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Fortress Investment Group LLC (NYSE:FIG)

Q3 2012 Earnings Call

November 02, 2012 10:00 am ET

Executives

Gordon Runté

Randal Alan Nardone - Co-Founder, Interim Chief Executive Officer, Principal and Director

Daniel N. Bass - Chief Financial Officer

Peter Lionel Briger - Co-Chairman of the Board, President, Principal and Member of Management/Organization Development Committee

Wesley Robert Edens - Principal, Co-Chairman of the Board, and Member of Management Committee

Analysts

Roger A. Freeman - Barclays Capital, Research Division

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

Marc S. Irizarry - Goldman Sachs Group Inc., Research Division

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Operator

Good morning. My name is Holly, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Fortress Third Quarter Earnings Call. [Operator Instructions] I would now like to turn today's conference over to Gordon Runté. Please go ahead.

Gordon Runté

Thank you, Holly. Good morning everyone, and welcome to the Fortress Investment Group's Third Quarter 2012 Earnings Conference Call. First, thank you for rearranging your calendars to be with us today. We thought it would be prudent to reschedule our call given all the storm-related issues that I know are far too familiar to many of you. So thank you for your patience, and more importantly, we hope that you and your state are well clear of harm's way.

We will begin our call today with opening remarks from Fortress interim Chief Executive Officer, Randy Nardone; and Chief Financial Officer, Dan Bass. After these remarks, we'll save most of our time this morning for your questions.

Joining us for that portion of our call, we have with us co-Chairman and Head of Private Equity, Wes Edens; co-Chairmen and Head of Credit, Pete Briger; Principal and Head of Liquid Markets, Mike Novogratz; Principal and Director, Rob Kauffman; co-CEO of Credit, Dean Dakolias, along with other members of our management team.

Now before we begin, let me remind you that statements made today that are not historical facts may be forward-looking statements. These statements are by their nature uncertain and may differ materially from actual results. We encourage you to read the forward-looking statement disclaimer in today's earnings release in addition to the risk factors described in our quarterly and annual filings.

With that, let me hand off to Randy.

Randal Alan Nardone

Thanks, Gordon, and thanks, everyone, for joining us today. Fortress had a solid third quarter with pretax distributable earnings of $64 million. That's a 28% increase over Q2. Third quarter and year-to-date investment returns and capital raising have been strong across all of our businesses. These are the clearest leading indicators of performance, and we believe they point to earnings and valuation upside.

Here's the highlights. Our AUM eclipsed $50 billion, up 8% in the third quarter and 18% for the year. We raised over $5 billion in new commitments through the third quarter, and each of our businesses is currently in the market raising capital.

We delivered strong investment performance in the quarter and year-to-date in all of our businesses. Through September, we had double-digit returns for our main credit and Macro Funds and over 20% valuation gains across our PE Funds. Logan Circle continued to outperform benchmarks in virtually all strategies.

Strong investment performance contributed to an increase in the value of our balance sheet, which I'll address further in a minute. And we paid off all remaining corporate debt in October. From a peak of over $800 million in 2009, we are now debt-free and will have greater capital management flexibility going forward.

Based on our performance to date, our financial strength and our confidence in our prospects going forward, our board approved a dividend of $0.05 a share for the third quarter.

Looking more closely at our financial results. Our distributable earnings continued to benefit from a stable, predictable stream of management fees. This reflects the high proportion of AUM in long-term and permanent structures. From the third quarter, we had management fees of $116 million. We expect to see continued growth in AUM, which will result in higher management fees in the near to medium term.

We finished the quarter with over $7 billion in dry powder that's not yet generating management fees. Obviously, the extent and pace at which we invest this will be determined by the opportunities we see in the market. But rough math is about $15 million in incremental management fees on each $1 billion invested. And as I mentioned, we're still raising capital in every one of our businesses.

