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Section 1: 10-Q (FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2008)

For the quarterly period ended March 31, 2008
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2008

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 001-33294

 

 

Fortress Investment Group LLC

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   20-5837959

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

1345 Avenue of the Americas, New York, NY   10105
(Address of principal executive offices)   (Zip Code)

(212) 798-6100

(Registrant’s telephone number, including area code)

 

(Former name, former address and former fiscal year, if changed since last report)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x    (Do not check if a smaller reporting company) Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date.

Class A Shares: 94,604,805 outstanding as of May 6, 2008.

Class B Shares: 312,071,550 outstanding as of May 6, 2008.

 

 

 


Table of Contents

FORTRESS INVESTMENT GROUP LLC

FORM 10-Q

INDEX

 

     PAGE
PART I. FINANCIAL INFORMATION

Item 1.

  

Financial Statements

  
  

Consolidated Balance Sheets as of March 31, 2008 (unaudited) and December 31, 2007

   1
  

The following statements are presented on a combined basis prior to the date of Fortress’s reorganization (Note 1) on January 17, 2007 and consolidated thereafter:

  
  

Statements of Operations (unaudited) for the three months ended March 31, 2008 and 2007

   2
  

Statement of Shareholders’ Equity (unaudited) for the three months ended March 31, 2008

   3
  

Statements of Cash Flows (unaudited) for the three months ended March 31, 2008 and 2007

   4
  

Notes to Consolidated and Combined Financial Statements (unaudited)

   5

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   31

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   55

Item 4.

  

Controls and Procedures

   58
PART II. OTHER INFORMATION

Item 1.

  

Legal Proceedings

   58

Item 1A.

  

Risk Factors

   59

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   83

Item 3.

  

Defaults upon Senior Securities

   83

Item 4.

  

Submission of Matters to a Vote of Security Holders

   83

Item 5.

  

Other Information

   83

Item 6.

  

Exhibits

   84

SIGNATURES

   85


Table of Contents

DEFINED TERMS

As used in this Quarterly Report on Form 10-Q, unless the context otherwise requires:

“Management Fee Paying Assets Under Management,” or “AUM,” refers to the management fee paying assets we manage, including, as applicable, capital we have the right to call from our investors pursuant to their capital commitments to various funds. Our AUM equals the sum of:

 

  (i) the capital commitments or invested capital (or NAV, if lower) of our private equity funds, depending on which measure management fees are being calculated upon at a given point in time, which in connection with funds raised after March 2006 includes the mark-to-market value of public securities held within the funds;

 

  (ii) the contributed capital of our publicly traded alternative investment vehicles, which we refer to as our “Castles;”

 

  (iii) the net asset value, or “NAV,” of our hedge funds; and

 

  (iv) the NAV of our managed accounts, to the extent management fees are charged.

For each of the above, the amounts exclude assets under management for which we charge either no or nominal fees, generally related to our principal investments in funds as well as investments in funds by our principals, directors and employees.

Our calculation of AUM may differ from the calculations of other asset managers and, as a result, this measure may not be comparable to similar measures presented by other asset managers. Our definition of AUM is not based on any definition of assets under management contained in our operating agreement or in any of our Fortress Fund management agreements.

“Fortress,” “we,” “us,” “our,” and the “company” refer, (i) following the consummation of the reorganization and the Nomura transaction on January 17, 2007, collectively, to Fortress Investment Group LLC and its subsidiaries, including the Fortress Operating Group and all of its subsidiaries, and, (ii) prior to the consummation of the reorganization and the Nomura transaction on January 17, 2007, to the Fortress Operating Group and all of its subsidiaries, in each case not including funds that, prior to March 31, 2007, were consolidated funds, except with respect to our historical financial statements and discussion thereof unless otherwise specified. Effective March 31, 2007, all of our previously consolidated funds were deconsolidated. The financial statements contained herein represent consolidated financial statements of Fortress Investment Group LLC subsequent to the reorganization and combined financial statements of Fortress Operating Group, considered the predecessor, prior to the reorganization. See Part I, Item 1, “Financial Statements.”

“Fortress Funds” and “our funds” refers to the private investment funds and alternative asset companies that are managed by the Fortress Operating Group.

“Fortress Operating Group” refers to the combined entities, which were wholly-owned by the principals prior to the Nomura transaction and in each of which Fortress Investment Group LLC acquired an indirect controlling interest upon completion of the Nomura transaction.

“principals” or “Principals” refers to Peter Briger, Wesley Edens, Robert Kauffman, Randal Nardone and Michael Novogratz, collectively, who prior to the completion of our initial public offering and the Nomura transaction directly owned 100% of the Fortress Operating Group units and following completion of our initial public offering and the Nomura transaction own a majority of the Fortress Operating Group units and all of the Class B shares, representing a majority of the total combined voting power of all of our outstanding Class A and Class B shares. The principals’ ownership percentage is subject to change based on, among other things, equity offerings by Fortress and dispositions by the principals.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of the statements under Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk,” Part II, Item 1A, “Risk Factors,” and elsewhere in this Quarterly Report on Form 10-Q may contain forward-looking statements which reflect our current views with respect to, among other things, future events and financial performance. Readers can identify these forward-looking statements by the use of forward-looking words such as “outlook,” “believes,” “expects,” “potential,” “continues,” “may,” “will,” “should,” “seeks,” “approximately,” “predicts,” “intends,” “plans,” “estimates,” “anticipates” or the negative version of those words or other comparable words. Any forward-looking statements contained in this report are based upon the historical performance of us and our subsidiaries and on our current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person that the future plans, estimates or expectations contemplated by us will be achieved. Such forward-looking statements are subject to various risks and uncertainties and assumptions relating to our operations, financial results, financial condition, business prospects, growth strategy and liquidity. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our actual results may vary materially from those indicated in these statements. These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included in this report. We do not undertake any obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise.


Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

 

 

     March 31,
2008
(Unaudited)
    December 31,
2007
 

Assets

    

Cash and cash equivalents

   $ 372,678     $ 100,409  

Due from affiliates

     52,088       198,669  

Investments

    

Equity method investees

     1,006,438       1,091,918  

Options in affiliates

     3,804       16,001  

Deferred tax asset

     508,380       511,204  

Other assets

     68,318       71,580  
                
   $ 2,011,706     $ 1,989,781  
                

Liabilities and Shareholders’ Equity

    

Liabilities

    

Accrued compensation and benefits

   $ 88,306     $ 269,324  

Due to affiliates

     477,221       455,734  

Dividends payable

     21,285       21,285  

Deferred incentive income

     167,679       173,561  

Debt obligations payable

     800,000       535,000  

Other liabilities

     65,468       36,729  
                
     1,619,959       1,491,633  
                

Commitments and Contingencies

    

Principals’ and Others’ Interests in Equity of Consolidated Subsidiaries

     226,820       308,023  

Shareholders’ Equity

    

Class A shares, no par value, 1,000,000,000 shares authorized, 94,597,646 shares issued and outstanding

     —         —    

Class B shares, no par value, 750,000,000 shares authorized, 312,071,550 shares issued and outstanding

     —         —    

Paid-in capital

     424,566       384,700  

Retained earnings (accumulated deficit)

     (260,008 )     (193,200 )

Accumulated other comprehensive income (loss)

     369       (1,375 )
                
     164,927       190,125  
                
   $ 2,011,706     $ 1,989,781  
                

See notes to consolidated and combined financial statements

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS (Unaudited)

(dollars in thousands, except share data)

 

 

     Three Months Ended March 31,  
     2008     2007  

Revenues

    

Management fees from affiliates

   $ 144,057     $ 43,287  

Incentive income from affiliates

     37,144       44,229  

Other revenues (affiliate portion disclosed in Note 6)

     19,679       19,784  

Interest and dividend income - investment company holdings

    

Interest income

     —         243,713  

Interest income from controlled affiliate investments

     —         4,707  

Dividend income

     —         7,436  

Dividend income from controlled affiliate investments

     —         53,174  
                
     200,880       416,330  
                

Expenses

    

Interest expense

    

Investment company holdings

     —         132,620  

Other

     10,336       12,019  

Compensation and benefits

     127,019       217,517  

Principals agreement compensation

     237,367       138,274  

General, administrative and other

     16,570       39,305  

Depreciation and amortization

     2,436       2,009  
                
     393,728       541,744  
                

Other Income (Loss)

    

Gains (losses) from investments

    

Investment company holdings

    

Net realized gains (losses)

     —         86,264  

Net realized gains (losses) from controlled affiliate investments

     —         715,024  

Net unrealized gains (losses)

     —         (19,928 )

Net unrealized gains (losses) from controlled affiliate investments

     —         (1,428,837 )

Other investments

    

Net realized gains (losses)

     1,613       1,789  

Net realized gains (losses) from affiliate investments

     247       136,041  

Net unrealized gains (losses)

     —         (280 )

Net unrealized gains (losses) from affiliate investments

     (29,817 )     (130,828 )

Earnings (losses) from equity method investees

     (49,129 )     195  
                
     (77,086 )     (640,560 )
                

Income (Loss) Before Deferred Incentive Income,
Principals’ and Others’ Interests in Income of
Consolidated Subsidiaries and Income Taxes

     (269,934 )     (765,974 )

Deferred incentive income

     —         307,034  

Principals’ and others’ interests in (income) loss of consolidated subsidiaries

     208,269       535,530  
                

Income (Loss) Before Income Taxes

     (61,665 )     76,590  

Income tax benefit (expense)

     (7,252 )     (14,447 )
                

Net Income (Loss)

   $ (68,917 )   $ 62,143  
                

Dividends declared per Class A share

   $ 0.2250     $ 0.1674  
                

Earnings Per Unit - Fortress Operating Group

         January 1
through
January 16
 

Net income per Fortress Operating Group unit

     $ 0.36  
          

Weighted average number of Fortress Operating Group units outstanding

       367,143,000  
          
    

Earnings Per Class A share - Fortress Investment Group

         January 17
through

March 31
 

Net income (loss) per Class A share, basic

   $ (0.74 )   $ (0.87 )
                

Net income (loss) per Class A share, diluted

   $ (0.74 )   $ (0.87 )
                

Weighted average number of Class A shares outstanding, basic

     94,894,636       82,256,078  
                

Weighted average number of Class A shares outstanding, diluted

     406,966,186       82,256,078  
                

See notes to consolidated and combined financial statements

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

CONSOLIDATED AND COMBINED STATEMENT OF SHAREHOLDERS’ EQUITY (Unaudited)

FOR THE THREE MONTHS ENDED MARCH 31, 2008

(dollars in thousands)

 

 

     Class A Shares    Class B Shares    Paid-In Capital     Retained
Earnings
(Accumulated
Deficit)
    Accumulated Other
Comprehensive
Income (Loss)
    Total Shareholders’
Equity
 

Shareholders’ Equity - December 31, 2007

   94,597,646    312,071,550    $ 384,700     $ (193,200 )   $ (1,375 )   $ 190,125  

Director restricted share grant

   —      —        35       —         —         35  

Dividends declared

   —      —        (21,285 )     —         —         (21,285 )

Capital increase related to equity-based compensation

   —      —        61,788       —         —         61,788  

Dividend equivalents accrued in connection with equity-based compensation (net of tax)

   —      —        (672 )     —         —         (672 )

Cumulative effect adjustment - adoption of SFAS 159 (Note 3)

   —      —        —         2,109       1,212       3,321  

Comprehensive income (loss) (net of tax)

              

Net income (loss)

   —      —        —         (68,917 )     —         (68,917 )

Foreign currency translation

   —      —        —         —         395       395  

Comprehensive income (loss) from equity method investees

   —      —        —         —         (5 )     (5 )

Allocation to Principals’ and others’ interests in equity of consolidated subsidiaries

   —      —        —         —         142       142  
                    

Total comprehensive income (loss)

                 (68,385 )
                                          

Shareholders’ Equity - March 31, 2008

   94,597,646    312,071,550    $ 424,566     $ (260,008 )   $ 369     $ 164,927  
                                          

See notes to consolidated and combined financial statements

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

CONSOLIDATED AND COMBINED STATEMENT OF CASH FLOWS (Unaudited)

(dollars in thousands)

 

 

     Three Months Ended
March 31,
 
     2008     2007  

Cash Flows From Operating Activities

    

