Fortress Investment Group Q3 2007 Earnings Call Transcript

Fortress Investment Group LLC (FIG)

Q3 2007 Earnings Call

November 13, 2007 12:00 pm ET

Executives

Lilly Donahue – IR

Wesley Edens – CEO

Daniel Bass – CFO

Peter Briger – President, Hybrid Hedge Fund

Michael Novogratz – President, Liquid Markets Hedge Fund

Randal Nardone – COO

David Brooks – General Counsel

Analysts

Roger Freeman – Lehman Brothers

Robert Lee – KBW

Marc Irizarry – Goldman Sachs

Matthew Fischer – Deutsche Bank

Michael Hecht - Banc of America Securities

Craig Siegenthaler - Credit Suisse

[Sig Vitale] – Glacier Capital

Roger Smith - FPK

George Denninghoff - Vista Research

Presentation

Operator

At this time I would like to welcome everyone to the Fortress third quarter earnings call. (Operator Instructions) I will now turn the call over to Lilly Donahue. Please go ahead.

Lilly Donahue

Good afternoon, everyone. I want to welcome all of you to our third quarter earnings conference call. Joining me today is Wes Edens, our Chairman and CEO and Dan Bass our Chief Financial Officer. Also joining us today is Pete Briger, who is the President and head of our Hybrid Hedge Fund business; Mike Novogratz, President and head of our Liquid Markets Hedge Fund business; Randy Nardone, our Chief Operating Officer; as well as David Brooks, our General Counsel.

Before I turn the call over to Wes, as the operator mentioned this call is being recorded. The replay numbers are [phone] from within the U.S. and outside of the U.S. is [phone], access code is 2324-1920. This call is also going to be available on our website, Fortress.com.

I want to point out that statements today which are not historical facts may be forward-looking statements. Our actual results may differ materially from the estimates or expectations in our forward-looking statements. These statements represent the company’s beliefs regarding events that, by their nature, are uncertain and outside of our control. I would encourage you to review the forward-looking disclaimer in our quarterly earnings release and ask that you review the risk factors contained in our annual and quarterly filings with the SEC.

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

Wesley Edens

Great, thanks Lilly. Welcome everyone, good afternoon and welcome to our third quarter earnings call. Interesting quarter for our businesses. Lots of volatility in the markets, very challenging market environments, but overall good results for the quarter and for the nine months ended in September.

For the third quarter, pre-tax distributable earnings were $111 million, that’s up from $67 million in the third quarter a year ago, a 65.7% increase. For the nine months ended September 30, pre-tax distributable earning were $474 million, which compared to last year at $259 million for the same period, an 83% increase over the same period from 2006.

Our expectation for the remainderment of the year is that our pre-tax distributable earnings currently represent about 80% or 85% to where we expect to end up at the end of the year. Which if it comes to pass, would leave us at about a 50% higher earnings for 2007 than 2006. Obviously a terrific year.

In many years, our fourth quarter has been one of the most productive ones for us. Last year at the end of the third quarter for example, we were about 65% of where we ended up for the full year; but this year given all the market disruptions, we’re forecasting little in the way of private equity realizations for the remainder of this year, which results in our current forecast.

To put that in context, at our current evaluation, we’re trading at about 15 times our 2007 numbers and about 11 times the ‘08 estimates from the equity analyst community; pretty modest evaluations for a company that’s growing at a 50% pace year over year.

Overall, business activity across the board has been robust. Hedge funds had another good quarter, private equity funds completed several large investments for the quarter as well as a couple of material realizations. Capital formation for existing products was a very good one for the quarter and we’re in the market now with several new initiatives that I’ll talk about in a little bit. So for the quarter, a good one overall.

Maybe just to start, let’s review the business model. Although there are a lot of moving parts, the simplest way of thinking of our business is fee paying asset management times the net result that we realize. We report assets under management in two ways.

Total assets under management is meant to give visibility on all the assets that we oversee, but does not necessarily reflect the assets with which we earn fees. For example, we include the capital of the firm and our employees in this figure as well as the market value of our public portfolio companies and our private equity businesses and Castles so that number ends up being the highest number for us. At the end of the quarter, our total assets under management is about $40 billion.

Another measure that we track closely is fee paying assets under management. Fee paying assets under management refers to the amount on which we earn management fees. The metric varies from Fortress fund to Fortress fund. Our businesses are entirely alternative investment businesses where we earn management fees of 1% to 2% and performance fees that are generally 20% of the profits. At the end of the third quarter, our fee paying assets under management were $31.2 billion which compares to $20.8 billion at the end of 2006.

The average fee paying assets under management that we expect for the year will be $28 billion or $29 billion for 2007. If you simply took the average fee paying assets under management number -- that $28 billion or $29 billion number -- and multiply it times 2%, it would be a very good rough estimate of what our pre-tax distributable earnings would be for the year. The 2% is a combination of management fees and performance fees so obviously there is some variability here, but we have many different funds.

In the past we’ve found that if you assume a total revenue number of 4%, i.e. a combination of both a management fee and a performance fee, bring about half of that to the bottom line to get to that 2% number. It’s been a good rough estimate to our earnings and something that I would recommend that folks pay attention to because that’s how we think of it.

Now let’s talk about the performances across the businesses. We’ll start with the hedge fund group. Hedge funds at Fortress in the aggregate total about $15 billion or 48% of our fee paying assets under management and had a very solid year thus far. In the aggregate, year- to-date through 9/30, our hedge funds posted gross returns 12.2% and net returns of 8.2%. Taking into consideration the month of October, the hedge funds posted gross returns of 15.6% and net returns to investors of 10.9% for the ten months ended 2007. So obviously a terrific return set in a pretty volatile market.

