Cash for Fortress, a bath for investors

Portfolio manager David Swensen has dubbed the firm 'greedy.' And that was before Fortress quietly floated a second public offering last month.

By William D. Cohan, contributor

NEW YORK, (Fortune) -- In the latest edition of his seminal textbook, "Pioneering Portfolio Management," David F. Swensen, the chief investment officer of the $22.5 billion Yale Endowment, wrote that "strangely absent" from hedge fund Fortress Investment Group's SEC registration filing in 2006 was a section on "Greed." Since Swensen's book was published in January of this year, Fortress has once again demonstrated the risks of investing with the fast-money crowd: this time through a little-noticed $200 million, secondary stock offering on May 14 that is already trading 20% below its $5 per share offering price.

Swensen had a number of bones to pick with Fortress (FIG) in his book, but chief among them is the fact that what is good for Fortress' partners may not always be good for its shareholders, the mere mortals and institutional investors who buy shares through the public markets. In this respect, Fortress is not markedly different than The Blackstone Group and Och-Ziff, which are also publicly traded. But the misalignment of interests at Fortress has come into stark relief during the past few months as Fortress's principals have been able to raise a new war chest while investors in the secondary offering took a bath.

Swensen, like other critics of asset-management company IPOs, believes that by going public Fortress created a whole range of conflicts for itself. First, the five Fortress principals keep the lion's share of the plenty generous "2 and 20" fee structure the limited partners cough up while the minority shareholders get just a taste.

Swensen reckons that another problem is that the interests of garden-variety investors and limited partners are often misaligned because investors who buy stock in the public markets are reliant on the uptick of the stock for their paydays, while limited partners care only about how Fortress' investments perform. Third, the Fortress principals are using money lent to the public company to invest in deals rather than exclusively money from their own pockets. All of which taken together may encourage them to at times be more interested in what could charitably be called daring feats of financial engineering for their own enrichment rather than those that build shareholder or investor value.

The Yale Endowment has been an investor in a number of Fortress funds, Wes Edens, the CEO of Fortress, explained in an interview. And Edens said he has always "had a good relationship with Dave." But, Edens said, Swensen is "just dead wrong" about what he wrote in his book about the reasons Fortress went public and the potential conflicts that were created as a result. "Saying we did this for 'Greed' is not right," Edens said. "That's not who I am and that's not what I am about. And I take exception to that. I try really hard every day, from early in the morning to late at night, to always put my investors first."

Before we dissect Fortress latest offering, let's look at a bit of back-story: Fortress is a hedge-fund and private-equity firm with some $26.5 billion in assets under management (down from $35 billion a year ago). It went public on February 9, 2007 at $18.50 a share, traded up that first day to $28.80, then as high as $31.10 and currently trades around $4 a share. In prose dripping with faintly veiled ire, Swensen documents the $1.66 billion the five Fortress principals -- CEO Wes Edens, president Peter Briger, Robert Kauffman, Randal Nardone and Michael Novogratz -- vacuumed out of the firm and into their pockets in the months leading up to the firm's first public offering through a series of dividend payments and private stock sales.

For instance, a new, $750 million credit agreement the firm entered into prior to the IPO allowed the firm to make a "one-time $250 million distribution of capital to our principals," according to the IPO prospectus, to refinance an existing $175 million credit line and to use the balance to make investments in existing and any new Fortress investment funds.

The last detail -- using the bank loan to make investments -- allowed the five principals to use borrowed money to make future investments in the firm's funds, instead of only having to dip into their own pockets, as many other hedge fund and private equity fund managers do to make an investment. As they say in Vegas, Fortress could play with the house's money and not have to put as much skin in the game as the average hedge-fund or private-equity manager.

Edens disputes this notion. He said that the five principals have together re-invested more than $1.1 billion back into the funds, or more than the after-tax proceeds of what they took out leading up to the IPO. "If we were truly greedy," he said, "we would have taken the money out and put it into a bank. Instead, we have re-invested the money in our funds and our deals."

