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Fortress Investment Group LLC (NYSE:FIG)

Q1 2007 Earnings Call

May 15, 2007 5:30 pm ET

Executives

Lilly Donohue - MD of IR

Wes Edens - Chairman & CEO

Pete Briger - President & Head of Hybrid Hedge Fund Business

Mike Novogratz - President & Head of Liquid Markets Hedge Fund Business

Dan Bass - CFO

Randy Nardone - COO

Rob Kauffman - Head of European Investment Operations

David Brooks - General Counsel

Analysts

Scott Appleby - Deutsche Bank

Michael Hecht - Banc of America Securities

Marc Irizarry - Goldman Sachs

Roger Freeman - Lehman Brothers

Steve Ballentine - Ballentine Capital

Presentation

Operator

Good day and welcome to today's Fortress Investment’s First Quarter Earnings Conference Call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Ms. Lilly Donohue. Please go ahead.

Lilly Donohue

Thank you, Al. Good afternoon, everyone. This is Lilly Donohue, Director of Investor Relations at Fortress. I would like to welcome all of you to our first quarter 2007 earnings conference call.

Joining me today are our Chairman and Chief Executive Officer, Wes Edens; President and Head of our Hybrid Hedge Fund Business, Pete Briger; President and Head of our Liquid Markets Hedge Fund Business, Mike Novogratz; and our Chief Financial Officer, Dan Bass.

We also have with us here today our Chief Operating Officer, Randy Nardone, President; and Head of our European Investment Operations, Rob Kauffman; as well as our General Counsel, David Brooks.

Before I turn the call over to Wes, as the operator mentioned, this call is being recorded, and the replay number is 888-203-1112 from within the United States, and outside of the U.S. it's 719-457-0820; access code is 4156453. This call is also going to be available on our website, www.fortress.com.

I would also like to point out that statements today, which are not historical facts maybe forward-looking statements. Our actual results may differ materially from the estimates or expectations in any forward-looking statements. These statements represent the Company's beliefs regarding events that, by their nature, are uncertain and outside of the Company's control.

I would encourage you all to review the forward-looking statement disclaimer in our quarterly earnings release, including the recommendation to review the risk factors contained in our annual and quarterly reports as filed with the SEC.

Now, I would like to turn the call over to Wes Edens. Wes?

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Wes Edens

Great. Thanks, Lilly, and welcome, everyone. Welcome to our first earnings call for Fortress since our IPO back in February. First of all, I apologize for pushing back the call for an hour here at the last minute, but I was serving my civic duty the last couple of days on jury duty, so I wanted to make sure that I got out of there in time to come here in time for the call, so apologies for that.

We're delighted by the reception that our company has gotten since the IPO in the market. And as a group, we're very focused on being the best-performing alternative asset management company in the world.

Today, the Fortress business is a highly-diversified global business. We've got just over $36 billion under management. In our first quarter as a public company, we had terrific performance from all of our operating segments.

For the quarter, pretax distributable earnings was $220 million, which is a healthy 90% increase from the first quarter a year ago. As we told many of you during our IPO roadshow, any given quarter for the company is not as good of an indicator of our business as the annual performance of the company.

But having said that, the business is a very healthy one right now, and we had a wonderful quarter to start the year off. The industry is still quite dynamic and very healthy. Alternative investments constitute one of the fastest-growing sectors in asset management, and our business reflects that growth.

The world continues to be a very competitive one in our business, but we continue to see great opportunities to invest capital and grow our company. I think our results actively reflect that. That's a great segue into the different business segments.

First, I'll take the occasion to talk about the private equity business and the capital businesses, and then I'll turn it over to first Pete and then Mike to talk about the various hedge funds, and then Dan to summarize with financial results, and then we'll turn it over to Q&A for all of you.

So first, a few words on the earnings. At the time of the IPO, we paid an annualized dividend of $0.68 per share. Based on estimated taxes and a 75% target payout ratio, that implies a pretax distributable earnings number of $620 million.

Just to reiterate, distributable earnings is our rough justice for, really, the cash flows of our business, and we think most accurately reflects exactly what is going on from a financial perspective in our business. There are a number of adjustments between distributable earnings and GAAP that we try to be quite clear about.

Dan will talk a little bit about that as we get to his statement, but this, again, is something that we're going to continue to reiterate with you, is that distributable earnings is what we think of when we talk about the health of our businesses.

We believe that our dividend, the 75% of that distributable earnings number, is the clearest window that we can offer to investors of our operating performance. And as we said, we increased our dividend from $0.68 to $0.85, so a 25% increase from the beginning of the year, and that obviously reflects terrific performance in all these different business segments.

Across the board, asset management grew substantially, and we in turn invested a substantial amount of capital in all the different businesses. I'll talk about the private equity sector here in just a second, but the folks in hedge funds also had a very, very active quarter.

Assets under management at quarter end was just a shade over $36 billion, which is up 72% from just one year ago, so again, very, very kind of high-growth numbers. And indeed, we just announced post the end of the first quarter a closing of Fortress Fund V, which is our latest private equity fund.

That was not something we had forecasted necessarily to raise this year, but we had a very, very busy investment period over the first part of the year. We closed $2.84 billion into Fund V. We have capped that fund at $5 billion of primary capital and a $1 billion co-investment fund.

