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Section 1: 10-Q (FORM 10-Q)

Form 10-Q
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2009
or
     
o   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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
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 o   Accelerated filer þ   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
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: 94,638,415 outstanding as of May 6, 2009.
Class B Shares: 312,071,550 outstanding as of May 6, 2009.
 
 

 

 


 

FORTRESS INVESTMENT GROUP LLC
FORM 10-Q
INDEX
         
    PAGE  
 
       
PART I. FINANCIAL INFORMATION
 
       
       
 
       
    1  
 
       
    2  
 
       
    3  
 
       
    4  
 
       
    5  
 
       
    31  
 
       
    56  
 
       
    59  
 
       
PART II. OTHER INFORMATION
 
       
    59  
 
       
    60  
 
       
    89  
 
       
    89  
 
       
    89  
 
       
    89  
 
       
    90  
 
       
    91  
 
       
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

 


Table of Contents

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 and hybrid PE 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, collectively, to Fortress Investment Group LLC and its subsidiaries, including the Fortress Operating Group and all of its subsidiaries.
“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 January 2007, and in each of which Fortress Investment Group LLC acquired an indirect controlling interest in January 2007.
“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 related transactions directly owned 100% of the Fortress Operating Group units and following completion of our initial public offering and related transactions own a majority of the Fortress Operating Group units and 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 and grants by Fortress and dispositions by the principals.

 

 


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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some of the statements under Part II, Item 1A, “Risk Factors,” 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” 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. Accordingly, you should not place undue reliance on any forward-looking 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.
SPECIAL NOTE REGARDING EXHIBITS
In reviewing the agreements included as exhibits to this Quarterly Report on Form 10-Q, please remember they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. The agreements contain representations and warranties by each of the parties to the applicable agreement. These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and:
    should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate;
    have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement;
    may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and
    were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments.
Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time. Additional information about the Company may be found elsewhere in this Quarterly Report on Form 10-Q and the Company’s other public filings, which are available without charge through the SEC’s website at http://www.sec.gov.

 

 


Table of Contents

PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
FORTRESS INVESTMENT GROUP LLC
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
                 
    March 31,     December 31,  
    2009     2008  
    (Unaudited)        
Assets
               
Cash and cash equivalents
  $ 43,308     $ 263,337  
Due from affiliates
    64,188       38,504  
Investments
               
Equity method investees
    759,980       774,382  
Options in affiliates
    72       39  
Deferred tax asset
    411,656       408,066  
Other assets
    93,299       93,407  
 
           
 
  $ 1,372,503     $ 1,577,735  
 
           
 
               
Liabilities and Shareholders’ Equity
               
 
 
Liabilities
               
Accrued compensation and benefits
  $ 42,679     $ 158,033  
Due to affiliates
    350,380       346,265  
Deferred incentive income
    163,635       163,635  
Debt obligations payable
    604,041       729,041  
Other liabilities
    59,333       26,741  
 
           
 
    1,220,068       1,423,715  
 
           
 
               
Commitments and Contingencies
               
 
               
Equity
               
Class A shares, no par value, 1,000,000,000 shares authorized, 94,638,415 and 94,609,525 shares issued and outstanding at March 31, 2009 and December 31, 2008, respectively
           
Class B shares, no par value, 750,000,000 shares authorized, 312,071,550 shares issued and outstanding
           
Paid-in capital
    663,848       596,803  
Retained earnings (accumulated deficit)
    (580,538 )     (513,379 )
Accumulated other comprehensive income (loss)
    (939 )     (866 )
 
           
Total Fortress shareholders’ equity
    82,371       82,558  
 
           
Principals’ and others’ interests in equity of consolidated subsidiaries — Note 6
    70,064       71,462  
 
           
Total equity
    152,435       154,020  
 
           
 
  $ 1,372,503     $ 1,577,735  
 
           
See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(dollars in thousands, except share data)
                 
    Three Months Ended March 31,  
    2009     2008  
Revenues
               
Management fees from affiliates
  $ 105,652     $ 144,057  
Incentive income from affiliates
          37,144  
Expense reimbursements from affiliates
    13,047       14,270  
Other revenues (affiliate portion disclosed in Note 6)
    3,597       5,409  
 
           
 
    122,296       200,880  
 
           
Expenses
               
Interest expense
    8,186       10,336  
Compensation and benefits
    109,236       127,019  
Principals agreement compensation
    234,759       237,367  
General, administrative and other
    17,185       16,570  
Depreciation and amortization
    2,641       2,436  
 
           
 
    372,007       393,728  
 
           
Other Income (Loss)
               
Gains (losses) from investments
               
Net realized gains (losses)
    (396 )     1,613  
Net realized gains (losses) from affiliate investments
    (248 )     247  
Net unrealized gains (losses)
           
Net unrealized gains (losses) from affiliate investments
    (1,829 )     (29,817 )
Tax receivable agreement liability reduction
    (55 )      
Earnings (losses) from equity method investees
    (34,849 )     (49,129 )
 
           
 
    (37,377 )     (77,086 )
 
           
Income (Loss) Before Income Taxes
    (287,088 )     (269,934 )
Income tax benefit (expense)
    407       (7,252 )
 
           
Net Income (Loss)
  $ (286,681 )   $ (277,186 )
 
           
 
 
Principals’ and Others’ Interests in Income (Loss) of Consolidated Subsidiaries
  $ (219,522 )   $ (208,269 )
 
           
 
 
Net Income (Loss) Attributable to Class A Shareholders — Note 6
  $ (67,159 )   $ (68,917 )
 
           
 
 
Dividends declared per Class A share
  $     $ 0.225  
 
           
 
               
Earnings Per Class A share — Fortress Investment Group
               
 
               
Net income (loss) per Class A share, basic
  $ (0.71 )   $ (0.74 )
 
           
Net income (loss) per Class A share, diluted
  $ (0.71 )   $ (0.74 )
 
           
Weighted average number of Class A shares outstanding, basic
    95,202,243       94,894,636  
 
           
Weighted average number of Class A shares outstanding, diluted
    95,202,243       406,966,186  
 
           
See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC
CONSOLIDATED STATEMENT OF EQUITY (Unaudited)
FOR THE THREE MONTHS ENDED MARCH 31, 2009
(dollars in thousands)
                                                                 
                                                    Principals’ and        
                            Retained     Accumulated         Others’ Interests in        
                            Earnings     Other     Total Fortress     Equity of        
                    Paid-In     (Accumulated     Comprehensive     Shareholders’     Consolidated        
    Class A Shares     Class B Shares     Capital     Deficit)     Income (Loss)     Equity     Subsidiaries     Total Equity  
Equity — December 31, 2008
    94,609,525       312,071,550     $ 596,803     $ (513,379 )   $ (866 )   $ 82,558     $ 71,462     $ 154,020  
Contributions from principals’ and others’ interests in equity
                                        3,117       3,117  
Distributions to principals’ and others’ interests in equity (net of tax)
                9                   9       (5,225 )     (5,216 )
Director restricted share grant
    28,890             99                   99       113       212  
Capital increase related to equity-based compensation
                66,937                   66,937       220,718       287,655  
Comprehensive income (loss) (net of tax)
 
Net income (loss)
                      (67,159 )           (67,159 )     (219,522 )     (286,681 )
Foreign currency translation
                            (2 )     (2 )     (244 )     (246 )
Comprehensive income (loss) from equity method investees
                            (71 )     (71 )     (355 )     (426 )
 
                                                             
Total comprehensive income (loss)
                                                            (287,353 )
 
                                               
 
                                                               
Equity — March 31, 2009
    94,638,415       312,071,550     $ 663,848     $ (580,538 )   $ (939 )   $ 82,371     $ 70,064     $ 152,435  
 
                                               
See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(dollars in thousands)
                 
    Three Months Ended March 31,  
    2009     2008  
Cash Flows From Operating Activities
               
Net income (loss)
  $ (286,681 )   $ (277,186 )
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities
               
Depreciation and amortization
    2,641       2,436  
Other amortization and accretion
    3,414       628  
(Earnings) losses from equity method investees
    34,849       49,129  
Distributions of earnings from equity method investees
    11       3,252  
(Gains) losses from investments
    2,473       27,957  
Deferred incentive income
          (31,959 )
Deferred tax (benefit) expense
    (3,759 )     279  
Tax receivable agreement liablity reduction
    55        
Equity-based compensation
    287,803       265,792  
Cash flows due to changes in
               
Due from affiliates
    (25,932 )     104,038  
Other assets
    (1,257 )     5,839  
Accrued compensation and benefits
    (108,216 )     (164,335 )
Due to affiliates
    (1,367 )     11,446  
Deferred incentive income
          26,077  
Other liabilities
    32,657       28,462  
 
           
Net cash provided by (used in) operating activities
    (63,309 )     51,855  
 
           
Cash Flows From Investing Activities
               
Contributions to equity method investees
    (31,792 )     (70,215 )
Distributions of capital from equity method investees
    10,538       155,006  
Purchase of fixed assets
    (1,110 )     (2,248 )
Proceeds from disposal of fixed assets
    6       53  
 
           
Net cash provided by (used in) investing activities
    (22,358 )     82,596  
 
           
Cash Flows From Financing Activities
               
Borrowings under debt obligations
          450,000  
Repayments of debt obligations
    (125,000 )     (185,000 )
Payment of deferred financing costs
    (4,162 )     (61 )
Dividends and dividend equivalents paid
          (26,381 )
Principals’ and others’ interests in equity of consolidated subsidiaries — contributions
    25        
Principals’ and others’ interests in equity of consolidated subsidiaries — distributions
    (5,225 )     (100,740 )
 
           
Net cash provided by (used in) financing activities
    (134,362 )     137,818  
 
           
Net Increase (Decrease) in Cash and Cash Equivalents
    (220,029 )     272,269  
Cash and Cash Equivalents, Beginning of Period
    263,337       100,409  
 
           
Cash and Cash Equivalents, End of Period
  $ 43,308     $ 372,678  
 
           
Supplemental Disclosure of Cash Flow Information
               
Cash paid during the period for interest
  $ 3,730     $ 9,462  
 
           
Cash paid during the period for income taxes
  $ 3,008     $ 1,109  
 
           
Supplemental Schedule of Non-cash Investing and Financing Activities
               
Employee compensation invested directly in subsidiaries
  $ 1,701     $ 16,743  
 
           
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  
 
           
See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(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:
  a)   Private equity funds which make significant, control-oriented investments in debt and equity securities of public or privately held entities in North America and Western Europe, with a focus on acquiring and building assets-based businesses with significant cash flows; and
 
  b)   Publicly traded alternative investment vehicles, which Fortress refers to as “Castles,” which are companies that invest primarily in real estate and real estate related debt investments.
  2)   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.
 
  3)   Hybrid funds:
  a)   Hybrid hedge funds, which make highly diversified investments globally in assets, opportunistic lending situations and securities throughout the capital structure with a value orientation, as well as in investment funds managed by external managers; and
 
  b)   Hybrid private equity (“PE”) funds which are comprised of a family of “credit opportunities” funds focused on investing in distressed and undervalued assets, a family of ''long dated value’’ funds focused on investing in undervalued assets with limited current cash flows and long investment horizons, and a family of “real assets” funds focused on investing in tangible and intangible assets in four principal categories (real estate, capital assets, natural resources and intellectual property).
  4)   Principal investments in the above described funds.
2007 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.
On January 17, 2007, Nomura Investment Managers U.S.A Inc. (“Nomura”) completed a transaction (the “Nomura Transaction”) whereby it purchased 55,071,450 Class A shares of the Registrant 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. On February 8, 2007, the Registrant completed an initial public offering (“IPO”) of 39,428,900 of its Class A shares.
Financial Statement Guide
             
Selected Financial Statement   Note    
Captions   Reference   Explanation
 
 
Balance Sheet
           
 
           
Due from Affiliates
    6     Generally, management fees, expense reimbursements and incentive income earned from Fortress Funds which are expected to be received in the short term.
 
           
Investments in Equity Method
Investees
    3     The carrying value of Fortress’s principal investments in the Fortress Funds.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
             
Selected Financial Statement   Note    
Captions   Reference   Explanation
 
           
Options in Affiliates
    3     The fair value of common stock options received from the Castles.
 
           
Due to Affiliates
    6     Generally, amounts due to the Principals related to their interests in Fortress Operating Group and the tax receivable agreement.
 
           
Deferred Incentive Income
    2     Incentive income already received from certain Fortress Funds based on past performance, which is subject to contingent repayment based on future performance.
 
           
Debt Obligations Payable
    4     The balance outstanding on the credit agreement.
 
           
Principals’ and Others’ Interests in Equity of Consolidated Subsidiaries
    6     The GAAP basis of the Principals’ ownership interests in Fortress Operating Group as well as employees’ ownership interests in certain subsidiaries.
 
           
Income Statement
           
 
           
Management Fees from Affiliates
    2     Fees earned for managing Fortress Funds, generally determined based on the size of such funds.
 
           
Incentive Income from Affiliates
    2     Income earned from Fortress Funds, based on the performance of such funds.
 
           
Compensation and Benefits
    7     Includes equity-based, profit-sharing and other compensation to employees.
 
           
Principals Agreement
Compensation
    N/A     As a result of the principals agreement, the value of a significant portion of the Principals’ equity in Fortress prior to the Nomura Transaction is being recorded as an expense over a five year period. Fortress is not a party to this agreement. It is an agreement between the Principals to further incentivize them to remain with Fortress. This GAAP expense has no economic effect on Fortress or its shareholders.
 
           
Gains (Losses) from Other
Investments
    N/A     Subsequent to the IPO, the result of asset dispositions or changes in the fair value of assets which are marked to market (primarily the Castles and GAGFAH).
 
           
Tax Receivable Agreement
Liability Reduction
    5     Represents a change in the amount due to the Principals under the tax receivable agreement.
 
           
Earnings (Losses) from Equity
Method Investees
    3     Fortress’s share of the net earnings (losses) of Fortress Funds resulting from its principal investments.
 
           

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
             
Selected Financial Statement   Note    
Captions   Reference   Explanation
 
           
Income Tax Benefit (Expense)
    5     The net tax result related to the current period. Certain of Fortress’s revenues are not subject to taxes because they do not flow through taxable entities. Furthermore, Fortress has significant permanent differences between its GAAP and tax basis earnings.
 
           
Principals’ and Others’ Interests in (Income) Loss of Consolidated Subsidiaries
    6     Primarily the Principals’ and employees’ share of Fortress’s earnings based on their ownership interests in subsidiaries, including Fortress Operating Group. This amount is disclosed in order to provide a net income (loss) which relates only to Fortress’s Class A shareholders.
Earnings Per Share
    8     GAAP earnings per Class A share based on Fortress’s capital structure, which is comprised of outstanding and unvested equity interests, including interests which participate in Fortress’s earnings, at both the Fortress and subsidiary levels.
 
           
Other
           
 
           
Distributions
    8     A summary of dividends and distributions, and the related outstanding shares and units, is provided.
 
           
Distributable Earnings
    10     A presentation of our financial performance by segment (fund type) is provided, on the basis of the operating performance measure used by Fortress’s management committee.
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, 2008 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, 2008.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
2. MANAGEMENT AGREEMENTS AND FORTRESS FUNDS
Management Fees, Incentive Income and Related Profit Sharing Expense
Fortress has two principal sources of income from its agreements with the Fortress Funds: contractual management fees, which are generally based on a percentage of fee paying assets under management, and related incentive income, which is generally based on a percentage of profits subject to the achievement of performance criteria. Substantially all of Fortress’s net assets, after deducting the portion attributable to principals’ and others’ interests, are a result of principal investments in, or receivables from, these funds.
The Fortress Funds are divided into segments and Fortress’s agreements with each are detailed below.
Fortress recognized management fees and incentive income as follows:
                 
    Three Months Ended March 31,  
    2009     2008  
Private Equity
               
Private Equity Funds
               
Management fees — affil.
  $ 37,669     $ 39,808  
Incentive income — affil.
          34,640  
 
               
Castles
               
Management fees — affil.
    11,390       12,937  
Incentive income — affil.
          12  
Management fees — non-affil. (A)
    646       882  
 
               
Liquid Hedge Funds
               
Management fees — affil.
    22,604       52,647  
Incentive income — affil.
          2,492  
Management fees — non-affil. (A)
    25       72  
Incentive income — non-affil. (A)
          203  
 
               
Hybrid Funds
               
Hybrid Hedge Funds
               
Management fees — affil.
    27,908       36,656  
Incentive income — affil.
           
Management fees — non-affil. (A)
    215       189  
Incentive income — non-affil. (A)
    822        
 
               
Hybrid PE Funds
               
Management fees — affil.
    6,081       2,009  
Incentive income — affil.
           
 
               
Total
               
Management fees — affil.
  $ 105,652     $ 144,057  
Incentive income — affil. (B)
  $     $ 37,144  
Management fees — non-affil. (A)
  $ 886     $ 1,143  
Incentive income — non-affil. (A)
  $ 822     $ 203  
     
(A)   Included in Other Revenues on the statement of operations.
 