Net income (loss)

   $ (68,917 )   $ 62,143  

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities

    

Depreciation and amortization

     2,436       2,009  

Other amortization and accretion

     628       797  

(Earnings) losses from equity method investees

     49,129       (195 )

Distributions of earnings from equity method investees

     3,252       753  

(Gains) losses from investments

     27,957       640,755  

Deferred incentive income

     (31,959 )     (307,034 )

Principals’ and others’ interests in income (loss) of consolidated subsidiaries

     (208,269 )     (535,530 )

Deferred tax (benefit) expense

     279       3,116  

Options received from affiliates

     —         (811 )

Assignments of options to employees

     —         2,751  

Equity-based compensation

     265,792       173,479  

Cash flows due to changes in

    

Cash held at consolidated subsidiaries and restricted cash

     —         (166,199 )

Due from affiliates

     104,038       264,551  

Receivables from brokers and counterparties and other assets

     5,839       (9,976 )

Accrued compensation and benefits

     (164,335 )     (47,239 )

Due to affiliates

     11,446       (8,713 )

Deferred incentive income

     26,077       —    

Due to brokers and counterparties and other liabilities

     28,462       113,887  

Investment company holdings

    

Purchases of investments

     —         (5,105,865 )

Proceeds from sale of investments

     —         3,398,739  
                

Net cash provided by (used in) operating activities

     51,855       (1,518,582 )
                

Cash Flows From Investing Activities

    

Proceeds from sale of other loan and security investments

     —         317  

Contributions to equity method investees

     (70,215 )     (9,378 )

Distributions of capital from equity method investees

     155,006       2,326  

Cash received on settlement of derivatives

     —         132  

Purchase of fixed assets

     (2,248 )     (4,173 )

Proceeds from disposal of fixed assets

     53       —    
                

Net cash provided by (used in) investing activities

     82,596       (10,776 )
                

Cash Flows From Financing Activities

    

Borrowings under debt obligations

     450,000       1,574,070  

Repayments of debt obligations

     (185,000 )     (1,657,872 )

Payment of deferred financing costs

     (61 )     (706 )

Issuance of Class A shares to Nomura

     —         888,000  

Issuance of Class A shares in initial public offering

     —         729,435  

Costs related to initial public offering

     —         (76,766 )

Dividends and dividend equivalents paid

     (26,381 )     (2,474 )

Fortress Operating Group capital distributions to Principals

     —         (219,112 )

Purchase of Fortress Operating Group units from Principals

     —         (888,000 )

Principals’ and others’ interests in consolidated subsidiaries - contributions

     —         3,183,727  

Principals’ and others’ interests in consolidated subsidiaries - distributions

     (100,740 )     (1,709,555 )
                

Net cash provided by (used in) financing activities

     137,818       1,820,747  
                

Net Increase (Decrease) in Cash and Cash Equivalents

     272,269       291,389  

Cash and Cash Equivalents, Beginning of Period

     100,409       61,120  
                

Cash and Cash Equivalents, End of Period

   $ 372,678     $ 352,509  
                

Supplemental Disclosure of Cash Flow Information

    

Cash paid during the period for interest (excluding interest paid by master funds while such funds were consolidated of $85.1 million in 2007)

   $ 9,462     $ 60,905  
                

Cash paid during the period for income taxes

   $ 1,109     $ 10,199  
                

Supplemental Schedule of Non-cash Investing and Financing Activities

    

Employee compensation invested directly in subsidiaries

   $ 16,743     $ 12,930  
                

Investments of receivable amounts into Fortress Funds

   $ 42,782     $ —    
                

Dividends, dividend equivalents and Fortress Operating Group unit distributions declared but not yet paid

   $ 96,657     $ 27,484  
                

Fortress Operating Group pre-IPO distributions of investments to Principals

   $ —       $ 196,764  
                

Fortress Operating Group pre-IPO distributions of investments to employees

   $ —       $ 23,338  
                

See Note 1 regarding the non-cash deconsolidation transaction

    

See notes to consolidated and combined financial statements

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

1. ORGANIZATION AND BASIS OF PRESENTATION

Fortress Investment Group LLC (the “Registrant,” or, together with its subsidiaries, “Fortress”) is a global alternative asset management firm whose predecessor was founded in 1998. Its primary business is to sponsor the formation of, and provide investment management services for, various investment funds and companies (the “Fortress Funds”). Fortress generally makes principal investments in these funds.

Fortress has three primary sources of income from the Fortress Funds: management fees, incentive income, and investment income on its principal investments in the funds. The Fortress Funds fall into the following business segments in which Fortress operates:

 

  1) Private equity funds:

 

  a) Funds which invest in debt and equity securities of public or privately held entities; and

 

  b) Publicly traded alternative investment vehicles that Fortress refers to as the “Castles,” which are companies that invest in operating real estate and real estate related loans and securities (debt and equity).

 

  2) Hedge funds:

 

  a) Liquid hedge funds, which invest in the global fixed income, commodities, currency and equity markets, and their related derivatives; and

 

  b) Hybrid hedge funds, which invest in undervalued, distressed and other less liquid investments, as well as investment funds managed by external managers.

 

  3) Principal investments in the above described funds.

The accompanying consolidated and combined financial statements include the following:

 

   

subsequent to Fortress’s reorganization and the inception of operations of Fortress Investment Group LLC on January 17, 2007, the accounts of Fortress Investment Group LLC and its consolidated subsidiaries, and

 

   

prior to such reorganization and the inception of operations of Fortress Investment Group LLC, the accounts of eight affiliated entities under common control and management (“Fortress Operating Group” or the “predecessor”) and their respective consolidated subsidiaries. Each of the eight entities was owned either directly or indirectly by its members, Peter Briger, Wesley Edens, Robert Kauffman, Randal Nardone, and Michael Novogratz (the “Principals”).

Reorganization of Fortress Operating Group

Fortress Investment Group LLC was formed on November 6, 2006 for the purpose of becoming the general partner of Fortress Operating Group, completing the Nomura Transaction (described below), and effecting a public offering of shares and related transactions (the “Transactions”) in order to carry on the business of its predecessor, Fortress Operating Group, as a publicly traded entity. The Registrant is a limited liability company and its members are not responsible for any of its liabilities beyond the equity they have invested. Fortress’s formation documents allow for an indefinite life.

Nomura Transaction

In December 2006, the Principals entered into a securities purchase agreement with Nomura Investment Managers U.S.A., Inc., or Nomura (whose ultimate parent is Nomura Holdings, Inc., a Japanese corporation). On January 17, 2007, Nomura completed the transaction by purchasing 55,071,450 Class A shares of the Registrant for $888 million and the Registrant, in turn, purchased 55,071,450 Fortress Operating Group units, which then represented 15% of Fortress Operating Group’s economic interests, from the Principals for $888 million.

Initial Public Offering (“IPO”)

On February 8, 2007, the Registrant completed an initial public offering of 39,428,900 of its Class A shares for net proceeds of approximately $652.7 million.

Consolidation and Deconsolidation of Fortress Funds

Certain of the Fortress Funds were consolidated into Fortress prior to the Transactions, notwithstanding the fact that Fortress has only a minority economic interest in these funds. Consequently, Fortress’s financial statements reflected the assets, liabilities, revenues, expenses and cash flows of the consolidated Fortress Funds on a gross basis through the date of their deconsolidation, as described below. The majority ownership interests in these funds, which are not owned by Fortress, were reflected as Principals’ and others’ interests in equity of consolidated subsidiaries in the accompanying financial statements during periods in which such funds were consolidated. The management fees and incentive income earned by Fortress from the consolidated

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

Fortress Funds were eliminated in consolidation; however, Fortress’s allocated share of the net income from these funds was increased by the amount of these eliminated fees. Accordingly, the consolidation of these Fortress Funds had no net effect on Fortress’s earnings from the Fortress Funds.

Following the IPO, each Fortress subsidiary that acts as a general partner of a consolidated Fortress Fund granted rights, effective March 31, 2007, to the investors in the fund to provide that a simple majority of the fund’s unrelated investors are able to liquidate the fund, without cause, in accordance with certain procedures, or to otherwise have the ability to exert control over the fund. The granting of these rights has led to the deconsolidation of the Fortress Funds from Fortress’s financial statements as of March 31, 2007. The deconsolidation of the Fortress Funds has had significant effects on many of the items within these financial statements but has had no net effect on net income or equity. Since the deconsolidation did not occur until March 31, 2007, the statement of operations and the statement of cash flows for the three months ended March 31, 2007 are presented with these funds on a consolidated basis. The unaudited pro forma effects of the deconsolidation on these financial statements are described in Note 12.

The accompanying consolidated and combined financial statements and related notes of Fortress have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, all adjustments considered necessary for a fair presentation of Fortress’s financial position, results of operations and cash flows have been included and are of a normal and recurring nature. The operating results presented for interim periods are not necessarily indicative of the results that may be expected for any other interim period or for the entire year. These financial statements should be read in conjunction with Fortress’s consolidated and combined financial statements for the year ended December 31, 2007 and notes thereto included in Fortress’s annual report on Form 10-K filed with the Securities and Exchange Commission. Capitalized terms used herein, and not otherwise defined, are defined in Fortress’s consolidated and combined financial statements for the year ended December 31, 2007.

Certain prior period amounts have been reclassified to conform to the current period’s presentation.

2. MANAGEMENT AGREEMENTS AND FORTRESS FUNDS

Management Fees, Incentive Income and Related Profit Sharing Expense

Fortress recognized management fees and incentive income as follows:

 

     Three Months Ended
March 31,
     2008    2007(A)

Private Equity

     

Funds

     

Management fees

   $ 41,817    $ 26,664

Incentive income

     34,640      206,440

Castles

     

Management fees

     12,937      11,029

Management fees- options

     —        811

Incentive income

     12      3,688

Hedge Funds

     

Liquid Hedge Funds

     

Management fees

     52,647      29,858

Incentive income

     2,492      45,688

Hybrid Hedge Funds

     

Management fees

     36,656      27,997

Incentive income

     —        95

Total

     

Management fees

   $ 144,057    $ 96,359

Incentive income

   $ 37,144    $ 255,911

 

(A) Presented on a pro forma basis (Note 12), as adjusted for the deconsolidation of the Fortress Funds as if it has occurred on January 1, 2007.

 

6


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

Incentive Income Subject to Annual Performance Criteria

Incentive income from certain Fortress Funds is earned based on achieving annual performance criteria. Accordingly, this incentive income is recorded as revenue at year end (in the fourth quarter of each year) and has not been recognized for these funds during the three months ended March 31, 2008 and 2007. If the amount of incentive income contingent on achieving annual performance criteria was not contingent on the results of the subsequent quarters, $0.0 million and $45.6 million of additional incentive income from affiliates would have been recognized during the three months ended March 31, 2008 and 2007, respectively. Incentive income based on achieving annual performance criteria that has not yet been recognized is included as “undistributed” deferred incentive income in the table below.

Deferred incentive income from the Fortress Funds, subject to contingent repayment, was comprised of the following, on an inception to date basis:

 

     March 31,
2008
    December 31,
2007
 

Distributed - gross

   $ 470,798     $ 444,721  

Less: Recognized (A)

     (303,119 )     (271,160 )
                

Distributed - unrecognized

   $ 167,679     $ 173,561  
                

Undistributed (B)

     164,745       384,520  
                

Total

   $ 332,424     $ 558,081  
                
 
  (A) All related contingencies have been resolved.
  (B) On a deconsolidated basis, subsequent to March 31, 2007, undistributed incentive income is no longer recorded and is not reflected on the balance sheet.

From inception to March 31, 2008, Fortress has recognized and paid compensation expense under its employee profit sharing arrangements in connection with the $470.8 million of distributed incentive income. If the $164.7 million of undistributed incentive income were realized, Fortress would recognize and pay an additional $63.6 million of compensation expense.