And thus, if we are successful in closing out that fund, that fund is well oversubscribed at this point. That will bring our assets under management, just on that basis alone, to north of $40 billion, so a breathtaking number from our perspective, from where we had been only a few years ago.

Talk about the performance in private equity, we had a great quarter. Pretax distributable earnings, and you look at the segment table, of $148 million. That was up from $26 million one year ago. All the three major components that make up that result; management fees, incentive fees and investment income, all made significant contributions.

Assets under management in private equity, was also up substantially, 75% higher than a year ago, ending the quarter at $17.9 billion. With the subsequent capital raise, we're now north of $20 billion and growing.

An important measure of our ability to continue to generate the kinds of incentive fees that we have in our business is our unrealized investment return, of which there are two basic components, the first of which is a very simple calculation to give, and we give you a lot of disclosure about this in our documents.

But we call it the public surplus, which is just simply the market value of the stocks that we own in the private equity portfolio less our cost basis. So at the end of the quarter, we owned a total of $10.9 billion in public stocks in the private equity funds. Our cost basis was roughly $4 billion, and we ended up with $6.1 billion in unrealized gains in that portion of the portfolio.

That's something that is an easy than to keep a telltale on, and again, that's a good measure. If you just take that $6.1 billion, multiply it times 20%, because that's the portion of it that we keep, less the amount that our employees own, and that gives you the public equity surplus, which is a number that we refer to in the documents. That's north of $700 million when you run the math on that calculation.

The other element of the unrealized profit is just the amount of capital that is working for the company's behalf in the private equity funds. As of March 31st, 2007, we had $6.1 billion in original capital invested in those funds that is not included in this public surplus number, so $6 billion invested in a variety of investments that we hope will bear fruit over time.

In addition to that, we've got another $3.3 billion in capital that we have committed that is not yet funded. So if all those things come to pass, we have got just a shade under $10 billion in capital working on behalf of the company.

And again, the math on that, if you're going to forecast it, is if we perform as we have in the past, of which, of course, there is no assurance. But if we perform as we have in the past we earn kind of two or three times that amount of capital invested, it means there's still another $10 billion to $20 billion in unrealized profits in the private portion of that.

So those two numbers in total are the ones that we will refer to constantly, but that's the simple way of kind of keeping track of it. The health of our private equity business is in large part reflected by just the dimensions of those two components.

A couple of specifics. You know, since the beginning of the year, we have made several new notable investments that are worth mentioning. First, on Valentine's Day, we closed on our first railroad investment, a public company called RailAmerica. It's a company that is comprised of 42 local short-line railroads scattered throughout the United States, a total of 7,700 miles of track.

So it's a large short-line railroad company. We like the railroad sector a great deal and along with some other notable folks out there, and believe that it is an irreplaceable transportation asset that, with rising fuel costs and increased intermodal traffic, is only going to improve in value.

We invested a total of $464 million in equity in that transaction. In addition, in the same space, last week there was a transaction announced that we had an agreement to buy another public railroad and real estate company, a public company called Florida East Coast Railroad, for approximately $3.5 billion in asset value.

It will be a very large equity check for us, probably in the dimensions of a couple of billion dollars. So a very large equity investment in the space. In addition to being a great railroad, it also has a terrific collection of real estate and people, so it's a very exciting transaction for us.

Other large transaction to highlight in the quarter -- we made another large commitment to the senior housing sector. We bought a company called Holiday Retirement for a total of $6.8 billion, investing in various Fortress funds a total of just over $2 billion in equity.

The senior living sector for us has been a very productive one. We are now, by far and away, the largest investor in the United States in senior housing. We have a public company that is in a similar space called Brookdale that has been a big investment return for us, but we still think has a long ways to go, and with Holiday we just add to that portfolio, so very, very exciting as well.

Lastly, one that’s a smaller investment, but is one that is worthy of note, just given all the interest in the sectors, is we made an investment in the first quarter, an additional investment in the subprime area.

As many of you know, there was a big dislocation in those markets earlier in the year. It was really much more of a liquidity crisis than a credit crisis, at least thus far, and we were able to pick up a pool of a couple billion dollars in mortgages that what we think are very attractive prices.

Again, our sense on it thus far is that the operating term to refer to that market is that there has not been a credit crisis thus far. We'll see how the second half of the year plays out, but we have a modest investment now in the sector. We are happy with the additional investment we made there, but just something also to keep your eye on.

So that's the update from the private equity business. So a very, very busy and productive start to the year.

The Castles -- we had a good quarter in the Castles, a quiet quarter, marked by good performance and steady growth in both -- Newcastle, which is our U.S. business, and Eurocastle, our European, German-based business.

We generated $6 million distributable earnings this quarter, which is $2 million in the first quarter a year ago. Assets under management up 62% in that business, another big growth year. We think that that's poised for some great activity in the second half of the year.

Probably the key development of those businesses to reflect on is just what we're seen happening in Germany. As many of you know, we have large investments in the private equity business in the apartment sector in Germany.

The Eurocastle is a very large -- in fact, it's the largest listed commercial property company in all of Germany, has a total of just over 26 million square feet. It's a large company, and we continue to see great things in Germany.