(B)   See “Deferred Incentive Income” below.
Deferred Incentive Income
Incentive income from certain Fortress Funds, primarily private equity funds and hybrid PE funds, is received when such funds realize profits, based on the related agreements. However, this incentive income is subject to contingent repayment by Fortress to the funds until certain overall fund performance criteria are met. Accordingly, Fortress does not recognize this incentive income as revenue until the related contingencies are resolved. Until such time, this incentive income is recorded on the balance sheet as deferred incentive income and is included as “distributed-unrecognized” deferred incentive income in the table below. Incentive income from such funds, based on their net asset value, which has not yet been received is not recorded on the balance sheet and is included as “undistributed” deferred incentive income in the table below.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Incentive income from certain Fortress Funds, primarily hybrid hedge funds, as well as liquid hedge funds beginning in the second quarter of 2009, 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), is generally received subsequent to year end, and has not been recognized for these funds during the three months ended March 31, 2009 and 2008. As a result of not achieving incentive income thresholds, if the amount of incentive income contingent on achieving annual performance criteria was not contingent on the results of the subsequent quarters, no additional incentive income from affiliates would have been recognized during the three months ended March 31, 2009 or 2008. Incentive income based on achieving annual performance criteria that has not yet been recognized, if any, is not recorded on the balance sheet and 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:
                                 
                            Undistributed net of  
    Distributed-     Distributed-     Distributed-     intrinsic clawback  
    Gross     Recognized (A)     Unrecognized (B)     (C) (D)  
Deferred incentive income as of December 31, 2008
  $ 470,798     $ (307,163 )   $ 163,635     $ (89,085 )
 
                               
Share of income (loss) of Fortress Funds
                      (15,022 )
 
                               
Recognition of previously deferred incentive income
                       
 
                       
 
 
Deferred incentive income as of March 31, 2009
  $ 470,798     $ (307,163 )   $ 163,635     $ (104,107 )
 
                       
     
(A)   All related contingencies have been resolved.
 
(B)   Reflected on the balance sheet.
 
(C)   At March 31, 2009, the undistributed incentive income is comprised of $25.3 million of gross undistributed incentive income, net of $129.4 million of previously distributed incentive income that would be returned by Fortress to the related funds if such funds were liquidated on March 31, 2009 at their net asset values.
 
(D)   From inception to March 31, 2009, Fortress has paid $137.7 million of compensation expense under its employee profit sharing arrangements (Note 7) in connection with distributed incentive income, of which $19.5 million has not been expensed because management has determined that it is not probable of being incurred as an expense and will be recovered from the related employees. If the $25.3 million of gross undistributed incentive income were realized, Fortress would recognize and pay an additional $10.0 million of compensation expense.
Private Equity Funds and Hybrid PE Funds
During the three months ended March 31, 2009, Fortress did not form any new private equity funds or hybrid PE funds.
Unrealized losses in a significant portion of Fortress’s private equity funds and hybrid PE funds have resulted in higher future returns being required before Fortress earns incentive income from such funds.
In February 2009, one of the private equity Fortress Funds issued notes in the amount of $80 million. These notes bear interest at 20% per annum, payable at maturity, and mature in January 2014. The notes were offered to existing investors in proportion to their ownership of the fund’s equity and Fortress consequently subscribed to and received $0.5 million of these notes, which are recorded as part of Fortress’s investment in such fund. In addition, the Principals concurrently acquired $4.7 million of these notes.
In March 2009, one of the private equity Fortress Funds which was formed as a coinvestment fund to invest solely in GAGFAH (XETRA: GFJ), was liquidated and distributed all of its shares in GAGFAH to its investors, including Fortress. As a result, Fortress received 5.7 million shares of GAGFAH valued at $28.2 million as of March 31, 2009. Fortress elected to account for these shares at fair value pursuant to SFAS 159.
Liquid Hedge Funds and Hybrid Hedge Funds
During the three months ended March 31, 2009, Fortress did not form any new hedge funds.
Historical redemptions during the periods, including affiliates, have been as follows:
                                 
    Liquid Hedge Funds     Hybrid Hedge Funds  
    Redemption Notices             Redemption Notices        
Three Months Ended March 31,   Received     Redemptions Paid     Received     Redemptions Paid  
2009
  $ 582,785     $ 2,801,035     $     $ 141,092  
2008
  $ 8,587     $ 138,862     $     $ 549,315  

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
The differences between notices received and redemptions paid are a result of timing (notices received prior to quarter end, paid afterwards) and the contractual agreements regarding redemptions, which in some cases allow for delayed payment.
As a result of not meeting the incentive income thresholds with respect to current investors, the incentive income from a significant portion of the capital invested in Fortress’s liquid and hybrid hedge funds has been discontinued for an indeterminate period of time. Returns earned on capital from new investors continue to be incentive income eligible.
3. INVESTMENTS IN EQUITY METHOD INVESTEES AND OTHER EQUITY INVESTMENTS
Investments consist primarily of investments in equity method investees and options in these investees. The investees are primarily Fortress Funds.
Investments in Equity Method Investees
Fortress holds investments in certain Fortress Funds which are recorded based on the equity method of accounting. 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, plus any receivables from such entities as described in Note 6. In addition, unconsolidated affiliates also hold 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,     December 31,     Three Months Ended March 31,  
    2009     2008     2009     2008  
Private equity funds, excluding NIH (A)
  $ 450,578     $ 455,691     $ (32,308 )   $ (41,459 )
NIH
    3,382       3,666       (279 )     1,059  
Castles (B)
    1,027       1,171       N/A       N/A  
 
                       
Total private equity
    454,987       460,528       (32,587 )     (40,400 )
 
 
Liquid hedge funds (C)
    28,777       29,338       1,012       963  
 
 
Hybrid hedge funds
    183,527       185,676       (2,149 )     (10,823 )
Hybrid PE funds
    88,516       96,610       (1,528 )     1,130  
 
                       
Total hybrid funds
    272,043       282,286       (3,677 )     (9,693 )
 
 
Other
    4,173       2,230       403       1  
 
                       
 
  $ 759,980     $ 774,382     $ (34,849 )   $ (49,129 )
 
                       
     
(A)   Includes Fortress’s $28.2 million direct investment in GAGFAH (XETRA:GFJ) common stock (a private equity portfolio company).
 
(B)   Fortress elected to record these investments, as well as its direct investment in GAGFAH, at fair value pursuant to SFAS 159.
 
(C)   Of this amount, $15.0 million was redeemed on April 1, 2009.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
A summary of the changes in Fortress’s investments in equity method investees is as follows:
                                                                 
    Three Months Ended March 31, 2009  
    Private Equity     Liquid     Hybrid              
    NIH     Other Funds (A)     Castles (B)     Hedge Funds     Hedge Funds     PE Funds     Other     Total  
Investment, beginning
  $ 3,666     $ 455,691     $ 1,171     $ 29,338     $ 185,676     $ 96,610     $ 2,230     $ 774,382  
Earnings from equity method investees
    (279 )     (32,308 )     N/A       1,012       (2,149 )     (1,528 )     403       (34,849 )
Other comprehensive income from equity method investees
    (5 )           N/A                   (462 )           (467 )
Contributions to equity method investees
          29,102       N/A                   3,986       1,560       34,648  
Distributions of earnings from equity method investees
                N/A                         (11 )     (11 )
Distributions of capital from equity method investees
          (198 )     N/A       (1,573 )           (10,090 )     (9 )     (11,870 )
 
                                               
Total distributions from equity method investees
          (198 )     N/A       (1,573 )           (10,090 )     (20 )     (11,881 )
 
                                               
Mark to fair value — during period (C)
    N/A       (981 )     (132 )     N/A       N/A       N/A       N/A       (1,113 )
Translation adjustment
          (728 )     (12 )                             (740 )
 
                                               
Investment, ending (D)
  $ 3,382     $ 450,578     $ 1,027     $ 28,777     $ 183,527     $ 88,516     $ 4,173     $ 759,980  
 
                                               
 
                                                               
Ending balance of undistributed earnings
  $ 776     $       N/A     $ 87     $ 301       5,859     $ 392     $ 7,415  
 
                                               
     
(A)   Includes Fortress’s $28.2 million direct investment in GAGFAH (XETRA:GFJ) common stock (a private equity portfolio company).
 
(B)   Fortress elected to record these investments, as well as its direct investment in GAGFAH, at fair value pursuant to SFAS 159.
 
(C)   Recorded to Other Investments — Net Unrealized Gains (Losses) from Affiliate Investments.
 
(D)   Of this amount, $15.0 million was redeemed on April 1, 2009 from the liquid hedge fund.
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.
                                 
                    Newcastle Investment Holdings LLC  
    Private Equity Funds excluding NIH     (“NIH”)  
    March 31,     December 31,     March 31,     December 31,  
    2009     2008     2009     2008  
 
                               
Assets
  $ 8,693,410     $ 9,362,237     $ 268,891     $ 278,161  
Liabilities
    (856,169 )     (1,058,392 )     (212,065 )     (215,416 )
 
                       
Equity
  $ 7,837,241     $ 8,303,845     $ 56,826     $ 62,745  
 
                       
Fortress’s Investment (A)
  $ 450,578     $ 455,691     $ 3,382     $ 3,666  
 
                       
 
                               
Ownership (B)
    5.7 %     5.5 %     4.8 %     4.8 %
 
                       
                                 
    Three Months Ended March 31,     Three Months Ended March 31,  
    2009     2008     2009     2008  
Revenues and gains (losses) on investments
  $ (767,348 )   $ (1,178,032 )   $ (1,021 )   $ 30,363  
Expenses
    (121,035 )     (103,852 )     (4,474 )     (7,398 )
 
                       
Net Income (Loss)
  $ (888,383 )   $ (1,281,884 )   $ (5,495 )   $ 22,965  
 
                       
Fortress’s equity in net income (loss)
  $ (32,308 )   $ (41,459 )   $ (279 )   $ 1,059  
 
                       
     
(A)   Includes Fortress’s $28.2 million direct investment in GAGFAH (XETRA:GFJ) common stock (a private equity portfolio company). GAGFAH’s summary financial information is not included in this table.
 
(B)   Excludes ownership interests held by other Fortress Funds, the Principals, employees and other affiliates.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
                                                 
    Liquid Hedge Funds     Hybrid Hedge Funds     Hybrid PE Funds (C)  
    March 31,     December 31,     March 31,     December 31,     March 31,     December 31,  
    2009     2008     2009     2008     2009     2008  
 
                                               
Assets
  $ 5,099,120     $ 7,819,859     $ 10,518,758     $ 10,803,738     $ 4,486,562     $ 4,103,809  
Liabilities
    (634,141 )     (540,204 )     (4,153,920 )     (4,407,170 )     (2,187,367 )     (1,517,607 )
Minority interest
                (38,242 )     (29,922 )            
 
                                   
Equity
  $ 4,464,979     $ 7,279,655     $ 6,326,596     $ 6,366,646     $ 2,299,195     $ 2,586,202  
 
                                   
Fortress’s Investment (A)
  $ 28,777     $ 29,338     $ 183,527     $ 185,676     $ 88,516     $ 96,610  
 
                                   
 
                                               
Ownership (B)
    0.6 %     0.4 %     2.9 %     2.9 %     3.8 %     3.7 %
 
                                   
                                                 
    Three Months Ended March 31,     Three Months Ended March 31,     Three Months Ended March 31,  
    2009     2008     2009     2008     2009     2008  
Revenues and gains (losses) on investments
  $ 158,965     $ 106,405     $ 172,679     $ (123,468 )   $ (18,429 )   $ 23,413  
Expenses
    (48,119 )     (156,539 )     (77,849 )     (109,619 )     (31,590 )     (6,658 )
 
                                   
Net Income (Loss)
  $ 110,846     $ (50,134 )   $ 94,830     $ (233,087 )   $ (50,019 )   $ 16,755  
 
                                   
Fortress’s equity in net income (loss)
  $ 1,012     $ 963     $ (2,149 )   $ (10,823 )   $ (1,528 )   $ 1,130  
 
                                   
     
(A)   Of this amount, $15.0 million was redeemed on April 1, 2009 from the liquid hedge funds.
 
(B)   Excludes ownership interests held by other Fortress Funds, the Principals, employees and other affiliates.
 
(C)   Includes one entity which is recorded on a one quarter lag (i.e. the balances reflected for this entity are for December 31, 2008 and 2007, respectively, and the periods then ended). 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.
Investments in Variable Interest Entities
Fortress is not 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, 2009 which caused a change in Fortress’s accounting.
The following table presents information as of March 31, 2009 regarding entities formed during the three months ended March 31, 2009 that were determined to be VIEs in which Fortress holds a variable interest. The amounts presented below are included in, and not in addition to, the equity method investment tables above. The only VIE formed during this period was not yet capitalized as of quarter end and therefore had no assets or liabilities.
                         
    Fortress is not Primary Beneficiary  
Business Segment   Gross Assets     Financial Obligations     Fortress Investment (A)  
Hybrid PE Funds
  $     $     $  
     
(A)   Represents Fortress’s maximum exposure to loss with respect to these entities, which includes direct and indirect investments in these funds, which in this case is zero. In addition to the table above, Fortress is exposed to potential changes in cash flow and revenues attributable to the incentive income Fortress earns from these entities.
Fair Value of Financial Instruments
The following table presents information regarding Fortress’s financial instruments which are recorded at fair value:
                     
    Fair Value    
    March 31, 2009     December 31, 2008     Valuation Method
Assets — Carried at Fair Value
                   
Newcastle, Eurocastle and GAGFAH common shares
  $ 29,249     $ 1,171     Level 1 — Quoted prices in active markets for identical assets
Newcastle and Eurocastle options
  $ 72     $ 39     Level 2 — Lattice-based option valuation models using significant observable inputs

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
4. DEBT OBLIGATIONS
The following table presents summarized information regarding Fortress’s debt obligations:
                                         
                            March 31, 2009  
    Face Amount and             Weighted     Weighted  
    Carrying Value     Contractual   Final   Average     Average  
    March 31,     December 31,     Interest   Stated   Funding     Maturity  
Debt Obligation   2008     2008     Rate   Maturity   Cost (A)     (Years)  
Credit agreement (B)
                                       
Revolving debt (C)
  $ 54,041     $ 104,041     LIBOR + 2.50% (D)   May 2012     3.04 %     3.11  
Term loan
    350,000       350,000     LIBOR + 2.50%   May 2012     3.20 %     2.40  
Delayed term loan (C)
    200,000       275,000     LIBOR + 2.50%   May 2012     3.11 %     0.77  
 
                               
 
                                       
Total
  $ 604,041     $ 729,041               3.16 %     1.92  
 
                               
     
(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 0.48%.
 
(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 $11.4 million was undrawn on the revolving debt facility as of March 31, 2009. The revolving debt facility includes a $25 million letter of credit subfacility of which $9.6 million was utilized. Lehman Brothers Commercial Paper, Inc., which is committed to fund $7.2 million (including $1.0 million of the outstanding letters of credit) of the $75 million revolving credit facility, has filed for bankruptcy protection, did not fund its pro rata portion of the last borrowing under this facility, and it is reasonably possible that it will not fund its portion of the commitments. As a result, $5.2 million of the undrawn amount was available.
 
(D)   Subject to unused commitment fees of 0.50% per annum.
On March 12 and March 13, 2009, Fortress entered into amendments to its credit agreement. The amendments, among other things: (i) modified the financial covenants by (a) amending the amount of required management fee earning assets to $22 billion as of the end of each fiscal quarter through December 31, 2009 and $20 billion as of the end of each fiscal quarter thereafter; (b) reducing the amount of investment assets required as of any point in time to an amount equal to the term loans and revolving loans (including outstanding letters of credit) then outstanding; (c) changing the required Consolidated Leverage Ratio to 3.5 to 1.0 for the remainder of the term of the credit agreement; (ii) increased the rate on LIBOR loans to LIBOR + 2.50 (and Base Rate loans to the prime rate plus 1.50%); (iii) reduced the revolving credit facility commitments to $75 million; (iv) established an annual requirement, beginning in 2010, that outstanding loans be prepaid in an amount equal to 75% of Free Cash Flow (as defined in the agreement) generated during the previous year; (v) increased the amount of Fortress’s scheduled amortization payments (the amortization schedule now requires the following payments: $50 million in July 2009, $25 million in each of October 2009 and January, April, July and October 2010, and $75 million in January 2011); (vi) established a requirement that 50% of the net proceeds from any equity issuance by the Fortress Operating Group be applied to prepay outstanding term loans; (vii) reduced the amount of certain types of distributions Fortress can make to equity holders of the Fortress Operating Group and, in turn, Fortress’s Class A shareholders, and (viii) provided that the dissolution or termination of specified material funds would not constitute an event of default. In connection with the amendment, Fortress prepaid $75 million of outstanding term loans and $50 million of outstanding revolving facility loans.
To management’s knowledge, there have not been any market transactions in Fortress’s debt obligations. However, management believes the fair value of this debt was between 55% and 60% of face value at March 31, 2009.
Fortress was in compliance with all of its debt covenants as of March 31, 2009. The following table sets forth the financial covenant requirements as of March 31, 2009 (dollars in millions).
                 