The change in deferred incentive income is summarized as follows:

 

     Distributed     Undistributed     Total  

Deferred incentive income as of December 31, 2007

   $ 173,561     $ 384,520     $ 558,081  

Share of income (loss) of Fortress Funds

     26,077       (219,775 )     (193,698 )

Recognition of previously deferred incentive income

     (31,959 )     —         (31,959 )
                        

Deferred incentive income as of March 31, 2008

   $ 167,679     $ 164,745     $ 332,424  
                        

Recognized profit sharing compensation expense is summarized as follows:

 

     Three Months Ended
March 31,
     2008    2007

Private equity funds

   $ 1,398    $ 71,753

Castles

     1,166      2,356

Liquid hedge funds

     16,998      28,947

Hybrid hedge funds

     2,055      19,518
             

Total

   $ 21,617    $ 122,574
             

 

7


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

Principals’ and Others’ Interests in Consolidated Subsidiaries

This balance sheet caption was comprised of the following:

 

     March 31, 2008    December 31, 2007

Principals’ Fortress Operating Group units

   $ 171,807    $ 232,826

Employee interests in majority owned and controlled fund advisor and general partner entities

     54,427      75,062

Other

     586      135
             

Total

   $ 226,820    $ 308,023
             

This statement of operations caption was comprised of shares of consolidated net income related to the following, on a pre-tax basis:

 

     Three Months Ended March 31,  
     2008 Actual     2007 Actual     2007 Pro Forma (A)  

Principals’ Fortress Operating Group units

   $ (208,877 )   $ (77,642 )   $ (77,642 )

Employee interests in majority owned and controlled fund advisor and general partner entities

     139       2,842       2,842  

Third party investors in Fortress Funds

     —         (460,615 )     —    

Other

     469       (115 )     (115 )
                        

Total

   $ (208,269 )   $ (535,530 )   $ (74,915 )
                        
 
  (A) Presented on a pro forma basis (Note 12), as adjusted for the deconsolidation of the consolidated Fortress Funds as if it had occurred on January 1, 2007.

Private Equity Funds

In 2008, Fortress made an additional $100 million commitment to Fund V. Fortress’s affiliates, including employees and the Principals, made additional commitments to this fund of $67.3 million at the same time.

During the three months ended March 31, 2008, Fortress formed new private equity funds which had capital commitments as follows:

 

Fortress’s commitments

   $ 10,076

Fortress’s affiliates’ commitments

     10,000

Third party investors’ commitments

     661,700
      

Total capital commitments

   $ 681,776
      

Liquid Hedge Funds and Hybrid Hedge Funds

During the three months ended March 31, 2008, Fortress formed new hedge funds with net asset values as follows:

 

     March 31, 2008 NAV
     Liquid    Hybrid

Fortress (A)

   $ 1,391    $ —  

Fortress’s affiliates

     310,706      —  

Third party investors

     656,553      —  
             

Total NAV

   $ 968,650    $ —  
             
 
  (A) Includes a first quarter incentive income allocation of $0.5 million.

 

8


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

3. INVESTMENTS IN EQUITY METHOD INVESTEES AND OTHER EQUITY INVESTMENTS

Fortress elected to record its investments in and options from Newcastle and Eurocastle at fair value pursuant to SFAS 159 (“The Fair Value Option For Financial Assets and Financial Liabilities”) beginning January 1, 2008. Fortress made this election to simplify its accounting for these publicly traded equity securities (and related options), which were previously recorded based on the equity method of accounting. As a result, Fortress recorded an aggregate increase to the carrying amounts of these assets of $22.9 million, which was recorded as a cumulative effect adjustment to retained earnings ($2.1 million) and also impacted the Principals’ interests in the equity of consolidated subsidiaries (Fortress Operating Group) ($17.6 million), deferred tax assets ($1.9 million), and accumulated other comprehensive income ($1.2 million). Fortress accounts for dividends received from these investments as dividend income, a component of Other Revenues.

Investments in Equity Method Investees

Fortress holds investments in certain unconsolidated Fortress Funds which are recorded based on the equity method of accounting. Upon the deconsolidation of the consolidated Fortress Funds on March 31, 2007 (Note 1), these funds also became equity method investees. Fortress’s maximum exposure to loss with respect to these entities is generally equal to its investment plus its basis in any options received from such entities as described below. In addition, unconsolidated affiliates also hold an ownership interests in certain of these entities. Summary financial information related to these investments is as follows:

 

     Fortress’s Investment    Fortress’s Equity in Net Income (Loss)  
     March 31,
2008
   December 31,
2007
   Three Months Ended March 31,  
         2008     2007  

Private equity funds, excluding NIH (A)

   $ 655,290    $ 623,830    $ (40,329 )   $ (A )

NIH

     4,727      5,770      1,059       (181 )

Newcastle (B)

     8,473      3,184      N/A       729  

Eurocastle (B)

     12,058      11,799      N/A       (398 )
                              

Total private equity

     680,548      644,583      (39,270 )     150  

Liquid hedge funds (A)

     62,702      73,748      963       (A )

Hybrid hedge funds (A)

     260,707      371,310      (10,823 )     (A )

Other

     2,481      2,277      1       45  
                              
   $ 1,006,438    $ 1,091,918    $ (49,129 )   $ 195  
                              

 

(A) These entities were consolidated prior to March 31, 2007.
(B) Fortress elected to record these investments at fair value pursuant to SFAS 159 beginning on January 1, 2008.

A summary of the changes in Fortress’s investments in equity method investees is as follows:

 

     Three Months Ended March 31, 2008  
     Private Equity Funds     Castles (A)     Liquid
Hedge
Funds
    Hybrid
Hedge
Funds
    Other    Total  
     NIH     Other     Newcastle     Eurocastle           

Investment, beginning

   $ 5,770     $ 623,830     $ 3,184     $ 11,799     $ 73,748     $ 371,310     $ 2,277    $ 1,091,918  

Earnings from equity method investees

     1,059       (40,329 )     N/A       N/A       963       (10,823 )     1      (49,129 )

Other comprehensive income from equity method investees

     —         —         N/A       N/A       —         —         —        —    

Contributions to equity method investees

     —         68,806       N/A       N/A       43,727       261       203      112,997  

Distributions of earnings from equity method investees

     (2,102 )     (180 )     N/A       N/A       (1,011 )     —         —        (3,293 )

Distributions of capital from equity method investees

     —         (240 )     N/A       N/A       (54,725 )     (100,041 )     —        (155,006 )
                                                               

Total distributions from equity method investees

     (2,102 )     (420 )     N/A       N/A       (55,736 )     (100,041 )     —        (158,299 )
                                                               

Sale of investments

     —         —         —         —         —         —         —        —    

Mark to fair value - January 1, 2008 (B)

     N/A       N/A       10,110       12,762       N/A       N/A       N/A      22,872  

Mark to fair value - during period (C)

     N/A       N/A       (4,821 )     (14,524 )     N/A       N/A       N/A      (19,345 )

Translation adjustment

     —         3,403       —         2,021       —         —         —        5,424  
                                                               

Investment, ending

   $ 4,727     $ 655,290     $ 8,473     $ 12,058     $ 62,702     $ 260,707     $ 2,481    $ 1,006,438  
                                                               

Ending balance of undistributed earnings

   $ 1,369     $ —         N/A       N/A     $ 1     $ 5,306     $ 1    $ 6,677  
                                                               

 

(A) Fortress elected to record the investments at fair value pursuant to SFAS 159 beginning on January 1, 2008.
(B) Recorded as a cumulative effect adjustment to Retained Earnings.
(C) Recorded to Other Investments – Net Unrealized Gains (Losses) from Affiliate Investments.

 

9


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

The ownership percentages presented in the following tables are reflective of the ownership interests held as of the end of the respective periods. For tables which include more than one Fortress Fund, the ownership percentages are based on a weighted average by total equity of the funds as of period end.

 

     Private Equity Funds excluding NIH (C)     Newcastle Investment Holdings LLC (“NIH”)  
     March 31,
2008
    December 31,
2007
    March 31,
2008
    December 31,
2007
 
        

Assets

   $ 16,290,470     $ 16,982,495     $ 309,751     $ 336,176  

Liabilities

     (3,136,409 )     (3,445,658 )     (224,918 )     (230,457 )
                                

Equity

   $ 13,154,061     $ 13,536,837     $ 84,833     $ 105,719  
                                

Fortress’s Investment

   $ 655,290     $ 623,830     $ 4,727     $ 5,770  
                                

Ownership (A)

     5.0 %     4.6 %     4.8 %     4.8 %
                                
     Three Months Ended March 31,     Three Months Ended March 31,  
     2008     2007     2008     2007  

Revenues and gains (losses) on investments

   $ (1,154,619 )   $ (699,980 )   $ 30,363     $ (207 )

Expenses

     (110,510 )     (49,185 )     (7,398 )     (3,587 )
                                

Net Income (Loss)

   $ (1,265,129 )   $ (749,165 )   $ 22,965     $ (3,794 )
                                

Fortress’s equity in net income (loss)

   $ (40,329 )   $ —       $ 1,059     $ (181 )
                                
       (B )    

 

(A) Excludes ownership interests held by other Fortress Funds, the Principals, employees and other affiliates.
(B) The revenues and expenses of these entities were consolidated through March 31, 2007, the effective date of the deconsolidation (Note 1). As a result, the amounts shown for Fortress’s equity in net income of these entities relate to the period subsequent to March 31, 2007 (zero for the three months then ended).
(C) Includes one entity which is recorded on a one quarter lag (i.e. the balances reflected for this entity are for December 31, 2007 and the period then ended). Fortress’s cash invested in this entity totaled $41.5 million. It is recorded on a lag because it is a German entity and does not provide financial reports under U.S. GAAP within the reporting timeframe necessary for U.S. public entities.

 

     Newcastle Investment Corp.     Eurocastle Investment Ltd.  
     March 31,
2008
    December 31,
2007
    March 31,
2008
    December 31,
2007
 
        

Assets

   $ 6,253,504     $ 8,037,770     $ 11,385,659     $ 10,713,687  

Liabilities

     (6,318,483 )     (7,590,145 )     (9,679,708 )     (8,865,921 )

Minority interest

     —         —         (8 )     (8 )
                                

Equity

   $ (64,979 )   $ 447,625     $ 1,705,943     $ 1,847,758  
                                

Ownership, basic (A)

     1.9 %     1.9 %     1.6 %     1.6 %
                                

Ownership, diluted (A) (B)

     4.7 %     4.7 %     9.8 %     9.8 %
                                

Ownership by Fortress and affiliates, diluted (B)

     15.5 %     15.5 %     29.3 %     29.3 %
                                

Market value of shares owned (A) (C)

   $ 8,473     $ 13,293     $ 12,058     $ 24,561  
                                
     Three Months Ended March 31,     Three Months Ended March 31,  
     2008     2007     2008     2007  

Revenues and gains (losses) on investments

   $ 132,894     $ 162,216     $ 187,128     $ 144,580  

Expenses

     (99,871 )     (129,730 )     (216,792 )     (169,757 )

Other income (loss)

     (70,239 )     3,776       —         —    

Discontinued operations

     (3,688 )     (71 )     —         —    

Preferred dividends

     (3,375 )     (2,515 )     —         —    
                                

Net Income (Loss)

   $ (44,279 )   $ 33,676     $ (29,664 )   $ (25,177 )
                                

Fortress’s equity in net income (loss)

     N/A     $ 729       N/A     $ (398 )
                                

 

(A) Excludes ownership interests held by other Fortress Funds, the Principals, employees and other affiliates.
(B) Fully diluted ownership represents the percentage of outstanding common shares assuming that all options are exercised. Currently, all of the options are out of the money (that is, their strike price is below the current market price per share).
(C) Based on the closing price of the related shares and, if applicable, the foreign currency exchange rate on the last day of trading in the applicable period.