As we mentioned on our last earnings call, our liquid markets hedge fund at that time was down for the quarter but as of October 31 we’re back up to the high water mark for the year. A great couple of months for the trading folks.

The big story in our credit businesses is there is no big story. Pete runs a business around a highly diversified portfolio of uncorrelated idiosyncratic risk with very low leverage and even with the difficult market for credit; the businesses have very little in the way of write-downs, positive returns to the quarter and no substantial exposure to the sub-prime mortgages. Great performance out of that credit business and needless to say, we think that there’s likely to be very good opportunities to expose additional capital to the credit markets in the coming months given the current conditions.

Private equity is $13 billion or 41% of our total fee paying assets under management has also had a very good year investing capital, and has had a couple of realizations including one large one in the third quarter. In our private equity fund we invested $3 billion of capital for the third quarter and $6 billion year to date as of 9/30. We also have commitments for an additional $2.8 billion which we expect to close in the fourth quarter or first quarter of next year. That would bring our total capital invested or committed this year to private equity up to a total of $8.8 billion compared to $4.7 billion in 2006. So a very solid year in the investments side.

As for realizations, we sold our position in Crown Castle which was originally an investment in Global Signal. It’s an investment in the tower space we made back in 2002 which in the quarter generated proceeds of $900 million of which we distributed $600 million of promotable income. A good investment for us, we invested a total of about $120 million back in 2002 and with this realization, our total return for the investment was about $1.7 billion, so obviously one of the good ones.

As for our surplus, the underlying performance of the private equity portfolio companies has been very good, while the stock price performance of the public companies has been pretty poor. Consider in the last 12 months, on average we’ve raised the dividends of the private equity companies by about 30%, that percentage being rough justice for what the free cash flow growth of those companies has been. Over that period, the stocks declined on total about 40%, so really a tale of two different things going on.

Our private equity business is focused on investing in asset-based companies with good growth prospects, stable cash flowing businesses like real estate, transportation, senior living, etc. and at least for the moment the market’s been focused on other things. For the year, if you look at the S&P, the best performance sectors have been energy and technology which have both had terrific runs albeit having a bit of a sell-off here in the past week or two, but in the end we think that hard assets and growing businesses have a lot to be said for them and that things tend to adjust back to fair value.

However, if we see the gap between asset value and market value stay out of whack for a long period, we have many alternatives in those businesses including the ability to liquidate assets and close the gap between market prices and NAV. It’s one of the many things we love about asset-based private equity.

Overall this is the kind of market that should yield excellent investment opportunities in our private equity businesses. A lack of availability of debt capital tends to depress asset prices and reduces competition both of which are good for us in the market for new investments and I would expect that next year will be a busy one for us.

The only real disappointment for us in the quarter was within the Castle business. Newcastle’s performance, even though Newcastle had modest exposure to sub-prime, it had $159 million of total investment in 2006 vintage sub-prime securities. With the ferocity of the down turn in the sub-prime market a little bit of exposure goes a long way and we took a writedown in that business although cash flow remained unchanged.

For the firm, this had relatively little impact as NCT represents only about 1.5% or so of our overall earnings and we have very modest capital exposed to the business. Away from Newcastle and the private equity investment in Nation Star, we have little to no exposure to either the sub-prime or the SIV market.

CDO is another buzz word that’s been on top of everyone’s list and Fortress has no direct CDO exposure, actually quite the opposite. We use CDOs to permanently finance assets in several of our businesses but we’re not investors in CDO bonds in any material way and thus have no balance sheet or earnings from the CDO market.

In summary, excellent performance from the hedge fund and private equity businesses, strong continued growth in fee paying assets under management and no liquidity or credit events of real consequences out of FIG directly or any of the underlying businesses, so a very good quarter.

Maybe just a few comments about markets and I’ll turn this over to Dan. Starting with the sub-prime business of which much has been written about and talked about and it’s something that we’ve had a lot of experience around the residential businesses here both between myself, Pete and many others here. If you look back at the 2006 vintage of sub-prime which totaled about $600 billion, its where most people assessed there to be the principal amount of risk.

Most of the people expected this cohort will have $50 billion to $100 billion of realized losses eventually and which -- although this is a sizable number -- it’s really only a fraction of all the damage that it’s caused in the marketplace. Sub-prime became the proverbial straw, albeit a very large one, that exposed many of the excesses of leverage in the financial markets.

First and foremost, the investment banks and then the banks directly, now you see insurance company, surety issues, other participants in the market so it has actually caused a great deal of damage in the market and the market still, in my opinion at least, is in the very late stages of what has primarily been a liquidity crisis and it’s just now beginning to show the effects of credit performance.

In fact, we were looking at the performance of a number of the vintages of the sub-prime stuff that we have access to ‘02, ‘03, ‘04, ‘05 vintages were basically very similar levels of foreclosure and delinquencies of what they have been in the past and really it’s just the 2006 vintage that took a material turn for the worst here recently. You’re just starting to see it manifest itself in the credit performance, and my view is that the residential market is already priced to what would make it the worst performance in history. You really have to go back to 1991, the worst vintage ever or 2000, even worse than that.

While I believe that certainly prices on residential real estate could and most likely will continue to go down for the foreseeable future, the market prices for many of the highest rated securities are at very attractive levels now. I would suspect that all things being equal, a year from now, prices of many of those securities could easily be higher than they are today. Underlying credit performance may be very poor; some of the investment opportunities may be very good.

Having said that, many of the other credit-related businesses and assets, consumer, commercial, etc., have not been under nearly as much stress as the residential markets and I think are likely to get tagged in the coming months and quarters and show some stress as well, still a lot to go in the credit markets and something we’re following very closely.