    Requirement     Actual  
AUM
  ≥ $ 22,000     $ 26,538  
 
               
Consolidated Leverage Ratio
  3.50       1.98  
 
               
Required Investment Assets
  ≥ $ 614     $ 731  
 
               
Fortress Fund Investments
  ≥ $ 245     $ 394  
 
               
Total Investments
  ≥ $ 368     $ 521  

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
5. INCOME TAXES AND TAX RELATED PAYMENTS
For the three months ended March 31, 2009, an estimated annual effective tax rate of 0.62% 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.
The provision for income taxes consists of the following:
                 
    Three Months Ended March 31,  
    2009     2008  
Current
               
Federal income tax
  $ 814     $ 2,654  
Foreign income tax
    411       637  
State and local income tax
    2,127       3,682  
 
           
 
    3,352       6,973  
 
           
Deferred
               
Federal income tax expense (benefit)
    (1,518 )     1,291  
Foreign income tax expense (benefit)
    (96 )     166  
State and local income tax expense (benefit)
    (2,145 )     (1,178 )
 
           
 
    (3,759 )     279  
 
           
Total expense (benefit)
  $ (407 )   $ 7,252  
 
           
The tax effects of temporary differences have resulted in deferred income tax assets and liabilities as follows:
                 
    March 31, 2009     December 31, 2008  
Total deferred tax assets
  $ 507,723     $ 504,017  
Valuation allowance
    (96,067 )     (95,951 )
 
           
Net deferred tax assets
  $ 411,656     $ 408,066  
 
           
Total deferred tax liabilities (A)
  $ 482     $ 592  
 
           
     
(A)   Included in Other Liabilities.
For the three months ended March 31, 2009, a deferred income tax provision of $0.11 million was credited to other comprehensive income, primarily related to the equity method investees. A current income tax benefit of $0.01 million was credited to additional paid in capital, related to (i) dividend equivalent payments on RSUs (Note 7), and (ii) distributions to Fortress Operating Group restricted partnership unit holders (Note 7), 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 three months ended March 31, 2009, the payments which would have been made pursuant to the tax receivable agreement, if such period was calculated by itself, were estimated to be $3.9 million.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
6. RELATED PARTY TRANSACTIONS AND INTERESTS IN CONSOLIDATED SUBSIDIARIES
Affiliate Receivables and Payables
Due from affiliates was comprised of the following:
                                                         
    Private Equity             Hybrid              
                    Liquid Hedge     Hedge                    
March 31, 2009   Funds     Castles     Funds     Funds     PE Funds     Other     Total  
Management fees and incentive income
  $ 28,014     $ 3,933     $ 127     $ 1,300     $ 6,080     $     $ 39,454  
Expense reimbursements
    7,957       2,960       2,708       3,371       3,726             20,722  
Dividends and distributions
    1,509                                     1,509  
Other
    166                         509       1,828       2,503  
 
                                         
Total
  $ 37,646     $ 6,893     $ 2,835     $ 4,671     $ 10,315     $ 1,828     $ 64,188  
 
                                         
                                                         
    Private Equity             Hybrid              
                    Liquid Hedge     Hedge                    
December 31, 2008   Funds     Castles     Funds     Funds     PE Funds     Other     Total  
Management fees and incentive income
  $ 7,833     $ 4,094     $ 329     $ 1,285     $ 6,907     $     $ 20,448  
Expense reimbursements
    6,289       2,734       1,211       2,115       3,536             15,885  
Dividends and distributions
          89                               89  
Other
    1                               2,081       2,082  
 
                                         
Total
  $ 14,123     $ 6,917     $ 1,540     $ 3,400     $ 10,443     $ 2,081     $ 38,504  
 
                                         
Due to affiliates was comprised of the following:
                 
    March 31, 2009     December 31, 2008  
Principals
               
- Tax receivable agreement — Note 5 (A)
  $ 338,765     $ 338,649  
- Distributions payable on Fortress Operating Group units
           
Other
    11,615       7,616  
 
           
 
  $ 350,380     $ 346,265  
 
           
     
(A)   Includes $17.4 million due currently with respect to the tax return filed for the tax year ended December 31, 2007.
Other Related Party Transactions
For the three months ended March 31, 2009 and 2008, Other Revenues included approximately $1.7 million and $0.7 million, respectively, of revenues from affiliates.
Fortress has entered into cost sharing arrangements with the Fortress Funds, including market data services and 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 three months ended March 31, 2009 and 2008, these expenses, mainly related to subscriptions to market data services, approximated $2.9 million and $5.3 million, respectively.
In February 2007, we entered into an agreement with two employees who were departing from Fortress to form their own investment management company. We received a minority ownership interest in the management company, which receives management fees and incentive income from all funds formed by such company, and as part of the transaction a Fortress Fund received certain rights to invest at discounted fee rates in the fund being formed by the departing employees, and committed to invest $200 million in that fund subject to certain conditions (of which that Fortress Fund has invested approximately $100 million as of April 2009). In December 2008, the Fortress Fund agreed to eliminate its $100 million unfunded commitment and provide that fund with a $25 million revolving credit facility.
In March 2009, a private equity Fortress Fund repaid in full the remaining $14.4 million of non-dividend bearing preferred equity it had issued to three of the Principals.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Principals’ and Others’ Interests in Consolidated Subsidiaries
These amounts relate to equity interests in Fortress’s consolidated, but not wholly owned, subsidiaries, which are held by the Principals, employees and others.
This balance sheet caption was comprised of the following:
                 
    March 31, 2009     December 31, 2008  
Principals’ Fortress Operating Group units
  $ 46,950     $ 47,305  
Employee interests in majority owned and controlled fund advisor and general partner entities
    22,285       23,981  
Other
    829       176  
 
           
Total
  $ 70,064     $ 71,462  
 
           
This statement of operations caption was comprised of shares of consolidated net income (loss) related to the following, on a pre-tax basis:
                 
    Three Months Ended March 31,  
    2009     2008  
Principals’ Fortress Operating Group units
  $ (219,623 )   $ (208,877 )
Employee interests in majority owned and controlled fund advisor and general partner entities
    28       139  
Other
    73       469  
 
           
Total
  $ (219,522 )   $ (208,269 )
 
           
In December 2007, the FASB issued SFAS No. 160 “Accounting for Noncontrolling Interests.” SFAS 160 clarifies the classification of non-controlling interests in consolidated statements of financial position and the accounting for and reporting of transactions between the reporting entity and holders of such non-controlling interests. SFAS 160 applies to reporting periods beginning after December 15, 2008. SFAS 160 had the following effects on Fortress’s financial statements: (i) reclassification of Principals’ and Others’ Interests in Equity of Consolidated Subsidiaries from the “mezzanine” section of the balance sheet (between liabilities and equity) to equity, (ii) removal of Principals’ and Others’ Interests in Income of Consolidated Subsidiaries from the calculation of Net Income (Loss) on the statement of operations, and disclosure thereof below Net Income (Loss), and (iii) with respect to potential future transactions in which Fortress could acquire Fortress Operating Group units from the Principals pursuant to their exchange (along with Class B shares) for Class A shares (or otherwise), these transactions would be accounted for as equity transactions rather than as a step acquisition of Fortress Operating Group (as would be required under prior accounting principles). There is no effect from adoption of SFAS 160 on the equity which pertains to Class A shareholders, or net income (loss) allocable to Class A shareholders, or on Fortress’s liquidity.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
7. EQUITY-BASED AND OTHER COMPENSATION
Fortress’s total compensation and benefits expense, excluding Principals Agreement compensation, is comprised of the following:
                 
    Three Months Ended March 31,  
    2009     2008  
Equity-based compensation, per below
  $ 53,045     $ 28,425  
Profit-sharing expense, per below
    3,605       21,818  
Discretionary bonuses
    22,859       44,457  
Other payroll, taxes and benefits
    29,727       32,319  
 
           
 
  $ 109,236     $ 127,019  
 
           
Equity-Based Compensation
The following tables set forth information regarding equity-based compensation activities.
                                                                 
    RSUs     Restricted Shares     RPUs  
    Employees     Non-Employees     Issued to Directors     Employees  
    Number     Value (A)     Number     Value (A)     Number     Value (A)     Number     Value (A)  
Outstanding as of December 31, 2008
    40,865,316     $ 16.53       8,600,867     $ 14.84       109,174     $ 17.76       31,000,000     $ 13.75  
 
                                                               
Issued
                            28,890       2.25              
 
                                                               
Forfeited
    (196,759 )     14.54       (705,885 )     14.93                          
 
                                               
 
                                                               
Outstanding as of March 31, 2009 (B)
    40,668,557     $ 16.54       7,894,982     $ 14.83       138,064     $ 14.52       31,000,000     $ 13.75  
 
                                               
                 
    Three Months Ended March 31,  
    2009     2008  
Expense incurred (B)
               
Employee RSUs
  $ 24,423     $ 26,572  
Non-Employee RSUs
    4,461       (10 )
Restricted Shares
    148       149  
LTIP
    1,696       1,714  
RPUs
    22,317        
 
           
Total equity-based compensation expense
  $ 53,045     $ 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, 2009 for awards granted to non-employees was $2.51, which is equal to the closing trading price per share of Fortress’s Class A shares on such date.
 
(B)   In future periods, Fortress will recognize compensation expense on its non-vested equity based awards of $800.8 million, with a weighted average recognition period of 3.87 years. This does not include amounts related to the Principals Agreement.
When Fortress records equity-based compensation expense, including that related to the Principals Agreement, it records a corresponding increase in capital.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Profit Sharing Expense
Recognized profit sharing compensation expense is summarized as follows:
                 
    Three Months Ended March 31,  
    2009     2008  
Private equity funds (A)
  $ (15 )   $ 4,971  
Castles (A)
    (137 )     1,128  
Liquid hedge funds
    2,564       13,425  
Hybrid hedge funds
    1,193       2,055  
Other
          239  
 
           
Total
  $ 3,605     $ 21,818  
 
           
     
(A)   Negative amounts reflect the reversal of previously accrued profit sharing expense resulting from the determination that this expense is no longer probable of being incurred.
8. EARNINGS PER SHARE AND DISTRIBUTIONS
                                 
    Three Months Ended March 31,  
    2009     2008  
    Basic     Diluted     Basic     Diluted  
Weighted average shares outstanding
                               
Class A shares outstanding
    94,500,351       94,500,351       94,500,350       94,500,350  
Fully vested restricted Class A share units with dividend equivalent rights
    631,260       631,260       394,286       394,286  
Fully vested restricted Class A shares
    70,632       70,632              
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
    95,202,243       95,202,243       94,894,636       406,966,186  
 
                       
Basic and diluted net income (loss) per Class A share
                               
Net income (loss) attributable to Class A shareholders
  $ (67,159 )   $ (67,159 )   $ (68,917 )   $ (68,917 )
Dilution in earnings due to RPUs treated as a participating security of Fortress Operating Group and fully vested restricted Class A share units with dividend equivalent rights treated as outstanding Fortress Operating Group units (4)
    (359 )     (359 )            
Dividend equivalents declared on non-vested restricted Class A share units
                (1,117 )     (1,117 )
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 taxes 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
  $ (67,518 )   $ (67,518 )   $ (70,034 )   $ (303,057 )
 
                       
Weighted average shares outstanding
    95,202,243       95,202,243       94,894,636       406,966,186  
 
                       
Basic and diluted net income (loss) per Class A share
  $ (0.71 )   $ (0.71 )   $ (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. To the extent charges, particularly tax related charges, are incurred by the Registrant (i.e. not at the Fortress Operating Group level), the effect may be anti-dilutive.
 
(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 Fortress’s Class A shares and therefore participate fully in the results of Fortress’s 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.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
     
(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 in the periods presented, the effect of the units on the calculation is anti-dilutive for each of the periods. The weighted average restricted Class A share units which are not entitled to receive dividend or dividend equivalent payments outstanding were:
         
Period   Share Units  
Three months ended:
       
March 31, 2009
    25,347,250  
March 31, 2008
    27,817,295  
     
(4)   Fortress Operating Group RPUs are eligible to receive partnership distribution equivalent payments when distributions are declared and paid on Fortress Operating Group units. The RPUs represent a participating security of Fortress Operating Group and the resulting dilution in Fortress Operating Group earnings available to Fortress is reflected in the computation of both basic and diluted earnings per Class A share using the method prescribed for securities issued by a subsidiary. For purposes of the computation of basic and diluted earnings per Class A share, the fully vested restricted Class A share units with dividend equivalent rights are treated as outstanding Class A shares of Fortress and as outstanding partnership units of Fortress Operating Group.
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,  
    2009     2008  
Class A shares (public shareholders)
    94,500,351       94,500,350  
Restricted Class A shares (directors)
    135,496       97,296  
Restricted Class A share units (employees) (A)
    631,260       394,286  
Restricted Class A share units (employees) (B)
    22,955,132       23,765,492  
Fortress Operating Group units (Principals)
    312,071,550       312,071,550  
Fortress Operating Group RPUs (senior employee)
    31,000,000        
 
           
Total
    461,293,789       430,828,974  
 
           
                 
    As of March 31, 2009     As of December 31, 2008  
Class A shares (public shareholders)
    94,500,351       94,500,351  
Restricted Class A shares (directors)
    138,064       109,174  
Restricted Class A share units (employees) (A)
    631,260       631,260  
Restricted Class A share units (employees) (B)
    22,955,132       22,955,132  
Fortress Operating Group units (Principals)
    312,071,550       312,071,550  
Fortress Operating Group RPUs (senior employee)
    31,000,000       31,000,000  
 
           
Total
    461,296,357       461,267,467  
 
           
     
(A)   Represents fully vested restricted Class A share units which are entitled to dividend equivalent payments.
 
(B)   Represents nonvested restricted Class A share units which are entitled to dividend equivalent payments.
Dividends and distributions during the three months ended March 31, 2009 are summarized as follows:
                                 
            Current Year  
    Declared in Prior Year,     Declared and     Declared but not        
    Paid Current Year     Paid     yet Paid     Total  
Dividends on Class A Shares
  $     $     $     $  
Dividend equivalents on restricted Class A share units (A)
                       
Distributions to Fortress Operating Group unit holders (Principals) (B)
          963             963  
Distributions to Fortress Operating Group RPU holders (Note 7) (B)
          96             96  
 
                       
Total distributions
  $     $ 1,059     $     $ 1,059  
 
                       
     
(A)   A portion of these dividend equivalents, if any, 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.
 
(B)   Fortress Operating Group made distributions to the principals and RPU holders in connection with distributions made to FIG Corp. to pay Fortress’s income taxes.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
The following table summarizes our comprehensive income (loss) (net of taxes) for the three months ended March 31, 2008:
                         
            Impact to Principals’        
    Impact to Total     and Others’ Interests        
    Fortress     in Equity of        
    Shareholders’     Consolidated     Impact to  
    Equity     Subsidiaries     Total Equity  
Net income (loss)
  $ (68,917 )   $ (208,269 )   $ (277,186 )
Foreign currency translation
    533       (138 )     395  
Comprehensive income (loss) from equity method investees
    (1 )     (4 )     (5 )
 
                 
Total comprehensive income (loss)
  $ (68,385 )   $ (208,411 )   $ (276,796 )
 
                 
9. COMMITMENTS AND CONTINGENCIES
Other than as described below, Fortress’s commitments and contingencies remain materially unchanged from December 31, 2007.
Private Equity Fund and Hybrid PE Fund Capital Commitments — Fortress has remaining capital commitments to certain of the Fortress Funds which aggregated $132.4 million as of March 31, 2009. These commitments can be drawn by the funds on demand.
Minimum Future Rentals — Fortress is a lessee under a number of operating leases for office space.
Minimum future rent payments under these leases is as follows:
         
April 1 to December 31, 2009
  $ 13,763  
2010
    21,332  
2011
    11,530  
2012
    10,893  
2013
    10,874  
2014
    10,311  
Thereafter
    21,691  
 
     
Total
  $ 100,394  
 
     
Rent expense recognized on a straight-line basis during the three months ended March 31, 2009 and 2008 was $4.9 million and $4.8 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, 2009, if any, will not materially affect Fortress’s results of operations, liquidity or financial position.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
10. SEGMENT REPORTING
Fortress conducts its management and investment business through the following six primary segments: (i) private equity funds, (ii) Castles, (iii) liquid hedge funds, (iv) hybrid hedge funds, (v) hybrid private equity (“PE”) funds, and (vi) principal investments in these funds as well as cash that is available to be invested. Due to the increased significance of the hybrid PE funds segment, it has been disaggregated from the private equity fund segment in this period and for all periods presented.
“Distributable earnings” is a measure of operating performance used by management in analyzing its segment and overall results. For the existing Fortress businesses it is equal to net income (loss) attributable to Fortress’s Class A shareholders adjusted as follows:
Incentive Income
  (i)   a. for Fortress Funds which are private equity funds and hybrid PE 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 by Fortress’s chief operating decision maker as described below (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 private equity funds and hybrid PE 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 and hybrid PE funds,
  d.   subtracting unrealized gains (or adding unrealized losses) on direct investments in publicly traded portfolio companies and in the Castles,
  (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,

 

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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 and RPUs (including the portion of related dividend and distribution 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,
  (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 benefit or 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.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Distributable Earnings Impairment
Investment Impairment for DE purposes
Fortress had the following direct and indirect investments in private equity funds, Castles and hybrid PE funds as of March 31, 2009:
                                                         
                                            Three Months Ended        
    Fortress     Fortress             % Below     Periods     Mar 31, 2009        
    Share of     Cost             Cost     in     DE Impairment        
Fund   NAV     Basis (A)     Deficit     Basis     Deficit     Recorded     Notes  
Main Funds
                                                       
Fund I
  $ 159     $       N/A               N/A     $          
Fund II
    2,317       2,565       (248 )     (10 %)   2 Quarters     (248 )     (B )
Fund III and Fund III CO
    4,798       5,030       (232 )     (5 %)   4 Quarters     (232 )     (B )
Fund IV and Fund IV CO
    98,747       104,931       (6,184 )     (6 %)   6 Quarters     (6,184 )     (B )
Fund V and Fund V CO
    34,926       40,479       (5,553 )     (14 %)   6 Quarters     (5,553 )     (B )
Mortgage Opportunities Funds
    3,097       3,615       (518 )     (14 %)   4 Quarters     (518 )     (B )
Long Dated Value Funds
    19,277       17,792       N/A               N/A                
Real Assets Funds
    17,264       12,586       N/A               N/A                
Credit Opportunities Funds
    11,157       11,747       (590 )     (5 %)   4 Quarters     (562 )     (B )
Single Investment Funds and Investments (combined)
                                                       
GAGFAH (XETRA: GFJ)
    33,866       39,682       (5,816 )     (15 %)   4 Quarters     (6,588 )     (B )
Brookdale (NYSE: BKD)
    9,637       10,386       (749 )     (7 %)   6 Quarters     (749 )     (B )
Aircastle (NYSE: ACT)
    318       366       (48 )     (13 %)   2 Quarters              
Private investment #1
    43,064       53,066       (10,002 )     (19 %)   4 Quarters     (10,002 )     (B )
Private investment #2
    590       1,273       (683 )     (54 %)   5 Quarters     (683 )     (B )
Private investment #3
    242,945       275,705       (32,760 )     (12 %)   6 Quarters           (C )
Other
    25,473       35,028       (9,555 )     (27 %)   Various     (760 )     (D )
Castles
                                                       
Eurocastle (EURONEXT: ECT)
    360       309       N/A             4 Quarters              
Newcastle (NYSE: NCT)
    667       862       (195 )     (23 %)   3 Quarters     (195 )     (B )
 
                                         
 
                                                       
Total
  $ 548,662     $ 615,422     $ (73,133 )                   $ (32,274 )        
 
                                         
     
(A)   Before impairment taken at March 31, 2009.
 