 

10


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

     Liquid Hedge Funds     Hybrid Hedge Funds  
     March 31,
2008
    December 31,
2007
    March 31,
2008
    December 31,
2007
 
        

Assets

   $ 9,816,162     $ 8,358,378     $ 12,083,501     $ 12,098,175  

Liabilities

     (79,552 )     (67,483 )     (4,081,160 )     (4,493,901 )

Minority Interest

     —         —         (33,079 )     (26,834 )
                                

Equity

   $ 9,736,610     $ 8,290,895     $ 7,969,262     $ 7,577,440  
                                

Fortress’s Investment

   $ 62,702     $ 73,748     $ 260,707     $ 371,310  
                                

Ownership (A)

     0.6 %     0.9 %     3.3 %     4.9 %
                                
     Three Months Ended March 31,     Three Months Ended March 31,  
     2008     2007     2008     2007  

Revenues and gains (losses) on investments

   $ 106,405     $ 351,964     $ (123,468 )   $ 264,400  

Expenses

     (156,539 )     (215,052 )     (109,619 )     (54,823 )
                                

Net Income

   $ (50,134 )   $ 136,912     $ (233,087 )   $ 209,577  
                                

Fortress’s equity in net income (loss)

   $ 963     $ —       $ (10,823 )   $ —    
                                
       (B )       (B )

 

(A) Excludes ownership interests held by other Fortress Funds, the Principals, employees and other affiliates.
(B) The revenues and expenses of these entities were consolidated through March 31, 2007, the effective date of the deconsolidation (Note 1). As a result, the amounts shown for Fortress’s equity in net income of these entities relate to the period subsequent to March 31, 2007 (zero for the three months then ended).

Options in Affiliates

Fortress holds options to purchase additional shares of its equity method investees with carrying values as follows:

 

     March 31,
2008
   December 31,
2007
  

Accounting Treatment

Newcastle options

   $ 257    $ 5    Recorded at fair value

Eurocastle options

     3,547      15,996    Recorded at fair value
                
   $ 3,804    $ 16,001   
                

Investments in Variable Interest Entities

As part of the deconsolidation of the consolidated Fortress Funds (Note 1), Fortress caused reconsideration events to occur in each of the variable interest entities in which it was deemed to be the primary beneficiary. As a result of these reconsideration events, Fortress is no longer considered the primary beneficiary of, and therefore does not consolidate, any of the variable interest entities in which it holds an interest. No reconsideration events occurred during the three months ended March 31, 2008 which caused a change in Fortress’s accounting.

The following table presents information as of March 31, 2008 regarding entities formed during the three months ended March 31, 2008 that were determined to be VIEs in which Fortress holds a variable interest:

 

     Fortress is not Primary Beneficiary

Business Segment

   Gross Assets    Fortress Investment (A)

Private Equity Funds

   $ 15,961    $ 73

 

(A) Includes $40,000 of management fees receivable. Also represents Fortress’s maximum exposure to loss with respect to these entities.

Fair Value of Financial Instruments

The following table presents information regarding Fortress’s financial instruments which are recorded at fair value:

 

     March 31, 2008
Fair Value
  

Valuation Method

Assets - Carried at Fair Value

     

Newcastle and Eurocastle common shares

   $ 20,531    Level 1 - Quoted prices in active markets for identical assets

Newcastle and Eurocastle options

   $ 3,804    Level 2 - Lattice-based option valuation models using significant observable inputs

 

11


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

4. DEBT OBLIGATIONS

The following table presents information regarding Fortress’s debt obligations:

 

     Month
Issued
             Contractual
Interest Rate
    Final
Stated
Maturity
   March 31, 2008
        Face Amount and
Carrying Value
        Weighted
Average
Funding
Cost (A)
    Weighted
Average
Maturity
(Years)

Debt Obligation

      March 31,
2008
   December
31, 2007
         

Credit agreement (B)

                  

Revolving debt (C)

   May 2007    $ —      $ 185,000    LIBOR + 0.65 % (D)   May 2012    0.00 %   N/A

Term loan

   May 2007      350,000      350,000    LIBOR + 0.65 %   May 2012    3.52 %   4.11

Delayed term loan (C)

   May 2007      450,000      —      LIBOR + 0.65 %   May 2012    3.79 %   4.11
                                

Total

      $ 800,000    $ 535,000         3.67 %   4.11
                                

 

(A) The weighted average funding cost is calculated based on the contractual interest rate (utilizing the most recently reset LIBOR rate) plus the amortization of deferred financing costs. The most recently reset LIBOR rate was 2.56%.
(B) Collateralized by substantially all of Fortress Operating Group’s assets as well as Fortress Operating Group’s rights to fees from the Fortress Funds and its equity interests therein.
(C) Approximately $189 million was undrawn and available under the revolving debt facility as of March 31, 2008, including a $25 million letter of credit subfacility of which $11 million was utilized.
(D) Subject to unused commitment fees of 0.20% per annum.

In connection with the repayment of a portion of a prior term loan, $2.0 million of deferred loan costs were written off to interest expense in February 2007. In May 2007, Fortress entered into a new credit agreement to refinance its existing credit agreement, reduce the amount of interest and other fees payable under its credit facilities, and increase the amount of funds available for investments.

Fortress was in compliance with all of its debt covenants as of March 31, 2008.

Fortress’s debt agreement was amended subsequent to March 31, 2008 – see Note 11.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

5. INCOME TAXES AND TAX RELATED PAYMENTS

The provision for income taxes consists of the following:

 

     Three Months Ended March 31,  
     2008     2007  

Current

            

Federal income tax

   $ 2,654     $ 6,241  

Foreign income tax

     637       706  

State and local income tax

     3,682       4,384  
                
     6,973       11,331  
                

Deferred

            

Federal income tax expense (benefit)

     1,291       5,982  

Foreign income tax expense (benefit)

     166       (514 )

State and local income tax expense (benefit)

     (1,178 )     (2,352 )
                
     279       3,116  
                

Total

   $ 7,252     $ 14,447  
                

The tax effects of temporary differences have resulted in deferred income tax assets and liabilities as follows:

 

     March 31, 2008    December 31, 2007

Deferred tax assets

   $ 508,380    $ 511,204
             

Deferred tax liabilities (A)

   $ 888    $ 891
             

 

(A) Included in Other Liabilities

For the three months ended March 31, 2008, an estimated annual negative effective tax rate of (11.76%) was used to compute the tax provision. Fortress incurred a loss before income taxes for financial reporting purposes, after deducting the compensation expense arising from the Principals’ forfeiture agreement. However, this compensation expense is not deductible for income tax purposes. Also, a portion of Fortress’s income is not subject to U.S. federal income tax, but is allocated directly to Fortress’s shareholders. For the three months ended March 31, 2008, a deferred income tax liability of $1.2 million was debited to other comprehensive income, primarily related to the equity method investees. A current income tax benefit of $0.6 million was credited to additional paid in capital, related to dividend equivalent payments on RSU’s, which are currently deductible for income tax purposes.

Tax Receivable Agreement

Although the tax receivable agreement payments are calculated based on annual tax savings, for the period ended March 31, 2008, the payments which would have been made pursuant to the tax receivable agreement, if such period was calculated by itself, were estimated to be $3.8 million.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

6. RELATED PARTY TRANSACTIONS

Due from affiliates was comprised of the following:

 

     Private Equity
Funds
   Castles    Liquid Hedge
Funds
   Hybrid Hedge
Funds
   Other    Total

March 31, 2008

                             

Management fees and incentive income

   $ 8,315    $ 12,828    $ 10,098    $ —      $ —      $ 31,241

Expense reimbursements

     7,015      3,141      4,499      3,290      —        17,945

Dividends and distributions

     —        732      —        —        —        732

Other

     —        —        —        17      2,153      2,170
                                         

Total

   $ 15,330    $ 16,701    $ 14,597    $ 3,307    $ 2,153    $ 52,088
                                         

 

     Private Equity
Funds
   Castles    Liquid Hedge
Funds
   Hybrid Hedge
Funds
   Other    Total

December 31, 2007

                             

Management fees and incentive income

   $ 1,733    $ 45,004    $ 40,751    $ 98,197    $ —      $ 185,685

Expense reimbursements

     1,307      2,051      3,074      3,487      —        9,919

Dividends and distributions

     —        739      —        —        —        739

Other

     —        —        —        1      2,325      2,326
                                         

Total

   $ 3,040    $ 47,794    $ 43,825    $ 101,685    $ 2,325    $ 198,669
                                         

Due to affiliates was comprised of the following:

 

     March 31, 2008    December 31, 2007

Principals

     

-Tax receivable agreement - Note 5

   $ 393,265    $ 393,265

- Distributable payable on Fortress Operating Group units

     70,216      60,176

Other

     13,740      2,293
             
   $ 477,221    $ 455,734
             

For the three months ended March 31, 2008 and 2007, Other Revenues included approximately $15.0 million and $10.2 million, respectively, of revenues from affiliates, primarily expense reimbursements. Dividend income from affiliates of approximately $0.7 million was recorded during the three months ended March 31, 2008.

Fortress has entered into cost sharing arrangements with the Fortress Funds, including subleases of certain of its office space. Expenses borne by the Fortress Funds under these agreements are generally paid directly by those entities (i.e. they are generally not paid by Fortress and reimbursed). For the period ended March 31, 2008, these expenses, mainly related to subscriptions to market data services, approximated $5.3 million.

 

14


Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

7. EQUITY-BASED COMPENSATION

The following tables present information regarding equity-based compensation during the three months ended March 31, 2008.

 

     RSUs     
     Employees    Non-Employees    Restricted Shares
Issued to Directors
     Number     Value
(A)
   Number     Value
(A)
   Number    Value
(A)

Outstanding as of December 31, 2007

   43,215,535     $ 16.74      9,318,968     $ 15.22    97,296    $ 18.50

Issued

   215,620       6.96      98,020       12.00    —        —  

Forfeited

   (1,258,374 )     18.70      (205,497 )     14.54    —        —  
                                       

Outstanding as of March 31, 2008 (B)

   42,172,781     $ 16.63      9,211,491     $ 15.20    97,296    $ 18.50
                                       

Expense incurred (B)

               

Employee RSUs

        $ 26,572          

Non-Employee RSUs

          (10 )        

Restricted Shares

          149          

LTIP

          1,714          
                     

Total equity-based compensation expense

        $ 28,425          
                     

 

(A) Represents the weighted average grant date estimated fair value per share or unit. The weighted average estimated fair value per unit as of March 31, 2008 for awards granted to non-employees was $8.67.
(B) In future periods, Fortress will recognize compensation expense on its non-vested equity based awards of $628.9 million, with a weighted average recognition period of 4.9 years.

When Fortress records equity-based compensation expense, including that related to the Principals Agreement, it records a corresponding increase in capital. Of the total increase in capital during the three months ended March 31, 2008 from equity-based compensation arrangements of $265.8 million, $61.8 million increased Fortress’s paid-in capital, as reflected in the Statement of Shareholders’ Equity, and $204.0 million increased Principals’ interests in equity of consolidated subsidiaries, corresponding to the Principals’ interest in the equity-based compensation expense.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

8. EARNINGS PER SHARE AND DISTRIBUTIONS

As a result of Fortress’s reorganization in January 2007 (Note 1), Fortress has calculated its earnings per share for two different periods within the three months ended March 31, 2007. For the first period, prior to the reorganization on January 17, 2007, the calculation is based on the income and outstanding units of Fortress Operating Group, which were owned by the Principals, as if such units had been outstanding from the beginning of the period. For the second period, subsequent to the reorganization and commencement of operations of the Registrant, the calculation is based on the consolidated income of Fortress from January 17, 2007 through March 31, 2007 and the Class A shares outstanding for such period.