Macro views of the market as expressed by our trading business are the following: slow growth is expected for the U.S. and Europe and is a direct result of the credit contraction, how slow that growth is of course is a source of a lot of concern and chatter. Central banks are being forced to be responsive, i.e. lowering rates, but are nervous about inflation. That’s one of the principal risks that certainly we are very focused on here. And then, of course, growth in the developing markets should be very strong. That’s been one of the big macro themes over the past year, which you’d think with the weak dollar should have material benefits to U.S. companies that export to them.

Lastly the key issue that’s been played out is that of decoupling, i.e. the developing markets have grown their domestic economies to the point where they are no longer totally dependent on the U.S. and are likely to continue to have growth even in the absence of a strong U.S. economy.

In summary, the markets overall have been very volatile. Our trading business had a tough July and August after a terrific first half of the year, but then a tremendous September and October and have really been the star performers of the firm in the second half of the year.

One of the strengths of the firm lies in the diversity of our businesses, our company plays a team sport here at Fortress and certain of our businesses are better suited to different markets which has clearly been the case this year. The current environment is expected to be good for our liquid markets businesses while not ideal for realizing private equity investments; however, there are great opportunities to seed new investments within the private equity and credit businesses that we have here.

That’s why we believe having a very large hedge fund complex alongside the private equity complex gives us the best possible opportunity to have good performance in many different markets which has certainly been the case for us this year.

Looking forward into 2008, I feel great about the prospects for the firm. Not only is the existing book of business solid, we’re in the process of organizing capital around a number of new ventures which if successful, could add another $10 billion or $15 billion to fee paying assets under management. We have a half a dozen new funds in the works ranging from additional capital in existing businesses to new strategies on the infrastructure, emerging markets, commodities, Asian real estate, etc. and we’re optimistic that those are going to come to fruition here sooner rather than later.

In the long run, market disruptions are very good for us. It clears away irrational behavior and creates good investment opportunities and absent just a complete shut down of the markets we think that the coming months and quarters look good for us.

With that, I’d like to turn it over to Dan Bass now to review the financial results in more detail.

Daniel Bass

Thanks, Wes. I’ll now walk you through the highlights of our financial results for the quarter and year to date and which have strengthened versus the same period from 2006. Within my remarks I will cover a number of key performance metrics which have improved in comparison with the third quarter of 2006, in particular growth in fee paying assets under management. This is our measure of net inflows and net appreciation of capital which we earn fees from our funds; growth in distributable earnings and our balance sheet activities during the quarter including the funding of our private equity and commitment and making further investments in our hedge funds.

Fee paying assets under management totaled $31 billion, up 62% from a year ago. Each of our business segments significantly contributed to this growth as follows: private equity fee paying assets under management grew by 60% primarily due to the raising and investing of a number of our private equity funds including the closing of private equity Fund V and Fund V Coinvestment fund that together raised $5 billion of third party capital earlier this year and Drawbridge Real Assets Fund which raised $300 million at the end of the second quarter of this year.

Growth in liquid hedge funds fee paying AUM up 64% primarily due to the capital raises and net positive appreciation over the past year. Since the beginning of 2007 we raised over $2.2 billion of capital, as well as net capital raises of $500 million during the third quarter 2007.

Growth in our Hybrid Hedge Fund fee paying AUM up 58% due to significant capital raises and positive appreciation over the past year. Such capital raises include the establishment of Fortress Partners’ Fund in the third quarter of 2006 which has grown significantly since that original establishment. And Capital raises for Newcastle in the first half of this year and Eurocastle in the fourth quarter of last year which increased fee paying AUM by 71%.

Next I want to talk about distributable earnings, but before discussing the growth in distributable earnings results, I want to reiterate what was discussed in previous earnings calls of why we believe distributable earnings 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. We also use it to measure earnings available for periodic distributions to shareholders. As well, it allows us to evaluate the entirety of our business which we are managing since it looks at the businesses as if the principals’ interests are entirely exchanged into Class A shares.

Pre-tax distributable earnings has been reconciled to our GAAP earnings in our 10-Q and in our press release and the main adjustments include share-based non-cash compensation which includes the principals’ agreement expense which will never result in a cash expense to the company, incentive income and adjusting for unrealized gains and losses from investments.

For the third quarter 2007 our pre-tax distributable earnings was $111 million, up 66% from the third quarter of 2006. For the first three quarters of 2007, our pre-tax distributable earnings was $474 million, up 83% from the same period last year. Pre-tax distributable earnings per dividend paying share were $0.26 for the third quarter, up from an equivalent of $0.18 from the third quarter of 2006.

A significant component of distributable earnings is the segment revenues which increased to $219 million for the third quarter, an 80% increase year over year. Management can be attributed to the following: management fees increased by $50 million or 67% versus the same quarter from last year due to significant capital raises as I previously detailed. Incentive income grew by $47 million or 100% versus the same quarter last year, primarily due to our private equity funds selling their remaining shares in Crown Castle which generated $84 million in gross incentive income, $56 million net of profit sharing compensation compared to no private equity incentive in the same period in 2006.

This increase was partially offset by a decrease in incentive income from our hedge fund businesses due to lower returns in particular the negative 1.74% gross quarterly return in the case of our liquid markets hedge fund. Further, there was limited incentive income from our Castles as Wes has previously mentioned.

Segment expenses increased by $29 million versus the same quarter from last year, due to greater profit sharing comp expense and average headcount growth of 44% which spans across all of our businesses as well as our continued investment in infrastructure.

Our operating income margin was 53% for the third quarter, primarily due to private equity realization events and 51% year to date through September. As I discussed in prior earnings calls, any quarter’s margin will be affected by the overall level of incentive income recognized during that quarter; however to date, we have been able to generate a consistent operating income margin.