Basically, Germany has followed the lead of a number of countries outside the U.S. and has adopted basic REIT legislation, which we believe over time will fuel the emergence of a large public real estate business that will complement businesses like Eurocastle. But off to a very good start in that business thus far this year.

With that, let me turn the call over to Pete and Mike and Dan to finish with the conversation.

Pete Briger

Thanks, Wes. First, the numbers in the first quarter for hybrid hedge funds. Pretax distributable earnings were up 106% to $44 million versus $21 million last year. That's total revenues up 66% to $75 million from $45 million a quarter a year ago. Total expenses is up 57% to $44 million from $28 million a year ago.

Capital flows, total assets under management, including committed capital, are up to about $7.5 million, up over 96% from $3.8 billion a year ago.

Fund performance this quarter, hybrid hedge funds, gross returns before management and incentive fees of 6.1%. That's roughly 4.5% on a net basis in Q1 2007 versus 5.25% last year at a 3.77% net basis.

Significant developments for this quarter, our Drawbridge Special Opportunities Fund received the highest possible operational quality rating from Moody's, a number one, as a result of their extensive review of our operations and infrastructure. We originated a $1.2 billion loan in connection with a significant New York City real estate transaction.

Fortress syndicated $300 million of this to a friendly competitor and set up a managed account for external investors for $425 million, and the rest, $475 million, was placed in various Fortress funds.

In summary, the first quarter of 2007 was a good one for hybrid hedge funds, in terms of earnings, capital closed and performance. The market environments for Drawbridge Special Opportunities Fund continues to be challenging, as credit continues to be mispriced by the market and asset prices for the most part appear expensive by any historical measure.

Liquidity seems to be at a cyclical high, but we are starting to see cracks in both the commercial and residential mortgage markets. We're playing good defense, and opportunities for the remainder of the year will be driven mainly by market conditions. As the market for financing becomes impaired and defaults pick up, our business will get better and we will grow our business faster for some significant period of time.

In order to be better prepared for a potential shock to the credit and asset market, Drawbridge Special Opportunities Fund established a $1.2 billion commitment line during the quarter that can be drawn down through the end of 2008. This will ensure that we are adequately positioned to take advantage of market opportunities as they arrive.

In the meantime, we're looking for idiosyncratic investments where our downside is projected. Of course, we're pleased with the progress of Fortress Partners Fund, which has had strong returns and $900 million in assets as of the end of the first quarter since its inception last July. Mike.

Mike Novogratz

The liquid market business. Listen, the hedge fund businesses are pretty simple -- returns and assets, and you can kind of model it straight up. We had a good first quarter. Distributive earnings was $33 million, and that's on revenue of $76 million. It reflects approximately 5% gross returns, which is a little better than we budget for but, quite frankly, not as good as I would like.

There was a severe deleveraging in the markets in late February-early March. It caught us as well as most market participants. That said, we finished the quarter in the top quartile of our peer group. I point that out because I think it's significant going forward.

Markets are in a secular decline in volatility across asset classes, and our belief is that, while it's a robust environment for investing, you're going to see more frequent periodic spikes in volatility, and navigating those is going to determine who wins and who loses.

Assets under management, we grew $752 million in the quarter to end at $5.9 billion. That's a 36% increase from a year ago.

Finally, we continue to grow our business at what we think is a measured pace. We have added three portfolio managers this quarter. We have opened a London office as a trading center for us. We think these developments should continue to enhance our ability to scale and diversify.

Lastly, we are off to a robust start in the second quarter, in terms of both performance and asset growth.

Dan Bass

Thanks, Mike. First, I want to thank you all for taking an interest in fortress in joining our call. I'm very pleased to be here, not only as our first earnings release since becoming a public company, but I also have the pleasure of reporting to you a strong first-quarter performance.

The first quarter was marked by a number of very significant transactions, including the Nomura transaction, our IPO and our first quarterly dividend. It is important for you to understand that when we plan and manage our businesses, we do so with a long-term financial perspective.

What I will emphasize in my remarks is the underlying strength of our financial performance and our significant growth achievements. To that end, I intend to cover three major areas; one, our growth in assets under management, including management fee, paying assets under management; second; the growth in our distributable earnings; and, finally; our investing and financing activities during the quarter.

With respect to assets under management or AUM, as we call it, as of the end of the first quarter, total assets under management reached $36 billion, up 72% from a year ago and management-fee-based AUM, which are the assets upon which we charge management fees, is up 65% to $23 billion from a year ago.

The major components of management-fee-based AUM growth are as follows; growth in private equity assets under management of 75%, which is primarily due to the raising of an investing of numerous private equity funds during the period; significant capital raises in our hedge fund businesses, and in particular, the raise of $1.3 billion in the first quarter of 2007; and capital raises in our Castle business.

Next, I want to talk about our distributable earnings but before discussing the growth in our distributable earnings results, I will provide some insight into our distributable earnings measure and why we believe it is a meaningful way to look at our business.

First and foremost, this measure is how we manage and evaluate our businesses and their operating performance. As Wes mentioned, we also use it in determining our dividend. Further, it allows us to evaluate the entirety of our business that we are managing, because it looks at our results as if all of the principals' interests are entirely exchanged into Class A shares.

