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— Private Equity —
 Word on the Street is that Fortress Investment Group LLC, the New York alternative asset manager, took a bath on the $1.3 billion it loaned Harry Macklowe to finance his $7 billion purchase of seven Manhattan office towers in early 2007 at the crest of a frothy real estate market. But like a good deal of what passes for truth about Fortress, that bit of Wall Street folklore is all wet. In fact, Fortress presciently hedged its outlay to Macklowe in a way the developer's lead lender, Deutsche Bank AG, did not. After the market tanked and Macklowe lost control of the buildings to Deutsche, the bank offloaded them for less than he had paid, recording a loss. But not Fortress. The junior lender insisted that its loan be collateralized not by the seven buildings purchased in 2007 but by another, the longtime crown jewel of Macklowe's domain, the General Motors Building in Manhattan. And when the beleaguered Macklowe was forced to sell even that prize, Fortress, say sources familiar with the matter, not only recouped its entire loan but rang up a tidy profit besides.
Since the markets began to swoon, Fortress has been under siege, a target of investors' anxiety and jokes about crumbling ramparts. And rightly so. Last year, bombarded with redemption requests from investors, Fortress temporarily barred withdrawals from its money-losing flagship hedge fund, Drawbridge Global Macro, but not before about $2 billion had drained away. Its total asset base shriveled from $35.1 billion last June to $27.1 billion as of Jan. 1; it suffered a net loss of $322 million in calendar 2008, a figure that included noncash compensation costs and write-downs of unsold private equity investments; and the market capitalization of its stock has nose-dived 91%, from $13.3 billion soon after Fortress' debut as a public company in early 2007 to $1.2 billion today. The reversal in fortune has been dizzying for a firm that for a brief, shining moment held sway as a leading force in leveraged buyouts and hedge funds and whose initial public offering made instant billionaires of its CEO and co-founder, Wesley Edens, and his four partners. The financial slump, meanwhile, has thrown into relief some key vulnerabilities, including the firm's heavy exposure across much of its platform to mortgages and real estate -- a segment hit especially hard -- along with its thin investment history, a byproduct of its being only 11 years old, and the fact that unlike other publicly traded alternative asset managers, Fortress' own balance sheet is laden with debt. But as the Macklowe episode shows, and as many Wall Streeters, even some of his counterparts, have yet to grasp, Edens, who heads Fortress' private equity business, and his partners are arguably as adroit as anyone at mining profits from hard assets while curbing downside risk. In contrast to Macklowe, who frittered away a real estate empire by flagrantly overleveraging and overpaying, Fortress so far has been able to stave off foreclosures and hang tough because of its unusually conservative financing habits. As the financial crisis plays out, Fortress' prudence may prove its salvation. Its chary practices aren't widely understood, even by some presumably in the know. Consider this critique from a leading private equity rival: "No one was more capital-markets savvy than Fortress, but they took huge financing risks. They levered their deals 10-to-1 in the real estate and asset securitization market, where you could get much more leverage than in the corporate market. They were more levered than anyone else, more than Och-Ziff, Apollo, Blackstone. They took full advantage of a euphoric market, and they grossly overpaid." Now, while this isn't devoid of truth, in that Fortress at the market's peak sometimes paid enriched multiples for properties and made ample use of asset-backed securitization, the comment's central point is flat-out wrong. In transaction after transaction, a close examination of some of its buyouts shows, Fortress has refrained from maxing out on debt when banks were tripping over each other to lend. If anything, Fortress was guilty of overequitizing. Though Edens refused to discuss individual investments, he had this to say about how Fortress has capitalized its private equity deals in general: "On average, I'd say we've capitalized our deals with 45% equity. If you stack up all the private equity firms side by side, I think we use lower leverage than much of the industry." He adds: "There's a real misconception that we use securitization as a primary part of our investment strategy. But it is never our intention to leverage things as highly as we can." For Fortress, he says, the "chief appeal" of the asset-backed market has been low-cost finance. That's not to say Fortress has had smooth sailing with creditors. Much like Macklowe, it financed its deals in 2006 and 2007 with short-term bridge loans, the idea being to replace the bridges after