(B)   The investments in these funds were impaired in prior quarters. Further downward movement in underlying estimated fair values has resulted in additional required impairment.
 
(C)   This fund is a single asset fund invested in a railroad and commercial real estate company. The net asset value of this investment is only 13% below Fortress’s basis and the fund’s life extends to 2017. Fortress anticipates that this value will recover during the fund’s life and has the intent and ability to hold its investment until recovery. As a result, Fortress’s CODM has determined that this decline in value does not meet the definition of other than temporary impairment at this time.
 
(D)   This primarily represents indirect investments in funds through hedge fund special investment accounts, including Fortress Funds not represented individually in the table as well as funds managed by third parties. Fortress’s CODM has analyzed each of these investments individually and recorded other than temporary impairment where it was deemed appropriate.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Clawback Reserve on Incentive Income for DE Purposes
Fortress had recognized incentive income for DE purposes from the following private equity funds and hybrid PE funds, which are subject to contingent clawback, as of March 31, 2009:
                                                                                 
                                                                    Three Months Ended        
    Incentive     No Longer     Subject to     Intrinsic     Employee             Prior Net     Periods     March 31, 2009        
    Income     Subject to     Clawback     Clawback     Portion     Net     DE Reserves     in Intrinsic     Gross DE Reserve        
Fund   Received     Clawback     (A)     (B)     (C)     Clawback     Taken (D)     Clawback   Recorded (D)     Notes  
 
 
Fund I
  $ 308,633     $ 296,882     $ 11,751     $     $     $     $     N/A   $       (E)
Fund II
    254,688       113,872       140,816       46,742       17,312       29,430       (25,842 )   2 Quarters           (F)
Fund III
    72,483             72,483       72,483       27,375       45,108       (45,108 )   5 Quarters           (G)
FRID
    16,739             16,739       16,739       6,698       10,041       (10,041 )   7 Quarters           (G)
 
                                                           
 
                                                                               
Total
  $ 652,543     $ 410,754     $ 241,789     $ 135,964     $ 51,385     $ 84,579     $ (80,991 )           $          
 
                                                               
     
(A)   Includes deferred incentive income from the consolidated balance sheet plus the maximum payment under the guarantee, in both cases gross of promote related to non-fee paying investors (affiliates).
 
(B)   Intrinsic clawback is the maximum amount of clawback that would be required to be repaid to the fund if the fund were liquidated at its NAV as of the reporting date. It has not been reduced for any tax related effects.
 
(C)   Employees who have received profit sharing payments in connection with private equity or hybrid PE incentive income are liable to repay Fortress for their share of any clawback. Fortress remains liable to the funds for these amounts even if it is unable to collect the amounts from employees (or former employees).
 
(D)   Net of promote related to non-fee paying investors (affiliates).
 
(E)   This fund had significant unrealized gains at March 31, 2009. As a result, the CODM determined that no reserve for clawback was required.
 
(F)   The net intrinsic clawback in this fund, after the employee portion, in excess of previously recorded reserves was approximately $3.6 million at March 31, 2009. Increases in the values of underlying investments have reversed this excess subsequent to March 31, 2009. As a result, no further reserve was deemed necessary.
 
(G)   The potential clawback on these funds has been fully reserved in prior quarters.
Impairment Determination
Fortress has recorded a total of approximately $32.3 million of impairment and reserves for DE purposes on certain private equity funds and hybrid PE funds as described above for DE purposes during the three months ended March 31, 2009. Fortress expects aggregate returns on its other private equity funds and hybrid PE funds that are in an unrealized investment loss or intrinsic clawback position to ultimately exceed their carrying amount or breakeven point, as applicable. If such funds were liquidated at their March 31, 2009 NAV (although Fortress has no current intention of doing so), the result would be additional impairment losses and reserves for DE purposes of approximately $45.2 million.
Summary financial data on Fortress’s segments is presented on the following pages, together with a reconciliation to revenues, assets and net income (loss) for Fortress as a whole. Fortress’s investments in, and earnings (losses) from, its equity method investees by segment are presented in Note 3.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)

March 31, 2009 and the Three Months Then Ended
                                                                 
                    Liquid     Hybrid                      
    Private Equity     Hedge     Hedge     PE     Principal             Fortress  
    Funds     Castles     Funds     Funds     Funds     Investments     Unallocated     Subtotal  
Segment revenues
                                                               
Management fees
  $ 37,631     $ 11,911     $ 22,629     $ 28,123     $ 6,081     $     $     $ 106,375  
Incentive income
                      822                         822  
 
                                               
Segment revenues — total
  $ 37,631     $ 11,911     $ 22,629     $ 28,945     $ 6,081     $     $     $ 107,197  
 
                                               
Pre-tax distributable earnings
  $ 29,289     $ 3,989     $ 5,975     $ 2,904     $ 2,233     $ (35,034 )   $ (151 )   $ 9,205  
 
                                               
 
                                                               
Total segment assets
  $ 36,137     $ 6,910     $ 2,860     $ 4,800     $ 10,315     $ 804,208     $ 493,696     $ 1,358,926  
 
                                               
 
                                                    (A )        
                                         
                                    GAAP  
    Fortress     Reconciliation     Fortress     Principals     Net Income  
    Subtotal     to GAAP     Consolidated*     and Others     (Loss)  
Revenues
  $ 107,197     $ 15,099     $ 122,296                  
 
                             
Pre-tax distributable earnings / net income (loss)
  $ 9,205     $ (76,364 )   $ (67,159 )   $ (219,522 )   $ (286,681 )
 
                             
 
                                       
Total assets
  $ 1,358,926     $ 13,577     $ 1,372,503                  
 
                                 
(A) Unallocated assets include deferred tax assets of $411.7 million.
March 31, 2008
                                                                 
                    Liquid     Hybrid                      
    Private Equity     Hedge     Hedge     PE     Principal             Fortress  
  Funds     Castles     Funds     Funds     Funds     Investments     Unallocated     Subtotal  
Segment revenues
                                                               
Management fees
  $ 39,771     $ 13,694     $ 52,719     $ 36,844     $ 2,009     $     $     $ 145,037  
Incentive income
    28,741       12       2,695       425                         31,873  
 
                                               
Segment revenues — total
  $ 68,512     $ 13,706     $ 55,414     $ 37,269     $ 2,009     $     $     $ 176,910  
 
                                               
Pre-tax distributable earnings
  $ 50,056     $ 4,276     $ 14,731     $ 2,048     $ (112 )   $ (13,330 )   $ 38     $ 57,707  
 
                                               
                                         
                                    GAAP  
    Fortress     Reconciliation     Fortress     Principals     Net Income  
    Subtotal     to GAAP     Consolidated*     and Others     (Loss)  
Revenues
  $ 176,910     $ 23,970     $ 200,880                  
 
                                 
Pre-tax distributable earnings / net income (loss)
  $ 57,707     $ (126,624 )   $ (68,917 )   $ (208,269 )   $ (277,186 )
 
                             
*     Net income (loss) presented herein represents net income (loss) attributable to Fortress’s Class A shareholders.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Reconciling items between segment measures and GAAP measures:
                 
    March 31, 2009 and        
    the Three Months then     Three Months Ended  
    Ended     March 31, 2008  
Adjustments from segment revenues to GAAP revenues
               
Adjust management fees*
  $ 163     $ 163  
Adjust incentive income
          5,899  
Adjust income from the receipt of options
           
 
 
Other revenues*
               
Adjust management fees from non-affiliates
    (886 )     (1,143 )
Adjust incentive income from non-affiliates
    (822 )     (628 )
Adjust other revenues (including expense reimbursements)
    16,644       19,679  
 
           
 
    14,936       17,908  
 
           
 
               
Total adjustments
  $ 15,099     $ 23,970  
 
           
     
*   Segment revenues do not include GAAP other revenues, except to the extent they represent management fees or incentive income; such revenues are included elsewhere in the calculation of distributable earnings.
                 
Adjustments from pre-tax distributable earnings to GAAP net income (loss)**
               
Adjust incentive income
               
Incentive income received from private equity funds and hybrid
               
PE funds, subject to contingent repayment
  $     $ (26,077 )
Incentive income accrued from private equity funds and hybrid
               
PE funds, no longer subject to contingent repayment
          31,959  
Incentive income received from private equity funds and hybrid
               
PE funds, not subject to contingent repayment
          17  
Incentive income received from hedge funds, subject to annual performance achievement
           
Reserve for clawback, gross (see discussion above)
           
 
           
 
          5,899  
Adjust other income
               
Distributions of earnings from equity method investees***
          (365 )
Earnings (losses) from equity method investees***
    (38,921 )     (40,642 )
Gains (losses) on options in equity method investees
    24       (12,493 )
Unrealized gains (losses) on publicly traded investments
    (1,853 )     (17,324 )
Impairment of investments (see discussion above)
    32,274        
Adjust income from the receipt of options
           
 
    (8,476 )     (70,824 )
Adjust employee compensation
               
Adjust employee equity-based compensation expense (including Castle options assigned)
    (53,044 )     (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 )
 
           
 
    (53,044 )     (25,957 )
Adjust Principals’ equity-based compensation expense
    (234,759 )     (237,367 )
Adjust Principals’ interests related to Fortress Operating Group units
    219,623       208,877  
Adjust tax receivable agreement liability
    (55 )      
Adjust income taxes
    347       (7,252 )
 
           
 
               
Total adjustments
  $ (76,364 )   $ (126,624 )
 
           
     
**   Net income (loss) presented herein represents net income (loss) attributable to Fortress’s Class A shareholders.
 
***   This adjustment relates to all of the Castles, private equity and hybrid PE 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
    (11,135 )
Adjust investments gross of employee portion
    24,640  
Adjust option investments from intrinsic value
    72  
 
     
Total adjustments
  $ 13,577  
 
     

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
Fortress’s depreciation expense by segment was as follows:
                                                         
                    Liquid     Hybrid              
    Private Equity     Hedge     Hedge                    
    Funds     Castles     Funds     Funds     PE Funds     Unallocated     Total  
Three Months Ended March 31,
                                                       
2009
  $ 284     $ 169     $ 611     $ 696     $ 107     $ 774     $ 2,641  
2008
  $ 229     $ 192     $ 728     $ 772     $ 30     $ 485     $ 2,436  
11. SUBSEQUENT EVENTS
These financial statements include a discussion of material events which have occurred subsequent to March 31, 2009 (referred to as “subsequent events”) through May 11, 2009. Events subsequent to that date have not been considered in these financial statements.
On May 5, 2009, consolidated affiliates of Fortress executed several agreements to become the investment manager of certain investment funds currently managed by D.B. Zwirn & Co., L.P. (the “Zwirn Funds”) and to effect other related transactions. Consummation of these transactions is currently anticipated to occur in the second quarter of 2009 subject to the satisfaction of various conditions, including the approval of investors in certain of the Zwirn funds. As of May 5, 2009, the Zwirn Funds managed approximately $2 billion of assets.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
NOTE 12 — 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, 2009.
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.
The consolidating balance sheet information is as follows:
                                 
    As of March 31, 2009  
    Fortress     Fortress             Fortress  
    Operating     Investment             Investment  
    Group     Group LLC     Intercompany     Group LLC  
    Combined     Consolidated (A)     Eliminations     Consolidated  
Assets
                               
Cash and cash equivalents
  $ 42,541     $ 767     $     $ 43,308  
Due from affiliates
    64,188                   64,188  
Investments
                               
Equity method investees
    759,980       20,320       (20,320 )     759,980  
Options in affiliates
    72                   72  
Deferred tax asset
    10,280       401,376             411,656  
Other assets
    88,733       4,566             93,299  
 
                       
 
  $ 965,794     $ 427,029     $ (20,320 )   $ 1,372,503  
 
                       
Liabilities and Shareholders’ Equity
                               
 
                               
Liabilities
                               
Accrued compensation and benefits
  $ 42,679     $     $     $ 42,679  
Due to affiliates
    11,615       338,765             350,380  
Deferred incentive income
    163,635                   163,635  
Debt obligations payable
    604,041                   604,041  
Other liabilities
    59,333                   59,333  
 
                       
 
    881,303       338,765             1,220,068  
Commitments and Contingencies
                               
 
 
Equity
                               
Paid-in capital
    1,918,740       663,848       (1,918,740 )     663,848  
Retained earnings (accumulated deficit)
    (1,850,576 )     (580,538 )     1,850,576       (580,538 )
Accumulated other comprehensive income (loss)
    (6,787 )     (939 )     6,787       (939 )
 
                       
Total Fortress shareholders’ equity (B)
    61,377       82,371       (61,377 )     82,371  
 
                       
Principals’ and others’ interests in equity of consolidated subsidiaries
    23,114       5,893       41,057       70,064  
 
                       
 
                               
Total Equity
    84,491       88,264       (20,320 )     152,435  
 
  $ 965,794     $ 427,029     $ (20,320 )   $ 1,372,503  
 
                       
     
(A)   Other than Fortress Operating Group.
(B)   Includes the Principals’ members’ equity in the Fortress Operating Group column, which is eliminated in consolidation.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
The consolidating statement of operations information is as follows:
                                 
    Three Months Ended March 31, 2009  
    Fortress     Fortress             Fortress  
    Operating     Investment             Investment  
    Group     Group LLC     Intercompany     Group LLC  
    Consolidated     Consolidated (A)     Eliminations     Consolidated  
Revenues
                               
Management fees from affiliates
  $ 105,652     $     $     $ 105,652  
Incentive income from affiliates
                       
Expense reimbursements from affiliates
    13,047                   13,047  
Other revenues
    3,594       3             3,597  
 
                       
 
    122,293       3             122,296  
 
                       
Expenses
                               
Interest expense
    8,125       61             8,186  
Compensation and benefits
    109,236                   109,236  
Principals agreement compensation
    234,759                   234,759  
General, administrative and other
    17,185                   17,185  
Depreciation and amortization
    2,641                   2,641  
 
                       
 
    371,946       61             372,007  
 
                       
Other Income (Loss)
                               
Gains (losses) from investments
                               
Net realized gains (losses)
    (396 )                 (396 )
Net realized gains (losses) from affiliate investments
    (248 )                 (248 )
Net unrealized gains (losses)
                       
Net unrealized gains (losses) from affiliate investees
    (1,829 )                 (1,829 )
Tax receivable agreements liability reduction
          (55 )           (55 )
Earnings (losses) from equity method investees
    (34,849 )     (66,606 )     66,606       (34,849 )
 
                       
 
    (37,322 )     (66,661 )     66,606       (37,377 )
 
                       
 
                               
Income (Loss) Before Income Taxes
    (286,975 )     (66,719 )     66,606       (287,088 )
Income tax benefit (expense)
    847       (440 )           407  
 
                       
 
                               
Net Income (Loss)
  $ (286,128 )   $ (67,159 )   $ 66,606     $ (286,681 )
 
                       
 
                               
Principals’ and Others’ Interests in Income (Loss) of Consolidated Subsidiaries
  $ 101     $     $ (219,623 )   $ (219,522 )
 
                       
 
                               
Net Income (Loss) Attributable to Class A Shareholders (B)
  $ (286,229 )   $ (67,159 )   $ 286,229     $ (67,159 )
 
                       
     
(A)   Other than Fortress Operating Group.
(B)   Includes net income (loss) attributable to the Principals’ interests in the Fortress Operating Group column, which is eliminated in consolidation.