In contrast, certain aspects in our GAAP results cause the understanding of such results to be challenging without significant further explanation. The major items requiring such explanation are with respect to the principals' forfeiture agreement, due to the unusual accounting rules, the company will be required to amortize a substantial amount of the equity, which is already owned by the principals.

This would mean that approximately $4.8 billion of expense will be amortized over the next five years. This translates into a $950 million per year or $237 million per quarter charge in our GAAP results. This expense will never be an actual expense to the company in any shape or form. Moreover, the company is not even a party to the agreement.

Our results of operations on a GAAP basis only provide a partial view of the consolidated group, due to representing only the interests of the Class A public shareholders, which are 23% of the capital structure of FIG, as well as the significant delay in recognizing incentive income under GAAP from realized private equity transactions, where such delays can be many years.

As I mentioned before, we had strong growth in pretax distributable earnings, which was up 90% in the first quarter of 2007 versus the first quarter of 2006. Pretax distributable earnings per dividend paying share was $0.55 in the first quarter of 2007, up from an equivalent of $0.31 a year ago.

Significant components of distributable earnings include increased segment revenues, which grew 129% to $383 million. Segment management fees grew by 75% due to capital raises, as previously discussed by Wes, Pete and Mike, across each of our core businesses. Segment incentive income grew by 157%, primarily due to realizations from our private equity funds.

The percentage increase in operating expenses lagged revenue increases, as mentioned before. The net effect of these increases resulted in our operating margin on a distributable earnings basis increasing to 54% for the first quarter of 2007, in comparison to 50% for the first quarter of 2006. If our business continues with this mix, we expect 50% is a good assumption to make.

With respect to our investing and financing activities, we raised $653 million in our IPO in February. We deployed $335 million from such proceeds to pay down our existing debt. In addition, during the quarter, we made new commitments to our funds of $176 million and funded capital calls on these commitments and previously made commitments of $128 million.

Looking forward, we have already had two significant events in the second quarter that we have already disclosed. As Wes mentioned, we raised Fund 5, which will create additional management fees and potential future incentive income.

We also closed on a new credit facility with more favorable terms and interest rates. In connection with our financing activities, we continuously evaluate our cost of capital, and in accordance, we executed this upside to $1 billion. And it has no interim principal payments during the five-year term.

With that, I would like to turn it back to Wes.

Wes Edens

Yes, just the last thing I would like to chat about before we turn it over to questions and answers is with regards to the investment of our own balance sheet. One of the things that Dan mentioned is that we just recently successfully completed the $1 billion financing, which gives us a lot of investment capital on the firm's balance sheet, which is one of the principal reasons why we took the firm public.

And I think that you have yet to see the impact of that and what we hope will come about as a result of that. The goal as a firm is, number one, of course, just to increase investment in our own current vehicles. So the great investment products that we've got, be it the hedge fund products, private equity products, the Castles, just increase our own investment in those vehicles.

Number two, obviously, provide capital to invest in new initiatives that we have, and we have a number of initiatives that we are currently focused on. And then, third and perhaps least easy to put your finger on is just to look for investment management opportunities that leverage our investment capabilities as a firm.

And we've got a number of different things which we are in the process of taking a hard look at, none of which are really worth speculating about at this point. But hopefully, in the next quarter or the quarter after, we will have some interesting things to talk to you about with regards to those activities as well.

So with that, Lilly?

Lilly Donohue

If we can turn it over to questions and answers, please.

Question-and-Answer Session

Operator

(Operator instructions) And we will go first to Scott Appleby with Deutsche Bank.

Scott Appleby - Deutsche Bank

Hey thanks. Nice quarter, by the way. I'm trying to figure out, I'm actually on a cellphone; I apologize. So I'm not sure if you covered this, but I thought the, trying to rectify the profit surplus. I thought it was going to be around (inaudible) at the end of the quarter.

Wes Edens

I'm sorry, could you repeat the question?

Scott Appleby - Deutsche Bank

Yes. Just trying to understand where the profit surplus is right now.

Wes Edens

Well, the profit surplus for the private equity funds in the public stocks is, as I said, it's about $6.1 billion of profit above and beyond our basis in those investments, number one.

Number two, on the private side, which, as I was trying to walk through the arithmetic in the private side, is that as of the end of the quarter, we have a total of just over $6 billion in capital that has manifest some of the earnings potential that we think could be there.

If those investments doubled in value or tripled in value, which is really the range of what’s happened to our investments historically, it would then create another $6 billion to $12 billion of incremental surplus on that side.

Those numbers, those gross numbers, the $6 billion and the $6 billion to $12 billion number, just simply take those times 20% as the profit portion that we keep of them, and then the firm-owned, in round terms, about 65% to 70%, depending on the fund.

So I think, just to follow the most straightforward calculation, if you look at just the public surplus numbers, $6.1 billion times 20% times about two-thirds ends up with $711 million, is the number that I think is actually in the disclosure.

And so again, we've got, we think, prospectively two or three times that in the private part of that calculation, if things come to pass as well. Those are the surplus numbers that we think of, in terms of the prospective incentive fees.

Scott Appleby - Deutsche Bank

Okay. The other question, maybe for Dan, is I was surprised to see the tax rate in the mid to upper 20's for the rest of the year. I guess, one, what did you learn, or what is different than earlier? Then, two, is that something we can expect even in ‘08?

