The Fall of Fortress
The asset manager is selling itself at a premium, but it’s still trading at a fraction of its IPO price. The big losers? Us.
Last December business executives from around the globe made their way to Manhattan’s Trump Tower to meet with president-elect Donald Trump. But few made as big of a splash as Masayoshi Son, head of SoftBank Group Corp., who had Trump crowing on Twitter about the Japanese mogul’s pledge to invest $50 billion in the U.S. and create 50,000 American jobs.
“He’s one of the great men of industry, so I just want to thank you very much,” Trump said of Son, who took over as SoftBank’s CEO last year following poor performance by his predecessor. One might have predicted that Son’s first U.S. investments during the Trump era would be in the kinds of high-flying tech companies, like Alibaba Group Holding, that SoftBank has become famous for staking. Instead, on February 14, SoftBank agreed to pay $3.3 billion to buy Fortress Investment Group, the struggling alternative-investment firm that went public to great fanfare ten years ago but whose shares have since lost 74 percent of their market value.
Despite the slide in the firm’s stock, Fortress’s principals have made out well, pulling billions out of the company — thanks in part to the latest deal with SoftBank.
“The founders got a big payday when they took it public, and now they’re getting a second good payday,” says Myron Kaplan, a founding partner of law firm Kleinberg, Kaplan, Wolff & Cohen, who counsels hedge fund firms like Elliott Management Corp. on organizational structure and succession planning. Kaplan says Fortress has been “terrible” for public investors.
Fortress was the first U.S. alternatives firm to go public, in 2007, starting a trend that burned red-hot, then quickly flamed out, proving over the past ten years that these deals have been a disaster for public shareholders, which include big mutual funds catering to both retail and institutional investors. Among Fortress’s shareholders: Allianz Asset Management, Fidelity Investments, Wellington Management Co., and even the State Teachers Retirement System of Ohio.
And there is another ominous takeaway. Unlike most of its hedge fund and private equity peers, Fortress makes its numbers public, and they shine a harsh light on the alternative-investment business over the past decade. Fortress’s assets have more than doubled since 2005, but the firm’s net income was lower in 2016 than it was in 2005.
“Fortress hasn’t performed great,” says Ann Dai, an analyst at Keefe, Bruyette & Woods who says the “complexity” of the firm’s business model also has made investors wary. Complicated tax issues, a plethora of esoteric investment strategies, and a dual share-class structure that gives the principals disproportionate voting power aren’t for the faint-hearted. Although almost half of its $69.6 billion in assets under management are in the staid, low-fee world of fixed income, Fortress’s private equity funds invest in senior-living centers and railroads, and its hedge funds buy distressed real estate credit. Meanwhile, its best-known macro hedge funds have flopped, its vaunted private equity funds haven’t surpassed their hurdle rates in years, and even its highly regarded credit funds seem to have hit a wall.
Fortress co-founder and co-chairman Wes Edens may have inadvertently summed up his firm’s value last fall, on a third-quarter conference call, when he talked about the environment for Fortress’s private equity business: “I think it’s a time to be cautious. There are lots of things for sale, and there are few things that are really worth buying.”
That isn’t stopping SoftBank. Though primarily an Internet and telecommunications company, it recently said it planned to parlay its hefty cash hoard into a $100 billion investment fund. Fortress’s $3.3 billion deal with SoftBank was driven by Rajeev Misra, a former Deutsche Bank derivatives expert who is now in charge of investment strategy for the Japanese firm. A few years ago Misra worked briefly at Fortress, where he developed a relationship with Edens and Peter Briger Jr., who cochair the board of directors. (Briger also has ties to Japan, where he previously worked for Goldman Sachs Group.)
SoftBank’s purchase of Fortress may be part of a grand strategic vision that has yet to be articulated. But Fortress had long been looking to sell, analysts say. Indeed, just months after going public, the firm reportedly hoped to secure a tie-up with Bear Stearns Cos., before the latter imploded into the arms of JPMorgan Chase & Co. The sale to SoftBank wasn’t easy to pull off, either.
