Fortress Investment Group's First 10-K

Fortress Investment Group (FIG) filed its first Annual Report this morning. As the first major hedge fund/private equity shop to go public the 10-K will be heavily scrutinized and for many it will be the first real peak inside an otherwise incredibly secretive part of our economy.

Needless to say, FIG has been enormously successful. They have grown their Assets Under Management (AUM) from $1.2 billion on December 31st, 2001 to $35.1 billion on December 31st, 2006. That is a 96.4% compound annual growth rate (CAGR). To handle the growth the firm employed 580 at the end of 2006, up from 400 the year before. With $1.52 billion of revenue that amounts to roughly $2.62 million of revenue per employee. For a comparison consider that Google produces $950K of revenue per employee and Wal-Mart manages just $183K. FIG's revenue mix consists of management fees and incentive income on its private equity funds, hedge funds and its publicly traded alternative investment vehicles which FIG calls "Castles." FIG also generates revenue from interest and dividends from its funds. Below is the PE/Hedge/Castle mix pulled straight off of the report:
The risks inherent in this revenue mix should be obvious. First of all the incentive fees make up a full 60% of the 2006 numbers shown above. This revenue is not guaranteed and is linked entirely to FIG's skill in outperforming its benchmarks. In some sense that portion of FIG's revenue is not entirely unlike investing directly in a FIG fund. In fairness however, the numbers above are only a small part of the story. A full 73% of FIG's revenues are derived from "interest and dividend income" as seen below:

The I&D income increased for a variety of reasons, but it too is linked the underlying performance of FIG's funds. Again the risk here is linked to FIG's underlying investment performance.

What are some other risks mentioned in the report?

1. Key Man Risk: In other words it is the importance of FIG's human capital. If one of the key partners or MD's were to leave, provisions in the funds allow investors to withdraw capital. This is not even to mention the potential damage to returns.
2. Competition: FIG hasn't been the only PE/Hedge firm to rapidly grow their AUM. There are only so many companies/strategies to invest in and it will be harder and harder to generate excess returns in such a competitive market.
3. Litigation and Reputation Risk: When a firm consistently takes on new types of risk and is engaged in sophisticated investing techniques it is only a matter of time before one of their funds loses money. If litigation follows, perhaps combined with a general pock mark on FIG's sterling reputation assets may quickly leave the fold. Remember, most pension funds are at least somewhat sensitive to the reputation of their managers with whom they invest.
4. Difficulty in Valuing Nonliquid Assets: FIG estimates that "as of December 31, 2006, $2.8 billion of investments in our private equity funds, $31.7 million of investments in our hybrid hedge funds and $256.4 million of investments in our liquid hedge funds are valued by internal models with significant unobservable market parameters." For those counting at home that is 10% of FIG's total AUM. If there is a change in the value of these assets this could materially change the performance of the company. In other words, because it has to "mark to market" its illiquid assets the firms numbers will always be estimates which may be revised.

Much of this information wasn't entirely new to the market, but certainly the most recent numbers were. The market seemed to have no problem digesting the 10-K as FIG was up 6% since market close on the 13th of April. This too after rising over 15% in the month leading up to the 13th. This puts the stock up roughly 70% or so from its IPO on February 8th. It is trading at a P/E in the low 40's. As many have predicted, the appetite of investors for exposure to this area of the market is substantial, no wonder Blackstone and Carlyle are both mulling over their options. It certainly seems that this party is not quite over yet.