Dan Bass

What we learned is we have figured out that certain aspects of our business can run safely through the partnership side of our structure. As you know, our effective tax rate is a function of the mix of our businesses.

So to the extent that businesses can run through the partnership side of our structure, it bears a zero entity level tax. And when you put that combined with our taxable businesses, we come up with a blended effective tax rate. To project forward at this point in time wouldn't -- it's really a function of the mix of our businesses.

Scott Appleby - Deutsche Bank

Okay, fair enough. And just lastly, is Fund 5 -- is that already earmarked for the Florida East Coast Railway?

Wes Edens

The Florida East Coast Railway will be funded in a number of different funds, of which the largest fund thus far is in Fund 5. We have yet to make the allocation among the different funds.

We've made a commitment in total. As I said, the purchase price of that investment is about $3.5 billion. We have not included exactly how much in equity we are going to put into it, but I think the answer at the end of the day is we're going to equitize this investment highly, given the nature of it.

So it will be a very large investment for us, probably the third or fourth largest investment the firm has made from an equity standpoint. It will be allocated among a number of funds, of which Fund 5 may well be the largest of those funds.

Scott Appleby - Deutsche Bank

Okay. All right, I will get back in the queue. Thanks a lot.

Operator

We’ll go next to Michael Hecht with Banc of America Securities.

Michael Hecht - Banc of America Securities

Hey good afternoon everyone. How are you doing?

Wes Edens

Great.

Michael Hecht - Banc of America Securities

Just a question on the recent fund you raised. It seems a bit larger than past capital raises, so I'm just wondering, is that more based on demand you're seeing from investors, or just more a function of the fact that you're seeing more interesting opportunities to invest at favorable returns?

And then any difference in kind of distribution mix you're seeing in terms of where the capital raise is coming from? And are you seeing any early benefits from the Nomura relationship, in that regard?

Wes Edens

We have held off raising very, very large private equity funds that some of the other private equity folks have done, really preferring to raise funds that we think we can invest in the next 12 to 24 months; that's kind of the operant timeframe.

Fund IV was raised in the first part of last year; I think it closed in March. So that fund is now 100% committed and closed. So we actually had an investment pace which was greater than what we had thought was likely at the time we raised that fund.

That fund was capped at $3 billion in third-party capital -- ended up being, I think, $3.56 billion with the direct fund, and then there was a $750 million co-investment fund. Then we raised a couple of other sidecar funds for large investment last year.

So last year, the total invested capital in our private equity business was just over $4 billion, so it was quite a productive year for private equity.

Obviously, this year, we're off to an even bigger start. It was a couple of these larger transactions that made a big difference. The Holiday transaction, in particular, was a large one, and now Florida East Coast, if that indeed comes to get funded.

So we incrementally raised the size of that fund a little bit, but only a little bit. As I said, we have indications of interest that are materially greater than the size of that fund right now. So, again, we could have raised a larger fund but, again, have chosen to raise just what we think we can invest in the next 12 to 24 months.

Michael Hecht - Banc of America Securities

Okay, that's fair enough. And then you kind of mentioned this, but given the competitive dynamic out there, with a lot of your competitors raising big kind of war chests, does that have some impact on your ability to generate returns or the industry's ability to generate excess returns?

Wes Edens

I am very, very happy with the portfolio of investments that we have got right now, and I'm very happy with the investments that we have made in the past six months.

So it is a very competitive world that we live in, but the railroad stuff, the transportation assets and sector in general, we think, is very interesting. We think that there's a lot more to do in that sector.

If the mix has been different, it has been that it has been more U.S. centric in the past year than it has been historically. We have had a good mix coming out of Europe, so perhaps a bit more of increased competition in Europe, at least in the short term.

But again, our experience is that those things tend to be cyclical. So I don't expect that that's some long-term phenomenon. But the tide will shift back, and we will be more active, perhaps, in Europe in the coming years.

Michael Hecht - Banc of America Securities

And then maybe to follow up on Scott's question, is it possible to frame the private equity surplus and the private company surplus, how they compare to, say, a quarter ago?

Wes Edens

Well, it's very easy to do in the public side, because you have apples-to-apples comparative, because those numbers -- the $711 million number was -- of the $6 billion was off of $7.5 billion as of the end of the year, so its down a little bit over that period, on the one hand.

On the other hand, the private surplus number is quite a bit larger. So we’ve got -- as I said, from a year ago, we've got, now, $6 billion invested plus another $3.3 billion committed. So we've got nearly $10 billion in capital that should be working for us in the private equity business, whereas a year ago that was that was just a shade over $3 billion.

Most of the difference in surplus can come as a result of just one investment, which is the public market flotation of our apartment business in Germany, which is down a little bit in value. That's a sector that we think, for a bunch of different reasons, has got tremendous prospects, and we like that business a great deal, though.

So we're not a seller of that business anytime in the short run, so we like the prospects for it. But those are the two numbers that you can really point to.

Michael Hecht - Banc of America Securities

On the public side, that would also come down as a result of promotable income or gains realized in the first quarter?

Wes Edens

Yes. Yes, there were some gains taken in the first quarter. And again, the gains are not really driven on a quarter-to-quarter basis. They are a result of as we see opportunities and we think investments are maturing, that we will look to perhaps take some gains.

