lessons certainly in their investment portfolios, too. And I think that in a healing process it's going to take some time, but I do think you're going to get back into the ordinary course of allocating capital, making new investments, etc., as the markets continue to stabilize.

So overall clearly in a much better place today than it was at the beginning of the year. I still think it's got a long ways to go in terms of regaining normalcy of capital formation and it's going to go to those folks that I think have done a good job in [inaudible] existing capital, which has been our focus as a firm. We've had some great new initiatives, certainly in the credit businesses and also very notably in the macro business. They've had a tremendous year thus far; have actually raised new capital.

The markets will return, we think, to the ordinary course and we'll get our share or hopefully more than our share of the capital, but it's clearly in a much, much better place today than it was at the beginning of the year.

Marc Irizarry - Goldman Sachs

And then just continuing on private equity capital formation, if we do start to see some more IPOs hitting the market and LPs do get some capital returned to them, do you expect that that's going to also accelerate the opportunity for investing going forward?

Wesley Edens

I do. I do. I think that it's not going to happen overnight. And I think one of the things that clearly is going to happen in the private equity business is a fundamental re-looking at allocations of capital and how you allocate capital between different strategies. We see probably the two greatest focus, I'd say, across the firm in terms of new investments of capital coming in is kind of a bifurcation between people very interested still in taking exposure to credit in its various forms and then on the very, very opposite extreme are people that are focused on very liquid strategies and a great deal of transparency.

You know, one thing that I think is clearly going to be the case going forward is you're going to see a real proliferation of separate accounts to give people absolute certainty on what they own, how it's doing, etc. It's something we have done a fair bit of. It takes a fair bit of operational capability which, obviously, we have and some of the other big complexes do. But I think it's going to, again, one more step down the consolidation path as you look at the industry.

Marc Irizarry - Goldman Sachs

And then just on the leadership change, if you think about the buckets distribution product and investing products, if you will, and acquisitions for the GP, what are sort of the priorities? And then also what led to the timing of this? I mean, obviously this is an argument that you could have made, that you wanted to focus more time on investing versus running the GP. Why now?

Wesley Edens

Well, it's been something we've been talking about for a long time. I think that there's a lot of very successful models in the investment management business of people that have done a good job in separating out the investment focus from the day-to-day management. Probably at the top of the list I'd say is the folks at PIMCO where Bill Gross and others spend their day-to-day looking for investment opportunities and managing the capital they manage and Mr. Thompson and the rest actually focus on running the business day by day.

I think in our case it was just simply a matter of being in the right place at the right time with Dan. I feel like we were very fortunate to have a person of his caliber on our Board, who knew the company intimately, that we had a personal relationship between myself and Pete and others. So it really is an opportunistic situation as opposed to something which had some sentinel kind of timing associated with it.

I think in terms of the allocation across the firm in priorities investment management firms live and die with performance. Period. Full stop. So we're very focused on performing at the highest level possible for our investors across all the businesses.

I do think that incremental to that there's another series of initiatives that reflect our ambitions with respect to our public investors, the people who have bought the stock and are investors in the public company. And we think there's a whole other raft of potential acquisitions and business opportunities that we could be taking advantage of and I think with the right folks focusing on that on a full-time basis we put ourselves in a great position there.


Peter Briger

Marc, the other thing I would say, just coming out of the fourth quarter of last year it became very apparent to us that practically we have a full-time job managing our funds. It became much more clear, obviously, in the trauma of the fourth quarter that this was something that we should place at a much higher level of importance. Dan was really the logical person to do this and so we were fortunate that he was in a position to be able to accept an offer.

Marc Irizarry - Goldman Sachs

And, Pete, just a question on the investing environment out there. It seems like we're moving to a little bit more normalized environment in credit and a little more stability on the economic front. What are you doing tactically to position these days and, you know, maybe if that extends to the macro, to the liquid hedge funds as well, just how are you thinking tactically about investing?

