When I add a portfolio holding, I'm ideally looking for a great story, a great stock, AND a great price. This 'requirement' can significantly transform your risk and reward. Make a poor decision on one attribute, and hopefully the others bail you out! Get them all right, and you can really accelerate & increase your returns...
A Great Story:
Here's my lead-in - yes, I prefer emerging to developed markets! But there are tremendous opportunities still to come in discounted asset and special situation investments in developed markets. These are best accessed through private equity (PE), event driven and distressed debt strategies. Other absolute return strategies with low/negative correlation to equity markets are attractive also. While good PE and absolute return managers can make their own "luck," I expect the best returns to come from distressed debt. I've been reading Ray Dalio - in Barron's, he recently highlighted an age of de-leveraging has only started in developed markets.
The U.S. is slightly ahead of Europe in this cycle, but there's still plenty of action in US banking/FDIC assets and an impending wall of real estate debt maturities - Europe hasn't even warmed up yet ... Speaking with Colony Financial (CLNY) recently, they have plenty to occupy them in the U.S. Yes, they're interested in European distressed assets, but note (bank) sellers are still unrealistic on price or reluctant to sell (or unable to face the write-downs!). This will change - and once the game of chicken's over, European distressed assets may well represent a generational investment opportunity.
These days, (specialized) investment funds offer these types of opportunities. But the alternative asset managers offer the real pure play exposure, and sometimes the only exposure ... There's precious little private investor access to European distressed assets right now, but alternative managers offer the chance to get in on the ground floor. They also offer access to another equally large business opportunity: Spare a thought for the poor old pension funds! They dream of 8% returns, even after earning zip on equities for the past decade. Now bonds promise them an even worse decade! Eventually they will be (painfully) forced to change their allocations and drown alternative asset managers in cash...
A Great Stock:
Fortress Investment Group (FIG): Fortress was founded in 1998 by Wes Edens, Rob Kauffman and Randy Nardone (Peter Briger and Mike Novogratz joined in 2002). A new Agreement has just been signed to lock the Principals in for another 5 years. Like all (large-cap) listed alternative managers, this is a top tier firm in terms of assets, talent and performance. They manage funds in 4 categories: i) Private Equity - control-oriented and real estate investing, ii) Credit - distressed asset and special situation investing, iii) Liquid - hedge funds, and iv) Traditional - long-only fixed income. Over 80% of their alternative Assets Under Management (AUM) is in long-term structures, ensuring stable/predictable management fees.
Their strength is in value-oriented asset-based investing, combined with deep industry knowledge and operations management, and supported by strong corporate M&A and Capital Markets experience. They have 3 main PE themes: Financial Services, Senior Living and Care, and Transportation and Infrastructure. Geographical focus is on North America and Western Europe, with Asia growing in importance. Their traditional fixed-income business (an acquisition of Logan Circle Partners) is not as exciting. However, half their strategies are top-quartile, while virtually all strategies outperformed benchmarks since inception. They also increased AUM a rather amazing 19% in Q1 2012, so this might prove to be a performance and market share success story.
Take a look at their long term (Yahoo) price chart. Looks rather sick?! What's really sick is the absurdly high valuation the market awarded the company in early 2007. The chart also demonstrates the exquisite IPO timing of the Fortress team:
In contrast, here's a (far healthier) chart of Fortress' AUM in the last decade or so:
And another interesting table I've put together:
|Yr-End AUM ($B)||43.7||44.6||31.5||29.2||32.9|
|Avg AUM ($B)||44.2||38.0||30.4||31.1||27.0|
|% of AUM||1.15%||1.24%||1.40%||1.92%||1.74%|
|% of AUM||0.45%||0.97%||0.25%||(0.20)%||2.26%|
|Fund Mgt DE||253||358||208||216||525|
|% of Mgt/Inc Fees||36%||43%||42%||40%||49%|
Note: Fund Management Distributable Earnings (DE) is equivalent to Operating Profit. I've included GAAP Revenues, but ignore them for analytical purposes (the gap between GAAP Revenues and Mgt/ Incentive Fees is basically Expense Reimbursements).