And we certainly have some investments that are older, as opposed to some of the newer ones that are more likely candidates in the coming quarters or even years. But those are not -- that's part of the explanation for the decline in the surplus value.

Michael Hecht - Banc of America Securities

As we think about the realization of the private company portfolio, I mean just in terms of timing, how should we be thinking about this?

I'm sure there's some things that are maybe a little bit more aged than others, but is this kind of a one to three-year kind of thing or even longer-term?

Wes Edens

In general, the public surplus companies are ones that we have owned for longer periods of time. That's not always the case, but that is more likely the case.

I think most of the realizations you'll see in the next 12 to 24 months are likely to come out of the public sector, just in general, because a lot of the private companies will turn into public companies, and hopefully be grown before they are actually ready for any harvesting activities.

So I think most of it will come, actually, out of the public sector. But we don't make predictions or comments about any specific investment, obviously.

Michael Hecht - Banc of America Securities

Okay great, thanks. I'll get back in the queue. I don’t want to monopolize the call. Thanks Wes.

Operator

We'll go now to Marc Irizarry of Goldman Sachs.

Marc Irizarry - Goldman Sachs

Great thank. Wes, this is just a question, I guess, on the environment now versus the environment when you put forth the increased dividend guidance at the end of the last quarter. Can you kind of give us maybe a sense of what the environment looks like today on a kind of go-forward basis versus what the environment looked for when you raised your dividend last time around?

Wes Edens

Well, we raised the dividend. It was really a consultant process between the management of the company and the Board, obviously, after looking at what our forecasts are for the total year. So, rather than trying to predict the earnings or distributable earnings on any one quarter, we look at over the next 12 months and try and use that as the predictive matter with respect to what we think is going to happen.

And we had, as you've heard, great performance across the board, in both private equity and the hedge fund businesses. We also had a very productive quarter in our tax department, and just a better understanding for the tax process.

And a combination of those two things led us to believe that a 25% increase, which is obviously a very substantial increase, but a 25% increase nonetheless was the right thing to do for our dividend, and that's what we ended up doing.

So obviously, those conditions that existed, though, I think, in direct response to your question, are prevalent today. We feel very good about the year as we sit here right now. Of course, that could all change tomorrow. But right now, it looks like it's going to be, knock wood, a very, very good year.

Marc Irizarry - Goldman Sachs

Okay. And then obviously, the incentive income in the first quarter was large in the private equity segment. Can you just give a little more help in terms of maybe what the realizations look like going forward? Thanks

Wes Edens

You know, we don't comment about the realizations of any one specific transaction. Obviously, to the extent we liquidated any of the public holdings, you will be able to follow that from the filings.

We do think that the large amount that you had in the first quarter, if you normalized that over the course of the year, it would have raised the dividend more than 25% because that's obviously a big number. So we don't expect to get that quarter in and quarter out, but we do think that the year is on track to be a very good one.

So hopefully, you'll get some visibility out of the public side. The private stuff and investments in general, we just don't make comments about the specific underlying, because that's not therefore the right thing to do.

Marc Irizarry - Goldman Sachs

Okay. And then for Fund 5, it looked like maybe you put a little bit more of the firm's capital to work along with that fund. I think it was $1 billion, if I remember correctly, in your own principal capital, if you will. It seems a bit higher, I guess, than what you've done in the past. Is it a change in the way you're thinking about investing going forward principally, or is this just a bit more opportunistic?

Wes Edens

It's one of the principal reasons. Again, why we wanted to take the firm public was to raise capital to increase our exposure to our different investment activities. In the last fund, Fund IV, it was $3 billion in third-party capital, the total of $560 million in capital spread out between individuals and the firm. But now it will really come together, and you'll see one number with respect to that.

We haven't determined the final amount of investment that we're going to make as a firm. We did use $1 billion as kind of a placeholder to set our expectations and those of our investors as to what we anticipate will be invested. But the final amount will be determined here over the course of the year.

But yes, it does definitely reflect an emphasis on our part. As I said, only about 10% of the investment of the total distributable earnings return to the firm in that first quarter came out of the investment side. That's something we'd like to see be a bigger number, and I think it will be, as we are successful in deploying some of the capital that Dan helped us raise on that side.

Marc Irizarry - Goldman Sachs

Thanks. And then for Pete and Mike, I guess, separately, if you can each maybe share a little bit of your outlook for how you think the return expectations are kind of shaping up for the remainder of the year? Thanks.

Mike Novogratz

You know macro funds are difficult to predict where your next month of returns are going to be. I would tell you that our business feels great, that of the 21 portfolio managers, 18 of the 21 are in the black on the year. In general, this is a momentum business.

The global investment opportunity seems to be much healthier than the domestic. Global growth is strong. We've got a lot of our capital deployed in emerging markets and overseas markets. So we sit here relatively optimistic.

What I did say in my comments that I kind of want to highlight that this is an environment of extremely low volatility in every single asset class, record low volatility in most asset classes. And I think the winners are going to be people who navigate the sporadic periods of turbulence. We're constantly investing in risk management and thought process to try to make sure we don't get caught in one of those episodes.