“The consummation of the deal was in serious doubt as late as February 12, 2017,” according to a complaint by the Securities and Exchange Commission regarding suspected insider trading in Fortress shares at two brokerages in Singapore and London (Maybank Kim Eng Securities and R.J. O’Brien) ahead of the announcement.
Both Fortress execs and Son are appropriately ecstatic about the deal. “SoftBank is an extraordinary company that has thrived under the visionary leadership of Masayoshi Son,” Briger and Edens said in a public statement. “We anticipate substantial benefits for our investors and business as a whole, and we have never been more optimistic about our prospects going forward.”
Son said in the same statement, “Fortress’s excellent track record speaks for itself, and we look forward to benefiting from its leadership, broad-based expertise and world-class investment platform.” Neither Fortress nor SoftBank responded to requests for comment beyond those public statements.
SoftBank is paying a huge premium for Fortress, having agreed on $8.08 per share when the stock was trading at $5.83, with a book value of $4 per share. That has led some analysts to applaud the deal. “Fortress wasn’t getting credit in the public markets,” says JMP Securities analyst Devin Ryan. “This transaction gives them a bigger partner to grow their business at a faster rate.”
A source close to Fortress says, “The sale seems to reflect the principals’ belief in the business model and investment platform, but probably a profound skepticism that an alternative manager will ever be ascribed a premium valuation in the public markets.”
It has left some hedge fund veterans scratching their heads. “Culturally, it is such a disconnect,” says Bruce Ruehl, a former executive at hedge fund consulting firm Aksia. Fortress has virtually no footprint in the high-tech world, and the Japanese record in asset management isn’t strong. Yet the pressure on alternative-investment firms to sell will continue, Ruehl reckons, given that they are under siege. “There’s tons of fee pressure on any products sold into the institutional space,” he explains. “I’ve seen a lot of cycles, but this one is different. You better be doing it well and have some kind of hook that really differentiates you.”
Fortress is arguably not in the top tier of alternative-investment firms, but even the star managers have hit hard times. Last year investors yanked more than $70 billion from hedge funds, according to Hedge Fund Research, as the industry underperformed the broader markets for the seventh year running. A few big names, like Perry Capital, shut their doors, and regulatory woes hit firms as diverse as Omega Advisors, which faces insider trading charges, and Och-Ziff Capital Management Group, whose African subsidiary pleaded guilty to bribing foreign government officials. Even industry legends like Paul Tudor Jones are slicing their firms’ fees, and the pressure shows no signs of abating.
More firms will shrink, disappear, or — if they’re lucky, like Fortress — be gobbled up. The Japanese aren’t the only foreigners who are circling. A subsidiary of China’s HNA Capital, an aviation and shipping conglomerate, was part of a consortium that agreed to buy out Anthony Scaramucci’s stake in $12 billion fund of funds SkyBridge Capital so he could work for the White House. It was an opportune time for Scaramucci to sell, as SkyBridge had lost money for the past two years.
Fortress’s woes exploded into public view in 2015, when Michael Novogratz, one of the firm’s principals and an industry luminary who had joined from Goldman Sachs, retired after shutting down his Drawbridge Macro fund following wrongheaded bets on everything from Brazil to China. The Novogratz departure made headlines, but in fact the problems at Fortress had been brewing almost from the time it went public.
The year Fortress tapped the public markets, 2007, was an auspicious time for hedge funds, which had just burst into the public consciousness: Institutional investors like pension funds had started piling into them after losing money in the stock market crash earlier in the decade. Multibillion-dollar fund launches were not uncommon, banks were trying to gain a toehold by taking stakes in top funds, and a mystique of riches surrounded the highfliers. Although the Fortress IPO was priced at $18.50, it was oversubscribed, leading to a market debut at $35 per share. Both Blackstone Group and Och-Ziff Capital followed suit, debuting later that year at $31 and $32 per share, respectively.
Fortress had quickly grown assets during the hedge fund heyday, amassing $29.7 billion by the time of its IPO. The firm’s initial valuation of $7.5 billion was 37 times its 2005 pretax income, an indication that investors thought they’d found the next great growth stock. Instead, it was a market top indicator. Fortress principals Edens, Robert Kauffman, and Randal Nardone (all from UBS), and ex-Goldman stars Briger and Novogratz became billionaires on paper, owning more than 77 percent of the stock.