Incentive income for the quarter was $65 million, up nearly 40% from Q2. As with management fees, we have visibility of higher incentive income in future periods. Our gross undistributed incentive income is over $540 million in PE style funds. That's up over 20% from Q2. Most of this resides in our credit funds, where 100% of NAV is above incentive thresholds. This should generate incentive income when realizations pick up, without any assumptions about incremental investment gains.

We've also had standout performance on our Macro Funds this year. Nearly all Macro NAV and all Asia Macro NAV is above high watermarks. In Private Equity, we've continued to see substantial gains in investment valuations. That moves us closer to preferred thresholds in our most recent funds. We need continued outperformance to hit those marks, and we have years left before these funds mature.

Strong investment performance typically leads to success in attracting new capital. I'd like to highlight a few key points on our fundraising in 2012. We broadened and deepened our LP relationships. Over 220 investors have committed capital to our funds in 2012. About 1/3 are new to Fortress, accounting for over $1.2 billion in commitments. We also continued to benefit from a geographically diverse investor base. Approximately 1/4 of the capital raised this year has come from investors in Europe, Asia, Australia and the Middle East. Every one of our businesses has had a strong year raising capital.

Next-generation credit PE style funds have raised $3.2 billion. Our Liquid and Credit Hedge Funds have raised approximately $700 million. New strategies have added about $900 million in commitments in 2012. These strategies include real estate opportunities, Convex Asia, transportation and infrastructure and our dedicated mortgage-servicing rights fund. We've also raised approximately $435 million for the year in additional permanent equity capital at Newcastle, largely to focus on the MSR opportunity.

Last point on capital raising. For 4 straight quarters now, we've had strong net inflows at Logan Circle. AUM has pushed north of $20 billion, from about $12 billion when we acquired Logan in 2010. Logan's pipeline remains strong and the business is on the cusp of profitability. With strong performance and a scalable platform, we have high expectations for business growth going forward.

The value we create in our businesses contributes to the growth and the value of our balance sheet. Here, we've had a very positive trajectory for some time. Our net cash and investments have increased by nearly 60% in the last 2 years.

At the end of the third quarter, net cash and investments totaled almost $1.3 billion or $2.37 a share, net of the RailAmerica sale in October, that's $2.68 a share. Either way, it's more than half of our share price today. Net of our balance sheet value, our stock is trading today at less than 3.5x consensus earnings estimates for 2013.

Looking at all of our businesses, we have strong momentum across-the-board, strong investment performance and a great year of capital raising. We're running on all cylinders. And with 0 debt and substantial balance sheet value, we've never operated from a position of greater financial strength as a company. So good quarter, good year so far, and we're solidly optimistic going forward.

With that, let me hand it off to Dan.

Daniel N. Bass

Thanks, Randy. Good morning, everyone. I will open with the key financials and then discuss drivers that we believe have the greatest potential to unlock future earnings.

Pretax DE was $64 million or $0.12 per share in the third quarter, up 28% quarter-over-quarter. This brings year-to-date pretax DE to $171 million or $0.32 per share. Fund management DE was $63 million, up from $53 million in the second quarter. AUM continued its upward trajectory, ending the quarter at $51.5 billion. Driving this result was alternative asset growth of 4% and traditional asset growth of 14%.

With another quarter still remaining, to-date we have now raised $5.2 billion of capital, already exceeding our capital raised last year. This brings our 3-year total of capital raised to nearly $15 billion.

And finally, fund investment performance remains a core strength. Let me give you a few examples. In our traditional PE Funds, the value of our fund investments appreciated by 9.4% or over $1.3 billion during the quarter. This is appreciation of nearly $3 billion or 21% in the first 9 months of this year. Our public company investments again drove this result, up nearly 24% in the third quarter.

In our Liquid Hedge Funds, our Fortress Macro Fund generated returns of 2.9% net in the quarter, bringing year-to-date returns to over 11% for the year. These returns brought about 96% of the Macro business capital above their respective high watermarks. And our Fortress Asia Macro Fund is also up nearly 11% net for the year, and 100% of its capital exceeds its respective high watermarks. So in aggregate, this brings $2.4 billion of capital above high watermarks in this business and eligible to generate incentive income.