Pete Briger

I think, from Drawbridge Special Opportunities, the real question of how our fund is going to do this year, from an earnings perspective, is somewhat a function of where we are in the cycle.

Right now risk, as I mentioned, is mispriced and assets seem to be expensive across the board. So what I'm hoping for individually is that we do have some sort of a financing crisis or some kind of a meltdown. That obviously increases my margins. Even though we might see one or two or three months of that performance, it will make the business a lot better.

So trying to look into a crystal ball as to when risk is going to start being priced correctly is a little bit difficult, with all the liquidity that's in the marketplace. But I would say we have a very strong portfolio right now.

We have 200 investment professionals, plus or minus around the globe who are looking for all sorts of neat investments that I think have very good downside protection. But right now, you just don't get paid a ton for the risk that you're taking in anything, so what we're really looking for is some kind of change in the markets.

Operator

(Operator Instructions) And we will go to Roger Freeman with Lehman Brothers.

Roger Freeman - Lehman Brothers

Hi. I just wanted to come back to the tax rate again. How much of the difference between the 37% that you had talked about and what you're talking about now is because you are running more of the incentive fees through the PTP as opposed to through FIG Corp?

Wes Edens

On the rates? Is that what you're asking?

Dan Bass

The question is on how much is --

Roger Freeman - Lehman Brothers

Yes. That differential -- are you running more of the incentive fees through the PTP as opposed to through FIG Corp, where you would be paying a 35% plus tax rate?

Dan Bass

Yes. We are running some of our promotes through there. The range, as we said, is wide. So I can't really give you a specific number, but there is a proportional amount of promotes that are running through the partnership side.

Roger Freeman - Lehman Brothers

So I guess, other than that, can you put a little bit more color as to why the magnitude of change relative to what you were talking about? Is it because of the regional income product?

Is there something that we can think about here, in terms of whether we can make an assessment as to how permanent this is? And I guess the corollary to that is how much of the improvement or the increase, that 25% increase in the dividend is really was done because of that expected better tax rate?

Dan Bass

Our initial 37% was a conservative estimate based on all the information we had in our mix of businesses at the time. The tax attributes of all of our businesses were evaluated, and some of the tax attributes relating from the Nomura transaction had been reflected in the setting of our range.

Roger Freeman - Lehman Brothers

Okay. Let me ask a question on the latest fund that you are raising. That is being done somewhat sooner, I think, than expected. And can you just comment on, is that a function of just the environment or opportunities that you identified that you wanted to raise capital for?

Wes Edens

Its a little bit of a guessing game in terms of trying to estimate when is the right time to raise the fund. Basically, once we get to two-thirds or 75% invested, then we start to think seriously about raising it.

In this case, we did so in the nick of time. We had a number of large transactions that we were pursuing, a couple of public companies, obviously, Interpool being one of them, which is another transportation and logistics company, and then Florida East Coast Railroad, and then there was an insurance company in Bermuda, in the U.K.

All those things came to pass in a relatively short period of time, and so we had started the process of raising Fund 5, and we literally raised it kind of at the last possible moment. So it was actually a fortuitous timing of it, but frankly not an alarming one, because that's really how we have run our business over the years, is just to raise the amount of capital we need.

But at the time of the roadshow back in February, we did not forecast raising a Fund 5 this year. Similar to what Dan's answer was, we took a very conservative position with regards to what we thought the fundraising would be necessary for this year. That ended up being, as it turns out, quite conservative, and we've made some substantial investments, and frankly, the investment pipeline right now is still very robust.

So can't predict what we think will make investments in the private equity business later this year. But I'm pretty optimistic about it as it stands here right now.

Roger Freeman - Lehman Brothers

It's likely, given how you've done this in the past, that you would raise the sidecar funds alongside of that, so that ultimately this will end up being a larger fund than what you're talking about?

Wes Edens

Yes. Actually, our expectation, if it all comes to pass, we will have a $5 billion main fund, of which $4 billion will be third-party capital, $1 billion from the firm and individuals, $1 billion of sidecar funds. And then, incremental to that, we may well choose to raise additional funds for specific large investments such as we did in the past, for InterWest last year and for Holiday earlier this year.

So it may well be that we have a bit more capital than even the direct fund has raise.

Roger Freeman - Lehman Brothers

Got it. And then just lastly and I apologize if you talked about this earlier. The CDO that you announced, I think, yesterday that you're launching, where is that? What’s that being done out of? Which of the divisions is this?

Lilly Donohue

Roger, do you have the name of the CDO? I'm just…

Wes Edens

Was it one of the, I think the CDO you are referencing was a financing, a long-term financing that we did to consolidate a bunch of short-term financing in Newcastle, I believe.

Roger Freeman - Lehman Brothers

It was for Newcastle? Okay.

Wes Edens

I believe so.

Roger Freeman - Lehman Brothers

Got it. Okay, all right. Thanks a lot.

Operator

And we’ll take a follow-up from Michael Hecht.

Michael Hecht - Banc of America Securities

Thanks guys. I just wanted to come back, you talked about this a little bit upfront, but can you talk a little bit about your overall kind of level of subprime exposure?

It sounds like you are already being opportunistic there. Is that an area where you think you will continue to have some appetite to benefit from the dislocation you're seeing there?