 

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FORTRESS INVESTMENT GROUP LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
MARCH 31, 2009
(dollars in tables in thousands, except share data)
The consolidating statement of cash flows information is as follows:
                                 
    Three Months Ended March 31, 2009  
    Fortress     Fortress             Fortress  
    Operating     Investment             Investment  
    Group     Group LLC     Intercompany     Group LLC  
    Consolidated     Consolidated (A)     Eliminations     Consolidated  
Cash Flows From Operating Activities
                               
Net income (loss)
  $ (286,128 )   $ (67,159 )   $ 66,606     $ (286,681 )
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities
                               
Depreciation and amortization
    2,641                   2,641  
Other amortization and accretion
    3,414                   3,414  
(Earnings) losses from equity method investees
    34,849       66,606       (66,606 )     34,849  
Distributions of earnings from equity method investees
    11                   11  
(Gains) losses from investments
    2,473                   2,473  
Deferred incentive income
                       
Deferred tax (benefit) expense
    (2,937 )     (822 )           (3,759 )
Tax receivable agreement liability reduction
          55             55  
Equity-based compensation
    287,803                   287,803  
Cash flows due to changes in
                               
Due from affiliates
    (25,932 )                 (25,932 )
Other assets
    (3,317 )     2,060             (1,257 )
Accrued compensation and benefits
    (108,216 )                 (108,216 )
Due to affiliates
    (1,428 )     61             (1,367 )
Deferred incentive income
                       
Other liabilities
    33,857       (1,200 )           32,657  
 
                       
Net cash provided by (used in) operating activities
    (62,910 )     (399 )           (63,309 )
 
                       
Cash Flows From Investing Activities
                               
Contributions to equity method investees
    (31,792 )                 (31,792 )
Distributions of capital from equity method investees
    10,538       292       (292 )     10,538  
Purchase of fixed assets
    (1,110 )                 (1,110 )
Proceeds from disposal of fixed assets
    6                   6  
 
                       
Net cash provided by (used in) investing activities
    (22,358 )     292       (292 )     (22,358 )
 
                       
Cash Flows From Financing Activities
                               
Borrowings under debt obligations
                       
Repayments of debt obligations
    (125,000 )                 (125,000 )
Payment of deferred financing costs
    (4,162 )                 (4,162 )
Dividends and dividend equivalents paid
    (292 )           292        
Principals’ and others’ interests in equity of consolidated subsidiaries — distributions
    25                   25  
Principals’ and others’ interests in equity of consolidated subsidiaries — contributions
    (5,225 )                 (5,225 )
 
                       
Net cash provided by (used in) financing activities
    (134,654 )           292       (134,362 )
 
                       
Net Increase (Decrease) in Cash and Cash Equivalents
    (219,922 )     (107 )           (220,029 )
Cash and Cash Equivalents, Beginning of Period
    262,463       874             263,337  
 
                       
Cash and Cash Equivalents, End of Period
  $ 42,541     $ 767     $     $ 43,308  
 
                       
     
(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 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.
General
Our Business
Fortress is a leading global alternative asset manager with approximately $26.5 billion in AUM as of March 31, 2009. We raise, invest and manage private equity funds, liquid hedge funds and hybrid 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, 2009, we managed alternative assets in three core businesses:
Private Equity — a business that manages approximately $13.2 billion of AUM comprised of two business segments: (i) private equity funds that primarily make significant, control-oriented investments in debt and equity securities of public or privately held entities in North America and Western Europe, with a focus on acquiring and building asset-based businesses with significant cash flows; 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.
Liquid Hedge Funds — a business that manages approximately $4.8 billion of AUM. These funds invest globally in fixed income, currency, equity and commodity markets and related derivatives to capitalize on imbalances in the financial markets.
Hybrid Funds — a business that manages approximately $8.5 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 throughout the capital structure with a value orientation, as well as in investment funds managed by external managers; and (ii) hybrid private equity (“PE”) funds which are comprised of a family of “credit opportunities” funds focused on investing in distressed and undervalued assets, a family of ''long dated value’’ funds focused on investing in undervalued assets with limited current cash flows and long investment horizons, and a family of “real assets” funds focused on investing in tangible and intangible assets in four principal categories (real estate, capital assets, natural resources and intellectual property).
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 six primary segments: (i) private equity funds, (ii) Castles (iii) liquid hedge funds, (iv) hybrid hedge funds, (v) hybrid private equity (“PE”) funds, and (vi) 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 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 operating performance used by management in analyzing its segment and overall results. 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).
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.

 

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Market Considerations
Our revenues consist primarily of (i) management fees based generally on the size of our funds, (ii) incentive income based on the performance of our funds and (iii) investment income from our investments in those funds. Our ability to maintain and grow our revenues — both at Fortress and within our funds — depends on our ability to attract new capital and investors, secure investment opportunities, obtain financing for transactions, consummate investments and deliver attractive risk-adjusted returns. Our ability to execute this investment strategy depends upon a number of market conditions, including:
The strength and liquidity of U.S. and global financial institutions and the financial system.
Many market participants have become increasingly uncertain about the health of a number of financial institutions as well as the financial system in general. Continuing write-downs and capital related issues in the financial services industry have contributed to the recent wave of significant events affecting financial institutions, including the insolvency of Lehman Brothers, the government’s placing of Fannie Mae, Freddie Mac and AIG under its supervision, the government’s increasing its equity investment in Citigroup, and the announced distressed sales of all or portions of Bear Stearns, Merrill Lynch, Wachovia and Washington Mutual. These events have impacted the credit and equity markets and global economy in a number of ways (some of which are discussed in more detail below under “-The strength and liquidity of the U.S. and global equity and debt markets”). In addition, certain of these institutions serve as key counterparties for a tremendous number of derivatives and other financial instruments held by Fortress and our funds. The consolidation and elimination of counterparties has increased our concentration of counterparty risk, decreased the universe of potential counterparties and reduced our ability to obtain competitive financing rates. Moreover, the insolvency of Lehman Brothers affected some of our funds in various ways. For example, some of our hedge funds had prime brokerage accounts with Lehman Brothers, and Lehman Brothers was the counterparty on a number of these funds’ derivatives, repurchase agreements and other financial instruments. These funds are working to close out such arrangements, and we do not currently expect losses as a result of the Lehman insolvency to have a material effect on the net asset value of any Fortress Fund or on Fortress. However, due to the sudden nature of Lehman’s insolvency, the complexity and ambiguity of both the contractual arrangements and applicable regulations, this process will take time, may be expensive and may result in one or more funds receiving only a portion of the amount they are owed (or potentially receiving nothing at all). Additional failures of financial institutions, particularly those who serve as counterparties to our financing arrangements, would have a meaningfully negative impact on the financial markets in which we operate and could have a meaningfully negative impact on Fortress and one or more of our funds.
The strength and liquidity of the U.S. and global equity and debt markets.
Strong equity market conditions enable our private equity funds and hybrid PE funds to increase the value, and effect realizations, of their portfolio company investments. In addition, strong equity markets make it generally easier for our funds that invest in equities to generate positive investment returns. The condition of debt markets also has a meaningful impact on our business. Several of 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 investments. 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.
Although equity and debt market conditions had been favorable for a number of years, the debt market conditions began to deteriorate in mid-2007, as the United States experienced considerable turbulence in the housing and sub-prime mortgage markets, which negatively affected other fixed income markets. The difficult conditions in the fixed income markets prompted lenders to cease committing to new senior loans and other debt, which, in turn, made it extremely difficult to finance new and pending private equity acquisitions or to refinance existing debt. Recently announced private equity-led acquisitions have been smaller, less levered, and subject to more restrictive debt covenants than acquisitions done prior to the disruption.
As the turbulence continued and its intensity increased, equity market conditions also began to deteriorate in the latter part of 2007 as concerns of an economic slowdown began to affect equity valuations. The resulting reduction in liquidity and increase in volatility caused several commercial and investment banks, hedge funds and other financial institutions to reduce the carrying value of a significant amount of their fixed income holdings, which further reduced the liquidity of debt and, to a lesser extent, equity instruments. Although the United States and other governments took a number of significant steps to improve market conditions, such efforts to date have not brought stability or liquidity to the capital markets, and we cannot predict the future conditions of these markets or the impact of such conditions on our business.
The current market conditions have negatively impacted our business in several ways:
    There currently is less debt and equity capital available in the market relative to the levels available in recent years, which, coupled with additional margin collateral requirements imposed by lenders on some types of investments, debt and derivatives, 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 have sufficient liquidity in the current market environment. However, maintaining this liquidity rather than investing available capital, and the reduced availability of attractive financing, has reduced our returns. Furthermore, we expect that our ability to access liquidity through the raising of equity capital or the issuance of debt obligations has been limited by the current market environment. This, in turn, may limit our ability to make investments, distributions, or engage in other strategic transactions. The dislocation of values and associated decreased liquidity in the global equity and debt markets have caused a material depreciation in equity and fixed income asset values, greater price volatility and weaker economic conditions around the globe. This has resulted in a significant reduction in the value of our investments, which in turn impacts our management fees, incentive income and investment income as described below.

 

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    There has been a prolonged reduction in market trading activity. This reduction and concern over market conditions have resulted in significant reductions in valuations by third party brokers and pricing agents.
    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. A decrease in this surplus hinders our ability to realize gains within these funds and therefore our ability to earn incentive income. Furthermore, the disruptions in the debt and equity markets have made exit strategies for private investments more difficult to execute as potential buyers have difficulty obtaining attractive financing and the demand for IPOs has been greatly reduced.
    These conditions have made it more difficult to generate positive investment returns and have contributed to increased redemption requests from investors throughout the hedge fund industry, and a number of our funds have been affected by this trend.
    As a result of the above factors:
    We did not pay a dividend on our Class A shares for the third quarter of 2008 through the first quarter of 2009. The decision to pay a dividend, as well as the amount of any dividends paid, is subject to change at the discretion of our board of directors based upon a number of factors, including actual and projected distributable earnings. If current conditions persist or deteriorate, we may be unable to pay any dividends.
    Our share of the NAV of certain fund investments, including certain investments on which we have received incentive returns, has declined below their related carrying amounts for distributable earnings purposes. During the three months ended March 31, 2009, we have taken $32.3 million of impairments and reserves related to such funds for distributable earnings purposes. While we expect aggregate returns on our other private equity fund and hybrid PE fund investments to ultimately exceed their carrying amount, if such funds were liquidated at their current NAV (although we have no present intention of doing so), the result would be additional impairment and reserves of approximately $45.2 million. Declines in the NAV of our fund investments have also caused us to record GAAP losses from equity method investees of $34.8 million in 2009. Furthermore, such declines impact our future management fees, generally at an annual rate of between 1% — 3% of the decline in aggregate fund NAV. See “- Fee Paying Assets Under Management” below for a table summarizing our AUM.
    Our liquid hedge funds received a total of $0.6 billion in redemption requests, including affiliates, for the three months ended March 31, 2009. These redemptions will directly impact the management fees we receive in 2009 from such funds (which pay management fees of between 2% — 3% of AUM). Investors in our hybrid hedge funds are permitted to request that their capital be returned on an annual basis, and such returns of capital are paid over time as the underlying investments are liquidated, in accordance with the governing documents of the applicable funds. During this period, such amounts continue to be subject to management fees and, as applicable, incentive income. The 2009 notice date for the hybrid hedge funds has not yet occurred.
    As a result of not meeting the incentive income thresholds with respect to such funds’ current investors, the incentive income from substantially all of our liquid and hybrid hedge funds has been discontinued for an indefinite period of time. Returns earned on capital from new investors continue to be incentive income eligible. Unrealized losses in substantially all of our private equity funds and hybrid PE funds have resulted in significantly higher future returns being required before we earn incentive income from such funds. The returns required are subject to a number of variables including: the amount of loss incurred, the amount of outstanding capital in the fund, the amount and timing of future capital draws and distributions, the rate of preferential return earned by investors, and others. We do not expect to earn a substantial amount of incentive income in 2009.
    The current ratio of our distributable earnings to our AUM is lower than it has been historically, and it is reasonably likely that the future ratios may also be below historic levels for an indeterminate period of time.
    Decreases in revenues and in the value of our principal investments could potentially affect our ability to comply with our debt covenants in the future. See “— Covenants” below.
    We are currently focused on preserving capital and liquidity rather than making investments.
The strength of, and competitive dynamics within, the alternative asset management industry, including the amount of capital invested in, and withdrawn from, alternative investments.
The strength of the alternative asset management industry, and our competitive strength relative to our peers, are dependent upon several factors, including, among other things, (1) the investment returns alternative asset managers can provide relative to other investment options, (2) the amount of capital investors allocate to alternative asset managers and (3) our performance relative to our competitors and the related impact on our ability to attract new capital.

 

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First, the strength of the alternative asset management industry is dependent upon the investment returns alternative asset managers can provide relative to other investment options. This factor depends, in part, on the interest rate and credit spreads (which 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) available on other investment products because as interest rates rise and/or spreads widen, returns available on such investments would tend to increase and, therefore, become more attractive relative to the returns offered by investment products offered by alternative asset managers. We have benefited in the past from relatively tight spreads, which have allowed us and the funds we manage to obtain financing for investments at attractive rates and made our investment products attractive relative to many other products. Over the past two years, spreads have widened significantly. In addition to potentially reducing the relative attractiveness of our investment products, 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. Furthermore, wider spreads reduce the value of investments currently owned by our funds. A reduction in the value of our funds’ investments directly impacts our management fees and incentive income from such funds. As a result, this dynamic could slow capital flow to the alternative investment sector.
A second and related factor is the amount of capital invested with such managers. Over the past several years, institutions, high net worth individuals and other investors (including sovereign wealth funds) have increased their allocations of capital to the alternative investment sector. However, investors have recently begun reducing the amount of capital they are allocating to certain alternative asset investment products, particularly hedge funds, for three reasons. First, as discussed above, challenging market conditions have reduced the returns generated by hedge funds, with many funds posting negative returns in 2008. Second, the lack of available credit has prompted many investors to maximize their cash holdings. Because the terms of many hedge funds allow investors to redeem their capital periodically (as opposed to most private equity funds, which do not allow redemptions), investors have begun redeeming their investments at rates that are generally higher than redemptions rates in previous years. This wave of redemptions may affect the investment decisions, and impair the viability, of many hedge funds who may not have sufficient cash on hand to satisfy redemption requests and may thus be forced either to sell assets at distressed prices in order to generate cash or take other measures. Certain of our hedge funds have recently received higher levels of redemption requests than those received in previous years. Third, negative investment performance has significantly reduced the amount of capital held by university endowments, pension funds, insurance companies and other traditionally significant investors in the alternative assets sector. As a result, many of these investors are decreasing the amount of capital they will allocate to alternative assets.
The third factor, which most directly impacts our results, is our investment performance relative to other investment alternatives, including products offered by other alternative asset managers. As a historical leader in the alternative asset management sector based on the size, diversity and historical performance of our funds, we have been able to attract a significant amount of new capital. However, as noted above, current market conditions have reduced the flow of new capital into the alternative asset management sector, and we have recently experienced stronger headwinds in our capital raising efforts, and we expect to continue to experience these trends during 2009. These factors have prompted us to reduce our expectations regarding future management fees and potential incentive income.
Market Considerations Summary
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, particularly in distressed asset classes. 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 funds. No assurance can be given that future trends will not be disadvantageous to us, particularly if current challenging conditions persist or intensify.
We do not currently know the full extent to which this disruption will affect us or the markets in which we operate. If the disruption continues, or results in a permanent, fundamental change in the credit markets, we and the funds we manage may experience further tightening of liquidity, reduced earnings and cash flow, impairment charges, increased margin requirements, as well as challenges in maintaining our reputation, raising additional capital, maintaining compliance with debt covenants, obtaining investment financing and making investments on attractive terms, and may need to make corresponding fundamental changes in our investment practices. However, to date we have been able to continue raising capital for our funds, on a net basis, both through new and existing funds, which serves both to increase our AUM and our management fee income and to give us a significant amount of capital available to be invested at a time when we believe attractive returns in distressed and other asset classes are available.