Positive fund performance has continued in October in Liquids with our Macro Fund up an estimated 1.9% net and our Asia Macro Fund up an estimated 1.4% net through last Friday.

Moving on. In our Credit Hedge Funds, our DBSO Fund continued their great run of performance. They have generated 13% net returns year-to-date through September with a 5% net return in the third quarter. These returns have allowed us to record over $90 million of incentive income in this segment this year.

And in our Credit PE Funds, exceptional returns continued in this quarter. Of the $651 million of unrealized undistributed incentive income, $430 million resides in our Credit PE Funds. This grew $84 million or 24% during the quarter and $186 million for the year.

As we close out 2012 and begin 2013, let me share with you 5 key earnings drivers that we are focused on. First, capital deployment. We called over $750 million of capital in the third quarter, nearly double our deployment rate during the first 2 quarters. Notably, we still have over $7 billion of dry powder available for investment. So you can see, there could be substantial management fee potential as we continue to invest additional capital. And as I've stated previously, our dry powder is largely long-term locked up capital structures, so the benefits from calling this capital will accrue over many years.

Second, liquid incentive income. As I said earlier, we have over $2 billion of liquid capital now eligible for generating incentive income. This $2 billion combined with positive returns in our October leaves us well positioned for incentive income both in the fourth quarter this year and future years.

Third, additional capital raising. We remain in the market with funds in all of our businesses, and investment performance has started to translate into capital raising momentum as well, which adds to our earnings potential. As an example, in our Liquid Funds, we raised almost $200 million in October and another $250 million in November. This capital has already started paying management fees and is eligible for incentive income.

Fourth, as I just mentioned, our distributed incentive income continues to grow. Importantly, as Randy stated, over $540 million of this value resides in PE style structures and has not been included in our DE to date. This will convert to DE upon realization of the underlying investment in these funds, representing significant earnings upside as realization activity increases.

Fifth and final, our debt retirement. Paying down all of our debt essentially eliminates all of our covenants and will add about $0.03 per share of earnings on an annual run rate basis.

A quick point on taxes before I close. For full year 2012, we expect our DE effective tax rate to be between 5% and 9%.

So in closing, let me summarize. Going into this year, we had an ambitious set of financial objectives for the firm, and we have tracked very well against each one of these objectives to date. We have raised over $5 billion of new third-party capital, including $1 billion in our Private Equity business, plus $6 billion of net inflows in our Logan Circle traditional business. AUM has continued to grow and has now crossed the $50 billion threshold. Our Macro Funds have performed very well, reaching and crossing their respective high watermarks in the third quarter. And our balance sheet value continues to grow as well. After cash received from the closing of the RailAmerica transaction and the subsequent debt paydown, the pro forma value of the cash and investments is approximately $2.68 a share. This value reflects year-to-date growth of 23% and represents nearly 60% of our current share value.

With that, we will now take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Roger Freeman, Barclays.

Roger A. Freeman - Barclays Capital, Research Division

Maybe, Dan, just picking up on that last comment you made, reiterating the cash investments. As you look at your sort of forward commitments alongside your fundraising and other uses of capital, is that sized appropriately at this point for that or do you have excess in there?

Daniel N. Bass

Yes, I mean, it's sized appropriately. We also have a $60 million revolver out there today. So $150 million of unfunded commitments, which we'll fund over many years, we certainly feel that it's -- and the revolver is completely undrawn, so we feel that we're rightsized at that level.

Roger A. Freeman - Barclays Capital, Research Division

Okay. And then just actually one more on sort of capital structure. Paying off the debt, you mentioned, freed you up of covenants. Can you just remind me what restrictions relative to anything that you might have [indiscernible]

Daniel N. Bass

There were no meaningful restrictions. It just provides greater flexibility for us.

