My Review of Fortress: On Valuation and Rationality

So it finally happened: Fortress Investment Group is now a public company. Congrats, guys. I've met a few of the principals over the years and they are super-smart, very commercial, savvy guys. Obviously. They were the logical first U.S.-based hedge fund to go public, and I've written about them quite a bit during my tenure as a blogger:

08/14/2006: Hedge Funds as Asset Management Complexes - The Day Has Come
09/15/2006: Fortress Going Public? The Writing's On The Wall
10/03/2006: Venture Capital - Becoming Like the Hedge Fund Industry?
12/05/2006: Citadel's Bond Financing: We're Going Public, Baby
12/26/2006: Hedge Fund Convergence: Strategy vs. Structure

So Fortress going public was clearly going to happen, it was logical it should happen, and now it has happened. But the response to the Fortress offering was, well, demonstrably insane. The salient details of yesterday's offering are chronicled in the today's Wall Street Journal:

Fortress Investment Group LLC, which manages $30 billion, became the first private-equity and hedge-fund manager to sell shares on U.S. markets and promptly emerged as one of the hottest initial public offerings in years. Its shares, issued at $18.50 apiece, opened for trading at $35 amid frenzied demand and closed at $31 -- 68% higher than its IPO price.

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Fortress estimates its private-equity funds have averaged 39.7% annual returns since 1999 and its hedge funds have averaged 14% annual returns since 2002. Fortress has been among the fastest growers in the business. In 2001, it managed $1.2 billion, and that rose to roughly $30 billion last year -- a 97% compound annual growth rate.

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After Friday's close, Fortress shares traded at roughly 40 times last year's earnings. Investment-banking giant Goldman Sachs Group Inc., by contrast, trades at 11 times earnings. Legg Mason Inc., a mutual-fund firm, trades at 24 times earnings.

Friends, I am generally not one to talk about stock valuation in the absence of empirical data from the Internet, but I simply can't remain silent in the wake of investors' response to the Fortress offering. FIG's shares at 40x P/E? Are you stoned? It is a great firm run by top pros (as I've written many times), but the profit dynamics of the business simply don't support that kind of a multiple. I was interviewed a few months ago about how a firm like Fortress might be valued, and I responded in what I thought was a logical and fact-based manner. Basically, the firm has two components:

Annuitized cash flows relating to management fees. This is a function of fee level, asset level, asset growth, tenor of lock-up and the probability of assets being redeemed. I would afford this type of stream a high multiple - say 20-25x earnings - due to its persistence, stability and growth potential.

Variable cash flows relating to performance fees. This is a function of fee level, asset level and performance. FIG's performance variability is cushioned by the fact that it runs a highly diversified portfolio, likely offering benefits of non-correlated returns similar to a fund-of-funds. That said, correlations generally rise in market downdrafts and fees are driven by absolute - not relative - performance. Therefore I'd afford this stream a lower multiple of earnings - say 12-18x earnings - due to the risks involved but greater diversification than, say, Goldman Sachs.

Is this a rational way to look at it? I think so. So how does one get to 40x earnings? Probably if you expect FIG's AUM to grow for a long time at its 5 year historic rate of 97%. Is this realistic? I mean, FIG isn't a business that scales like Google. At least I don't think so, but others clearly do. I think they are mistaken. First of all, investment management at FIG isn't just a model business (which is more like what Renaissance is like) - it's a people business. People require management. People have egos, tempers, dreams, and attitudes. These all need to be managed. It's hard and it poses a risk. Doubling in size every year will place such dramatic stress of the FIG management structure (not to mention infrastructure) that something will break. It has to. And it will tarnish returns.

This is not a comment on the capabilities of the Big 5 at FIG - it is a comment on the Law of Large Numbers and the challenges of scale. I could rattle off another 10 reasons why this valuation is in cloud cuckoo land but I won't. You probably know them as well as I do. And I really wasn't planning on writing another post on Fortress given all that I've written in the past - but at a 40x P/E I felt compelled to say something. WAKE UP, PEOPLE.