The computations of net income per Fortress Operating Group unit are set forth below:

 

     January 1 through January 16,
2007
     Basic    Diluted

Weighted average units outstanding

     

Fortress Operating Group units outstanding

     367,143,000      367,143,000
             

Total weighted average units outstanding

     367,143,000      367,143,000
             

Net income per unit is calculated as follows:

     

Net income

   $ 133,397    $ 133,397

Dilution in earnings of certain equity method investees

     —        —  
             

Net income available to Fortress Operating Group unitholders

   $ 133,397    $ 133,397
             

Weighted average units outstanding

     367,143,000      367,143,000
             

Net income per unit

   $ 0.36    $ 0.36
             

The computations of basic and diluted net income (loss) per Class A share are set forth below:

 

     January 17 through March 31, 2007  
     Basic     Diluted  

Weighted average shares outstanding

    

Class A shares outstanding

     82,245,422       82,245,422  

Fully vested restricted Class A share units with dividend equivalent rights

     10,656       10,656  

Fortress Operating Group units exchangeable into Fortress Investment Group LLC Class A shares (1)

     —         —    

Class A restricted shares and Class A restricted share units granted to employees and directors (eligible for dividend and dividend equivalent payments) (2)

     —         —    

Class A restricted share units granted to employees (not eligible for dividend and dividend equivalent payments) (3)

     —         —    
                

Total weighted average shares outstanding

     82,256,078       82,256,078  
                

Basic and diluted net income (loss) per Class A share

    

Net income (loss)

   $ (71,254 )   $ (71,254 )

Dividend equivalents declared on non-vested restricted Class A share units

     (569 )     (569 )

Dilution in earnings of certain equity method investees

     —         —    

Add back Principals’ and others’ interests in loss of Fortress Operating Group, net of assumed corporate income tax at enacted rates, attributable to Fortress Operating Group units exchangeable into Fortress Investment Group LLC Class A shares (1)

     —         —    
                

Net income (loss) available to Class A shareholders

   $ (71,823 )   $ (71,823 )
                

Weighted average shares outstanding

     82,256,078       82,256,078  
                

Basic and diluted net income (loss) per Class A share

   $ (0.87 )   $ (0.87 )
                

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

     Three Months Ended March 31, 2008  
     Basic     Diluted  

Weighted average shares outstanding

    

Class A shares outstanding

     94,500,350       94,500,350  

Fully vested restricted Class A share units with dividend equivalent rights

     394,286       394,286  

Fortress Operating Group units exchangeable into Fortress Investment Group LLC

    

Class A shares (1)

     —         312,071,550  

Class A restricted shares and Class A restricted share units granted to employees and directors (eligible for dividend and dividend equivalent payments) (2)

     —         —    

Class A restricted share units granted to employees (not eligible for dividend and dividend equivalent payments) (3)

     —         —    
                

Total weighted average shares outstanding

     94,894,636       406,966,186  
                

Basic and diluted net income (loss) per Class A share

    

Net income (loss)

   $ (68,917 )   $ (68,917 )

Dividend equivalents declared on non-vested restricted Class A share units

     (1,117 )     (1,117 )

Add back Principals’ and others’ interests in loss of Fortress Operating Group, net of assumed corporate income tax at enacted rates, attributable to Fortress Operating

    

Group units exchangeable into Fortress Investment Group LLC Class A shares (1)

     —         (233,023 )
                

Net income (loss) available to Class A shareholders

   $ (70,034 )   $ (303,057 )
                

Weighted average shares outstanding

     94,894,636       406,966,186  
                

Basic and diluted net income (loss) per Class A share

   $ (0.74 )   $ (0.74 )
                

 

(1) The Fortress Operating Group units not held by Fortress (that is, those held by the Principals) are exchangeable into Class A shares on a one-to-one basis. These units are not included in the computation of basic earnings per share. These units enter into the computation of diluted net income (loss) per Class A share when the effect is dilutive using the if-converted method.
(2) Restricted Class A shares granted to directors and certain restricted Class A share units granted to employees are eligible to receive dividend or dividend equivalent payments when dividends are declared and paid on our Class A shares and therefore participate fully in the results of our operations from the date they are granted. They are included in the computation of both basic and diluted earnings per Class A share using the two-class method for participating securities, except during periods of net losses.
(3) Certain restricted Class A share units granted to employees are not entitled to dividend or dividend equivalent payments until they are vested and are therefore non-participating securities. These units are not included in the computation of basic earnings per share. They are included in the computation of diluted earnings per share when the effect is dilutive using the treasury stock method. As a result of the net loss incurred for the period, the effect of the units on the calculation is anti-dilutive for the periods. The weighted average restricted Class A share units which are not entitled to receive dividend or dividend equivalent payments outstanding for the periods from January 17, 2007 through March 31, 2007 and the three months ended March 31, 2008 were 17,394,787 and 27,817,295 share units, respectively.

The Class B shares have no net income (loss) per share as they do not participate in Fortress’s earnings (losses) or distributions. The Class B shares have no dividend or liquidation rights. Each Class B share, along with one Fortress Operating Group unit, can be exchanged for one Class A share, subject to certain limitations. The Class B shares have voting rights on a pari passu basis with the Class A shares. The number of Class B shares outstanding did not change subsequent to the IPO.

Fortress’s dividend paying shares and units were as follows:

 

     Weighted Average          
     Three Months Ended March 31,    As of March 31, 2008    As of December 31, 2007
     2008    2007      

Class A shares

   94,500,350    67,624,013    94,500,350    94,500,350

Restricted Class A share units (A)

   394,286    8,762    394,286    394,286

Restricted Class A shares

   97,296    55,134    97,296    97,296

Restricted Class A share units

   23,765,492    13,721,365    23,549,636    23,906,779

Fortress Operating Group units

   312,071,550    321,862,030    312,071,550    312,071,550
                   

Total

   430,828,974    403,271,304    430,613,118    430,970,261
                   

 

(A) Represents fully vested restricted Class A share units which are entitled to dividend equivalent payments.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

Dividends and distributions during the three months ended March 31, 2008 are summarized as follows:

 

     Declared in Prior
Year, Paid
Current Year
   Current Year
      Declared and
Paid
   Declared but
not yet Paid
   Total

Dividends on Class A Shares

   $ 21,285    $ —      $ 21,285    $ 21,285

Dividend equivalents on restricted Class A share units (A)

     5,428      —        5,387      5,387

Distributions to Fortress Operating Group unit holders (Principals)

     60,176      3,030      70,216      73,246
                           

Total distributions

   $ 86,889    $ 3,030    $ 96,888    $ 99,918
                           

 

(A) A portion of these dividend equivalents, related to RSUs expected to be forfeited, is included as compensation expense in the consolidated statement of operations and is therefore considered an operating cash flow.

9. COMMITMENTS AND CONTINGENCIES

Other than as described below, Fortress’s commitments and contingencies remain materially unchanged from December 31, 2007.

Private Equity Fund Capital Commitments – Fortress has remaining capital commitments to certain of the Fortress Funds which aggregated $176.9 million as of March 31, 2008. These commitments can be drawn by the funds on demand.

Minimum Future Rentals – Fortress is a lessee under operating leases for office space located in New York, Atlanta, Chicago, Dallas, Frankfurt, Geneva, Hong Kong, London, Los Angeles, Munich, New Canaan, Rome, San Diego, San Francisco, Sydney, Tokyo and Toronto.

Minimum future rent payments under these leases is as follows:

 

April 1, 2008 to December 31, 2008

   $ 13,210

2009

     17,828

2010

     13,798

2011

     8,973

2012

     6,206

2013

     5,643

Thereafter

     17,214
      

Total

   $ 82,872

Rent expense recognized on a straight-line basis during the three months ended March 31, 2008 and 2007 was $4.8 million and $3.6 million, respectively, and was included in General, Administrative and Other Expense.

Litigation – Fortress is, from time to time, a defendant in legal actions from transactions conducted in the ordinary course of business. Management, after consultation with legal counsel, believes the ultimate liability arising from such actions that existed as of March 31, 2008, if any, will not materially affect Fortress’s results of operations, liquidity or financial position.

On September 15, 2005, a lawsuit captioned David T. Atkins et al. v. Apollo Real Estate Advisors, L.P. et al. was brought on behalf of current and former limited partners in certain investing partnerships related to the sale of certain facilities to Ventas Realty Limited Partnership (“Ventas”) against a number of defendants, including one of the Portfolio Companies and a subsidiary of Fortress (“FIG”). FIG was the investment manager of consolidated Fortress Funds that were controlling shareholders of the Portfolio Company during the relevant time periods. The suit alleges that the defendants improperly obtained certain rights with respect to such facilities from the investing partnerships. The plaintiffs have asked for damages in excess of $100 million on each of nine counts, as to which FIG is a defendant on seven counts, including treble damages with respect to certain counts. On April 18, 2006, Fortress filed a motion to dismiss the claims with prejudice. On April 30, 2008, the court entered a memorandum and order granting the motion and dismissing the plaintiff’s complaint in its entirety, and granted the plaintiffs a period of 30 days from April 30, 2008 in which to file an amended complaint. Fortress believes that the resolution of this action will not have a material adverse effect on its financial condition, liquidity or results of operations.

In addition, in the ordinary course of business, the Fortress Funds are and can be both the defendant and the plaintiff in numerous actions with respect to bankruptcy, insolvency and other types of proceedings. Such lawsuits may involve claims that adversely affect the value of certain financial instruments owned by the Fortress Funds. Although the ultimate outcome of actions cannot be ascertained with certainty, Fortress believes that the resolution of any such actions will not have a material adverse effect on its financial condition, liquidity or results of operations.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

10. SEGMENT REPORTING

Fortress conducts its management and investment business through the following five primary segments: (i) private equity funds, (ii) Castles, (iii) liquid hedge funds, (iv) hybrid hedge funds, and (v) principal investments in these funds as well as cash that is available to be invested. These segments are differentiated based on their varying investment strategies. Due to the increased significance of the principal investments segment, it has been disaggregated from the other segments in this period and for all periods presented.

“Distributable earnings” for the existing Fortress businesses is equal to net income adjusted as follows:

Incentive Income

 

(i)    a.    for Fortress Funds which are private equity funds, adding (a) incentive income paid (or declared as a distribution) to Fortress, less an applicable reserve for potential future clawbacks if the likelihood of a clawback is deemed greater than remote (net of the reversal of any prior such reserves that are no longer deemed necessary), minus (b) incentive income recorded in accordance with GAAP,
   b.    for other Fortress Funds, at interim periods, adding (a) incentive income on an accrual basis as if the incentive income from these funds were payable on a quarterly basis, minus (b) incentive income recorded in accordance with GAAP,

Other Income

 

  (ii) with respect to income from certain principal investments and certain other interests that cannot be readily transferred or redeemed:

 

  a. for equity method investments in the Castles (prior to 2008) and private equity funds as well as indirect equity method investments in hedge fund special investment accounts (which generally have investment profiles similar to private equity funds), treating these investments as cost basis investments by adding (a) realizations of income, primarily dividends, from these funds, minus (b) impairment with respect to these funds, if necessary, minus (c) equity method earnings (or losses) recorded in accordance with GAAP,

 

  b. subtracting gains (or adding losses) on stock options held in the Castles,

 

  c. subtracting unrealized gains (or adding unrealized losses) from consolidated private equity funds,

 

  d. subtracting unrealized gains (or adding unrealized losses) from the Castles subsequent to the election of SFAS 159,

 

  (iii) adding (a) proceeds from the sale of shares received pursuant to the exercise of stock options in certain of the Castles, in excess of their strike price, minus (b) management fee income recorded in accordance with GAAP in connection with the receipt of these options,

Expenses

 

  (iv) adding or subtracting, as necessary, the employee profit sharing in incentive income described in (i) above to match the timing of the expense with the revenue,

 

  (v) adding back equity-based compensation expense (including Castle options assigned to employees, RSUs (including the portion of related dividend equivalents recorded as compensation expense), restricted shares and the LTIP),

 

  (vi) adding back compensation expense recorded in connection with the forfeiture arrangements entered into among the principals (Note 7),

 

  (vii) adding the income (or subtracting the loss) allocable to the interests in consolidated subsidiaries attributable to Fortress Operating Group units, and

 

  (viii) adding back income tax expense and any expense recorded in connection with the tax receivable agreement (Note 5).

Total segment assets are equal to total GAAP assets adjusted for:

 

  (i) the difference between the GAAP carrying amount of equity method investments and their carrying amount for segment reporting purposes, which is generally fair value for publicly traded investments and cost for nonpublic investments,

 

  (ii) employee portions of investments, which are reported gross for GAAP purposes (as assets offset by Principals’ and others’ interests in equity of consolidated subsidiaries) but net for segment reporting purposes, and

 

  (iii) the difference between the GAAP carrying amount for options owned in certain of the Castles and their carrying amount for segment reporting purposes, which is intrinsic value.

Summary financial data on Fortress’s segments is presented on the following pages, together with a reconciliation to revenues, assets and net income for Fortress as a whole. Fortress’s investments in, and earnings from, its equity method investees by segment are presented in Note 3.