Last month, Fortress' Gang of Five cooked up another way to lay the risk off on shareholders as they built up a war chest for future investing and paid off some of what they owed to their banks. Raising capital for new investing vehicles has been no easy trick since the unpleasantness in the capital markets last fall (although Fortress did raise a $3 billion distressed investing fund last October, Edens said.) And with Fortress's stock falling precipitously toward the end of 2008, raising capital for a new fund was looking like an uphill slog.

Complicating things further: Last November, Fortress' hedge fund clients asked to redeem some $4.5 billion of their money from the various funds, including some $3.5 billion alone from its Drawbridge Global Macro fund. The fund's gates went up for about three weeks, Edens said, so that covenants could be renegotiated with the prime brokers. After that period, investors who wanted money out were able to get it, partially in cash and partially through a deferred payment.

By the day after Christmas 2008, Fortress' stock reached its all-time low of 77 cents a share. "Turn out the lights, the party's over," one wag wrote on a Yahoo message board. "Anyone heard that fat lady yet?" In May, though, Edens and his partners were back with another stock offering for investors. In the days leading up to the offering, Fortress' stock had recovered modestly to $7.43 a share, just after the firm released its first-quarter results with a net loss of $287 million on May 6.

Fortress decided to take advantage of the window that had opened for "de-leveraging" stock offerings, whereby equity investors provided the capital to pay down existing debt. On May 13, Fortress filed the prospectus then wasted little time. The next day, in an upsized deal, the firm sold 40 million shares of its Class A stock at $5 per share, for a total of $200 million. The stock had closed at $5.26 the day the deal was priced (after the market closed.) "It was a good time to raise capital and get back in front of investors," Edens said.

The banks that underwrote Fortress' IPO in 2007 -- Goldman Sachs (GS, Fortune 500) and Lehman Brothers (for obvious reasons) -- were gone from the cover of the prospectus. Citigroup (C, Fortune 500), JPMorgan (JPM, Fortune 500), Merrill Lynch and Nomura (NMR), all of which were joint-book running managers, replaced the original underwriters and together split a fee of $7.65 million. "This was just a rotational thing," Edens said of how he chose the underwriters for the latest equity offering. "We have lots of relationships. It's all about who are the best people to do an underwriting at any given time." He said Goldman and Barclays -- the successor to Lehman's U.S. business -- had just done an underwriting for one of Fortress' portfolio companies.

Of the net proceeds of $191.4 million, Fortress agreed to repay $96 million to its lenders -- which, no surprise are Citigroup, JPMorgan and Bank of America (BAC, Fortune 500) (the parent company of Merrill Lynch). So, Fortress gets a new $95.4 million war chest thanks to investors whose shares are already underwater. The banks get paid back $96 million of the $750 million credit facility that the Gang of Five can use to make their ongoing investments, either in Fortress' hedge funds, private-equity funds or in their direct investments.

For its part, Nomura, which already owned 55.1 million Fortress shares (purchased from the Gang of Five for $888 million before the IPO at a 13% discount), agreed to buy another 5.4 million shares in the offering for $108 million bringing to $996 million the firm's investment in the hedge fund management company. The five principals of Fortress plus one, an unnamed "senior employee" agreed to buy four million shares in the offering, at a total price of $20 million, which means that the five principals have now taken out $1.66 billion minus around $20 million.

As for the investors -- including Nomura and the six Fortress guys -- who bought their new shares in May at $5 per share, they now own shares worth around $4 each, about a 20% decline. Edens said he feels badly about this. "But I hope we will have the opportunity to make these people back their money, and then some," he said. "I am very focused on that. I am quite confident in the long term we will make a lot of money for our investors." He said that in the "Great Liquidation" now underway on a global basis, there will be "historic" investment opportunities that he hopes that he and his partners will be smart enough to take advantage of.

And, of course, the Gang of Five still collectively own 312 million Fortress shares, which at their peak were worth $9.7 billion and now are worth around $1.3 billion. So although Swensen declined to comment on the latest Fortress stock offering, it does represent yet another example of how public investors are willing to support the activities of the so-called smartest guys in the room when the benefits to the investors are not yet readily apparent.

--William Cohan is the author of "House of Cards: A Tale of Hubris and Wretched Excess on Wall Street," published in March by Doubleday Books, a division of Random House, Inc. To top of page

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