Comments

[Buck Woodford]

Nice work on following them pre-IPO.. I was not that familiar.

The public listing brought about several issues for me, because of the nature of their business.

http://teewinot.us/manypeaks/2007/02/16/fortress-ipo-raises-questions/

[Roger]

Krish, you missed my point or I didn't explain it well enough. Clearly ANY business is a people business to some extent. It's just that you can't compare a business where people's daily decisions represent the economic engine, a la FIG, versus Google, where a neutron bomb could go off and cash would continue to be generated for quite some time. That was my point.

Concerning my view on valuation, and "putting my money where my mouth is," as I've written about on many occasions I don't trade single stocks. Mine is a perspective; feel free to take it or leave it.

Thanks for the comment.

[Krish]

Interesting. You say *it's not a scalable business like Google...it's a people's business and people require management as they have egos etc.*

Why would you think Google isn't a people's business ? I am sure even Google founders would never have dreamt it would scale as much as it did. It was just a case of market taking a liking to it because of the better user experience it gave to searchers and advertisers. It just evolved.

One thing irks me. How kindly would the Hedge Fund investors (who prefer relative anonymity and lower compliance costs ) take to FIG's public offering ( since it would submit it to higher level of probity by SEC, high cost SOX compliance etc. ) ?

Stock Market too has its own logic. A mashup of expectations of the investors & market makers who constitute it. On the 40X discounting offered for FIG IPO - since you figure it's overvalued, I suggest ....Go, short it !

[Yaser Anwar]

With record M&A deals in 06, and Jan 07 already outpacing Jan-Feb 06's deals, it is clearly evident that investors expect the PE boom to continue.

Goldman's recent plans to raise $19 bn and MS's 6 bn+, are like adding fuel to the fire. And with BoJ not expected to raise rates, the big boys can borrow more to finance their finances (though they won't need to, given investor willingness to pour money in buyout funds).

We can argue all day about FIG's valuation being out of line, heck FMs will also put up a relative value trade shorting FIG/long GS.

However, I don't need to remind anybody on this blog that investors can remain irrational longer than either of us can stay solvent.

Currently we're in a PE/M&A boom trend, so the smart and dumb money will keep chasing returns in this sector. And execs at Citadel and FIG don't mind raising $$$ from this cohort, 'cause as we discussed in the Citadel post, it gives them an alternate medium to raise $$.

As long as we keep seeing record M&A, LBOs & MBO deals, we'll keep seeing FIG's valuation reach astronomical levels.

As a Trend Follower, I'd wait for a pull-back in FIG and take a position, albeit a small one, because having watched trends develop in the past, investors irrationality can push the stock into stratosphere (read: Tech Bubble, most recently in early 06, Ethanol stocks).

Sure its safer in GS, I'd have most of my $$ in it, due to its undervaluation, but why not profit in the interim from irrationality that I expect will push FIG higher?

Just my $0.02.

[Finbar Taggit]

Spot on. This is an opportunistic listing and FIG and its investors (including Nomura who recently bought a slug pre IPO) will be the winners. If this price is sustained, FIG will have a higher valuation than Goldman Sachs ... and I know which one I would invest in.

The whole thing smacks of dot com mania.

[MRM]

you got that right

with 4x leverage they have some work to do now to put that LP dough out

http://www.wellingtonfund.com/blog/

[Roger]

I get that, Bill. It is also frequently true that sentiment can whipsaw pretty quickly when fundamentals come to light. While it may take some time, the rubberband always springs back. And when it does it really hurts.

[Bill aka NO DooDahs!]

It'll all make sense if you remember that investors aren't the "rational actors" demanded by valuation theory. Sentiment moves price, not valuation, and valuation is properly viewed as merely a sign of sentiment ...