Peter Briger

Well, there's obviously been trillions of dollars, $15 trillion, that's been put into the system in the form of cash and guarantees and the other by the government in the U.S. and similar initiatives in countries around the world with banking systems that were overextended, and so financial market prices have responded to that in a way that any kind of market would respond when there was more money put into the system.

I think that we feel at Fortress that you're still going to see significant employment loss and you're going to see economic deterioration for some period of time. You're certainly going to see asset value destruction in that we don't think that financing levels are going to return in any short period of time to where they were two and three years ago, and that corporate managers, real estate owners, etc., are going to be engaging in heroic efforts to keep their top line and their bottom line constant. So that equals asset value destruction.

I think the credit markets have responded well to the fact that the banking system around the world has not ended and so risk-adjusted discount rates associated with the world's senior-most cash flows have come in anywhere from 15% over the risk free to 25% over the risk free to still not a normalized relationship but a better relationship.

That doesn't mean that there won't be a significant amount of trauma or, as Wes said, that many of the financial institutions around the world that were not properly capitalized won't have to deleverage, liquidate, emerge on an assisted basis.

And so we think that there is going to be a replay in a much bigger and broader way of what happened during the RTC, maybe 30 to 50 times the size of that, to put that in context, and in many different countries around the world.

I think that we're looking at this from a Fortress perspective as the Great Liquidation. We sometimes refer to it as the Great Litigation because capital structures are a lot more complex than they used to be and there's going to be lots of debtor-creditor enforcement litigation. There's going to be lots of litigation in between creditor classes in these capital structures.

We also think that at various times this era is going to be referred to as the Great Taxation, because governments around the world are going to have to pay for all of this recapitalization and this economic deterioration.

And so from our perspective if we thought of this era as a lot of deleveraging and a lot of assets, bank assets, financial assets, real assets coming onto the market and changing hands, I think from our perspective we also really see this as an ability as operators to take advantage of that. We have a phrase around Fortress which we call a dog's breakfast, which is you have to be able to accommodate anything that's being sold. And so if you look at the Zwirn portfolio, that really is an example of a dog's breakfast. There are lots and lots of different asset types there that you need to be able to service and collect and certainly to price.

On the credit side if you ask me about tactics, I think that financial market prices for corporate debt, for real estate debt, has gone up significantly, particularly in the senior portion of the capital structure but in a lot of cases the junior portion of the capital structure. There are lots and lots and lots of hedge funds, lots of the shadow banking system that can take advantage of those opportunities. I think our emphasis is really going to be on the operational and infrastructure-intensive investing category. And so a big addition in terms of Dan Mudd, but also a big historical emphasis for us, and so I think that's where we will seek to differentiate ourselves.

That's not to say that we won't play in those securities markets. But I think certainly over the last four months you've seen a terrific run in those markets and, even though there will be lots of idiosyncratic opportunities to make investments both on the long and the short side, we see the emphasis being in the liquidations of financial institutions that are going to occur.


Your next question comes from Craig Siegenthaler - Credit Suisse.

Craig Siegenthaler - Credit Suisse

First, Wes, just on your comments regarding the banking sector and I understand some of the restrictions there for private equity dollars, but I'm wondering what changes would you like to see the Fed and Treasury do to kind of encourage Fortress and the rest of the private equity industry to recapitalize some of the banks?

Wesley Edens

Well, I think that just simply the way to think about it is before the FDIC came out and issued their thoughts on prospective limitations or parameters regarding private equity investment it was pretty hard for private equity investors to invest in banks, right? You have control issues, you have lots of difficult parameters with which to deal with, and I think that all the things that came out incrementally all make that incrementally more difficult.

And my own view is that while it's certainly appropriate to be thoughtful and mindful of what the issues might be in having private equity or other investors invest into the banking system, this is a sector that desperately still needs capital. And although the government and the markets have actually contributed to stability of the biggest financial institutions - as I said, of the $56 billion raised, I think 97% of it went to literally 15 institutions - you've got 8,285 other institutions, many of whom are undercapitalized and need capital.