On the topic of 2007 income taxes and tax-related payments, our effective tax rate for distributable earnings purposes for this year is expected to be in the low 20s. As we noted in previous calls, the final tax rate is a function of the business P&L mix and is very mix dependent.

With respect to our balance sheet activities during the quarter, we funded $276 million in private equity as well as $76 million in our hedge funds, increasing our total investment in our funds to $969 million as of September 30. In addition, we declared and paid our third quarter dividend paying a $0.225 per share dividend which represents a $0.90 per share on an annualized basis.

Now I’d like to give you a little color on our GAAP results and keep in mind that the results of operations on a GAAP basis reflect the results attributable only to our Class A Public Shareholders which is roughly a 23% economic interest in Fortress’ businesses.

Our GAAP net loss attributable to our Class A Shareholders was $38 million for the quarter and if you exclude the net effects of the principal agreement expense which is a non cash charge relating to an agreement to which the company is not even a party, our GAAP net income attributable Class A Shareholders would have been a positive $17 million for the same period.

In summary distributable earnings, one of our key performance metrics, has improved during the third quarter as well as year to date compared with the same periods from a year ago.

With that I will conclude my remarks and I’ll turn it over to questions and answers.

Question-and-Answer Session

Operator

Your first question comes from the line of Roger Freeman – Lehman Brothers

Roger Freeman – Lehman Brothers

Can you talk about how you have approached the mortgage market this year? There’s been a fair amount of speculation, obviously unfounded, that you had CDO exposure and you’ve made comments that you’ve had a negative view around that space and that you were playing that defensively. Would you characterize your positioning there as still defensive or is it more offensive in that you’ve been actively shorting?

Wesley Edens

Well let me make a comment and I’ll turn it over to Pete. On the defensive side, the largest exposure the firm as to sub-prime has been really in two places: the private equity investment in Nation Star which is a sub-prime originator and servicer. The bulk of our exposure in that investment comes to the servicing side so and we have [inaudible] the origination side of the business so the amount of overall exposure to credit in that is actually quite restrained, given the overall book.

And then in Newcastle, I think is probably where a lot of people have speculations that we had major exposure and really the exposure has been very modest as evidenced by our recent earnings announcement and the like. I think that perhaps there was some speculation that people had that somehow the firm had CDO exposure, we had balance sheet exposure, which was just simply not the case. So from the defensive standpoint, it was really in those two areas and overall we feel very good about the lack of exposure that we have.

The offensive side, maybe Pete, do you want to address that?

Peter Briger

I think this time last year, we probably didn’t have any mortgage exposure whatsoever in the Hybrid Hedge Fund Group. I think about the end of last year, early this year we started getting net shorts but we were not significantly net short. Certainly in retrospect, I would have liked to have been a lot more short, but we did have substantial profits from our short positions in mortgages. We are certainly on aggregate small in the whole area just because I figure our expertise is much more centered on being long credit opportunities then it is in playing the indexes just in terms of what we do and special opportunities.

Over the last three or four months, we’ve gotten interested in the residential whole loan market directly in special ops and we’ve been involved in some financial institution liquidations where we’ve bought some portfolios. I think that our residential whole loan position may be up to 2% or 3% of the portfolio right now and we certainly bought some AAA securities and some AA residential mortgage-backed securities but nothing of significance.

I would say the next two years certainly, but maybe as much as the next three years, we’re going to be very focused on the entire residential and asset-backed sector. That’s something that as Wes mentioned, we have deep experience at Fortress and something that we think we will significantly gear up. So I wouldn’t be surprised if those percentages went up significantly or that we raised separate additional funds to go after those opportunities on a standalone basis.

Operator

Your next question comes from the line of Robert Lee – KBW.

Robert Lee – KBW

Could you just update us on what’s going on outside the U.S. in terms of your initiatives there? I think particularly in the private equity business, if you’re seeing more opportunity say in Asia than in Europe and clearly the U.S.?

Wesley Edens

We have a substantial amount of capital exposed outside the U.S. both Canada and we have major investment operations in England and in Italy and in Germany. The businesses overseas are doing quite well. There’s a number of public companies that gives you some visibility into it, but the hard asset businesses in Europe have done very well.

The public markets in Europe have actually had a similar fate as the ones in the U.S. and they’ve had price reductions, there’s been interest rate increases in both England as well as on the continent that have put a lot of pressure on those markets. Those were specifically some of the companies I was referring to where I think that there is potentially a substantial gap between NAV and kind of where the prices of where those companies are trading at.

With respect to the existing businesses, we feel great about them. There still are good opportunities. We’ve had a very active year. In Germany on the real estate side we’ve had a very active year. In Italy on the real estate side.

One of the new initiatives for the firm that we’re excited about is an initiative that Pete has spearheaded to increase our exposure to Asia. Starting with the real estate side that we’ve also, our macro trading business has had a very prolific business in Asia for a number of years and we’re looking at potentially expanding that on the private equity side as well. So that falls in the categories of other initiatives that are on the docket right now, which we don’t want to be really specific about while we’re in marketing those things but there things that we think are interesting. Obviously we see opportunities and that’s what we’re responding to.

Robert Lee – KBW

A modeling question, you had the realization from the Crown Castle sale in Q3 and I’m just curious if I look at the private equity as a rollup, you don’t see the realization there. Was that netted into the new capital raise or how should I be thinking of that?

Daniel Bass

We had taken off the realization, we had very little capital that was left that we were charging management fees on for Crown Castle because we had taken most of our capital out prior to that so that’s why you’ll see when we roll forward the management fee capital that there was a very limited to no reduction in management fee capital by that realization.

Operator

Your next question comes from the line of Marc Irizarry – Goldman Sachs.