The balance sheet is strong, with $1.1 billion of investments - mostly in Private Equity and Credit funds, which have yielded Fortress' strongest returns. Commitments to PE funds is v manageable at $132 mio. They have $253 mio of debt, offset by $249 mio of cash. There is no fund consolidation on the balance sheet. They've re-started a $0.05 quarterly dividend based off net management fees, and an annual 'top-up' dividend based on FY performance is intended, equating to a minimum 6.4% dividend yield. I'm delighted to see (unlike some other firms) they don't include uncommitted capital in AUM. This represents another $6.4 bio of 'Dry Powder', or future AUM.
Ownership's relatively simple. Yes, the Principals have control, but it's a simple voting majority: They own 300 mio B shares out of a total 514 mio A and B shares (all pari-passu for voting purposes) - a 60% stake, while Nomura (NMEHF.PK) owns 12%. Obviously, the Principals are well compensated, but their stake ensures strong alignment with other shareholders. I was alarmed to see $559 mio of equity allocated to Principal's Interest in Consolidated Subsidiaries on the latest balance sheet. They own a majority of the listed company, AND half of the underlying business?! What's left for public shareholders? Actually, it's a red herring - 'Class B shares have no dividend or liquidation rights. Each Class B share, along with one Fortress Operating Group unit, can be exchanged for one Class A share...' After conversion of all B shares, there will be 514 mio A shares outstanding and NO Principal's Int. in Cons. Subs. Any valuation should be calculated on this basis also.
The other "difficulty" is taxation - pre-election, I'm sure we'll hear all about evil "vulture" funds and changes in taxation of carried interest. However, Fortress is a partnership, so shareholders primarily benefit from the treatment of partnership income. I'm happy to assume the REIT/MLP sector will lobby rabidly against any changes in that area! Changes would be blunted by the 'tax leakage' Fortress already suffers on its operations (about 15% of DE). I intend to value Fortress on a comparable basis to fully taxed companies anyway, so hopefully tax changes are irrelevant (except as a temporary price hit?).
Finally, I expect Fortress will gradually re-allocate AUM towards European distressed assets. That's such a giant opportunity, I'm confident they'll launch a dedicated multi-billion European fund in due course. Meanwhile, I'm fascinated by their focus on acquiring the mortgage servicing rights (MSRs) to $100s of billions of US mortgages. They even beat out Warren Buffett for the purchase of MSRs to $374 billion of loans from ResCap, formerly owned by Ally Financial (ALLY). Fortress have primarily implemented this strategy via Nationstar (NSM) and Newcastle (NCT), two listed entities they manage/control.
To step back: Mortgage securitization has sharply divided mortgage origination from ownership. Consequently, mortgage servicers came into being to provide certain administrative services (including foreclosures) for an annual 25-35 bps fee (on outstanding loan balances). MSRs can now be easily bought and sold - because of balance sheet volatility and constraints (plus reputational and political risk), the banks are now desperate sellers... A significant % of the ResCap MSRs offered lower sub-servicing fees, but they still appear to have sold for less than 1 times Sales. So what? But this isn't a regular business, you're paying 1 times revenues for a possibly v long & predictable fee stream, i.e. from a 30 yr mortgage. To put it another way, you're paying say 0.19% upfront to potentially receive 7.5% of the loan balance in fees! Of course, it's not that simple: i) you have significant expenses (but margins are high, with economies of scale), and ii) for every mortgage that's pre-paid, refinanced or foreclosed upon, you lose that revenue stream!
But ample foreclosures have already occurred, and who's left to still refinance?! Pricing appears pessimistic, and offers an incredible free option on rates/inflation. If/when rates rise, virtually all prepayment & refinancing activity will grind to a halt, and the duration of MSR revenue streams will extend out dramatically. This MSR trade may present an exceptional opportunity... Obviously, this demands more research - MSRs are a pretty obscure financial niche! Ocwen Financial (OCN) and PHH Corp (PHH) are also worth investigating.
First, let's revisit Fund Management Distributable Earnings (Fund Mgt DE) - I'm dubious of any non-GAAP figures, does Fund Mgt DE make sense, or is it just the bad stuff excluded?! Let's try a reconciliation:
|GAAP Net Income||(1,117)||(782)|
|Principal's Interest in Consolidated Subs.||686||497|
|Net Effect of Principals Agreement Comp.||360||445|
|Equity Based Comp.||235||218|
|Inv Gains/Losses and Net Interest||11||(14)|
|Contingent Incentive Income and Misc.||42||(61)|
|Fund Mgt DE||253||358|
Principal's Interest in Consolidated Subs: Strips out the Principal's Interest from Net Income. Rem: Once all B shares convert to A shares, this P&L (and balance sheet) item will disappear.