And I think that the real root result of that that is very problematic for the economy is that a lot of those smaller financial institutions that have not been able to access the public markets, have not recapitalized, are in fact the lenders to businesses and small businesses are the ones that, you know, provide a lot of the employment stability of the country and that's something I think has got to be an area of focus for the government. And to do so they've got to allow the free flow of capital into it in some way, shape or form or suffer the consequences of having a stagnant banking system that really could retard a real economic recovery that's meaningful.

We have had active dialogue - continue to have active dialogue, obviously - with the regulators and with the folks in Washington, and we believe that there are certainly can be constructive results that achieve kind of the middle ground, of them feeling that they're well served about making sure the investment in the sector is appropriate. But there's no doubt that there's still a lot of capital that needs to come in and I think encouraging one primary source, private equity, is part of that. It could be a big part of the solution.

Peter Briger

Just to add onto that point, we think that the government has done an admirable job in terms of bringing capital in, assuring confidence in the banking system, and putting us on the footing where we can now act in a coordinated fashion where the equity and debt markets are more normalized.

That being said, there were lots of actions that were taken in the fourth and first quarter which were actions taken in the middle of the heat of battle where you saw debtor-creditor rights being interfered with by the government, where you saw lots of uncertainty brought into the markets when the government really needed to make sure that the banking system was in a better position. So I think that what we'll see over the next 18 months is a time where clear minds can prevail in terms of debtor-creditor laws.

I personally think that when you're trying to get yourselves out of a credit crisis you need to make sure that the credit-granting process and debtor-creditor process is very clear. I think one thing that investors really do weigh heavily is certainty. There are no such things as uncertainty premiums in our business; only uncertainty discounts.

And so when we are taking actions, when the Fed and the Treasury are taking actions in the marketplace, they have to be really focused on the long-term implications of those, and I think that having investors be focused and be part of that process is incredibly important in terms of the path that we'll take out of this credit crisis.

Craig Siegenthaler - Credit Suisse

From our perspective it looked like the control and ownership issues was one preventative measure, but do you think the, you know, one [inaudible] actually could be the insurance fund, which seems to be underfunded, as they keep raising assessment fees on the banks. I mean, that seems like it would be one driver, although offsetting that is probably some mood in Washington for a lot of these smaller banks to go away.

Wesley Edens

Well, I think that there are 8,300 banks in the United States and I think it's fair to say there are not 8,300 great management teams of any industry around the world. So that's just an awful lot of banks. And it's probably true that there are not 8,300 good regulators for any business around the world. So I think it creates a lot of complexity from a financial system standpoint. You've got real consolidation in a handful of big institutions and then literally thousands and thousands of other smaller institutions. I think you're going to see a lot of real consolidation at different levels.

Consolidation happened the last time there was a financial crisis during the RTC days. The consolidators then in many cases were the big regionals that then became some of the bigger financial institutions, right? That's how MCNB and Wells Fargo and a number of the large regional banks became very large national banks. I think that that has already taken place.

The problem now is that many of the regional banks themselves are among those that are the most distressed in terms of their capital adequacy. So far from being solution providers they themselves are issues that have to be dealt with.

Wesley Edens

It needs capital and it needs attention, and I think that the markets and the government will get to the right place. It couldn't happen soon enough from our perspective.

Craig Siegenthaler - Credit Suisse

And then actually second question here, when you think about normalized earnings power for the Fortress stock, your three traditional strategies - private equity, liquid hedge funds, hybrid hedge funds - how can we think about where those fund to NAV levels are relative to high water marks and the potential for them to start generating [inaudible] maybe this year or is it too early for some buckets yet? Just that question, on earnings power.

Wesley Edens

Well, the earnings of the quarter and of the year-to-date are almost exclusively management fees, and historically it's been a pretty healthy mix between management fees and performance fees. Our businesses are geared towards performance. And we knew coming into the start of this year that we had a lot of work to do, really in every business line; every one had either NAV or high water marks. And through the first six, now seven months of the year, knock wood, we've had a tremendous run of closing the gap between those high water marks and actually getting back there.