The founders also cashed out. One of the more brazen aspects of the deal was that $250 million of the IPO proceeds was set aside to pay off a term loan facility that had been used to make a onetime capital distribution to the principals the previous year. In total, the five took $1.66 billion out of the firm before the IPO through dividend payments and private stock sales, including a 15 percent stake sold to Japanese bank Nomura right before the offering.
The deal caused a stir — and some hand-wringing in the industry. Writing about the Fortress IPO in the 2009 edition of Pioneering Portfolio Management, Yale University endowment chief David Swensen criticized the firm’s principals for the conflicts of interest inherent in their deal, and joked that a section on “greed” was absent from Fortress’s SEC offering document.
At the time of the IPO, Fortress had $17.3 billion in private equity funds, $9.4 billion in hedge funds, and $3 billion in real estate. The large asset base was achieved in part by using loan proceeds to invest in the funds, leveraging assets in a way many funds do not. Many of the funds’ investments were not publicly traded, making their valuation so suspect that some investors shied away from them. In fact, in its IPO prospectus Fortress acknowledged that the value of 29 percent of its assets was based on “internal models with unobservable market parameters.” Even many of its hedge funds, specifically the credit funds run by Briger, were relatively illiquid.
To say 2007 was the top for Fortress is an understatement. Shares started falling almost immediately out of the gate and by January 2009 had sunk to $1.00, a decline of 97 percent from the peak. With the financial world in collapse, Blackstone and Och-Ziff also suffered huge declines: Blackstone ended 2008 at $6.26, down 80 percent, and Och-Ziff fell to $5.19, an 84 percent drop. Since then Blackstone has performed the best, but it’s still up only 3 percent from its 2007 launch. Och-Ziff has fared the worst, down 90 percent from its October 2007 debut.
At Fortress troubles first surfaced in the macro funds run by Novogratz, a man known for his glitzy lifestyle, complete with a Tribeca duplex once owned by Robert De Niro and a flamboyant wardrobe featuring diamond-studded belts and cowboy boots. Of all of Fortress’s products, Novogratz’s were the most liquid, yet he had a two-year lock-up on investors’ money. Before the crash many hedge funds had adopted this feature, which at the time allowed them to avoid registering with the SEC. But because his funds were run out of a publicly traded firm, Novogratz had no such rationale, and there was no issue with liquidity.
The losses of 2008 threw that bit of arrogance into stark relief. Although Fortress had put up the gates to keep investors locked in when its funds suffered double-digit losses, it was forced to open them eventually, and some $4.6 billion was redeemed between 2012 and 2014 in the firm’s liquid hedge funds. By 2015, when the macro fund fell 18 percent — leaving it with an annualized return of 2.8 percent — Fortress was forced to shut it down, with only $1.6 billion left. By the end of 2016, the firm’s hedge fund assets were about half of what they were at the time of the IPO, and Novogratz was gone.
The shutdown of Fortress’s macro funds was a big loss. The hedge funds had charged investors as much as 3 percent in management fees and between 20 and 25 percent in incentive fees. But last year Fortress earned only $1 million in incentive fees and $14 million in management fees on its liquid hedge funds, down from $16 million and $138 million, respectively, in 2014. Total incentive income for the Fortress macro funds was less than $100,000 and $3.8 million for 2015 and 2014, respectively; management fees sank to $34.7 million in 2015 from $63.3 million in 2014.
Private equity, run by Edens, was originally considered Fortress’s crown jewel. Between 1998 and 2006 those funds netted 39.7 percent on an internal rate of return basis, according to the IPO prospectus, but such returns have disappeared. “Essentially, we view that business in runoff,” says Keefe Bruyette’s Dai. “It’s more or less a shrinking asset pool.”