Roger A. Freeman - Barclays Capital, Research Division

Okay. And I guess, Pete, if you're there, can you talk a little bit to the investing opportunities you're seeing in credit right now? Last quarter, you talked about credit being mispriced over in Europe, and we were just hearing on the Oxhead call, they're actually seeing opportunities there now, might be in some different areas than you're investing in, but just where do you kind of stand on that?

Peter Lionel Briger

Well, I don't think much has changed from our perspective. Government interference in the European credit markets especially, but to some extent in the U.S. continues. And I would say there are early signs of opportunities beginning to open up, particularly in the corporate debt sector in Europe, but I would still characterize the opportunity there as early. So we're beginning to see a bunch of issues occur on the corporate landscape, which have caused prices in certain situations to become more interesting, but I would still characterize them as not interesting enough. Again, when I'm speaking in that context, it's really for the alternative business. There are lots of credit businesses that we think are reasonably fairly priced for a long-only credit business. But in order to deliver 15%-plus returns for our locked-up funds on a net basis, that's the context in which I'm making that characterization.

Roger A. Freeman - Barclays Capital, Research Division

Okay, all right. And then, I guess, just on the Liquid Hedge Funds. I think performance was higher -- stronger than last quarter but the performance fees were lower. Is that just a function of returns being generated and assets that aren't above high watermarks?

Daniel N. Bass

No. The fees versus -- the fees are up in the quarter. And we've met -- we hit our high watermarks during the quarter so there was -- some of the performance didn't generate until we exceeded it.

Roger A. Freeman - Barclays Capital, Research Division

Okay, got it. All right. And just lastly, Wes, as you look out fundraising into next year, what are the -- can you just refresh us on what your sort of key areas of focus are? What funds you might be looking to -- or broad areas you might be looking to launch funds in?

Wesley Robert Edens

Well, we've raised capital in the quarter both for Newcastle, and we're actually in the market now raising more capital in the transportation fund, and we are raising MSR funds, so there's a bunch of different things that are going on. I think thematically, all those things I expect to continue through next year. There's a lot of opportunity in the transportation space. There's a lot of opportunity in the residential space here in the U.S, and so we think there's going to be a fair bit to do. I mean since we started raising capital again, middle of last year, we've raised about $1.4 billion, I think. And without a kind of a specific target for next year, I think that my expectations will raise at least that and quite possibly substantially more. But it's really a function of different opportunities and where we think we can deploy the capital, and so it's a good time for us.

Operator

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

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

First question I had was just on the undistributed incentive income. But that's, I guess, a gross number before comps so -- and I know you don't necessarily throw out your specific comp ratio, but how should we think of that at all in terms of kind of a net number? And should we think of it kind of roughly...

Daniel N. Bass

It's generally between 50% and 65% to the firm, that's -- so comp would be 1% minus debt.

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, great. Okay, that's helpful. And maybe going back to the credit businesses, Pete, I think I asked this last quarter, but I guess maybe I'll ask it again. Just given the nature of the underlying investments, and maybe I didn't ask it clearly. Just trying to get the sense of -- there's obviously coupons attached to a lot of what you're buying, maybe not all of it but a lot of it. There's some kind of natural flow of whether it's paydowns, runoffs, coupon interest. So is there any roughly gauging how the proportion of incentive or return that's kind of just generated from, for lack of a better way, just kind of clipping coupons, so to speak?

Peter Lionel Briger

I remember your question from last quarter, and I think you asked it perfectly, so I think I understood it. I think from our perspective, since we're running opportunistic funds, there is not a good way to estimate when and how we're going to create, promote. And I wouldn't want to mislead you. I think one of the most dangerous things that we can do in our alternatives business is try to forecast how we're going to create, promote, because that's not aligned with the interest of our LPs. And so we're focused on creating liquidity avenues when it's most appropriate, and we're focused on that everyday.

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

Okay, I appreciate that. Maybe a last question. Just curious, Randal, I guess you still have the title of interim CEO, so any movement towards to getting a more permanent search or just kind of where that may be in process?