Mike is approximately two-thirds of the way there. Pete is well over half of the way there. The private equity funds have had very substantial marked-to-market performance this year to give back. So there's no kind of one definitive statement I can make about when we're going to get there. I think that our expectations are that if things continue to get better and we continue to have good performance the performance fees will once again be a part of our earnings profile for next year. It's conceivable we could have some modest performance as we did in this quarter, but I think that the bulk of that we expect and hope for and look for, frankly, is really for next year.

Craig Siegenthaler - Credit Suisse

And then one quick question - ending share count. I didn't see it in the press release. We have the weighted average. Was it 507 million including the capital raise?

Daniel Bass

Yes, 507 million for the dividend-paying shares, yes, that's right. We added 46 million shares with the offering. That's right.


Your next question comes from Daniel Fannon - Jefferies & Co.

Daniel Fannon - Jefferies & Co.

Can you guys talk about fees on new capital that you're raising and how that compares with your existing funds? Then also talk about the redemptions that were posted in the quarter and how that might flow into the SPV and kind of how that's liquidating as well?

Daniel Bass

Well, the fee structures of the new capital forms are essentially unchanged from where they have been historically, so we haven't seen a significant change in fees. I think that there's a lot of differentiation in terms of people giving capital to folks that they think can earn incremental returns, but we haven't seen a real delineation in terms of the fee structures themselves. So number one.

With respect to the second question, Dan, with the redemptions of the $700 million shown in the quarter, roughly a third of those were from the SPV payouts in Mike and Pete's funds, Pete's funds being from the private equity [inaudible] payout, and Mike's fund on the SPV.

So I'd say a third were of the $700 million across the business was from the SPV.

Daniel Fannon - Jefferies & Co.

And what does the SPV stand at, then?

Daniel Bass

The SPV is about $1.1 billion, $1.2 billion.


Your next question comes from Robert Lee - Keefe, Bruyette & Woods.

Robert Lee - Keefe, Bruyette & Woods

The first question I have is really on the macro or the liquid hedge fund business. If I think back over the last year or so you've pretty much dramatically reshaped that, whittled it down to, if I'm not mistaken, I think the four key PMs and kind of refocused on the macro strategies and relaunch the fund, too, I guess. But could you talk a little bit about how you're thinking about that business going forward? Is it pretty much at this point just going to keep it where it is? Because one of the things I think about is, as a public company, as a business, to have a key business like that kind of dependent on just four people, one strategy, you kind of wonder about how much you should put a capitalized multiple on that. Is there a goal to kind of go back growing that business and diversifying strategies?

Mike Novogratz

You know, I think it's a two-step process. I think step one is to regain the credibility and trust of our investors, to put numbers back on the board, to return the SPV, to get to our high water mark. I think we learned a bunch of lessons in the 2008 episode that we won't repeat. Part of that is you're building a much better infrastructure underneath the investor platform. And part of that will be, I think, in the future, once we accomplish those goals, to grow separate silos, like our commodity fund.

And so I think the future growth will be businesses like the commodity fund where you start with a small business and you grow it organically as opposed to one mega fund.

Robert Lee - Keefe, Bruyette & Woods

I know it's still early in the game and still kind of working through the redemption cycle, but what kind of feedback are you hearing from prospective investors or existing investors to the extent you did have to put up some gates? Are you finding that a roadblock in your conversations? Is that something that a lot of prospective investors are kind of throwing back at you?

Mike Novogratz

Not really. I think no one was happy with us putting up gates or the industry in general late last year. That said, I think we've kind of done what we laid out what we were going to do. We're getting a lot of credit for that. Four of our six largest investors have reupped and put new money into the fund, which is a good sign. And we see a pretty healthy pipeline. There is a lot of demand for liquid transparent strategies out there, and so my guess is in the next 12 months we have a significant amount of capital inflow.

Robert Lee - Keefe, Bruyette & Woods

You guys don't report an after-tax DE each quarter, but how should we be thinking of or what your thoughts are about a kind of tax rate for a full year at this juncture?