One major problem, the analyst notes, is that the portfolios’ returns haven’t been high enough to push them over their hurdle rates so that Fortress can start charging incentive fees. Last year the firm said most of its private equity vehicles had hurdle rates of 8 percent. “We don’t have any intention to lower the hurdle rates,” Briger said on the third-quarter conference call, responding to questions from analysts. “I think in terms of private equity credit, if you’re really not going for substantially higher than 8 percent gross, our view would be why are you actually going out and investing in those types of investments, just given the illiquidity risk?”
In 2016, Fortress received no incentive income from its main private equity funds, compared with $2.9 million in 2014. Management fees also fell — to $93.8 million from $136 million — as funds matured and no new ones took their place. The firm’s third private equity fund, launched in September 2004, reaped management fees of $9.9 million and $13.8 million for 2015 and 2014, respectively. But there have been no incentive fees for years: Returns were a respective 5.8 percent, 6.9 percent, and 4.8 percent in 2012, 2013, and 2014. Last year the fund’s annualized return was 2.0 percent, and a fourth fund was in the red on an annualized basis.
The immediate future doesn’t look much better, according to Briger. “Our investing pace today in terms of [private equity] investments has slowed significantly,” he said on the conference call. “We have a bunch of dry powder, and I would say we need a better environment to be investing in the types of things that produce the types of returns, the types of PE incentive, than we are seeing now.”
Fortress’s credit funds, run by Briger, have been the best performers in recent years. Last year the Drawbridge Special Opportunities hedge fund gained 9.7 percent, annualizing at 10.7 percent, and its offshore equivalent gained 5.9 percent for an annualized 9.5 percent. Briger’s private equity credit funds also have been strong performers, with double-digit annualized returns.
But their future is unclear right now, and this has led Fortress to return capital to investors. “We are in a period of time where the opportunity set is low,” Briger said in November, adding that Fortress had given back 20 percent of the capital in the offshore credit fund. “We would look to do that in our credit hedge funds to the extent that we were building up more cash than the opportunity set, in our judgment, necessitated over some medium-term period.” Part of the problem, he said, was the lack of big investment themes in credit. “There’s nothing that is thematically interesting,” he told analysts. “Everything that we’re doing is idiosyncratic, based upon the specific circumstances of a transaction or an investment, and it is unlikely that that’s going to change in the real short term.”
The inside joke about hedge funds is that by bulking up assets they can make enough money from management fees so that profiting from their investment acumen — that is, earning incentive fees — becomes practically irrelevant. Asset gathering is the name of the game. But eventually that quits working. Investors pull capital, and it becomes harder to raise it.
Asset growth at Fortress was flat in the years after it went public, so in 2010 the firm grew by buying a fixed-income asset management firm, Logan Circle Partners, which now accounts for almost half of its assets under management — $33 billion of $69.6 billion. But managing fixed income throws off little in fees, analysts point out: Logan Circle has barely been breaking even.
The bottom line for Fortress is that its revenue and income have continued to shrink even as markets have come back. Total revenue was $1.2 billion last year, down 4 percent, or $50.1 million, from 2015. Since 2014 net income has fallen 25 percent, to $181 million. Pretax distributive earnings, which analysts look at, fell 19 percent between 2014 and 2016, to $362 million. They peaked at $551 million in 2007. In 2005, before it went public, Fortress grew profits at an annualized rate of more than 100 percent. That year it booked net income of $193 million on less than $30 billion in assets and $1 billion in revenue.
To many observers the Fortress saga proves that publicly traded alternatives firms aren’t a good idea. One problem, attorney Kaplan says, is the conflicting demands of running a hedge fund and operating a public company: “When you’re running a hedge fund, you’re trying to maximize value and return for investors in the fund, but if you’re a public shareholder, your interest is fees being as big as possible. Instead of running a fund strictly for the benefit of investors, now you’ve got shareholders to be responsible to.” Fortress doesn’t seem to have done well by either.
As Kaplan puts it, “It’s pretty clear now that public ownership is not the future of hedge funds.” And this time around, the principals can’t take the money and run. They will have to reinvest 50 percent of their sale proceeds in either their own funds or those of SoftBank. With the sale of Fortress to SoftBank, the cycle appears to have come full circle.