the deals closed with longer-term debt. But that plan backfired when credit markets blew up, leaving several bridges hanging. Edens and his lieutenants consequently had to scramble in 2007 to avert default on $7 billion of short-term loans, and in at least one case, a $1.7 billion loan to ski-resort operator Intrawest Corp. that matured in October, negotiations went down to the wire. In every case, they avoided Macklowe's fate. Now a superficially similar drama with a spicy subplot is brewing: In late July, a $1.6 billion loan to Florida East Coast Industries Inc., a railroad and real estate company Fortress bought for $3.7 billion in 2007, comes due. The makeup of the creditor group implies Fortress may be in for a vicious battle: Apollo Management LP, the biggest creditor, along with GSO Capital Partners LP and TPG Capital, three investment firms that last year bought a majority of the loan from Citigroup Inc. at a bargain price, are masters at parlaying debt positions into takeovers of troubled companies. Apollo, says a well-placed source, "would love to own this company." That hope, however, will likely be dashed if Feci is as financially solid as others say. The successor to a railroad and land barony founded more than a century ago by Henry Flagler, a partner of John D. Rockefeller, Feci has no difficulty meeting its interest payments. Even though its railroad income has dipped, Ebitda has risen nearly 10% overall since Fortress acquired it, owing to the surprisingly strong showing of its commercial properties, these sources say. Even a member of the creditor group allows, "The loan is definitely worth par." As a result, Apollo et al. may find it hard to wrest control away from Fortress, although they will surely capture some concessions. Fortress' risky behavior involves more than bringing on bridge loans. To generate cash returns for its LPs without actually selling stock, it has occasionally borrowed on margin against its stakes in portfolio companies that have gone public. That practice came back to bite Fortress early this year, when it had to tap LPs for $35 million to meet a margin call on Gagfah SA, a German apartment owner. Conceivably more worrisome are the massive equity bets Fortress has made in individual deals. It plowed $1.9 billion into Feci, $450 million into RailAmerica Inc., a Feci affiliate, $1.4 billion into Intrawest and $3 billion into Gagfah, outsized sums for a firm whose latest private equity fund weighs in at $5 billion. Though it parceled much of that money into a host of "sidecar" funds, it nevertheless risked an unusually high 20% of its $5 billion fund solely on Feci. If any one of those companies cratered, it would decimate Fortress' private equity investment returns. Fortress, like every buyout firm in creation, has seen the value of its investments slide. Some of its remaining stakes in portfolio businesses it has taken public, such as Gagfah, jet aircraft lessor Aircastle Ltd. and community newspaper publisher GateHouse Media Inc. have nose-dived. In 2008 it took $278 million in reserves to cover possible future losses on its own private equity holdings, representing 33% of their estimated worth at the start of the year. (These are monies Fortress invested as a firm alongside the private equity funds it manages. At year's end, it put the value of those investments at $560 million. That compared with $190 million it had invested in its own hedge funds.) Significantly, though, Fortress has succeeded in escaping the nuclear wipeouts that have hurt larger peers, including two of the vultures now hovering over Feci, Apollo and TPG. Since the economic slump set in, none of its companies has gone belly-up, a rarity in private equity. In the case of Gagfah, Fortress' largest-ever equity investment, the company's solid financial performance has belied the drop in its stock price. Fortress, too, clearly dodged a bullet in late July when it backed out of a pending $6.1 billion LBO of casino and racetrack operator Penn National Gaming Inc. Because it reneged, it had to cough up a hefty breakup fee, and it wound up investing $625 million in Penn National convertible preferred stock as a peace offering to the target. But at least by nixing the deal, it managed to avoid the misery that backers of another big gambling industry LBO, the $31 billion take-private of Harrah's Entertainment Inc., have experienced since that deal's successful conclusion. Harrah's backers, which include Apollo and TPG, have seen the value of their equity all but erased as Harrah's staggers toward Chapter 11 under crushing debt. If Edens can see his way past about $3 billion in portfolio company loans falling due this year, half represented by Feci, and also avoid defaults stemming from portfolio company failures, Fortress will have cleared a major hurdle. As Edens noted in a March 16 call with analysts, the "modest amounts of leverage" Fortress used in the acquisitions has been a "big plus" in seeking accommodations with creditors.