Randal Alan Nardone

Maybe the structure we have in place right now is working well. I don't see any need to introduce a distraction. That said, I don't have any intent to take the interim off my business card.

Operator

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

Marc S. Irizarry - Goldman Sachs Group Inc., Research Division

Wes, can you just give us an update on the Private Equity portfolio performance, I guess, of underlying companies? I know it's difficult to talk about what the harvesting environment could look like for you, but can you give some perspective on the performance of the portfolio of companies, exits, exit opportunities? And also maybe fundraising, if you can just give us some view on sort of how fundraising is going and maybe how sort of the real estate team is helping you raise up some capital?

Wesley Robert Edens

Sure. The big numbers in the Private Equity business, the total amount of capital originally invested is just over $20 billion. Current kind of paid-in capital net of returns is just under $10 billion,, so you use $10 billion as the denominator. So we, as Dan said, we are up almost 10% for the quarter and over 20% for the year, close to $3 billion actually. So it's -- the big number is the $9.9 billion, $9-9 billion of paid-in capital. Current carrying value is $50.34 billion, so we're kind of $5 billion over kind of paid-in capital, so it's been a very good last year or 2 actually. The big drivers for us has been financial services here in the U.S., where the impact of Dodd-Frank and kind of the banks becoming more utility like and forcing them out of businesses on the margin have created lots of opportunities so our -- it's a big servicing company, a Nationstar public company, has had a great run of it. I still think it is early in that whole opportunity. As well as it's done, I think that we won't look back at the 2nd of November 2012 and say that was the peak of the market. I think far from it, there's just a lot of stuff there to go. Yes, the mortgage market, I think you've got, in the U.S. have got a tremendous amount of dislocation still in them. And I think one of the things that will happen postelection is that they'll get focused on Fannie Mae and Freddie Mac and the GSCs, et cetera, et cetera, and I think there's likely to be substantial opportunities as we go from that. So financial services, both the consumer business, the residential business here have been great. Our transportation, we had a big liquidation in the quarter. We sold RailAmerica at the lower -- we paid for it kind of precrisis. That company did terrifically in last couple of years. They've more than doubled the EBITDA that sort of -- management did a great job, it's a great sector. We made money there. We think we've got really a great stable of companies in the transportation sector and we are raising capital for what we believe is going to be a very, very significant amount of investment activity to come. One of the aspects of the financial crisis in Europe that I think is worthy of note is that, the banks in Europe -- the banking system there is considerably large than the U.S. system, even given the same size, the economy, the same population. They were the dominant provider of finance in the transportation sectors worldwide and that is something that has reversed itself very dramatically and it's created lots and lots of asset-buying opportunities that are Asian [ph] product in nature around the world. I mean, transportation as an asset class is $2.4 trillion. It's a gigantic market and we bought well over $15 billion in assets in the last number of years. So we're a big player in it. We think that that's a big, big component of it. So I think that the hardest portfolio investment have been the stuff in Europe, which is no surprise given what's happened in Europe over the last couple of years. But even on that front, we've had a good quarter and we've got some, we think, some really good things going on. So when you're up $3 billion for the year, it's hard not to sound positive and we feel positive about it, but I think it's still pretty early on. And really, just like Pete said, you can't really predict precisely when you're going to have liquidations and generally promote, but I'm feeling quite positive that we're going to have substantial of both at some point in the not-too-distant future. And capital raising has really followed the line. I think on the capital raising side, what your -- what we see in Private Equity is much more bespoke strategies, a lot of what we did in the mortgage-servicing rights, so people are very keen to make investments of things that they can see or there's tangible kind of factors that are influencing the outcomes, and in that respect, I think that the capital raising environment is actually a good one. But it's a different form than it was certainly 4, 5 years ago.