Taxes/Inv Gains and Losses/Net Interest: Addback, to reach Operating Profit.
Net Effect of Principals Agreement Comp: Accounting entry with NO economic impact for Fortress/shareholders (and absent from 2012 onwards). I guess you'll have to trust me on this, unless you want to dig through lots of 10-Ks and the S-1!
Equity Based Comp: A non-cash expense.
Contingent Incentive Income and Misc: Fortress doesn't record contingent (i.e. subject to clawback) incentive income for GAAP, but includes it as a DE addback.
Surveying the adjustments, and digging into the 10K, I'm comfortable Fund Mgt DE is a sensible metric and equivalent to underlying Operating Profit. Of course, Equity Based Comp. is an 'expense' for shareholders, ultimately - but from my perspective, I usually exclude it as it's non-cash, somewhat contingent & vests in the future. Also, I prefer to focus on current and historical data in my valuation analysis - since I don't include future positives, it's only fair not to include future negatives either. This Comp. promises share dilution, but I'd expect to see it absorbed in current/future growth. Anyway, I refresh my valuation regularly (with an updated share count). OK, let's calculate current Net Cash/Investments, and incorporate it within 3 different valuation approaches I want to investigate:
$1,091 mio Investments + $249 mio Cash - $253 mio Debt = $1,087 mio Net Cash/Investments = $2.11 Net Cash/Inv per share
Wow, Fortress is trading on a 1.5 Price/Cash multiple. And the asset management business is only valued at $528 million, or 1.1% of AUM!
% of AUM: Fortress' management/incentive fee history deserves a true 7.5% of AUM alternative valuation. However, I'll mark down for the 35% in fixed income AUM (which merits a 1% of AUM valuation, at best). A blended rate is around 5.25% of AUM - a touch unfair, as Fortress earns a hefty 1.2% in management fees despite Logan's lower fees. End-March AUM is $46.4 billion, which prompts a fair value of:
$46.4 bio * 5.25% of AUM + $1,087 mio Net Cash/Inv = $3,525 mio
Current Price/Sales: Management and incentive fees are currently at 1.15% and 0.45% of AUM, respectively. Since incentive fees are relatively subdued right now, I'm not penalizing them in my valuation. Fund Mgt DE is at 36% of management/incentive fees (a lower/better measure of total revenues than GAAP revenues). This deserves at least a 3.25 Price/Sales multiple, corresponding to:
$46.4 bio * 1.60% Total Fees * 3.25 P/S + $1,087 mio Net Cash/Inv = $3,504 mio
Historical Price/Sales: Management fees averaged 1.20% in past 2 years, reflecting the impact of Logan Circle. Incentive fees are volatile, so a long term average makes better sense in arriving at an intrinsic valuation. The past 5 years span good and bad years - the average incentive fee was 0.74% of AUM. To be conservative, I won't average up the DE margin, so I'll stick to an unchanged Price/Sales multiple:
$46.4 bio * 1.94% Total Fees * 3.25 P/S + $1,087 mio Net Cash/Inv = $4,015 mio
Let me just return to the 6.4% dividend. Yes, tax treatment is more complicated, but why look a gift horse in the mouth? The dividend's funded from earnings so shouldn't dilute FIG's intrinsic valuation over time - it's a free lunch! And worth a little extra hassle or paperwork ... If you're in the US, a tax exempt account is perfect for FIG! Outside the US, you can likely avoid the paperwork, but will suffer some tax withholding. If you're willing to complete a W8-BEN you can probably eliminate some/all of the withholding (DYOR, of course!).
OK, reviewing all of the above, I'm not opting for an average valuation. My last valuation of $4.0 billion looks perfectly achievable - it's only an ex-cash 6.3% of AUM, which has been far exceeded in the past. Or even the present - look at current valuations for KKR (KKR), Och-Ziff (OZM) or Oaktree (OAK)?! This valuation equates to a $7.80 Fair Value per share, for an Upside Potential of 148% compared to the current $3.14 share price.
I now hold a 2.8% portfolio stake in FIG. My allocation would probably have been higher, only for: a) I intend to raise further cash (I sold a larger undisclosed holding to fund this purchase) in the next few months, but stand ready to buy at bargain prices, and b) I already have a (fairly) similar investment exposure in my existing Colony Financial holding.