 

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Results of Operations
The following is a discussion of our results of operations as reported under GAAP. For a detailed discussion of distributable earnings and revenues from each of our segments, see “— Segment Analysis” below.
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Revenues
                       
Management fees from affiliates
  $ 105,652     $ 144,057     $ (38,405 )
Incentive income from affiliates
          37,144       (37,144 )
Expense reimbursements from affiliates
    13,047       14,270       (1,223 )
Other revenues
    3,597       5,409       (1,812 )
 
                 
 
    122,296       200,880       (78,584 )
 
                 
Expenses
                       
Interest expense
    8,186       10,336       (2,150 )
Compensation and benefits
    109,236       127,019       (17,783 )
Principals agreement compensation
    234,759       237,367       (2,608 )
General, administrative and other expense (including depreciation and amortization)
    19,826       19,006       820  
 
                 
 
    372,007       393,728       (21,721 )
 
                 
Other Income (Loss)
                       
Net gains (losses) — other investments
    (2,473 )     (27,957 )     25,484  
Tax receivable agreement liability reduction
    (55 )           (55 )
Earnings (losses) from equity method investees
    (34,849 )     (49,129 )     14,280  
 
                 
 
    (37,377 )     (77,086 )     39,709  
 
                 
 
                       
Income (Loss) Before Income Taxes
    (287,088 )     (269,934 )     (17,154 )
Income tax benefit (expense)
    407       (7,252 )     7,659  
 
                 
Net Income (Loss)
  $ (286,681 )   $ (277,186 )   $ (9,495 )
 
                 
Factors Affecting Our Business
During the periods discussed herein, the following are significant factors which have affected our business and materially impacted our results of operations:
    changes in our AUM;
    level of performance of our funds; and
    growth of our fund management and investment platform and our compensation structure to sustain that growth.
Fee Paying Assets Under Management
We measure AUM by reference to the fee paying assets we manage, including the capital we have the right to call from our investors due to their capital commitments. As a result of raising new funds and increases in the NAVs of our hedge funds from new investor capital, our AUM has increased over the periods discussed. Recently, lower performance in our funds, coupled with redemptions in our liquid hedge funds, have caused offsetting reductions in our AUM.

 

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Our AUM has changed for the three months ended March 31, 2009 as follows (in millions):
                                                 
    Private Equity     Liquid Hedge     Hybrid        
    Funds     Castles     Funds     Hedge Funds     PE Funds     Total  
2009
                                               
AUM December 31, 2008
  $ 10,307     $ 3,182     $ 7,169     $ 6,494     $ 2,302     $ 29,454  
Capital raised (A)
                9                   9  
Increase in invested capital
    60                         376       436  
Redemptions (B)
                (2,494 )     (152 )           (2,646 )
Return of capital distributions
    (5 )                 (7 )     (565 )     (577 )
Adjustment for reset date (C)
                                   
Crystallized incentive income (D)
                                   
Income (loss) and foreign exchange (E)
    (201 )     (104 )     125       116       (74 )     (138 )
 
                                   
AUM March 31, 2009
  $ 10,161     $ 3,078     $ 4,809     $ 6,451     $ 2,039     $ 26,538  
 
                                   
     
(A)   Includes offerings of shares by the Castles, if any.
 
(B)   Excludes redemptions which reduced AUM subsequent to March 31, 2009. See “- Market Considerations” above.
 
(C)   The reset date is the date on which a private equity fund or hybrid PE fund stops paying management fees based on commitments and starts paying such fees based on invested capital, which therefore changes fee paying AUM.
 
(D)   Represents the transfer of value from investors (fee paying) to Fortress (non-fee paying) related to realized hedge fund incentive income.
 
(E)   Represents the change in fee-paying NAV resulting from realized and unrealized changes in the reported value of the fund.
Average Fee Paying AUM
Average fee paying AUM represents the reference amounts upon which our management fees are based. The reference amounts for management fee purposes are: (i) capital commitments or invested capital (or NAV, on an investment by investment basis, if lower) for the private equity funds and hybrid PE funds, which in connection with funds raised after March 2006 includes the mark-to-market value on public securities held within the fund, (ii) contributed capital for the Castles, or (iii) the NAV for hedge funds.
Management Fees
Changes in our average AUM have an effect on our management fee revenues. Depending on the timing of capital contributions in a given period, the full economic benefits of a change in AUM may not be recognized until the following period.

 

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Performance of Our Funds
The performance of our funds has been as follows (dollars in millions):
                                 
            AUM        
    Inception     March 31,     Returns (A)  
Name of Fund   Date     2009     2008     Inception to March 31, 2009  
Private Equity Funds
                               
Fund I
  Nov-99   $ 36     $ 36       25.6 %
Fund II
  Jul-02     328       143       34.3 %
Fund III
  Sep-04     880       1,084       (16.0 )%
Fund III Coinvestment
  Nov-04     106       162       (9.1 )%
Fund IV
  Mar-06     1,780       2,408       (21.3 )%
Fund IV Coinvestment
  Apr-06     412       643       (20.9 )%
Fund V
  May-07     4,000       4,000       (C )
Fund V Coinvestment
  Jun-07     938       553       (C )
FRID
  Mar-05     293       860       (29.3 )%
FECI
  Jun-07     532       532       (8.8 )%
GAGACQ Fund
  Sep-04                 2.1 %
GAGACQ Coinvestment Fund
  Sep-04     9       25       14.2 %
RIC Coinvestment Fund LP
  May-06     30       143       (45.5 )%
FICO
  Aug-06     113       606       (74.1 )%
FHIF
  Dec-06     626       1,028       (19.2 )%
                                                 
                            Returns (A)  
                                            Inception to  
                            Three Months Ended March 31,     March 31, 2009  
                            2009     2008     (B)  
Other Private Equity Funds
                                               
Mortgage Opportunities Funds I, II and III
  Apr-08     78             (C )     N/A       (C )
 
                                               
Castles
                                               
Newcastle Investment Corp.
  Jun-98     1,165       1,192       N/A       (22.2 )%     N/A  
Eurocastle Investment Limited
  Oct-03     1,913       2,311       (20.6 )%     6.2 %     N/A  
 
                                               
Liquid Hedge Funds
                                               
Drawbridge Global Macro Funds
  Jul-02     3,771       8,567       5.2 %     (0.2 )%     8.6 %
Fortress Commodities Fund
  Jan-08     1,028       657       (0.5 )%     (C )     4.9 %
 
                                               
Hybrid Hedge Funds
                                               
Drawbridge Special Opportunities Fund LP (D)
  Aug-02     4,383       5,668       3.1 %     (1.6 )%     6.3 %
Drawbridge Special Opportunities Fund LTD (D)
  Aug-02     449       644       3.5 %     (1.9 )%     5.6 %
Fortress Partners Fund LP
  Jul-06     862       1,126       (2.0 )%     (4.6 )%     (7.7 )%
Fortress Partners Offshore Fund LP
  Nov-06     674       605       (1.4 )%     (4.0 )%     (8.3 )%
                                         
                            Returns (A)  
                            Inception to March 31, 2009  
Hybrid PE Funds
                                       
Credit Opportunities Fund
  Jan-08     914       133     (C)  
Long Dated Value Fund I
  Apr-05     201       191     (C)  
Long Dated Value Fund II
  Nov-05     207       202     0.0%  
Long Dated Value Fund III
  Feb-07     115       103     (C)  
Long Dated Value Patent Fund
  Nov-07     14       21     (C)  
Real Assets Fund
  Jun-07     126       91     (C)  
Assets Overflow Fund
  Jul-08     82           (C  
 
                                   
 
                                       
Subtotal — all funds
            26,065       33,734                  
Managed accounts
            473       295                  
 
                                   
Total
          $ 26,538     $ 34,029                  
 
                                   
     
(A)   Represents the following:
 
    For private equity funds, other than the Mortgage Opportunities Funds, and hybrid PE funds, returns represent net internal rates of return to limited partners after management fees and incentive allocations, and are computed on an inception to date basis consistent with industry standards. Incentive allocations are computed based on a hypothetical liquidation of net assets of each fund as of the balance sheet date. Returns are calculated for the investors as a whole. The computation of such returns for an individual investor may vary from these returns based on different management fee and incentive arrangements, and the timing of capital transactions.
 
    For Castles, returns represent the return on invested equity (ROE) as reported by such entities. ROE is not reported on an inception to date basis. Newcastle’s 2009 ROE is not meaningful because Newcastle incurred a loss and had negative book equity. Eurocastle’s 2009 ROE is estimated as they have not yet finalized their first quarter results.
 
    For liquid and hybrid hedge funds, as well as the Mortgage Opportunities Funds, returns represent net returns after taking into account any fees borne by the funds for a “new issue eligible,” single investor class as of the close of business on the last date of the relevant period. Specific performance may vary based on, among other things, whether fund investors are invested in one or more special investments.

 

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(B)   For liquid hedge funds, hybrid hedge funds and the Mortgage Opportunities Funds, reflects a composite of monthly returns presented on an annualized net return basis.
 
(C)   These funds were in their investment periods, or less than one year had elapsed from their inception, through the end of these years. In some cases, particularly the Mortgage Opportunities Funds, Fund V, Fund V Coinvestment and Credit Opportunities Fund, returns during these periods were significantly negative.
 
(D)   The returns for the Drawbridge Special Opportunities Funds reflect the performance of each fund excluding the performance of the redeeming capital accounts which relate to December 31, 2008 redemptions.
Incentive Income
Incentive income is calculated as a percentage of profits earned by the Fortress Funds. Incentive income that is not subject to contingent repayment is recorded as earned. Incentive income received from funds that continue to be subject to contingent repayment is deferred and recorded as a deferred incentive income liability until the related contingency is resolved. The contingencies related to a portion of the incentive income we have received from certain private equity Fortress Funds have been resolved.
Fund Management and Investment Platform
In order to accommodate the demands of our funds’ growing investment portfolios, we have created investment platforms, which are comprised primarily of our people, financial and operating systems and supporting infrastructure. Expansion of our investment platform historically required increases in headcount, consisting of newly hired investment professionals and support staff, as well as leases and associated improvements to corporate offices to house the increased number of employees, and related augmentation of systems and infrastructure. Our headcount decreased from 833 employees as of March 31, 2008 to 819 employees as of March 31, 2009. This resulted in net decreases in our compensation, office related and other personnel related expenses, although there were increases in certain businesses.
Revenues
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Management fees from affiliates
  $ 105,652     $ 144,057     $ (38,405 )
Incentive income from affiliates
          37,144       (37,144 )
Expense reimbursements from affiliates
    13,047       14,270       (1,223 )
Other revenues
    3,597       5,409       (1,812 )
 
                 
Total Revenues
  $ 122,296     $ 200,880     $ (78,584 )
 
                 
For the three months ended March 31, 2009 compared with the three months ended March 31, 2008, total revenues decreased as a result of the following:
Management fees from affiliates decreased by $38.4 million primarily due to the net effect of increases (decreases) in average AUM of ($0.4) billion, ($0.5) billion, ($4.2) billion, ($1.9) billion and $1.1 billion in our private equity funds, our Castles, our liquid hedge funds, our hybrid hedge funds, and our hybrid PE funds, respectively. The combined net decrease to average AUM generated a reduction in the amount of $31.9 million in management fees. In addition, management fees from affiliates decreased by $6.3 million as a result of a decrease in the average management fee percentage earned and by $1.5 million as a result of changes in foreign currency exchange rates.
Incentive income from affiliates decreased by $37.1 million as a result of a decrease in performance in our funds that resulted in no incentive income being recognized for the three months ended March 31, 2009, compared to $37.1 million of incentive income recognized from our funds for the three months ended March 31, 2008.
Expense reimbursements from affiliates decreased by $1.2 million primarily due to a decrease in compensation and benefits expenses that we have incurred for the three months ended March 31, 2009, as compared to the three months ended March 31, 2008.
Other revenues decreased by $1.8 million primarily due to a decrease in interest income of $2.5 million and a net decrease of $0.2 million in fees from non-affiliates, offset by a net increase of $0.8 million in dividend income earned primarily from our direct investment in GAGFAH common stock compared to dividends earned from the Castles in the prior period.

 

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Expenses
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Interest expense
  $ 8,186     $ 10,336     $ (2,150 )
Compensation and benefits
    109,236       127,019       (17,783 )
Principals agreement compensation
    234,759       237,367       (2,608 )
General, administrative and other (including depreciation and amortization)
    19,826       19,006       820  
 
                 
Total Expenses
  $ 372,007     $ 393,728     $ (21,721 )
 
                 
For the three months ended March 31, 2009 compared with the three months ended March 31, 2008, total expenses decreased as a result of the following:
Interest expense decreased by $2.2 million primarily due to a combined decrease of $4.7 million due to a decrease in average interest rates and a decrease in average borrowings from the first quarter of 2008, offset by an increase of $2.8 million due to write-offs and increased amortization of deferred financing costs.
Compensation and benefits decreased by $17.8 million primarily due to a decrease in profit sharing compensation of $18.2 million and a decrease of $21.6 million in discretionary bonuses, offset by an increase in equity based compensation of $24.6 million primarily due to the 31 million FOG RPUs granted in April 2008 (see discussion below). Profit-sharing compensation decreased due largely to decreased profit from our liquid and hybrid hedge funds.
Principals agreement compensation is being amortized on a straight-line basis over the term of the agreement.
General, administrative and other expenses increased by $0.8 million, primarily as a result of an increase in professional fees and consulting fees of $2.5 million, offset by a net decrease of $1.7 million in other general expenses.
Future Compensation Expense
In future periods, we will further recognize non-cash compensation expense on our non-vested equity-based awards of $800.8 million with a weighted average recognition period of 3.87 years. This does not include amounts related to the Principals Agreement, which is discussed above.
In April 2008, we granted 31 million Fortress Operating Group (“FOG”) restricted partnership units (“RPUs”) to a senior employee. In connection with the grant of these interests, the employee receives 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 in three equal portions on the first business day of 2011, 2012 and 2013, respectively, subject to continued employment with Fortress. In connection with this grant, we have reduced the employee’s profit sharing interests in various Fortress Funds.
Other Income (Loss)
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Net gains (losses) — other investments
  $ (2,473 )   $ (27,957 )   $ 25,484  
Tax receivable agreement liability reduction
    (55 )           (55 )
Earnings (losses) from equity method investees
    (34,849 )     (49,129 )     14,280  
 
                 
Total Other Income (Loss)
  $ (37,377 )   $ (77,086 )   $ 39,709  
 
                 
For the three months ended March 31, 2009 compared with the three months ended March 31, 2008, total other income (loss) decreased as a result of the following:
Net (losses) — other investments decreased by $25.5 million primarily due to the recognition of an unrealized loss of $1.9 million for the three months ended March 31, 2009 on our investments in GAGFAH and in our Castles, as compared to the recognition of an unrealized loss of $15.5 million on our investments in our Castles and other securities and an unrealized loss of $12.7 million on our options in our Castles as a result of a decline in the relative performance of their underlying stock price for the three months ended March 31, 2008. Our investments in GAGFAH and the Castles are held at fair value pursuant to the provisions of SFAS 159.

 

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Losses from equity method investees decreased by $14.3 million primarily due to the net effect of (i) the recognition of a $34.8 million net loss from equity method investees in 2009 as a result of losses attributable to investments in our private equity funds, liquid hedge funds, hybrid hedge funds and hybrid PE funds, compared to (ii) the recognition of a $49.1 million loss on our equity method investments for the three months ended March 31, 2008. The overall decrease in loss was primarily a result of slightly improved returns within the funds.
Income Tax Benefit (Expense)
Fortress has recorded a significant deferred tax asset, primarily in connection with the Nomura Transaction and IPO. A substantial portion of this asset is offset by a liability associated with the tax receivable agreement with our Principals. This deferred tax asset is further discussed under “- Critical Accounting Policies” below.
For the three months ended March 31, 2009, Fortress recognized income tax expense (benefit) of ($0.4 million). For the three months ended March 31, 2008, Fortress recognized income tax expense (benefit) of $7.3 million. The primary reasons for the increase in income tax benefit for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 are (i) changes in the mix of business segments producing income, which may be subject to tax at different rates, and (ii) changes in the forecasts of annual taxable income which are used to calculate the tax provision.
Segment Analysis
Fortress conducts its management and investment business through the following six primary segments: (i) private equity funds, (ii) Castles, (iii) liquid hedge funds, (iv) hybrid hedge funds, (v) hybrid private equity (“PE”) funds, and (vi) 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 hybrid PE funds segment, it has been disaggregated from the private equity funds segment in this period and for all periods presented.
Discussed below are our results of operations for each of our reportable segments. They represent the separate segment information available and utilized by our management committee, which consists of our principals and certain key officers, and which functions as our chief operating decision maker to assess performance and to allocate resources. Management evaluates the performance of each segment based on its distributable earnings.
Management assesses our segments on a Fortress Operating Group and pre-tax basis, and therefore adds back the non-controlling interests in consolidated subsidiaries related to Fortress Operating Group units (held by the principals) and income tax expense.
Distributable earnings is defined in Note 10 to Part I, Item 1, “Financial Statements — Segment Reporting.” Furthermore, a complete discussion of distributable earnings basis impairment and reserves, including the methodology used in estimating the amounts as well as the amounts incurred in the relevant periods, is disclosed therein.
Private Equity Funds
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Management Fees
  $ 37,631     $ 39,771     $ (2,140 )
Incentive Income
          28,741       (28,741 )
 
                 
Segment revenues — total
  $ 37,631     $ 68,512     $ (30,881 )
 
                 
Pre-tax distributable earnings
  $ 29,289     $ 50,056     $ (20,767 )
 
                 
Pre-tax distributable earnings decreased by $20.8 million primarily due to:
    a $0.9 million net decrease in management fees. Management fees decreased by $2.1 million due to a decrease of $4.6 million primarily as a result of the net asset value of certain portfolio companies of Fund III, FRID, and special investments declining below their invested capital, partially offset by an increase of $2.5 million primarily generated by capital called for Fund V Coinvestment and Fund II after March 31, 2008. The management fee decrease of $2.1 million was partially offset by a corresponding reduction of $1.2 million in the employees’ percentage share of management fees;
    a $18.4 million net decrease in incentive income. The decrease in incentive income is primarily attributable to a decrease in performance in the private equity funds that resulted in no incentive income (and no employee’s share of incentive income) recognized for the three months ended March 31, 2009 as compared to $28.7 million in incentive income (reduced by the employees’ share of incentive income of $10.3 million) for the three months ended March 31, 2008; and
    a $1.4 million net increase in operating expenses primarily related to an increase in general and administrative expenses.