Daniel Bass

As I mentioned in my comments, we're looking at 21% to 27%, so I would say somewhere in the middle of that range is a reasonable estimate at this point.


Your next question comes from Roger Smith - Fox-Pitt Kelton.

Roger Smith - Fox-Pitt Kelton

The public companies, they did perform very well this quarter. Can you give us an idea of where Fortress stands right now in terms of the gain-loss position?

Wesley Edens

We don't disclose the gain-loss with respect to every underlying fund. We have had obviously very, very substantial gains in the quarter and continued to here through the month, primarily as a result of great performance of those businesses. I think that maybe we were overly penalized when the market went sideways in terms of the valuations of some of the public companies, and we still we think have got a long ways to go in terms of the ultimate performance of them.

The reported earnings yesterday on Birkdale, that has been a tremendous business for us and we think it has an incredible future. We're going to report earnings on a handful of the other companies here in the next couple of days. And, as I said, we think that the performance is really following the performance of the underlying businesses.

Our goal obviously is to get back to high water marks in each one of the funds and earn profits for our investors and I'm quite confident we're going to do so. We still have one or two things that we're very focused on in terms of financings, but the bulk of that, you know, we've had a tremendous amount of good success in the past couple of years in avoiding material problems, and now it's all about being focused on the businesses and making money going forward.

Roger Smith - Fox-Pitt Kelton

And then you did mention one IPO for a portfolio company, I'm guessing. How do you balance that versus growing the book or growing the companies through either acquisitions or extracting value through asset financing and stuff like that? How should we really think about the way the portfolio might shape up in the next two years?

Wesley Edens

Well, we think that there are lots of opportunities. Just as we believe there's opportunities for Fortress as a company to grow incrementally not only in our investment businesses but as a firm, we feel the same way about many of our portfolio companies. And having a clean balance sheet and access to capital puts you in a very good position vis-à-vis the competition in these industries.

The IPO that we have filed for our short-line railroad business is reflective of our views about what we think the future and our ambitions are for that particular company in that particular industry.

And I do think you'll find others. The equity capital markets have opened to an extent. I think they're quite discriminating with respect to the businesses that they will capitalize, but I think you will see actually a lot of capital markets activity out of our book of business and I suspect out of other firms like ours in the next 12 months.

Roger Smith - Fox-Pitt Kelton

And then if I just switch over to the banking opportunity here and let's assume that impediments do go away and that you guys can end up buying some of these banks, what would be a differentiated strategy that you guys might bring? I know in the past when we talked about the private equity business it's been really about asset financing. How do you kind of see your strategy in being somewhat superior to others in that space?

Wesley Edens

We have spent the bulk of our careers - myself, Pete, others - in the financial institution space. This is not us responding opportunistically to a sector that we think is going to have good upside. It's really us being focused on something which we've done for decades, both individually and as a group.

I think there's a lot of operational intensity, there's a lot of regulatory intensity when you get into those industries. And this is something that plays to kind of the experiences of the firm and of the individuals.

I think that a very vivid example of this is the awarding of this liquidation of the Zwirn funds earlier this past quarter was one that was hotly contested; a lot of different firms looking at it. As Pet said, there was a great variety of different assets and a great amount of operational intensity to that portfolio, and we were selected on the basis of both intellect and competency regarding the investments but also the operations and the minding of the store in terms of the day-to-day aspects of it.

And I think when we think of financial institutions they are very much of that ilk in that they've got lots and lots and lots of [inaudible] of different assets that they own that need to be resolved and dealt with, and that's something which has been a real strength of ours as a firm.

Roger Smith - Fox-Pitt Kelton

And then on the separate accounts you mentioned, I think, that that seems to be an operational viable type of product to offer in the hedge funds. Is that something we can end up seeing you guys offering on a separate account basis within 2009?

Wesley Edens

Well, we have already and we expect to actually do a fair bit more of it.