Marc Irizarry – Goldman Sachs

Wes this is a question for you just in terms of the private equity business, you did mention…

Operator

His line has disconnected. Your next question comes from the line of Matthew Fischer – Deutsche Bank.

Matthew Fischer – Deutsche Bank

Just regarding the hedge funds, you mentioned the liquid funds back at the high water mark, so is that saying that in the fourth quarter if you see positive returns you’ll start to generate some more incentive income within the liquid fund?

Wesley Edens

Yes, that is correct.

Matthew Fischer – Deutsche Bank

As far as we are today, if we close where we are today, are you already at that mark where you are earning?

Wesley Edens

Well the last period I referred to is October 31 which is the last month that we just closed and at October 31 we were basically back above the high water marks across all funds. Mike and the gang had a terrific late summer and early fall, on top of a very good first half of the year. So, the businesses are once again very productive for us.

Matthew Fischer – Deutsche Bank

Last just regarding your emerging market strategy, you have mentioned in Asia increasing some exposure to the on the hedge fund side. Any other areas where you would not only on the private equity side, but start to invest in funds overseas?

Wesley Edens

What I was referring to were really private equity and real estate initiatives that we are contemplating outside the United States specifically. So, both in Asia and in Japan, China, you know, non-Japan Asia real estate as well as on the private equity side. We have made a number of non-control private equity investments in the hedge funds businesses under Mike’s and Adam’s direction that have been extremely productive for us and we are looking hard at expanding that element of our business.

Operator

Your next question comes from the line of Michael Hecht - Banc of America Securities.

Michael Hecht - Banc of America Securities

I know you guys just recently closed last quarter the $5 billion fund, and I am just curious what portion of that would already be current?

Wesley Edens

The current number for the fund is about 30%. There’s a couple of large investments that go into that. The Penn Gaming transaction which is slated to close here in the middle of next year subject to gaming authorization and the licensing. The Florida East Coast investment, which is one I am excited about is in there and then there is a handful of other things.

We have made our first investment in the alternative energy space, on the solar side were we bought a 49% interest of one of the largest solar installations in the world, that is one area that we think obviously has great promise and there is a handful of other things. We have got a very substantial amount of dry powder and this is market where it’s obviously hard to set up very large transactions, given the constriction in the credit markets but there is no shortage of things to look at. So I am excited about the markets.

Operator

Your next question comes from the line of Craig Siegenthaler - Credit Suisse.

Craig Siegenthaler - Credit Suisse

Wes, earlier in the call, it sounded as if there is going to be little to no private equity incentive fees in the fourth quarter. Is this about right? Also, with the private opportunities right now fairly close I am just wondering what’s your six-month outlook is for IPOs or secondary? I thought you mentioned something could happen with your Italian business or your financial and real estate venture last quarter?

Wesley Edens

Yes. We are not forecasting substantial amounts of liquidations in the fourth quarter. These things are obviously fluid and dynamic and things can change. But it’s our expectation -- I said if you looked, Craig, historically at the pattern of our returns the fourth quarter in many cases is a very productive quarter for us in many areas of the firm. This year we are forecasting more subdued earnings as a result of just where the markets are. Obviously it’s a better time to be a buyer than a seller in many cases for us right now.

Six months, actually we have one of our portfolio companies is in registration in the United States right now, which is our consolidated shipping company called Seacastle, which we have been in registration now for the past six or eight weeks. That is moving down the tracks. We are looking hard at a couple other situations including the one that you mentioned.

So I feel like as difficult as the markets are, they are open for investments that fit the profile of the things that people want to have exposure to, and the transportation and energy sectors of course were high on that list.

One point I’d make is you said that the public to private market may be more difficult. I think that’s true, but I think there are still substantial opportunities. There are two clear cases of that we are involved in right now that may or may not come to pass, but I clearly think there are still opportunities to take companies private under good terms.

Craig Siegenthaler - Credit Suisse

One more in the ABS side and not to kill this discussion, but I was just wondering what Fortress’ aggregate exposure was, because don’t think we talked about SIVs yet, both through proprietary and third party capital, both your products and investment portfolio?

Daniel Bass

Well, we don’t have exposure SIVs. We don’t have exposure to the investment side of the CDOs which I think has reaped most of the havoc that’s happened on Wall Street as a result of all the sub-prime stuff. We have modest sub-prime exposure in the private equity business through Nationstar and Newcastle, and now we have some new exposure that Pete has in the credit businesses, it is actually new exposure.

If you had to total it all up versus all of Fortress assets, it would be 1% or 2%, probably at most of our assets that have exposure to this. So it’s truly is a modest amount.

Peter Briger

That being said going forward, hopefully those numbers will start to tick up and hopefully that will a significant profit contributor for us in the hedge funds business. I look at it, even though we can’t see residential real estate prices going up in the next 18 months, very much like when we were investing in Japan in declining real estate markets where rents were falling on the commercial side year over year we were still able to buy commercial properties and loans steadily and on a trading basis make money in those markets. I would very much expect the same thing in US markets in the current conditions.

Operator

Your next question comes from Sig Vitale – Glacier Capital.

Sig Vitale – Glacier Capital

I was wondering on the backlog of deals that are already announced, where are you guys in terms of closing those in the next three to six months?

Wesley Edens

The only significant private equity transaction which is outstanding, which is not yet closed is the Penn National Gaming transaction, which is a fully financed transaction, which we are absolutely intent on closing. We are in the process of going through the licensing process with a number of the different state authorities that Penn operates casinos in. Our expectation, as we announced at the time we did the transaction is that we would hope to be through that process by the middle of next year. We are in the thick of it right now and there are no material updates to that.

The shareholder vote the transaction should happen, we think before the end of the year, that’s out of our control, but that’s what it looks like the timing of it is and that really is the only one that’s outstanding for us.