 

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Publicly Traded Alternative Investment Vehicles (“Castles”)
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Management Fees
  $ 11,911     $ 13,694     $ (1,783 )
Incentive Income
          12       (12 )
 
                 
Segment revenues — total
  $ 11,911     $ 13,706     $ (1,795 )
 
                 
Pre-tax distributable earnings
  $ 3,989     $ 4,276     $ (287 )
 
                 
Pre-tax distributable earnings decreased by $0.3 million primarily due to:
    a $0.6 million net decrease in management fees. Management fees decreased by $1.8 million primarily due to a $1.5 million decrease as a result of changes in foreign currency exchange rates and a $0.3 million decrease as a result of a decrease in average AUM. These decreases to management fees were partially offset by a decrease in the employees’ share of management fees of $1.2 million; and
    a $0.3 million net decrease in operating expenses primarily due to a reduction in headcount resulting in lower anticipated compensation expenses.
Liquid Hedge Funds
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Management Fees
  $ 22,629     $ 52,719     $ (30,090 )
Incentive Income
          2,695       (2,695 )
 
                 
Segment revenues — total
  $ 22,629     $ 55,414     $ (32,785 )
 
                 
Pre-tax distributable earnings
  $ 5,975     $ 14,731     $ (8,756 )
 
                 
Pre-tax distributable earnings decreased by $8.8 million primarily due to:
    a $26.5 million net decrease in management fees. Management fees decreased $30.1 million primarily due to a $29.3 million decrease resulting from a decline in average AUM due to lower cumulative returns and investor redemptions from the Drawbridge Global Macro Funds subsequent to March 31, 2008 and a $5.0 million decrease due to a reduction in the average management fee percentage earned partially offset by (i) $3.0 million generated by the growth in the average AUM of Fortress Commodities Fund and (ii) $0.6 million due to management fees earned on a Drawbridge Global Macro fund raised in April 2008. The management fee decrease of $30.1 million was offset primarily by a $3.6 million reduction in the employees’ share of management fees;
    an $8.1 million net increase in incentive income. Incentive income decreased $2.7 million primarily due to incentive income generated by special investments and the Fortress Commodities Fund of $2.0 million and $0.5 million, respectively, for the three months ended March 31, 2008 as compared to no incentive income recognized for the three months ended March 31, 2009. The $2.7 million decrease was offset by a $10.8 million net decrease in the employees’ share of incentive income primarily as a result of (i) a $12.4 million decrease in the accrual of the employees’ share of incentive income due to the decreased performance in the Drawbridge Global Macro Funds partially offset by (ii) a $1.6 million increase in the employees’ share of incentive income earned on the Fortress Commodities Fund;
    a $9.6 million net decrease in operating expenses primarily due to a decrease in average headcount.

 

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Hybrid Hedge Funds
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Management Fees
  $ 28,123     $ 36,844     $ (8,721 )
Incentive Income
    822       425       397  
 
                 
Segment revenues — total
  $ 28,945     $ 37,269     $ (8,324 )
 
                 
Pre-tax distributable earnings
  $ 2,904     $ 2,048     $ 856  
 
                 
Pre-tax distributable earnings increased by $0.9 million primarily due to:
    an $8.9 million net decrease in management fees. Management fees decreased by $8.7 million and the employees’ share of management fees increased by $0.2 million (due to an increase in management fees eligible for profit sharing). The $8.7 million decrease in management fees was primarily a result of a decrease in average AUM, primarily due to negative fund returns in 2008;
    a $1.7 million net increase in incentive income. Incentive income increased by $0.4 million and the employees’ share of incentive income, reflected as profit sharing compensation expense, decreased by $1.3 million. The $0.4 million increase in incentive income was primarily attributable to a net increase of $0.4 million in incentive income primarily from third party accounts we manage. The decrease of $1.3 million in profit sharing compensation expense was primarily a result of a decline in the returns of our hybrid hedge funds; and
    an $8.3 million decrease in operating expenses primarily related to a decrease in average headcount.
Hybrid PE Funds
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
Management Fees
  $ 6,081     $ 2,009     $ 4,072  
Incentive Income
                 
 
                 
Segment revenues — total
  $ 6,081     $ 2,009     $ 4,072  
 
                 
Pre-tax distributable earnings
  $ 2,233     $ (112 )   $ 2,345  
 
                 
Pre-tax distributable earnings increased by $2.3 million primarily due to:
    a $4.1 million increase in management fees primarily due to $1.5 million of management fees generated by the creation of new Hybrid PE Funds, most notably the Assets Overflow Fund and a managed account, and an increase of $2.6 million in management fees primarily as a result of growth in average AUM; and
    a $1.8 million increase in operating expenses primarily related to an increase in average headcount primarily due to new funds.

 

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Principal Investments
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
 
                       
Pre-tax distributable earnings (loss)
  $ (35,034 )   $ (13,330 )   $ (21,704 )
 
                 
Pre-tax distributable loss increased by $21.7 million primarily due to:
    a $12.6 million increase in net investment income due to higher returns on our investments in our liquid hedge funds and hybrid hedge funds for the three months ended March 31, 2009 as compared to the three months ended March 31, 2008;
    a $0.8 million increase in net investment income due to dividend income earned primarily from our direct investment in GAGFAH common stock;
    a $32.3 million decrease in net investment income primarily as a result of impairments of $28.4 million, $0.2 million, $0.1 million, $3.0 million and $0.6 million in our investments in our private equity funds, Castles, liquid hedge funds, hybrid hedge funds and hybrid PE funds, respectively; and
    a $2.4 million decrease in net investment income primarily due to (i) a $2.3 million decrease in interest income as a result of lower interest rates and lower average cash balances, (ii) a $2.2 million decrease due to foreign currency translation adjustments, (iii) a net decrease of $0.2 million due to an increase in investment related expenses, offset by (iv) a net decrease of $2.2 million in interest expense primarily due to a decrease in average interest rates and a decrease in average borrowings during the three months ended March 31, 2009.
Unallocated
                         
    Three Months Ended March 31,        
    2009     2008     Variance  
 
                       
Pre-tax distributable earnings (loss)
  $ (151 )   $ 38     $ (189 )
 
                 
Pre-tax distributable earnings (loss) decreased by $0.2 million. The decrease in earnings is primarily due to an increase in general corporate expense.

 

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Sensitivity
For an analysis of the sensitivity of segment revenues to changes in the estimated fair value of the Fortress Fund investments, see Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”
Liquidity and Capital Resources
Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain investments, including our capital commitments to our funds, pay compensation, and satisfy our other general business needs including our obligation to pay U.S. federal income tax. In addition, we may require cash to make distributions. Our primary sources of funds for liquidity consist of cash flows provided by operating activities, primarily the management fees and incentive income paid to us from the Fortress Funds, borrowings under loans, and the potential issuance of debt and equity securities, as well as the investment returns on our principal investments in these funds. Our primary uses of liquidity include operating expenses (which include compensation, rent and interest among others), working capital expenses, amortization payments under our credit agreement, capital commitments to our funds, and tax and tax-related payments.
The receipt of management fees generally occurs on a fixed and fairly predictable schedule, subject to changes in the NAV of the Fortress Funds (due to performance or capital transactions). From time to time, we may elect, in our discretion, to defer the receipt of management or other fees, to which we are legally entitled, in order to optimize the operations of the underlying managed funds. The timing of receipt of cash flows from other operating activities is in large part dependent on the timing of distributions from our private equity funds and hybrid PE funds, which are subject to restrictions and to management’s judgment regarding the optimal timing of the monetization of underlying investments, as well as dates specified in our hedge funds’ operating documents, which outline the determination and payment of our incentive income, if any. The timing of capital requirements to cover fund commitments is subject to management’s judgment regarding the acquisition of new investments by the funds, as well as the ongoing liquidity requirements of the respective funds. The timing of capital requirements and the availability of liquidity from operating activities may not always coincide, and we may make short-term, lower-yielding investments with excess liquidity or fund shortfalls with short-term debt or other sources of capital.
We expect that our cash on hand and our cash flows from operating activities, capital receipts from balance sheet investments and available financing will be sufficient to satisfy our liquidity needs with respect to expected current commitments relating to investments and with respect to our debt obligations over the next twelve months. We estimate that our expected management fee receipts over the next twelve months, a portion of which may be deferred, will be sufficient (along with our cash on hand of $43.3 million at March 31, 2009 and expected capital receipts from our balance sheet investments) to meet our operating expenses (including compensation and lease obligations), required debt amortization payments, and fund capital commitments, in each case expected to be funded during the next twelve months (see obligation tables below). These uses of cash would not (barring changes in other relevant variables) cause us to violate any of our debt covenants. We believe that the compensation we will be able to pay from these available sources will be sufficient to retain key employees and maintain an effective workforce. We may elect, if we deem it appropriate, to defer certain payments due to our principals and affiliates or raise capital to enable us to satisfy the amortization payments required under our credit agreement.
We expect to meet our long-term liquidity requirements, including the repayment of our debt obligations and any new commitments or increases in our existing commitments relating to principal investments, through the generation of operating income (including management fees, a portion of which may be deferred), capital receipts from balance sheet investments and, potentially, additional borrowings and equity offerings. As discussed above, we believe that we will generate adequate operating cash flows to service our periodic debt payments, which will result in a gradual reduction in our debt level. Our ability to execute our business strategy, particularly our ability to form new funds and increase our AUM, depends on our ability to raise additional investor capital within our funds and on our ability to monetize our balance sheet investments, each of which is more challenging given current market conditions. Furthermore, strategic initiatives and the ability to make principal investments in funds may be dependent on our ability to raise capital at the Fortress level. Decisions by counterparties to enter into transactions with us will depend upon a number of factors, such as our historical and projected financial performance and condition, compliance with the terms of our current credit arrangements, industry and market trends and performance, the availability of capital and our counterparties’ policies and rates applicable thereto, the rates at which we are willing to borrow, and the relative attractiveness of alternative investment or lending opportunities. Furthermore, given the current, depressed level of the market price of our Class A shares as well as the illiquidity in the credit market (as described above under “— Market Considerations), raising equity capital could be highly dilutive to our current shareholders and issuing debt obligations could result in significant increases to operating costs, if either were achieved in this market. The level of our share price also limits our ability to use our equity as currency in the potential acquisition of businesses, other companies or assets.
On February 8, 2007, we completed an initial public offering of 39,428,900 of our Class A shares. We contributed the net proceeds from the offering to Fortress Operating Group in exchange for 39,428,900 limited partnership units. We are a publicly traded partnership and have established a wholly owned corporate subsidiary (“FIG Corp.”). Accordingly, a substantial portion of our income earned by the corporate subsidiary is subject to U.S. federal income taxation and taxed at prevailing rates. The remainder of our income is allocated directly to our shareholders and is not subject to any corporate level of taxation.

 

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As of March 31, 2009, our material cash commitments and contractual cash requirements were related to our capital commitments to our funds, lease obligations and debt obligations. Our potential liability for the contingent repayment of incentive income is discussed under “- Contractual Obligations” below.
Capital Commitments
We determine whether to make capital commitments to our private equity funds and hybrid PE funds in excess of the minimum required amounts based on a variety of factors, including estimates regarding our liquidity over the estimated time period during which commitments will have to be funded, estimates regarding the amounts of capital that may be appropriate for other funds which we are in the process of raising or are considering raising, and our general working capital requirements.
We generally fund our principal investments in the Fortress Funds with cash, either from working capital or borrowings, and not with carried interest. We do not hold any principal investments in the funds other than through the Fortress Operating Group entities. Our principals do not own any portion of the carried interest in any fund personally. Accordingly, their personal investments in the funds are funded directly with cash.
Our capital commitments to our funds with outstanding commitments as of March 31, 2009 consisted of the following (in thousands):
         
    Outstanding  
Private Equity Funds   Commitment  
Fund I
  $ 12  
Fund II
    566  
Fund III Coinvestment
    2  
Fund IV
    4,053  
Fund IV Coinvestment
    3  
Fund V
    45,292  
Fund V Coinvestment
    4  
Fund VI
    15,000  
FRID
    796  
FHIF
    11,446  
FECI
    1,551  
Karols Development Co
    5,153  
 
 
Hybrid PE Funds
       
Credit Opportunities Fund
    7,337  
Long Dated Value Fund I
    460  
Long Dated Value Fund II
    2,081  
Long Dated Value Fund III
    453  
Real Assets Fund
    37,521  
Assets Overflow Fund
    19  
FTS SIP L.P.
    610  
 
     
 
       
Total
  $ 132,359  
 
     
Lease Obligations
Minimum future rental payments under our operating leases are as follows (in thousands):
         
April 1, 2009 to December 31, 2009
  $ 13,763  
2010
    21,332  
2011
    11,530  
2012
    10,893  
2013
    10,874  
2014
    10,311  
Thereafter
    21,691  
 
     
Total
  $ 100,394  
 
     

 

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Debt Obligations
As of March 31, 2009, our debt obligations consisted of the amount outstanding under our credit agreement, as described below.
In May 2007, we entered into a new $1 billion credit agreement (as amended, the “2007 Credit Agreement” or “our credit agreement”) in order to refinance our then existing credit agreement, reduce the amount of interest and other fees payable under our credit facilities and increase the amount of funds available for investments. The credit facilities available under the 2007 Credit Agreement include a $200 million revolving credit facility (including a $25 million letter of credit subfacility) and an $800 million term loan facility. Borrowings and letters of credit issued under the 2007 Credit Agreement bore interest at a rate equal to (i) with respect to LIBOR loans, LIBOR plus 1.20%, or (ii) with respect to base rate loans, the base rate, as defined in the agreement, plus 0.20%. On February 1, 2008, the rate on LIBOR loans was reduced to LIBOR + 0.65% pursuant to the terms of the agreement. In addition, we were required to pay a commitment fee of 0.20% per annum on the unused portion of amounts available under our revolving credit facility.
On April 17, 2008, we entered into an amendment to the 2007 Credit Agreement. The amendment, among other things, (i) permits us to issue an unlimited amount of subordinated indebtedness with specified terms so long as 40% of the net proceeds are used to repay amounts outstanding under the 2007 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 us 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 addition, on May 29, 2008, we entered into an amendment of our credit agreement to change from a co-borrower structure to a single borrower structure.
On November 12, 2008, we entered into an additional amendment to the 2007 Credit Agreement. The amendment, among other things: (i) modified the definition of EBITDA, which is used to calculate our Consolidated Leverage Ratio, to exclude any realized or unrealized gains and losses on investments and to reflect private equity fund and hybrid PE fund incentive income clawbacks on a cash basis; (ii) modified the financial covenants by (a) reducing the amount of required investment assets to $975 million (less any future term loan repayments) and (b) changing the required Consolidated Leverage Ratios for the quarters ending June 30 and September 30, 2009 from 2.5 to 1.0 to 2.75 to 1.0; (iii) increased the rate on LIBOR loans to LIBOR + 2.00% (and Base Rate loans to the prime rate + 1.00%) — this rate is no longer subject to change pursuant to a ratings-based pricing grid; (iv) established the commitment fee for the unused portion of the revolving credit facility at 0.25% — this rate is also no longer subject to change pursuant to a ratings-based pricing grid; (v) reduced the revolving credit facility commitments to $125 million; (vi) established a requirement that outstanding term loans be prepaid with 25% of the amount by which EBITDA for any twelve-month period exceeds $370 million (unless and until the amount of outstanding term loans equals or is less than $250 million); (vii) required $50 million of additional term loan repayments ($25 million in July of 2009 and 2010); (viii) established a requirement that the borrower cash collateralize the letter of credit obligations of distressed lenders under certain circumstances, including lender non-funding or bankruptcy; and (ix) established an event of default under certain circumstances if the borrower, any guarantor or certain of their subsidiaries are required to make incentive income clawback payments in excess of $20 million during any calendar year. In connection with the amendment, we prepaid $75 million of the outstanding term loans.
On March 12 and March 13, 2009, we entered into additional amendments to the 2007 Credit Agreement. The amendments, among other things: (i) modified the financial covenants by (a) amending the amount of required management fee earning assets to $22 billion as of the end of each fiscal quarter through December 31, 2009 and $20 billion as of the end of each fiscal quarter thereafter; (b) reducing the amount of investment assets required as of any point in time to an amount equal to the term loans and revolving loans (including outstanding letters of credit) then outstanding; (c) changing the required Consolidated Leverage Ratio to 3.5 to 1.0 for the remainder of the term of the credit agreement; (ii) increased the rate on LIBOR loans to LIBOR + 2.50 (and Base Rate loans to the prime rate plus 1.50%); (iii) reduced the revolving credit facility commitments to $75 million; (iv) established an annual requirement, beginning in 2010, that outstanding loans be prepaid in an amount equal to 75% of Free Cash Flow (as defined in the agreement) generated during the previous year; (v) increased the amount of our scheduled amortization payments (the amortization schedule now requires the following payments: $50 million in July 2009, $25 million in each of October 2009 and January, April, July and October 2010, and $75 million in January 2011); (vi) established a requirement that 50% of the net proceeds from any equity issuance by the Fortress Operating Group be applied to prepay outstanding term loans; (vii) reduced the amount of certain types of distributions we can make to equity holders of the Fortress Operating Group and, in turn, our Class A shareholders, and (viii) provided that the dissolution or termination of specified material funds would not constitute an event of default. In connection with the amendment, we prepaid $75 million of outstanding term loans and $50 million of outstanding revolving facility loans.