Wes Edens

We made an investment in a subprime lender about a year ago, and that investment at the time was about $470 million. We bought the subprime business from Centex, which was a retail business that we were very, very happy about that was in private equity funds 3 and 4, I guess.

That investment was reduced at the end of the year; we had a large pay down of it. And it went from $470 million, $465 million in capital, down to $270 million was the amount of the investment as of the first of this year. And of that $270 million, about half of the exposure was exposure just to servicing rights and advances, so it wasn't credit exposure, per se.

So at the time that the market went sideways in February, we actually had given a $17 billion, now nearly $20 billion private equity business, we had a couple hundred million dollars of capital invested. So it was a very modest investment. When there was a liquidity crisis and it was actually a short one but a very, very severe re-pricing event.

We had a good opportunity to buy some loans that we thought we were at good prices. We did look at a number of the companies in the sector and concluded, for a variety of reasons, that there was not a lot of investment appeal from a corporate standpoint.

But we like to look at assets during those kind of dislocation timeframes, and we did successfully buy some assets that I think are going to prove to be a very attractive investment for us. As I said, to date it has not been a substantial credit crisis. That's something that may yet comes to pass.

But at least in our, when you look at the historical numbers and where things are performing right now, that is not our belief that right now it is in the middle of a credit crisis. But it is something that could change here in the second part of the year.

So right now, our overall exposure to the sector is fairly modest, and we don't really have any expectation of that changing maturely, absent some kind of change in market conditions.

Pete Briger

In the hybrid hedge fund area, we have a modest exposure to subprime. And we have been short some of the indexes. We've bought CVS, and we've made a modest amount of money. We've also bought good loans, and we think that those trades have been good liquidity trades where we have made some money.

But again, I think it is relatively small, relative to the hybrid hedge fund businesses. But it has all been profitable.

Michael Hecht - Banc of America Securities

Okay, great. Maybe just a quick numbers question. The run rate of, if we look at like the profit-sharing comp expense by the segments as a percent of revenues, it just seemed a little bit lower than expected, both in private equity and the hedge fund segments. I mean, how should we think about the level of the ratio by segment for the rest of the year?

Dan Bass

The levels are pretty consistent. They operate the current quarter will be roughly where they are at consistent levels right now.

Michael Hecht - Banc of America Securities

Okay. So, that’s helpful. And then just the last question, can you guys talk a little bit about the cultural impact that going public has had on morale, and just how employee retention has been so far this year?

Wes Edens

Well, there's also a big aspect of the firm going public was the ability to create ownership throughout the firm. And so on the 8th of February we had five principles that owned the firm. On the 9th of February, we had hundreds and hundreds of people, all with equity interest in the firm.

And it accomplished exactly what we hoped it would accomplish, which was to create a real cultural identity, both economically as well as in spirit. As we well know, compensation is a process, not an event, and it takes time to get to the level of the organization where we would like it to.

But we are very happy as a firm in the short term at the results of being public. We think there's lots of potential for the Company going forward.

Michael Hecht - Banc of America Securities

Hey, great. Thanks a lot.

Operator

We’ll go next to Steve Ballentine with Ballentine Capital.

Steve Ballentine - Ballentine Capital

Yes, hi. Just wanted to get a little more color on your thoughts on the opportunity for the balance sheet of FIG, any additional investments, new areas to focus on outside of the pure existing fund management businesses you've discussed?

Wes Edens

I think, as I said in my few minutes' remarks after Dan had finished up, I think it's something, which has got a lot of focus in the firm. Right now, our investment income as a percentage of our overall earnings is modest, so we've got a long ways to go and a lot of upside. The first thing to do was to put in place some long-term financing at attractive levels, which Dan and the finance guys were very successful at.

That is something we think we can improve on over time, and as I said, the three areas of focus are looking at investing in our existing funds, looking at new investment products that we can sponsor and invest in and then, third of all and probably most difficult to predict, are investments that we can make that will leverage the investment expertise as an asset management matter of the whole company.

And there's a bunch of different things, which we have looked at and are contemplating there, none of which are really ready for public consumption or worth talking about.

Steve Ballentine - Ballentine Capital

Okay. And how about Fortress Partners Fund? How is that progressing, and how large do you see that business being in the future?

Pete Briger

Steve, I would say Fortress Partners Fund is a 10 out of a 10 at this point, very good early returns, really leveraging all of the contacts and expertise of Fortress. As of quarter end, as I mentioned, it has $900 million under management, and we see that business being an excellent business for our investors and for Fortress itself.

It really is something that is quite excellent. The group that we've put in place is excellent. I couldn't be happier, and you should think about investing some money in the fund.

Steve Ballentine - Ballentine Capital

I already did. Thanks, Pete.

Operator

(Operator Instructions) It appears we have no further questions at this time, Ms. Donohue. I'd like to turn it back to you for any additional or closing remarks.

Lilly Donohue

Great. Well, thank you, everyone, for joining us today. I welcome you all to call our investor relations department if you have any follow-up questions, and we certainly look forward to speaking with you next quarter. Thank you.

Operator

And ladies and gentlemen, that concludes today's call. Thank you for your participation. You may now disconnect.

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Source: Fortress Investment Group Q1 2007 Earnings Call Transcript
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