Operator

Your next question comes from Michael Hecht - Banc of America Securities.

Michael Hecht - Banc of America Securities

Just a quick follow up, any update on what you’re hearing from Washington on the various tax bills floating out there?

Wesley Edens

No, no specific updates. Obviously there have been a number of prospective tax proposals made out of either side of the aisle in Washington, and we have had an active dialog with a number of lawmakers with regard to them. But there is nothing really of insight that I can offer to you right now.

Michael Hecht - Banc of America Securities

Looking at the core management fees in the private equity segment, as you guys talked, that is pretty good growth in assets quarter over quarter, although the management fee revenues were kind of down about $1 million quarter over quarter. Any sense of what drove the decline there? Is this fee pressure you are seeing in the business where just one fund comes in at a different fee rate and another one takes off?

Peter Briger

It just had to do with the raising of Fund V and the roll on a fee basis for what Fund IV would calculate as fees, but on a run rate basis going forward, you’ll see that that number will tick up, but it was just the conversion of Fund IV from a committed capital to invested capital. That was really the adjustment.

Operator

Your next question comes from Robert Lee - KBW.

Robert Lee - KBW

Thanks, just a follow up on the hedge fund business. I mean, can you talk a little bit about your new business pipelines or your new asset pipeline there in terms of Hybrid Hedge Fund business came through Q3 in pretty good shape as well as the Liquid Hedge Fund business. Should we be thinking that may be you would actually see some acceleration in organic growth, given the strong relative performance in those products?

Wesley Edens

Both of the major fund complexes here continue to attract capital throughout the year. They really both raise capital in and when they see opportunities to deploy, I think one of the major schematic themes that we think is playing out in the very near term in the hedge fund business is a real consolidation. New products coming into the firm, there’s a number of existing hedge fund platforms, we haven’t brought in material amounts of third party management groups here, although we’ve got the one in particular we’ve excited about on the commodity side and we are going to launch a new product around that.

But I think you are going to see continued consolidation in the hedge fund business, and I think that a number of folks of which of course we expect to be one of them will end up with large diversified groups of funds. So thinking of it as a business or a group of businesses, I think is, how I would encourage you to think about it. That is how we think about it right now.

Peter Briger

To respond specifically on the Hybrid side of things, one, Fortress Partners Fund continues to do very well from a return perspective and an asset gathering perspective. And on the hybrid side, on the credit and asset side, obviously, what’s going to happen with the current market conditions as we move from the liquidity crisis potentially to more of a liquidity and credit crisis and move into different asset categories, are going to be that liquidity in the markets are going to down. So I think that we will add some size to our Special Opportunities Fund, but probably more look at this is a private equity fund alternative just because the liquidity of the assets are going to dictate a more illiquid form of capital that makes those investments.

Operator

Your next question comes from the line of Roger Smith - FPK.

Roger Smith - FPK

I just have a couple of questions on the $9.4 billion committed in non-public transactions, how much of that is still in the management fee paying assets?

Daniel Bass

Of the $9.4 billion, most of it is in the fee paying assets because most of that is in Fund V which we get paid management fees on, on a committed basis. So, most of that is in the fee paying. A little bit of it will click into Fund IV, the commitments that relate to Fund IV will start to click in once we deploy that capital which occurred post the raising of Fund V. But I would say substantially, most of that capital is currently in the management fee paying calculation. There is some remaining committee for Fund IV that will click in when we deploy it.

Roger Smith - FPK

In the hybrid product, I did see that there was a CDO in there used, I guess like you said, as financing and it looked like it was very over collateralized. Why is it so over collateralized? Is that something that the rating agencies required when you set the CDO up or what are the real assets behind there that require that such an over collateralization.

Peter Briger

Well, when I started my business, my investors always used to ask me why I used so little leverage in my business and I always used to say because I don’t like go out of business in rough times. And so, there is no specific reason as to why we use low leverage around the firm and Fortress is just generally we don’t like to bet the ranch and lose the ranch, and the current environment is really a perfect example as to why you don’t want to be highly leveraged in instruments like the ones that we traffic in.

So, it’s true of any of the financing vehicles that I have in hybrid hedge funds or really that exist around the firm. I don’t like highly leveraged fixed income investments.

Roger Smith - FPK

The timeframe that I’m looking at would be at the end of 2006. Has there has been a lot of additional CDO activity at Fortress since then or is really it is about that same level?

Daniel Bass

We use CDOs as a permanent financing tool both in Newcastle as well as in the credit business on fee side. So those are really in the ordinary course of businesses, as Pete said, they tend to be quite low leveraged relative to the marketplace and are just really there to provide permanent financing against our liquid assets. So, there is nothing aberrant that would have occurred during the course of the year to make those numbers go up or down substantially.

Roger Smith - FPK

But then when I look really at my assets under management, how do I differentiate between that would be in the total assets under management but only the equity would be in the fee paying management?

Daniel Bass

No, the equity that was financed by those vehicles would be in management fee paying assets under management in the respective vehicles. So, if Pete had a $100 of investment that he then financed, $0.50 you have $50 then would be the net equity position that will show up. The gross numbers doesn’t show.

Roger Smith - FPK

In terms of the private equity deals going on right now that are in discussion, what are the biggest stumbling blocks in preventing them from getting done? Is it really that pricing of these deals has to come down and that benefit of the low financing had really accrued to the seller in the past, and that they are not comfortable yet that the pricing is coming down? Or is it really on the financing side and getting all the financing necessary to do new deals?

Wesley Edens

I think it’s primarily a matter of price. I think we had a substantial repricing of the market for assets, people are fond of the prices they could have gotten six or 12 months ago and so there is a natural disinclination to adjust their expectation to where the market is at this particular point in time.