Operator

[Operator Instructions] And your next question comes from the line of Chris Kotowski, Oppenheimer.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

A couple of things. One is, I'm wondering between the sale of RailAmerica and other presumed sales coming out of Funds III, IV and V, should we expect to see the base management fees in the Private Equity sector kind of decline steadily in the next 2 or 3 years? Or does it come in certain lock steps as funds leave the investment period? Or is it going to be a function of the assets -- the actual assets under management as opposed to committed? Can you remind us how all that works?

Wesley Robert Edens

Yes, generally, the way the fund works is that after the commitment period, their fees are calculated on invested capital as opposed to committed capital. So the natural pace of the management fees, they would decline as those funds returned capital and goes down. That, of course, assumes no additional fundraising, which is obviously not the plan. So the direct answer is I don't think management fees are going to go down because we think that we're going to continue to raise capital, invest capital and make money, that's our business. But specifically, the funds, they work as you described. So they do decline as you return capital in these older funds.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Okay. And I mean, will we expect, just to calculate the impact of RailAmerica, we'll just take $1.4 billion, multiply it by 111 basis points or something like that, and that will be the impact and that will be that?

Wesley Robert Edens

Our investment capital in that case is like $600-and-change million. That'd be the right number to multiply the volume, not the liquidation amount but rather the...

Daniel N. Bass

Correct.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Okay. And is it all funds, as I understand, III, IV and V, they're all still in the investment period, right? They're like between '15 and -- 2015 and 2017?

Wesley Robert Edens

No, they're not in the investment period. They're in the investment holding and eventual liquidation period.

Daniel N. Bass

Those are at the ends of the lives of those funds.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Okay, so -- right, so but the base management fees will then be a fund of -- a function of the size? There's no step-down in the accrual rate as we...

Daniel N. Bass

No, no, no. there's no step down in rate. The rate is the same throughout.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

All right. And then secondly, I guess I was thinking Pete sounded very cautious on the second quarter call, but I noticed he called $720 million this quarter, and it seems -- where are you finding opportunities to put that money to work? You sounded so incredibly cautious last quarter. I was somewhat a bit surprised by that this quarter that you'd call that much.

Peter Lionel Briger

Well, first of all, we have $11 billion NAV and so if you call $700 million, you can look at that as a percentage of what we have outstanding and what we have to invest. But the other thing I would say is we make investments, we commit to investments at a point in time and we fund investments at a different point in time, depending upon the contractual obligations in a specific transaction. So, for example, we recently made a funding on an investment that we committed to, in some sense, as much as a year ago. So we're having to make investments that are committed at an earlier point, could be 1 day, could be 3 days, could be 1 month and could be, in some cases, as much as 1 year, depending upon the contractual agreements that we have with the counterparty. So I don't think that, that -- I don't think that, that $700 million that you're referring to is evidence of us having a different view than what I mentioned on last quarter's conference call.

Christoph M. Kotowski - Oppenheimer & Co. Inc., Research Division

Okay. And then last for me, just with the improvement in the balance sheet. Most of the other alternative asset managers have a policy of distributing effectively all their fund management DE. And I'm wondering will you be transitioning to that kind of policy? Or do you think there's still benefit in kind of building out the cash balances and building the balance sheet further?

Randal Alan Nardone

This is Randy. I think as we said on the last call, that decision will be made by us with the board at the end of the year. The fourth quarter, of course, isn't over yet. Certainly, we'll take into account our liquidity and what our projections are, the share price and whether buybacks make sense as well as opportunities to invest in our business in addition to paying a dividend on top of dividend.

Operator

Your next question comes from the line of Jackie Earle, Compass Point.

[Technical Difficulty]

At this time, there are no further questions. I'd like to turn the conference back over to Gordon Runté for closing remarks.

Gordon Runté

Great. Thanks, everybody. To sum up, I'd say, we're pleased with our results throughout the quarter and a strong year-to-date across the house: solid capital raising momentum, new investors and new capital coming into each of our businesses. Investment performance has been very strong in all our main strategies, which bodes well for earnings in future periods. So again, pleased with the quarter and optimistic about our prospects going forward. Thanks.

Operator

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

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