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

     Private
Equity
Funds
   Castles    Liquid
Hedge
Funds
   Hybrid
Hedge
Funds
    Principal
Investments
    Unallocated     Fortress
Subtotal

March 31, 2008 and the Three Months Then Ended

           

Segment revenues

                 

Management fees

   $ 41,780    $ 13,694    $ 52,719    $ 36,844     $ —       $ —       $ 145,037

Incentive income

     28,741      12      2,695      425       —         —         31,873
                                                   

Segment revenues - total

   $ 70,521    $ 13,706    $ 55,414    $ 37,269     $ —       $ —       $ 176,910
                                                   

Pre-tax distributable earnings

   $ 49,944    $ 4,276    $ 14,731    $ 2,048     $ (13,330 )   $ 38     $ 57,707
                                                   

Total segment assets

   $ 9,717    $ 18,176    $ 5,575    $ 12,912     $ 1,393,979     $ 581,650     $ 2,022,009
                                                   
                  (A )  
               Fortress
Subtotal
   Reconciliation
to GAAP
    Fortress
Consolidated
           

Revenues

         $ 176,910    $ 23,970     $ 200,880      
                                 

Pre-tax distributable earnings / net income

         $ 57,707    $ (126,624 )   $ (68,917 )    
                                 

Total assets

         $ 2,022,009    $ (10,303 )   $ 2,011,706      
                                 

 

(A) Unallocated assets include deferred tax assets of $508.4 million.

 

20


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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

March 31, 2008 and the Three Months Then Ended

Reconciling items between segment measures and GAAP measures:

 

Adjustments from segment revenues to GAAP revenues

  

Adjust management fees*

   $ 163

Adjust incentive income

     5,899

Adjust income from the receipt of options

     —  

Other revenues*

     17,908
      

Total adjustments

   $ 23,970
      

 

* Segment revenues do not include GAAP other revenues; GAAP other revenues are included elsewhere in the calculation of distributable earnings.

 

Adjustments from pre-tax distributable earnings to GAAP net income

    

Adjust incentive income

    

Incentive income received from private equity funds, subject to contingent repayment

   $ (26,077 )  

Incentive income accrued from private equity funds, no longer subject to contingent repayment

     31,959    

Incentive income received from private equity funds, not subject to contingent repayment

     17    

Incentive income received from hedge funds, subject to annual performance achievement

     —      

Reserve for clawback

     —      
          
       5,899  

Adjust other income

    

Distributions of earnings from equity method investees**

     (365 )  

Earnings (losses) from equity method investees**

     (40,642 )  

Gains (losses) on options in equity method investees, treated as derivatives

     (12,493 )  

Unrealized gains (losses) on Castles

     (17,324 )  

Adjust income from the receipt of options

     —      
          
       (70,824 )

Adjust employee compensation

    

Adjust employee equity-based compensation expense (including Castle options assigned)

     (35,601 )  

Adjust employee portion of incentive income from private equity funds, accrued prior to the realization of incentive income

     9,648    

Adjust employee portion of incentive income from one private equity fund, not subject to contingent repayment

     (4 )  
          
       (25,957 )

Adjust Principals’ equity-based compensation expense

       (237,367 )

Adjust Principals’ interests related to Fortress Operating Group units

       208,877  

Adjust income taxes

       (7,252 )
          

Total adjustments

     $ (126,624 )
          

 

** This adjustment relates to all of the Castles, private equity Fortress Funds and hedge fund special investment accounts in which Fortress has an investment.

 

Adjustments from total segment assets to GAAP assets

  

Adjust equity investments from fair value

   $ —    

Adjust equity investments from cost

     (64,827 )

Adjust investments gross of employee portion

     50,720  

Adjust option investments to intrinsic value

     3,804  
        

Total adjustments

   $ (10,303 )
        

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

     Private
Equity
Funds
   Castles    Liquid
Hedge
Funds
   Hybrid
Hedge
Funds
    Principal
Investments
    Unallocated     Fortress
Unconsolidated
Subtotal

Three Months Ended March 31, 2007

Segment revenues

                 

Management fees

   $ 26,764    $ 10,905    $ 30,941    $ 29,013     $ —       $ —       $ 97,623

Incentive income

     190,298      3,688      45,279      46,105       —         —         285,370
                                                   

Segment revenues - total

   $ 217,062    $ 14,593    $ 76,220    $ 75,118     $ —       $ —       $ 382,993
                                                   

Pre-tax distributable earnings

   $ 138,773    $ 5,055    $ 30,516    $ 31,780     $ 15,991     $ (2,534 )   $ 219,581
                                                   
               Fortress
Unconsolidated
Subtotal
   Consolidation
of Fortress
Funds
    Eliminations     Reconciliation
to GAAP
    Fortress
Consolidated

Revenues

         $ 382,993    $ 317,114     $ (269,607 )   $ (14,170 )   $ 416,330
                                           

Pre-tax distributable earnings / net income

         $ 219,581    $ (326,375 )   $ 326,375     $ (157,438 )   $ 62,143
                                           

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

Three Months Ended March 31, 2007

Reconciling items between segment measures and GAAP measures:

 

Adjustments from segment revenues to GAAP revenues

  

Adjust management fees *

   $ —    

Adjust incentive income

     (29,417 )

Adjust income from the receipt of options

     811  

Other revenues*

     14,436  
        

Total adjustments

   $ (14,170 )
        

 

* Segment revenues do not include GAAP other revenues; GAAP other revenues are included elsewhere in the calculation of distributable earnings.

 

Adjustments from pre-tax distributable earnings to GAAP net income

    

Adjust incentive income

    

Incentive income received from private equity funds, subject to contingent repayment

   $ (138,822 )  

Incentive income received from private equity funds, not subject to contingent repayment

     (51,476 )  

Incentive income accrued from private equity funds, no longer subject to contingent repayment

     206,440    

Incentive income received from hedge funds, subject to annual performance achievement

     (45,559 )  

Reserve for clawback

     —      
          
       (29,417 )

Adjust unrealized gains and earnings from equity method investees

    

Distributions of earnings from equity method investees**

     (9,893 )  

Earnings (losses) from equity method investees**

     (11,150 )  

Gains (losses) on options in equity method investees, treated as derivatives

     5,150    
          
       (15,893 )

Adjust income from the receipt of options

       811  

Adjust employee portion of incentive income from one private equity fund, not subject to contingent repayment

       569  

Adjust employee equity-based compensation expense

       (38,429 )

Adjust Principals’ equity-based compensation expense

       (138,274 )

Adjust Principals’ interests related to Fortress Operating Group units

       77,642  

Adjust income taxes

       (14,447 )
          

Total adjustments

     $ (157,438 )
          

 

** This adjustment relates to all of the Castles, private equity Fortress Funds and hedge fund special investment accounts in which Fortress has an investment. On an unconsolidated basis, each of these funds is accounted for under the equity method.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

Fortress’s depreciation expense by segment was as follows:

 

     Private
Equity
Funds
   Castles    Liquid
Hedge
Funds
   Hybrid
Hedge
Funds
   Unallocated    Total

Three Months Ended March 31,

                             

2008

   $ 259    $ 192    $ 728    $ 772    $ 485    $ 2,436

2007

   $ 239    $ 214    $ 580    $ 576    $ 400    $ 2,009

11. SUBSEQUENT EVENTS

On April 17, 2008, Fortress entered into an amendment to its credit agreement (Note 4). The amendment, among other things, (i) permits Fortress to issue an unlimited amount of subordinated indebtedness with specified terms so long as 40% of the net proceeds are used repay amounts outstanding under the credit agreement, (ii) increased the applicable rate on Eurodollar loans and letters of credit by 20 basis points (making the current rate LIBOR plus 0.85%) and the undrawn commitment fee by 5 basis points (making the current fee 0.25%), (iii) added an amortization schedule requiring Fortress to repay $100 million of amounts outstanding under the agreement each year during the next three years (with the first payment due on January 15, 2009), (iv) modified the financial covenants by (a) replacing the EBITDA-based financial covenant with a Consolidated Leverage Ratio covenant, (b) increasing the minimum amount of management fee earning assets by $3 billion to $21.5 billion (which minimum amount increases annually by $500 million) and (c) eliminating the annual $50 million increase in required minimum investment assets, and (v) revised various definitions and clarified terms with respect to swap providers who are lenders under the agreement.

In April 2008, we granted interests in 31 million FOG units to a senior employee. In connection with the grant of interests, the employee will receive partnership distribution equivalent payments on such units with economic effect as from January 1, 2008. The interests will vest into full capital interests in FOG units over time, subject to continued employment with Fortress, on terms to be determined. In connection with this grant, we have reduced the employee’s profit sharing interests in various Fortress Funds.

12. PRO FORMA FINANCIAL INFORMATION

The unaudited pro forma financial information presented below was derived from the application of pro forma adjustments to the combined and consolidated financial statements of Fortress, as applicable, to give effect to the deconsolidation of the consolidated Fortress Funds. The deconsolidation transaction occurred effective March 31, 2007 as described in Note 1. The unaudited pro forma statement of operations and statement of cash flows information for the three months ended March 31, 2007 have been prepared as if this transaction had occurred on January 1, 2007.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

The unaudited pro forma effects of the deconsolidation of the Fortress Funds on the statement of operations information are as follows:

 

     Three Months Ended March 31, 2007  
     Consolidated     Deconsolidation
Adjustments
    Pro Forma
Deconsolidated
 

Revenues

      

Management fees from affiliates

   $ 43,287     $ 53,072     $ 96,359  

Incentive income from affiliates

     44,229       211,682       255,911  

Other revenues

     19,784       (3,232 )     16,552  

Interest and dividend income - investment company holdings

     309,030       (309,030 )     —    
                        
     416,330       (47,508 )     368,822  
                        

Expenses

      

Interest expense

      

Investment company holdings

     132,620       (132,620 )     —    

Other

     12,019       —         12,019  

Compensation and benefits

     217,517       (9,805 )     207,712  

Principals agreement compensation

     138,274       —         138,274  

General, administrative and other

     39,305       (22,024 )     17,281  

Depreciation and amortization

     2,009       —         2,009  
                        
     541,744       (164,449 )     377,295  
                        

Other Income (Loss)

      

Gains (losses) from investments

      

Investment company holdings

     (647,477 )     647,477       —    

Other investments

      

Net realized gains (losses)

     1,789       —         1,789  

Net realized gains (losses) from affiliate investments

     136,041       —         136,041  

Net unrealized gains (losses)

     (280 )     —         (280 )

Net unrealized gains (losses) from affiliate investments

     (130,828 )     —         (130,828 )

Earnings (losses) from equity method investees

     195       3,231       3,426  
                        
     (640,560 )     650,708       10,148  
                        

Income (Loss) before Deferred Incentive Income, Principals’ and Others’

      

Interests in Income of Consolidated Subsidiaries and Income Taxes

     (765,974 )     767,649       1,675  

Deferred incentive income

     307,034       (307,034 )     —    

Principals’ and others’ interests in (income) loss of consolidated subsidiaries

     535,530       (460,615 )     74,915  
                        

Income (Loss) Before Income Taxes

     76,590       —         76,590  

Income tax (benefit) expense

     (14,447 )     —         (14,447 )
                        

Net Income (Loss)

   $ 62,143     $ —       $ 62,143  
                        

Total comprehensive income for this period was calculated as follows:

      

Comprehensive income

      

Net income

       $ 62,143  

Foreign currency translation

         (20 )

Net unrealized (loss) on derivatives designated as cash flow hedges

         (4 )

Comprehensive income (loss) from equity method investees

         (1,720 )

Allocation to Principals’ and others’ interests in equity of consolidated subsidiaries

         (166 )
            

Total comprehensive income

       $ 60,233  
            

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

The unaudited pro forma effects of the deconsolidation of the Fortress Funds on the statement of cash flows information are as follows:

 

     Three Months Ended March 31, 2007  
     Consolidated     Deconsolidation
Adjustments
    Pro Forma
Deconsolidation
 

Cash Flows From Operating Activities

      

Net income (loss)

   $ 62,143     $ —       $ 62,143  

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities

      

Depreciation and amortization

     2,009       —         2,009  

Other amortization and accretion

     797       (483 )     314  

(Earnings) losses from equity method investees

     (195 )     (3,231 )     (3,426 )

Distributions of earnings from equity method investees

     753       3,231       3,984  

(Gains) losses from investments

     640,755       (647,477 )     (6,722 )

Recognition of deferred incentive income

     —         (156,326 )     (156,326 )

