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 $3 billion in portfolio company
loans falling due this year, half represented by Feci, and also avoid
defaults stemming from portfolio company failures, Fortress will have
cleared a major hurdle.
As Edens noted in a March 16 call with analysts, the "modest amounts
of leverage" Fortress used in the acquisitions has been a "big plus" in
seeking accommodations with creditors.
| Planes, trains and racetracks |
| Hard assets are a key ingredient of Fortress' private equity deals. |
Acquisition date |
Acquisition
(Sector) |
Enterprise value ($mil.) |
Equity invested ($mil.) |
Valuation (EV/Ebitda) |
Comment |
2008 |
Penn National Gaming Inc.
(casinos, racetracks) |
NM |
$625 |
8x |
Stock trades 31% below conversion price of Fortress' preferred |
2007 |
Florida East Coast Industries Inc.
(railroad, real estate) |
$3,700 |
1,900 |
15* |
$1.6 bill. bridge loan falls due in July |
2007 |
RailAmerica Inc.
(railroad) |
1,100 |
450 |
12 |
Now part of Florida East Coast Industries |
2006 |
Intrawest Corp.
(ski resorts) |
3,000 |
1,400 |
11 |
Refinanced $1.6 bill. bridge loan in October |
2006-07 |
Seacastle Inc.
(shipping containers and chassis) |
2,600 |
900 |
11 |
Bought Interpool Inc. for $2.4 bill. in 2007 |
2005-06 |
GateHouse Media Inc.
(community newspapers) |
950 |
215 |
12 |
Investment shows 74% loss |
2005-06 |
GAGFAH SA
(German apartments) |
NA |
3,000 |
NA |
Fortress recouped $2 bill.; remaining stake worth $900 mill. |
2004-06 |
Aircastle Ltd.
(aircraft leasing) |
NA |
400 |
NA |
Investment has returned $480 mill. cash, shows 73% gain |
2003 |
Green Tree Servicing LLC
(manufactured-home loan servicer) |
NA |
400 |
NA |
Sold stake in 2007 for $600 mill. gain |
2002-05 |
Global Signal Inc.
(wireless communications towers) |
NA |
274 |
6 |
Sold stake in 2007 for $1.4 bill. gain |
2000-06 |
Brookdale Senior Living Inc.
(retirement centers) |
NA |
1,200 |
NA |
Fortress recouped $600 mill., remaining stake worth $525 mill. |
* Excludes value of 200,000 acres of entitled land and right-of-way rights
Source: The Deal LLC |
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.
