Fortress Goes Public: A Rational Look At Valuation

So it finally happened: Fortress Investment Group is now a public company (FIG). 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.

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 Friday's FIG offering are chronicled in Saturday'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.