Deferred incentive income, net

     (307,034 )     307,034       —    

Principals’ and others’ interests in income (loss) of consolidated subsidiaries

     (535,530 )     460,615       (74,915 )

Deferred tax (benefit) expense

     3,116       —         3,116  

Options received from affiliates

     (811 )     —         (811 )

Assignments of options to employees

     2,751       —         2,751  

Equity-based compensation

     173,479       —         173,479  

Cash flows due to changes in

      

Cash held at consolidated subsidiaries and restricted cash

     (166,199 )     166,199       —    

Due from affiliates

     264,551       65,445       329,996  

Receivables from brokers and counterparties and other assets

     (9,976 )     32,131       22,155  

Accrued compensation and benefits

     (47,239 )     (144 )     (47,383 )

Due to affiliates

     (8,713 )     8,594       (119 )

Deferred incentive income

     —         142,041       142,041  

Due to brokers and counterparties and other liabilities

     113,887       (87,935 )     25,952  

Investment company holdings

      

Purchases of investments

     (5,105,865 )     5,105,865       —    

Proceeds from sale of investments

     3,398,739       (3,398,739 )     —    
                        

Net cash provided by (used in) operating activities

     (1,518,582 )     1,996,820       478,238  
                        

Cash Flows From Investing Activities

      

Proceeds from sale of other loan and security investments

     317       —         317  

Contributions to equity method investees

     (9,378 )     (148,812 )     (158,190 )

Distributions of capital from equity method investees

     2,326       22,685       25,011  

Cash received on settlement of derivatives

     132       —         132  

Purchase of fixed assets

     (4,173 )     125       (4,048 )
                        

Net cash used in investing activities

     (10,776 )     (126,002 )     (136,778 )
                        

Cash Flows From Financing Activities

      

Borrowings under debt obligations

     1,574,070       (1,564,070 )     10,000  

Repayments of debt obligations

     (1,657,872 )     1,312,872       (345,000 )

Payment of deferred financing costs

     (706 )     660       (46 )

Issuance of Class A shares to Nomura

     888,000       —         888,000  

Issuance of Class A shares in initial public offering

     729,435       —         729,435  

Costs related to initial public offering

     (76,766 )     —         (76,766 )

Dividends paid

     (2,474 )     —         (2,474 )

Fortress Operating Group capital distributions to Principals

     (219,112 )     —         (219,112 )

Purchase of Fortress Operating Group units from Principals

     (888,000 )     —         (888,000 )

Principals’ and others’ interests in consolidated subsidiaries - contributions

     3,183,727       (3,183,682 )     45  

Principals’ and others’ interests in consolidated subsidiaries - distributions

     (1,709,555 )     1,563,402       (146,153 )
                        

Net cash provided by (used in) financing activities

     1,820,747       (1,870,818 )     (50,071 )
                        

Net Increase in Cash and Cash Equivalents

     291,389       —         291,389  

Cash and Cash Equivalents, Beginning of Period

     61,120       —         61,120  
                        

Cash and Cash Equivalents, End of Period

   $ 352,509     $ —       $ 352,509  
                        

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

NOTE 13 – CONSOLIDATING FINANCIAL INFORMATION

The consolidating financial information presents the balance sheet, statement of operations and statement of cash flows for Fortress Operating Group (on a combined basis) and Fortress Investment Group LLC (including its consolidated subsidiaries other than those within Fortress Operating Group) on a deconsolidated basis, as well as the related eliminating entries for intercompany balances and transactions, which sum to Fortress Investment Group’s consolidated financial statements as of, and for the three months ended, March 31, 2008.

Fortress Operating Group includes all of Fortress’s operating and investing entities. The upper tier Fortress Operating Group entities are the obligors on Fortress’s credit agreement (Note 4). Segregating the financial results of this group of entities provides a more transparent view of the capital deployed in Fortress’s businesses and the relevant ratios for borrowing entities.

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

The consolidating balance sheet information is as follows:

 

     As of March 31, 2008  
     Fortress
Operating
Group
Combined
    Fortress
Investment
Group LLC
Consolidated (A)
    Intercompany
Eliminations
    Fortress
Investment
Group LLC
Consolidated
 

Assets

        

Cash and cash equivalents

   $ 353,804     $ 18,874     $ —       $ 372,678  

Due from affiliates

     52,088       3,369       (3,369 )     52,088  

Investments

        

Equity method investees

     1,006,438       57,820       (57,820 )     1,006,438  

Options in affiliates

     3,804       —         —         3,804  

Deferred tax asset

     5,972       502,408       —         508,380  

Other assets

     65,316       3,002       —         68,318  
                                
   $ 1,487,422     $ 585,473     $ (61,189 )   $ 2,011,706  
                                

Liabilities and Shareholders’ Equity

        

Liabilities

        

Accrued compensation and benefits

   $ 88,306     $ —       $ —       $ 88,306  

Due to affiliates

     83,955       393,266       —         477,221  

Dividends payable

     3,369       21,285       (3,369 )     21,285  

Deferred incentive income

     167,679       —         —         167,679  

Debt obligations payable

     800,000       —         —         800,000  

Other liabilities

     65,220       102       146       65,468  
                                
     1,208,529       414,653       (3,223 )     1,619,959  

Commitments and Contingencies Principals’ and Others’ Interests in Equity of Consolidated Subsidiaries

     55,015       5,893       165,912       226,820  

Shareholders’ Equity

        

Paid-in capital

     793,061       424,566       (793,061 )     424,566  

Retained earnings (accumulated deficit)

     (573,237 )     (260,008 )     573,237       (260,008 )

Accumulated other comprehensive income (loss)

     4,054       369       (4,054 )     369  
                                
     223,878       164,927       (223,878 )     164,927  
                                
   $ 1,487,422     $ 585,473     $ (61,189 )   $ 2,011,706  
                                

 

(A) Other than Fortress Operating Group

 

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Table of Contents

FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

The consolidating statement of operations information is as follows:

 

     Three Months Ended March 31, 2008  
     Fortress
Operating
Group
Consolidated
    Fortress
Investment
Group LLC
Consolidated (A)
    Intercompany
Eliminations
   Fortress
Investment
Group LLC
Consolidated
 

Revenues

         

Management fees from affiliates

   $ 144,057     $ —       $ —      $ 144,057  

Incentive income from affiliates

     37,144       —         —        37,144  

Other revenues

     19,665       14       —        19,679  
                               
     200,866       14       —        200,880  
                               

Expenses

         

Interest expense

     10,336       —         —        10,336  

Compensation and benefits

     127,019       —         —        127,019  

Principals agreement compensation

     237,367       —         —        237,367  

General, administrative and other

     16,570       —         —        16,570  

Depreciation and amortization

     2,436       —         —        2,436  
                               
     393,728       —         —        393,728  
                               

Other Income (Loss)

         

Gains (losses) from investments

         

Net realized gains (losses)

     1,613       —         —        1,613  

Net realized gains (losses) from affiliate investments

     247       —         —        247  

Net unrealized gains (losses)

     —         —         —        —    

Net unrealized gains (losses) from affiliate investees

     (29,817 )     —         —        (29,817 )

Earnings (losses) from equity method investees

     (49,129 )     (63,311 )     63,311      (49,129 )
                               
     (77,086 )     (63,311 )     63,311      (77,086 )
                               

Income (Loss) Before Principals’ and Others’ Interests in Income of

Consolidated Subsidiaries and Income Taxes

     (269,948 )     (63,297 )     63,311      (269,934 )

Principals’ and others’ interests in (income) loss of consolidated subsidiaries

     (608 )     —         208,877      208,269  
                               

Income Before Income Taxes

     (270,556 )     (63,297 )     272,188      (61,665 )

Income tax benefit (expense)

     (1,632 )     (5,620 )     —        (7,252 )
                               

Net Income (Loss)

   $ (272,188 )   $ (68,917 )   $ 272,188    $ (68,917 )
                               

 

(A) Other than Fortress Operating Group.

 

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FORTRESS INVESTMENT GROUP LLC

(PRIOR TO JANUARY 17, 2007, FORTRESS OPERATING GROUP – NOTE 1)

NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Unaudited)

MARCH 31, 2008

(dollars in tables in thousands, except share data)

 

 

The consolidating statement of cash flows information is as follows:

 

     Three Months Ended March 31, 2008  
     Fortress
Operating
Group
Consolidated
    Fortress
Investment
Group LLC
Consolidated (A)
    Intercompany
Eliminations
    Fortress
Investment
Group LLC
Consolidated
 

Cash Flows From Operating Activities

        

Net income (loss)

   $ (272,188 )   $ (68,917 )   $ 272,188     $ (68,917 )

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities

        

Depreciation and amortization

     2,436       —         —         2,436  

Other amortization and accretion

     628       —         —         628  

(Earnings) losses from equity method investees

     49,129       63,311       (63,311 )     49,129  

Distributions of earnings from equity method investees

     3,252       —         —         3,252  

(Gains) losses from investments

     27,957       —         —         27,957  

Deferred incentive income, net

     (31,959 )     —         —         (31,959 )

Principals’ and others’ interests in income (loss) of consolidated subsidiaries

     608       —         (208,877 )     (208,269 )

Deferred tax (benefit) expense

     (1,057 )     1,336       —         279  

Equity-based compensation

     265,792       —         —         265,792  

Cash flows due to changes in

        

Due from affiliates

     104,038       —         —         104,038  

Other assets

     (15 )     5,854       —         5,839  

Accrued compensation and benefits

     (164,335 )     —         —         (164,335 )

Due to affiliates

     11,446       —         —         11,446  

Deferred incentive income

     26,077       —         —         26,077  

Other liabilities

     30,093       (1,631 )     —         28,462  
                                

Net cash provided by (used in) operating activities

     51,902       (47 )     —         51,855  
                                

Cash Flows From Investing Activities

        

Contributions to equity method investees

     (70,215 )     —         —         (70,215 )

Distributions of capital from equity method investees

     155,006       37,076       (37,076 )     155,006  

Purchase of fixed assets

     (2,248 )     —         —         (2,248 )

Proceeds from disposal of fixed assets

     53       —         —         53  
                                

Net cash provided by (used in) investing activities

     82,596       37,076       (37,076 )     82,596  
                                

Cash Flows From Financing Activities

        

Borrowings under debt obligations

     450,000       —         —         450,000  

Repayments of debt obligations

     (185,000 )     —         —         (185,000 )

Payment of deferred financing costs

     (61 )     —         —         (61 )

Dividends and dividend equivalents paid

     (105,378 )     (21,285 )     100,282       (26,381 )

Principals’ and others’ interests in consolidated subsidiaries - distributions

     (37,534 )     —         (63,206 )     (100,740 )
                                

Net cash provided by (used in) financing activities

     122,027       (21,285 )     37,076       137,818  
                                

Net Increase (Decrease) in Cash and Cash Equivalents

     256,525       15,744       —         272,269  

Cash and Cash Equivalents, Beginning of Period

     97,279       3,130       —         100,409  
                                

Cash and Cash Equivalents, End of Period

   $ 353,804     $ 18,874     $ —       $ 372,678  
                                

 

(A) Other than Fortress Operating Group

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(tables in thousands except as otherwise indicated and per share data)

The following discussion should be read in conjunction with Fortress Investment Group’s consolidated and combined financial statements and the related notes (referred to as “consolidated financial statements” or “historical consolidated financial statements”) included within this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that are subject to known and unknown risks and uncertainties. Actual results and the timing of events may differ significantly from those expressed or implied in such forward-looking statements due to a number of factors, including those included in Part II, Item 1A, “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.

During the first quarter of 2007, we consummated a number of significant transactions, including the Nomura transaction, the formation transactions, our initial public offering, and the deconsolidation of a number of Fortress Funds. The deconsolidation of the Fortress Funds has had significant effects on many of the items within our financial statements but had no net effect on net income or equity. Since the deconsolidation did not occur until March 31, 2007, the statement of operations and the statement of cash flows for the three months ended March 31, 2007 are presented including these funds on a consolidated basis for the period prior to deconsolidation. The pro forma effects of the deconsolidation on these financial statements are described in Note 12 to Part I, Item 1, “Financial Statements – Pro Forma Financial Information.”