Having said that, the world goes on and there will be certainly be at least in my view, there will certainly be a robust amount of activity once the market is settled down and in particular for the kinds of things that we are focused on i.e. again, asset-based cash flowing investments, there is plenty of debt availability in our judgment around. The cost of it might be little higher but the amount of leverage that we have employed historically has always been quite low.

So it’s not that we are so exposed to lack of availability of capital, it is just the price of that debt goes up a little bit and as a result the price of the asset of the company has to come down a bit.

Roger Smith - FPK

No doubt. I am sort of hearing that now is the time to buy some of these mortgage securities from you guys right now, am I understanding that correctly? Is there some certain area of the mortgage market that looks more attractive than others? What’s your view on the commercial real estate market?

Wesley Edens

As both I said and Pete said, we think there are big opportunities in the debt markets they are hazardous though and I think it something that you would want to think pretty carefully about which are the sectors that are likely to benefit, which are the ones that still have exposure?

As I mentioned earlier, I think the sub-prime residential sectors have had the most stress and probably in the short term as a result they have the most opportunities. Some of the other sectors that have not been as affected may have less desire or a less favorable risk return characteristics. But those are very general comments about a very, very specific investment practice and we have had good success in the past.

I am optimistic, particularly in Pete’s business, in the credit business, that we are going to find some great opportunities going forward.

Pete Briger

I would just differentiate between the type of bet that you are making in residential mortgage-backed securities and residential housing and in the whole commercial sector. In the former, you’re making a very specific investment bet on one sector of the economy and in commercial real estate you have got many different tenants, many different geographies that are experiencing many different types of performance.

So on the residential side, it’s clearly a question of price and supply and demand imbalance and people’s assumptions on delinquencies and ultimate losses, which in a period like this tend to get over blown.

On the commercial side, you have really a gap in terms of the people who used to provide finance for many of the most senior of the securities and there is a repricing taking place in that market which ultimately may become a credit problem but at least as we sit right now, it is more of a liquidity repricing issue.

Roger Smith - FPK

What would be your guess on the timeframe that it will take for some of these credit markets to move out? I mean, are you guys in your view more optimistic that things normalized by the first quarter of 2008, or would it be the second half of ’08? What’s you’re thinking right now?

Wesley Edens

I think that even within the firm, there is a fair bit of discussion about what we think is going to happen in the marketplace itself. Of course, there are great differences of opinion over the absolute severity and timing of this stuff.

I don’t think that we are really in a position or want to really prognosticate about how we think this is all going to play out timing-wise. We are very focused in the markets, but I can’t really give you guidance as to what we think is going to happen from a short-term perspective.

Operator

Your next question comes from the line of George Denninghoff - Vista Research.

George Denninghoff - Vista Research

I have a just quick question regarding offshore financing and seeing how you see the Sovereign Wall funds impacting your business and the ability to raise assets?

Wesley Edens

We have a number of investors outside the United States, a number of them are Sovereign Wall investors. Primarily, they have been has been macro businesses and our trading businesses, more recently, we’ve had some investments in our private equity businesses as well. Obviously, given the flow of funds into those parts of the world particularly the Middle East they’re going to play a very, very prominent role in capital formation in both the short and long term for us.

So it is something we’re obviously well aware of. We have a substantial capital formation effort that has been quite productive for us and we expect that will continue and expand in the near term.

George Denninghoff - Vista Research

Where are you finding the better opportunities? Are they going to be here domestically or do you feel that they’re going to be primarily overseas at this point?

Wesley Edens

Hard to know. The US is such a big and robust place that when you get a big dislocation like this, it can yield some tremendous opportunities. But one of the real benefits of having a big and diversified business is you don’t have to predict where the next great opportunity is going to be. If you’ve got big operations as we do throughout North America then of course throughout Europe on the private equity side that gives us real access to those markets if and when the opportunities come up. That, frankly, is one of the real driving forces for us strategically as we look at the Far East and try to expand number of the hedge fund operations perhaps into a more private equity and real estate opportunities.

George Denninghoff - Vista Research

Do you see yourself listing funds overseas on the institutional exchanges?

Wesley Edens

We have a number of public companies overseas. So we have companies that are listed in Euronext and on The London Stock Exchange et cetera, at Frankfurt. Those can be the lowest cost of capital. We’ve not listed our core funds. We don’t list our private equity funds, we don’t have any of the hedge funds listed. There is some interesting capital structures that have been employed, but it has not been our view to date that those made sense for us to pursue.

George Denninghoff - Vista Research

The tax bills pending now, is there anything that you guys are doing strategically internally in the event that these bills do pass?

Wesley Edens

There is really nothing to do. We have an opinion about the tax structures, we are a taker of whatever the legislation is, not a maker of it obviously. We’ve expressed our views to those people that will listen to us, but ultimately those decisions will be made by lawmakers down in Washington not by us.

Pete Briger

We closely monitor the situation.

Wesley Edens

I mean, the one thing I would say is that the public partnership, the tax talk, centers around the utilization structures that we have used, that Blackstone has used following us. We have a modest amount of our income that we have run through that partnership. I think our current estimate is what, Dan, about 20%, plus or minus for the year? So if they did away with that on day one, which we think is quite unlikely we would have some modest increase in tax. But it is pretty easy to dimension. I think given that most the proposal seem to center around, a prolonged transition period. We don’t think that will have a material impact on our earnings that soon.

Operator

Your next question comes from the line of Marc Irizarry - Goldman Sachs.

Marc Irizarry - Goldman Sachs

You talked about the $10 billion to $15 billion potentially in these half dozen or so funds that are in the works. When do you see the rubber hitting the road in terms of those assets and what if anything would be when you would expect the next step, private equity fund to get off the ground? Thanks.