It has a lot of operational demands on a business and, again, from our standpoint we have invested a tremendous amount of money and time and human resources on building out those operations and this should be a big, big part of our business. You're going to see a lot of it in the industry, generally, but I think that a lot of smaller firms I think will have a more challenging time in actually implementing this.

But it's something clearly that investors want; we're responsive to it and we think we'll do a lot of it in the future.


Your next question comes from Roger Freeman - Barclays Capital.

Roger Freeman - Barclays Capital

Pete, just coming back to some of your comments before referencing sort of contract law and investor willingness to participate, there still is some discussion around potential mortgage cram-down legislation. You know, particular banks and servicers have been doing a pretty lousy job on the modification front. So I guess I'm wondering from your perspective how big a risk is there around that in terms of sort of investors feeling comfortable with the landscape around contract law?

Peter Briger

Well, I think that investors are concerned about government interference in debtor-creditor laws, and I think that there is a risk premium that exists in the U.S. market for the first time around debtor-creditor law interference. And I think that it's important that that uncertainty be removed to the greatest extent possible to give us every advantage to come out of this credit crisis.

I think in the mortgage area in particular there is a big issue right now in that first mortgage investors, security owners and the banking system, the commercial banking system, have a very different alignment, and currently the loan modification plan of the government does not properly deal with equitable treatment of senior and subordinated debt and so that is a big issue for really the second-biggest fixed-income market in the world. And I think when you look at situations like Chrysler and GMAC it only serves to hurt our ability to come out of the credit crisis in fine fashion.

That being said, in the context of what was going on with the banking system in the fourth and first quarter of this year, I'm not sure that the Treasury at that point made bad decisions with respect to coming up with solutions. I think now though that the pressure is off that the banking system might actually fail the Fed, the Financial Economic Council, the Treasury needs to step back and say what are the longer-term implications for doing some of these things which clearly in the short term help the banking industry, that's got a huge concentration in second mortgages and in servicing rights that they represent, you know, 65% to 70% of all mortgage servicing in the country? Short term it may help the banking industry, but long term it's going to hurt U.S. credibility with respect to the extension of credit and the collectibility of credit.

So my biggest fear is that you have some kind of permanent impairment in people's views of U.S. debtor-creditor laws. I think the Treasury is on it. I think that the Fed is on it. And I think that you're at a point in time where people can step back and start to make decisions that really flow in terms of the long-term best interests of the credit markets as opposed to a more parochial view of bailing out the banking industry through an alternative means.

Roger Freeman - Barclays Capital

And I guess, Wes, on the banking opportunity, let's take the other side of this. Assuming that the restrictions don't get any better, how far are you willing to sort of take the opportunity, i.e., do you have workaround solutions for Fortress to take advantage of this? Do you spin out, become a bank holding company because the opportunity here is so big?

Wesley Edens

You know, it's something we've talked about. Obviously, the decision to do something like that is a big decision and I think you need to get more clarity with regards to the regulatory environment before you ever really seriously contemplate doing that, but we think that, as Pete said earlier and I really believe, I think it's very early in terms of the financial recapitalization of the banking system and the associated assets. There has not been wholesale liquidations of assets off of balance sheets. There's been nothing close to the experiences that we had even in the RTC, and yet the size and the dimension of the problem is many, many times that.

A little bit of it, Roger, is going to be a function of how this plays out with the regulators and how they choose to encourage capital to come into the sector. And I think that it's a pretty lively topic around our firm and it's something that I think that we'll make some good decisions and good judgments about in the next number of months.

But everything is actually on the table in terms of the potential ways that we could expose ourselves from a capital perspective to the opportunity.

Roger Freeman - Barclays Capital

And in private equity, a couple questions there. I guess you sort of can't talk about returns, but can you talk about sort of where the portfolio in aggregate, how far below cost it is at this point?

Wesley Edens

We don't give disclosure on individual funds. Some of the funds are obviously above cost; some of them are below cost. The one thing you can say with great clarity is that they are in much, much better shape from a marked-to-market perspective today than they were a handful of months ago.