General

Our Business

Fortress is a leading global alternative asset manager with approximately $34.2 billion in AUM as of March 31, 2008. We raise, invest and manage private equity funds and hedge funds. We earn management fees based on the size of our funds, incentive income based on the performance of our funds, and investment income from our principal investments in those funds. We invest capital in each of our businesses.

As of March 31, 2008, we managed alternative assets in two core businesses:

Private Equity Funds  —  a business that manages approximately $16.5 billion of AUM comprised of two business segments: (i) funds that primarily make significant, control-oriented investments in North America and Western Europe, with a focus on acquiring and building asset-based businesses with significant cash flows. We also manage a family of ‘‘long dated value’’ funds focused on investing in undervalued assets with limited current cash flows and long investment horizons; and (ii) publicly traded alternative investment vehicles, which we refer to as “Castles,” that invest primarily in real estate and real estate related debt investments.

Hedge Funds  —  a business that manages approximately $17.7 billion of AUM comprised of two business segments; (i) hybrid hedge funds – which make highly diversified investments globally in assets, opportunistic lending situations and securities through the capital structure with a value orientation, as well as investment funds managed by external managers; and (ii) liquid hedge funds – which invest globally in fixed income, currency, equity and commodity markets and related derivatives to capitalize on imbalances in the financial markets.

In addition, we treat our principal investments in these funds as a distinct business segment.

Managing Business Performance

We conduct our management and investment business through the following five primary segments: (i) private equity funds, (ii) Castles (iii) liquid hedge funds, (iv) hybrid hedge funds, and (v) principal investments in those funds as well as cash that is available to be invested. These segments are differentiated based on the varying investment strategies of the funds we manage in each segment.

The amounts not allocated to a segment consist primarily of certain general and administrative expenses. Where applicable, portions of the general and administrative expenses have been allocated between the segments.

Management makes operating decisions and assesses performance with regard to each of our primary segments based on financial data that is presented without the consolidation of any Fortress Funds. Accordingly, segment data for these segments is reflected on an unconsolidated basis, even for periods prior to the deconsolidation. Management also assesses our segments on a Fortress Operating Group and pre-tax basis, and therefore adds back the interests in consolidated subsidiaries related to Fortress Operating Group units (held by the principals) and income tax expense.

Management assesses the net performance of each segment based on its ‘‘distributable earnings.’’ Distributable earnings is not a measure of cash generated by operations which is available for distribution. Rather distributable earnings is a supplemental measure of the value created during any period which management uses in its determination of its periodic distributions to its dividend paying share and unit holders. Distributable earnings should not be considered as an alternative to cash flow in accordance with GAAP or as a measure of our liquidity, and is not necessarily indicative of cash available to fund cash needs (including dividends and distributions).

 

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We believe that the presentation of distributable earnings enhances a reader’s understanding of the economic operating performance of our segments. For a more detailed discussion of distributable earnings and how it reconciles to our GAAP net income (loss), see “— Results of Operations — Segments Analysis” below.

Public Company Surplus

Our private equity funds have sponsored the initial public offerings of six portfolio companies since 2004 and have invested in one of the Castles, whose initial public offering was sponsored directly by us. Our funds’ investments (including those of our hedge funds) in these public companies include net unrealized gains based on their respective stock prices as of March 31, 2008. Our share of those profits, which we call our private equity unrealized “public company surplus,” represents Fortress’s unrealized potential incentive income in respect of these investments. This potential incentive income is not reflected currently in our revenues. The periods in which such incentive income will be realized on a distributable earnings basis will be a function of our decisions regarding the timing of realization of fund investments in our portfolio companies, with actual amounts, which may be significantly more or less than the amounts presented below, a function of market conditions at those times.

 

     March 31, 2008  

Portfolio Company

   IPO
Date
   Shares
Owned(1)
   Price Per
Share (2)
   Market
Value(3)
 
          (in thousands)         (dollars in
thousands)
 

Gatehouse Media (NYSE: GHS)

   10/06    22,050    $ 5.84    $ 128,772  

GAGFAH (FSE: GFJ)

   10/06    150,320    11.88      2,819,417  

Aircastle Limited (NYSE: AYR)

   8/06    25,326    $ 11.25      284,921  

Brookdale Senior Living (NYSE: BKD)

   11/05    61,268    $ 23.90      1,464,315  

Mapeley Limited (LSE: MAY)

   6/05    16,823    £ 14.15      472,207  

Eurocastle Investment Ltd (ENXT: ECT)

   N/A    8,571    7.60      102,848  
                 

Potential Proceeds

            $ 5,272,480  

Cost Basis (including debt) as of March 31, 2008

              4,493,045  
                 

Total Potential Unrealized Gains (4)

            $ 779,435  

Incentive Income Paying %

              81.51 %

Incentive Income Eligible Dollars

            $ 635,291  

Maximum Eligible Incentive Income %

              20.00 %

Total Potential Incentive Income

            $ 127,058  

Fortress Retained % of Incentive Income (5)

              63.73 %

Potential Incentive Income to Fortress Operating Group (unrealized public company surplus) (6)

            $ 80,974  

Potential Incentive Income to Fortress Operating Group adjusted for certain non-public investment write-downs (6) (7)

            $ 79,107  

 

(1) Includes shares owned in hedge fund special investment accounts.
(2) As of May 6, 2008, the closing price per share of each of the companies listed above was as follows: GHS $5.50; GFJ €11.63; AYR $15.82; BKD $26.69; MAY £12.93; ECT €7.82.
(3) In U.S. dollars. Foreign exchange rates, if applicable, are as of March 31, 2008. Calculated as the number of shares held multiplied by the closing stock price on the applicable stock exchange, without regard to liquidity discounts or other factors that could adversely impact the potential proceeds that might be realized upon disposition of these shares.
(4) Assumes all incentive income thresholds specified in applicable fund agreements are met.
(5) Represents percentage of incentive income not payable to employees.
(6) Amounts ultimately received by us may vary significantly based on a variety of factors, including future public market values of these investments as well as the performance of investments that are not listed above held by the funds that hold the investments listed above. See Part II, Item 1A, “Risk Factors — Risks Related to Our Funds — The historical performance of our funds should not be considered as indicative of the future results of our funds or of our future results or of any returns expected on our Class A shares.”
(7) In December 2007, certain Fortress Funds completed the sale of their Mapeley Limited shares to other Fortress Funds and realized a gain. As a result, unrealized public company surplus was reduced by $27.7 million subsequent to December 31, 2007, although the related shares are still held by Fortress Funds.

 

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Market Considerations

Our revenues consist primarily of (i) management fees which are based on the size of our funds, (ii) incentive income which is based on the performance of our funds and (iii) investment income from our investments in those funds. Our ability to grow our revenues depends on our ability to attract new capital and investors, which in turn depends on our ability to successfully invest our funds’ capital. The primary market factors that impact this are:

 

   

The strength of the alternative investment management industry, including the amount of capital invested and withdrawn from alternative investments. Our share of this capital is dependent on the strength of our performance relative to the performance of our competitors. The capital we attract is a driver of our AUM, as are our returns, which in turn drive the fees we earn.

 

   

The strength and liquidity of the U.S. and relevant global equity markets generally, and the IPO market specifically, which affect our ability to increase the value of our equity positions in our private equity portfolio companies.

 

   

The strength and liquidity of the U.S. and relevant global debt markets. Our funds make investments in debt instruments, which are assisted by a strong and liquid debt market. In addition, our funds borrow money to make acquisitions. Our funds utilize leverage in order to increase investment returns, which ultimately drive the performance of our funds. Furthermore, we utilize debt to finance our investments in our funds and for working capital purposes.

 

   

Volatility within the markets. Volatility within the debt and equity markets, as well as within the commodity market to a limited extent, increases opportunities for investments within each of our segments, and directly impacts the performance of our liquid hedge funds.

 

   

Other than in our liquid hedge funds, we benefit from stable interest rate and foreign currency exchange rate markets. The direction of the impact of changes in interest rates or foreign currency exchange rates on our liquid hedge funds is dependent on their expectations and the related direction of their investments at such time; therefore, historical trends in these markets are not necessarily indicative of future performance in these funds.

For the most part, we believe the trends in these factors have created a favorable investment environment for our funds in recent years. However, changes in several of these market factors have adversely impacted our funds.

 

   

In recent years, the U.S. economy and capital markets have been robust, and we have successfully identified opportunities within other economies where trends have also been favorable for investment, such as Germany and the United Kingdom. Partially as a result of the globalization of our operations and the internationalization of our investments, we continue to identify what we believe to be attractive investment opportunities in new markets. Furthermore, the U.S. and international debt markets have expanded significantly in recent years as a result of the widespread growth in the securitization markets. However, U.S. and European debt markets, as well as other debt markets around the world, have recently experienced a tightening of available credit beginning in the third quarter of 2007. This tightening continued during the fourth quarter and intensified during the first quarter of 2008. In addition, beginning in the fourth quarter of 2007, U.S., European and other equity markets became less favorable for IPOs and other issuances.

 

   

Institutions, high net worth individuals and other investors are increasing their allocations of capital to the alternative investment sector. As a leader in this sector based on the size, diversity and performance of our funds, we have been and continue to be able to attract a significant amount of new capital, at least in part as a result of this trend.

 

   

Allocations of capital to the alternative investment sector are also dependent, in part, on the strength of the economy and the returns available from other investments relative to returns from alternative investments. This, in turn, is also dependent on the interest rate and credit spread markets; as interest rates rise and/or spreads widen, returns available on other investments would tend to increase, which could slow capital flow to the alternative investment sector. In recent years, we have experienced relatively steady and historically low interest rates and tight credit spreads during the periods presented, which has been favorable to our business. However, market developments beginning in the third quarter of 2007, which are discussed in more detail below, have caused credit spreads to widen. Credit spreads represent the yield demanded on financial instruments by the market in comparison to a benchmark rate, such as the relevant U.S. treasury rate or LIBOR.

Historically, the trends discussed above have been generally favorable to our performance. No assurance can be given that future trends will not be disadvantageous to us, particularly if current challenging conditions persist or intensify.

While short-term disruptions in the markets, with respect to equity prices, interest rates, credit spreads or other market factors, including market liquidity, may adversely affect our existing positions, we believe such disruptions generally present significant new opportunities for investment. Our ability to take advantage of these opportunities will depend on our ability to access debt and equity capital, both at Fortress and within the Fortress Funds.

 

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During 2008, the per share market prices of the investments held by our private equity funds in public companies have decreased substantially. This, in turn, has contributed to a significant decrease in our public company surplus as described above under “— Public Company Surplus.” A decrease in this surplus hinders our ability to realize gains within these funds and therefore our ability to earn incentive income. We believe these decreases are a result of a general downturn in demand for dividend paying stocks rather than of a change in the strength of the underlying companies.

In recent months, disruption in the subprime mortgage lending sector has adversely affected the financial markets. The effects of the disruption have expanded beyond the subprime mortgage lending sector to affect the U.S. and other credit markets generally, primarily those markets tied to credit and corporate and real estate related fixed income securities. This disruption continued during the fourth quarter of 2007 and intensified during the first quarter of 2008. This disruption has negatively impacted the financial markets in which we operate in a number of ways:

 

   

We have benefited in recent years from relatively tight interest rate spreads. Tight spreads have allowed us and the funds we manage to obtain financing for investments at attractive rates. Over the past several months, interest rate spreads have widened significantly, particularly in the first quarter of 2008. This widening will typically increase our costs when financing our investments using debt, which in turn reduces the net return we can earn on those investments.

 

   

Moreover, there currently is less debt and equity capital available in the market relative to the levels available in recent years, which, coupled with recent additional margin collateral requirements imposed by lenders on some types of investments, has increased the importance of maintaining sufficient liquidity without relying upon additional infusions of capital from the debt and equity markets. Based on cash balances, committed financing and short-term operating cash flows, in the judgment of management we and the funds we manage have sufficient liquidity in the current market environment.

 

   

A number of financial institutions have been required to provide additional margin collateral as collateral to support their obligations under their existing investments. With respect to certain assets within various Fortress Funds, the relevant funds have posted a substantial amount of margin collateral.

 

   

There has been a reduction in market trading activity. This has made the valuation of investments more difficult and, in our opinion, has resulted in relatively conservative valuations by third party brokers and pricing