The mystery surrounding Fortress is largely of its own making. Even after its IPO forced it to be more open, it has remained guarded about how it runs its business. Most private equity houses list their portfolio companies on their Web sites. Not Fortress. It has even kept Wall Street analysts in the dark about its big faceoff with the Feci creditors and other credit battles that loom. To get a handle on the place, you must go back to its roots. Edens, now 47, founded Fortress in 1998 with Robert Kauffman, 45, its European private equity chief, and Randal Nardone, 51, the COO. Edens made his name at Lehman Brothers Inc. during a previous financial crisis as a buyer of troubled real estate and corporate loans from the Resolution Trust Corp., the government agency created in the late 1980s to auction assets of failed savings and loans. Only in 2002 did Fortress enter the hedge fund business with the hiring of Peter Briger Jr., 44, who runs the "hybrid" funds, which traffic in mortgages and other debt, and Michael Novogratz, 43, who oversees the "liquid" funds that trade currencies and the like. (It was Novogratz's operation that was swamped with investor withdrawals last year.) Edens' mastery at wringing profit from distressed assets propelled Fortress' returns early on. Starting in 2000, Edens fashioned a company called Brookdale Senior Living Inc. from financially troubled retirement centers bought on the cheap. Then came Fortress' biggest score: In 2002 it scooped up a bankrupt owner's wireless communications towers, built the company up with add-on acquisitions, took it public under the name Global Signal Inc. in 2004 and in 2007 sold it to a rival, Crown Castle International Corp. Fortress, which invested just $274 million in equity, reaped a $1.4 billion profit on the sale. A 2003 purchase of Green Tree Financial Holdings LLC, now Green Tree Servicing LLC, a servicer of mobile-home loans, from bankrupt Conseco Inc. delivered a 150% gain on a $400 million investment. The strength of that performance and Fortress' solid hedge fund returns set the stage for the firm's extraordinary IPO in February 2007. The stock soared from $18.50 to $31 the day it debuted, making paper billionaires of Edens, Kauffman, Nardone, Briger and Novogratz. Even before the IPO, all had contrived to rake off hundreds of millions in cash dividends, paid for by loans the firm took out in addition to the sale of a 15% stake in Fortress to Nomura Holdings Inc. The five reinvested their haul in Fortress' funds and operations. The market turned down, and Fortress' fortunes with it. Briger's and Novogratz's hedge fund operations, which together account for about 40% of Fortress' $27 billion in assets, suffered their first yearly losses ever, with returns down more than 20% for most funds. To stanch the bleeding at Drawbridge Global Macro, Fortress temporarily halted $2.4 billion in redemptions late last year but lifted the suspension in January. All told, since the end of 2007, hedge fund assets dropped by $5 billion, to $11.3 billion. As the losses mounted, Fortress cut loose about two dozen hedge fund portfolio managers. The turmoil, not surprisingly, has elicited disparaging comments from former insiders. One ex-Fortress trader describes the firm's culture as cutthroat: "They would hire two people for a similar role at a similar level and let them duke it out. It was survival of the fittest," the trader says. What's more, the investing and trading strategies weren't centrally coordinated, this person says: "The three groups -- PE and the hedge fund groups -- operated as separate silos and wouldn't talk to each other. Sometimes the groups would end up bidding against each other for the same assets." About last year's losses, this person observes: "They started buying residential real estate aggressively in the form of whole loans and mortgage-backeds. They did very little shorting. They bet the farm on mortgages. They missed the trade." Edens wouldn't respond to this last criticism for the record. But in the March 16 conference call, he conceded Fortress was long the market at the wrong time, saying, "Virtually anything you invested in [in 2008] was bought too soon. The only safe place for capital was short or on the sidelines." Fortress' missteps notwithstanding, one analyst, Barclays Capital's Roger Freeman, reckons that the firm's share price doesn't reflect its inherent long-term value. "On a discounted cash flow basis, you could argue the stock is easily worth $12," he says. Edens isn't sitting around licking his wounds. With the markets in the tank, he and Fortress are doing their best to capitalize on others' woes. The firm recently corralled 127 restaurants from a bankrupt steak-buffet chain, Buffets Holdings Inc., and reportedly is in the running to buy the operations of D.B. Zwirn & Co. LP, a hedge fund that's been the target of a federal investigation and whose clients have fled in droves. Edens has also been vocal about his desire to target troubled bank assets under the Federal Reserve's $200 billion Term Asset-Backed Securities Loan Facility program, calling TALF "a tremendous opportunity for investors." Just now, its capital reserves down to less than $5 billion, Fortress is said to be marketing a new credit opportunities funds, a follow-on to a similar $3 billion vehicle it raised last year, to snap up distressed assets. For Edens, the disarray in the markets is an invitation to return to
his roots, to reprise his feats as a distressed-assets buyer
extraordinaire. If Fortress is successful at raising additional
capital, the next couple of years should be Edens' time to shine. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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