So I'm sure that's not a satisfactory answer in terms of creating great amounts of clarity about that, but it's been a very positive series of returns and we think that there's every reason to believe that they're going to continue.

The cornerstone of the recovery of those funds is the performance of the underlying businesses and you can see it most visibly in some of the public companies, but we've had lots of great results in terms of the underlying companies as well. Although all that is to be said in that in many cases the earnings results are driven by a focus on curtailing expense and running the businesses from an operating perspective to the best possible way.

In a handful of companies - and I use the senior living as one of those examples - we've actually had actual revenue growth, substantial revenue growth over the past 12 months. And so once you get back to the place where you're generating revenue growth as well as maintaining expense levels then I think you'll see the performance continue to do well.

Roger Freeman - Barclays Capital

Do you have other companies potentially in the pipeline for IPOs in the next 12 months?

Wesley Edens

The only one that we have announced is the one that I mentioned, which is the railroad company. We do think there are other companies that, if they continue to do well and the markets continue to stabilize, would benefit from equity capital market activity. But there's nothing else that we are in a position to announce at this time.

Roger Freeman - Barclays Capital

And in private equity, maybe Dan, there was some step up in operating cost sequentially. Is any of that comp driven or is that mostly non-comp?

Daniel Bass

No, there's nothing really notable there. Anything that would really show is not something which is a material change. We didn't build those businesses up with personnel so much; we haven't really had to have substantial restructuring the other way. But there's nothing really notable in those numbers to be taken [inaudible].

Roger Freeman - Barclays Capital

So you didn't have any increase really in comp accrual? We saw that yesterday with [inaudible] and the comment was there's, from a competitive standpoint, there's [inaudible] incentive accrual that they wanted to build in at this point in the year. Do you feel any of that pressure given you've got some better returns here, the hiring environment's gotten better in terms of retention?

Wesley Edens

No. We're obviously very focused on our people; it's our most important asset. And we want to attract and retain the best and highest-quality people, and so we're focused on being competitive about it.

But at the end of the day there's a sequencing for compensation in our businesses - first, performance, then payment. And so we're right now very focused on the performance of the underlying businesses and I have no doubt whatsoever that we'll be able to attract and maintain the quality of the folks that we have as long as we have those numbers and we'll stay competitive to do so.

Roger Freeman - Barclays Capital

As you look out at the third quarter fundraising, the second quarter was, outside of what you took on from Zwirn, not a lot of new fundraising. It sounds like for what you're saying third quarter could be a decent pickup with the launch of this second credit fund, etc.

Wesley Edens

Yes. It's a little bit arbitrary when we break it into quarters simply because the markets are much better you also have, you know, July and August, which are summer months and that probably constrains things a little bit. But by and large the overall tenor of the capital formation for us and for the industry is clearly on the mend.

Roger Freeman - Barclays Capital

Okay. And then just lastly, Mike, can you maybe talk about what sort of drove the strong macro fund returns in the quarter in terms of asset classes, sort of how you were positioned? And then as far as redemptions go, does it look like from your seat here today we're done with net redemptions for the third quarter?

Mike Novogratz

You know, on the performance side the bulk of the gains were from the fixed income and currency strategies, first being long fixed-income and then being short fixed-income, mostly being long risk, high risk currencies, so emerging market currencies; a lot of trading gains as well within that performance, so it's been kind of a high, sharp ratio, a good grind up.

From the redemption side, I wish I had a crystal ball. Our general sense is most of the people that wanted to get their money out got their money out. There are a few investors that have their own issues that I'm sure will see some redemptions. My guess, though, is we're kind of turning the corner and the new pipeline of money will certainly outweigh redemptions in time.


At this time there are no further questions. I will now return the call to Lilly Donahue for any closing remarks.

Lilly Donahue

We really appreciate everyone joining us this morning. Obviously, I welcome everyone to call if you have any follow up questions to the Investor Relations group. Thanks so much, everyone. Bye, bye.


Thank you. That does conclude today's Fortress conference call. You may now disconnect.

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