Wesley Edens

The answer to the first question specifically is that we have a number of initiatives that we are in the marketplace with now. I would expect those to bear fruit sometime in the early part of next year in terms of the formation of that.

Our private equity business as I know you know, we have raised smaller core funds and have raised substantial funds as we made specific investments. I would expect that we will have one or more of those will also happen in the relatively short term. The core private equity fund, which will be our next material fund raised, in that business which we are currently at about 30% of the capacity of the overall fund. I think given the investing climate, it is quite possible by the end of next year we could be in the market again with our Fund VI. So that is highly subjective relative to the investment opportunities.

Marc Irizarry - Goldman Sachs

Then just in terms of the surplus and obviously the public securities that at least we can see in terms of where they are going on a day-to-day basis, they haven’t perform that great. I’d assume that your outlook for realizing those investments or your timeline on those might be pushed out a little bit?

Wesley Edens

It could be. I think the public companies as I said, the underlying performance from a cash flow standpoint have been terrific. The public market stock valuations within that have being quite poor there has been kind of rush to other sectors that are more prominent. So real estate and financials are at the bottom of the list of the performance via the S&P 500 for the last 12 months.

We don’t intend to sell into a market that we don’t think fairly reflects the value of these companies and we think we have got some great companies. We have lots of alternatives, rather than just selling the stock. It is a good time to be patient, it is good time to have lots of other business around here that are making money.

Marc Irizarry - Goldman Sachs

The profit-sharing of the minority interest of the incentive income seems like it keeps ticking up a little bit. Is there anything in the nature of the fund in terms of the mix that is happening going forward that would imply that the profit share would be a bit higher?

Daniel Bass

I would say as a general matter, no. It is really just a function of the mix for that period. I think that our levels as a percentage of the business are pretty consistent and constant. So you will see it from quarter to quarter, percentages may be a little bit higher or a lower because each business is not fixed or a fixed percentage across each business. So that would be why you will see it one quarter potentially higher versus another.

Operator

Your next question comes from the line of Roger Freeman - Lehman Brothers.

Roger Freeman - Lehman Brothers

A couple of follow-ups from things that have been asked here. As you look at the time horizon for realizing investments on the private equity side, you have the flexibility obviously to wait out a tough market, but is there a point in time where you are forced into doing realization because the timeline on that private equity fund gets to a point where LTs are looking for the cash to be returned?

Wesley Edens

No, there is really not. The capital structures that hold those investments had got very long timelines on them. The funds by and large have had a material amount of distribution already so there has been a lot of liquidity provided back to limited partners and they along with us are very focused on long-term returns. So there is no real time sensitivity of pressure in the short run from the investing of those funds.

Roger Freeman - Lehman Brothers

Just coming back to the residential mortgage base. Your comments suggests there is some value in the high quality stuff, I think those comments were reflected at Blackstone yesterday; Goldman made some overtures around that at some meetings we have had there. It seems like a lot of folks think that things are over sold, but nobody seems to be stepping into the market.

What is it that has to happen here to make that happen? Is it consensus around how bad delinquencies are going to get there or how far home prices are going to fall?

Wesley Edens

The matrix that is the easiest one to follow is to look at what the expectation is for cumulative total losses for a given mix, say the ‘06 sub-prime stuff were there still is a wide discrepancy in terms of the absolute amount of default that people think are going to roll through the system.

We did a poll of the different investment banks, including your own, about what people’s expectations are for that vintage and it is fair to say that they actually still are quite wide. But the ranges that people are using are 10% plus or minus on the low side and 20% plus or minus from the high side.

Again, to put those in a historical context that would make them the worst performing of all time, which may will be the case, but even with that I think that once you start to get more certainly about what those levels might be, then you will see a lot more transaction volumes as people then liquidate or invest in a variety of different investments, be there securities, whole loans, et cetera.

I do think the some of the highest rate securities already reflect what is likely to be the worst of the worst case on the stuff and as I said, as Pete said, that stuff is what we are actively looking at.

I think time, whether this quarter or next quarter you will see a substantial amount, a much tighter consensus band as to what the performance is as you actually get a few months on that.

Pete Briger

We want to make clear that’s our view of mortgage-backed securities, residential mortgage-backed securities. It is independent somewhat from what we think about residential housing prices. It could get a lot worse for the US economy and for US home investors. But the financial markets that contain the residential mortgage-backed securities seem like they are pretty [inaudible] pick up.

Roger Freeman - Lehman Brothers

Just in terms of some of the things you are looking at over in Asia, on private equity and the real estate side. Is there anything coming from Nomura yet? Are they helping out much in that region, or are you just on your own?

Wesley Edens

We have a great relationship with the Nomura folks. Mr. Shibata is on our board. We actually spoke with him this morning, We think that there is a lot of help that they can give us, in particular in Japan, and I know that one of the initiatives, Pete’s business has been working closely with those guys. There is nothing really tangible to point out in terms of formal relationships right now, but we have a very good relationship with those guys, and we are happy with their investments and hopefully, they are as well.

Roger Freeman - Lehman Brothers

Your tax rate guiding to 20% I think last quarter you were talking about I think 22% to 28%. It keeps moving down. What are you doing in terms of changing structures that are letting that rate come down further? I mean, incentive fees are actually a little bit lower, so you think that that tax rate actually will be moving up a bit?

Daniel Bass

It is really a blend of our businesses and so over time if certain businesses make money and certain businesses lose money that blend would generate. So it is really the blend of our income, nothing has magically changed in our structure since the first quarter, it is really just the mix of our business results.

Operator

At this time, there are no further questions. Are there any closing remarks?

Lilly Donohue

We appreciate everyone joining us today and we look forward to updating you next quarter. Thanks, everyone.

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