 

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The foregoing description of the terms of the amendments is not complete and is qualified in its entirety by the full text of both the amendments, and the 2007 Credit Agreement (including other amendments thereto), each of which has been filed with the Securities and Exchange Commission.
Increases in the interest rate on our debt obligations, whether through amendments, refinancings, or increases in LIBOR, result in a direct reduction in our earnings and cash flow from operations and, therefore, our liquidity.
The following table presents information regarding our debt obligations (dollars in thousands):
                                         
                            March 31, 2009  
                                    Weighted  
                    Final             Average  
    Face Amount and Carrying Value     Stated     Weighted Average     Maturity  
Debt Obligation   March 31, 2009     December 31, 2008     Maturity     Funding Cost (1)     (Years)  
Credit Agreement (2)
                                       
Revolving debt (3)
  $ 54,041     $ 104,041     May 2012     3.04 %     3.11  
Term loan
    350,000       350,000     May 2012     3.20 %     2.40  
Delayed term loan
    200,000       275,000     May 2012     3.11 %     0.77  
 
                               
Total
  $ 604,041     $ 729,041               3.16 %     1.92  
 
                               
     
(1)   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 0.48%.
 
(2)   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.
 
(3)   Approximately $11.4 million was undrawn under the revolving debt facility as of March 31, 2009. The revolving debt facility included a $25 million letter of credit subfacility of which $9.6 million was utilized. Lehman Brothers Commercial Paper, Inc., which is committed to fund $7.2 million (including $1.0 million of the outstanding letters of credit) of the $75 million revolving credit facility, has filed for bankruptcy protection, did not fund its portion of the last borrowing under this facility, and it is reasonably possible that it will not fund its portion of the commitments. As a result, $5.2 million of the undrawn amount was available.
Assuming no EBITDA-based required prepayments, our outstanding debt matures as follows as of March 31, 2009 (in thousands).
         
April 1 - December 31, 2009
  $ 75,000  
2010
    100,000  
2011
    75,000  
2012
    354,041  
 
     
Total
  $ 604,041  
 
     
As a result of the Nomura transaction and our initial public offering, FIG Asset Co. LLC lent excess proceeds of $215 million to FIG Corp. pursuant to a demand note. Since then, FIG Corp. has repaid a portion of the demand note and, as of March 31, 2009, the outstanding balance was $125.3 million. This intercompany debt is eliminated in consolidation.
Covenants
Fortress Operating Group is required to prepay the 2007 Credit Agreement upon the occurrence of certain events, including certain asset sales and other dispositions.
The events of default under the 2007 Credit Agreement are typical of such agreements and include payment defaults, failure to comply with credit agreement covenants, cross-defaults to material indebtedness, bankruptcy and insolvency, change of control, and adverse events (as defined in the 2007 Credit Agreement) with respect to our material funds. A default under this agreement would likely have a material, adverse impact on our liquidity and, given the current lack of available credit for refinancing in the market, could threaten our ability to continue as a going concern.
The 2007 Credit Agreement includes customary covenants. We were in compliance with all of these covenants as of March 31, 2009. Among other things, we are prohibited from incurring additional unsubordinated indebtedness or further encumbering our assets, subject to certain exceptions. In addition, Fortress Operating Group must not:
    Permit AUM to be less than $22.0 billion as of the end of each fiscal quarter through December 31, 2009 and $20.0 billion as of the end of each fiscal quarter thereafter;
 
    Permit the Consolidated Leverage Ratio, as defined in the 2007 Credit Agreement, to be greater than 3.5 to 1.0 for the remainder of the term of the credit agreement;
 
    Permit the aggregate value of investments held, including certain cash, as of any point in time, to be less than the amount equal to the sum of the term loans and the revolving loans (including outstanding letters of credit) then outstanding (the “Required Investment Assets”);

 

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    Permit the aggregate value of Fortress Fund Investments (generally defined in the 2007 Credit Agreement as the stock of Newcastle, Eurocastle and any other publicly traded company pledged as collateral (and any options in respect of such stock), and Fortress Operating Group’s interest in the Fortress private equity funds, liquid hedge funds and hybrid funds and certain other investment funds) to be less than 40% of the Required Investment Assets;
 
    Permit the aggregate value of the sum of (i) the Fortress Fund Investments plus (ii) certain investments in co-investment funds (in the aggregate, “Total Investments”) to be less than 60% of the Required Investment Assets (with no single co-investment fund investment exceeding $75 million).
 
    Make incentive income clawback payments in excess of $20 million during a calendar year. To date, no clawback payments have been required. See Note 10 to Part I, Item 1 “Financial Statements and Supplementary Data — Segment Reporting” for a further discussion of clawback.
The following table sets forth the financial covenant requirements as of March 31, 2009.
                         
    March 31, 2009        
    (dollars in millions)        
    Requirement     Actual     Notes  
AUM
  ≥ $ 22,000     $ 26,538       (A )
 
 
Consolidated Leverage Ratio
  ≤ $ 3.50       1.98       (B )
 
 
Required Investment Assets
  ≥ $ 614     $ 731       (C )
 
 
Fortress Fund Investments
  ≥ $ 245     $ 394       (C )
 
 
Total Investments
  ≥ $ 368     $ 521       (C )
     
(A)   Impacted by capital raised in funds, redemptions from funds, and valuations of fund investments.
 
(B)   Impacted by EBITDA, as defined, which is impacted by the same factors as distributable earnings, except EBITDA is not impacted by clawback reserves or the impairment of investments.
 
(C)   Impacted by capital investments in funds and the valuation of such funds’ investments.
Fortress expects to comply with these covenants as of the applicable testing dates. However, as a result of recent market conditions and their impact on Fortress, it is possible that we may not be able to comply with one or more of these covenants if conditions continue to worsen over time. As a result of the amortization requirements, we may take steps to ensure that we are able to make the required periodic cash amortization payments, including (i) deferring payments to our Principals and affiliates in order to preserve cash, including payments to our Principals under the tax receivable agreement, and (ii) considering potential capital raise transactions in order to increase investments, reduce debt, or a combination of the two options.
This summary is qualified by reference to our 2007 Credit Agreement, a copy of which, including all amendments thereto, has been filed with the SEC.
Dividends / Distributions
During the three months ended March 31, 2009, Fortress Operating Group made distributions of $1.1 million to the principals and RPU holders in connection with distributions made to FIG Corp. to pay Fortress’s income taxes.
Cash Flows
Our historical consolidated statements of cash flows reflect the cash flows of Fortress Operating Group, for the three months ended March 31, 2009.
The primary cash flow activities of Fortress Operating Group are: (i) generating cash flow from operations, (ii) making investments in Fortress Funds, (iii) meeting financing needs through, and making required amortization payments under, our credit agreement, and (iv) distributing cash flow to equity holders.
As described above in “— Results of Operations,” our AUM has changed throughout the periods reflected in our financial statements included in this Quarterly Report on Form 10-Q. This change is a result of the Fortress Funds raising and investing capital, and generating gains from investments, offset by redemptions and losses.
Our dividend policy has certain risks and limitations, particularly with respect to liquidity. Although we may pay dividends in accordance with our stated dividend policy, we may not pay the amount of dividends suggested by our policy, or at all, if, among other things, we do not have the cash necessary to pay the intended dividends, or if our board of directors determines it would be prudent to reduce or eliminate future dividend payments. To the extent we do not have cash on hand sufficient to pay dividends, we may borrow funds to pay dividends, but we are not obligated to do so. By paying cash dividends rather than investing that cash in our future growth, we risk slowing the pace of our growth, or not having a sufficient amount of cash to fund our operations or unanticipated capital expenditures, should the need arise.

 

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Operating Activities
Our net cash flow provided by (used in) operating activities was ($63.3) million and $51.9 million during the three months ended March 31, 2009 and 2008, respectively.
Operating Activities — Comparative (First Quarter of 2009 vs. First Quarter of 2008)
Cash received for management fees decreased by $42.4 million from $139.1 million in 2008 to $96.7 million in 2009. Management fees are based on average fee paying AUM, which decreased from 2008 to 2009 (private equity funds decreased by $0.4 billion, Castles decreased by $0.5 billion, liquid hedge funds decreased by $4.2 billion, hybrid hedge funds decreased by $1.9 billion, and hybrid PE funds increased by $1.1 billion) as a result of capital raising, including new fund formation, offset by redemptions and losses.
Incentive income is calculated as a percentage of profits earned by the Fortress Funds or is based on profitable realization events within private equity funds and hybrid PE funds. Severe market conditions have resulted in lower fund performance and reduced realizations and thus a decrease of $164.7 million in cash received for incentive income from 2008 to 2009.
Despite an increase in average headcount from March 31, 2008 to March 31, 2009, cash paid for compensation decreased by $65.0 million for the three month periods ended March 31, 2008 compared to March 31, 2009. This decrease is mainly attributable to reduced profit sharing compensation, as a result of lower performance within our funds.
Cash paid for interest decreased approximately $5.7 million due to a lower average debt balance of $703.1 million in 2009 compared to $722.4 million in 2008. The weighted average interest rate also decreased to 2.61% in 2009 as compared to 5.13% in 2008.
Investing Activities
Our net cash flow provided by (used in) investing activities was ($22.4) million and $82.6 million during the three months ended March 31, 2009 and 2008, respectively. Our investing activities primarily included: (i) contributions to equity method investees of ($31.8) million and ($70.2) million during the three months ended March 31, 2009 and 2008, respectively, (ii) distributions of capital from equity method investees of $10.5 million and $155.0 million during the three months ended March 31, 2009 and 2008, respectively, and (iii) purchases of fixed assets, net of proceeds from the disposal of fixed assets, of ($1.1) million and ($2.2) million during these periods, respectively.
Financing Activities
Our net cash flow provided by (used in) financing activities was ($134.4) million and $137.8 million during the three months ended March 31, 2009 and 2008, respectively. Our financing activities primarily included (i) distributions made to principals, including those classified within “principals’ and others’ interests in consolidated subsidiaries,” of ($1.0) million and ($63.2) million during these periods, respectively, (ii) distributions to employees related to their interests in consolidated subsidiaries of ($4.3) million and ($37.3) million during these periods, respectively, (iii) dividends to our shareholders, and (iv) our net borrowing and repayment activity.
Critical Accounting Policies
Consolidation
The analysis as to whether to consolidate an entity is subject to a significant amount of judgment. Some of the criteria considered are the determination as to the degree of control over an entity by its various equity holders, the design of the entity, how closely related the entity is to each of its equity holders, the relation of the equity holders to each other and a determination of the primary beneficiary in entities in which we have a variable interest. These analyses involve estimates, probability weighting of subjectively determined cash flow scenarios, and other estimates based on the assumptions of management.

 

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Revenue Recognition on Incentive Income
Incentive income is calculated as a percentage of the profits earned by the Fortress Funds subject to the achievement of performance criteria. Incentive income from certain of the private equity funds and hybrid PE funds we manage is subject to contingent repayment (or clawback) and may be paid to us as particular investments made by the funds are realized. If, however, upon liquidation of a fund the aggregate amount paid to us as incentive income exceeds the amount actually due to us based upon the aggregate performance of the fund, the excess is required to be returned by us (i.e. ''clawed back’’) to that fund. We have elected to adopt the preferred method of recording incentive income subject to contingencies, Method 1 of Emerging Issues Task Force Topic D-96 “Accounting for Management Fees Based on a Formula.” Under this method, we do not recognize incentive income subject to contingent repayment until all of the related contingencies have been resolved. Deferred incentive income related to a particular private equity fund or hybrid PE fund, each of which has a limited life, would be recognized upon the termination of such fund, or when distributions from the fund exceed the point at which a clawback of a portion or all of the historic incentive income distributions could no longer occur. Recognition of incentive income allocated to us prior to that date is deferred and recorded as a deferred incentive income liability. For GAAP purposes, the determination of when incentive income is recognized as income is formulaic in nature, resulting directly from each fund’s governing documents.
Profit Sharing Arrangements
Pursuant to employment arrangements, certain of Fortress’s employees are granted profit sharing interests and are thereby entitled to a portion of the incentive income realized from certain Fortress Funds, which is payable upon a realization event within the respective funds. Accordingly, incentive income resulting from a realization event within a fund gives rise to the incurrence of a profit sharing obligation. Amounts payable under these profit sharing plans are recorded as compensation expense when they become probable and reasonably estimable.
For profit sharing plans related to hedge funds, where incentive income is received on a quarterly or annual basis, the related compensation expense is accrued during the period for which the related payment is made.
For profit sharing plans related to private equity funds and hybrid PE funds, where incentive income is received as investments are realized but is subject to clawback (see “Revenue Recognition on Incentive Income” above), although Fortress defers the recognition of incentive income until all contingencies are resolved, accruing expense for employee profit sharing is based upon when it becomes probable and reasonably estimable that incentive income has been earned and therefore a profit sharing liability has been incurred. Based upon this policy, the recording of an accrual for profit sharing expense to employees generally precedes the recognition of the related incentive income revenue. Furthermore, such profit sharing expense may be reversed upon determination that the expense is no longer probable of being incurred based on the performance of the fund.
Our determination of the point at which it becomes probable and reasonably estimable that incentive income will be earned and therefore a corresponding profit sharing expense should be recorded is based upon a number of factors, the most significant of which is the level of realized gains generated by the underlying funds that may ultimately give rise to incentive income payments. Accordingly, profit sharing expense is generally recorded upon realization events within the underlying funds. A realization event has occurred when an investment within a fund generates proceeds in excess of its related invested capital, such as when an investment is sold at a gain. Changes in the judgments and estimates made in arriving at the appropriate amount of profit sharing expense accrual could materially impact net income.
For further information on amounts paid and payable in the future under our profit sharing arrangements, please see Note 2 to Part I, Item 1, “Financial Statements — Management Agreements and Fortress Funds.”
Valuation of Investments
Our investments in the Fortress Funds are recorded based on the equity method of accounting. The Fortress Funds themselves apply specialized accounting principles specified by the AICPA Audit and Accounting Guide — Investment Companies. As such, our results are based on the reported fair value of the investments held by the funds as of the reporting date with our pro rata ownership interest (based on our principal investment) in the changes in each fund’s NAV reflected in our results of operations. Fair value generally represents the amount at which an investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. We are the manager of these funds and in certain cases participate in the valuation of underlying investments, many of which are illiquid and/or without a public market. The fair value of these investments is generally estimated based on either values provided by independent valuation agents, who use their own proprietary valuation models, or proprietary models developed by us, which include discounted cash flow analyses, public market comparables, and other techniques and may be based, at least in part, on independently sourced market parameters. The material estimates and assumptions used in these models include the timing and expected amount of cash flows, the appropriateness of discount rates used, and, in some cases, the ability to execute, timing of, and estimated proceeds from expected financings. Significant judgment and estimation goes into the selection of an appropriate valuation methodology as well as the assumptions which generate these models, and the actual values realized with respect to investments could be materially different from values obtained based on the use of those estimates. The valuation methodologies applied impact the reported value of our investments in the Fortress Funds in our consolidated financial statements.

 

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Private Equity Funds
Under the valuation policies and guidelines of our private equity funds, investments are categorized into two types of securities: those for which there is a market quotation and those for which there is no market quotation. Securities for which there is a market quotation are valued at their quoted market price. A discount may be applied to those securities with sale restrictions. Securities for which there is no market quotation are referred to as private securities and are valued at fair value. Our guidelines state that the fair values of private securities are generally based on the following methods:
  1.   Public market transactions of similar securities
 
  2.   Private market transactions of similar or identical securities
 
  3.   Analytical methods
Our private equity funds have never based a valuation of a private security upon public or private market transactions in a similar security. There have been no circumstances to date in which a security in a public market transaction, or a private market transaction of which we were aware, has been considered to be sufficiently similar to a private security owned by one of our private equity funds to be used as a measure of valuation for such private security investment.
Our private equity funds have used the price of private market transactions in identical securities as a valuation method for investments. In cases in which there has been a significant private transaction in a private security held by our private equity funds, the value of private equity fund investments in the private security are based upon the price of such recent private transaction in that security and no sensitivity analysis is used.
If the fair value of private security investments held by our private equity funds cannot be valued by reference to a public or private market transaction, then the primary analytical methods used to estimate the fair value of such private securities are the discounted cash flow method, by reference to performance statistics of similar public companies (for example, EBITDA multiples) or the use of third party valuations. Sensitivity analysis is applied to the estimated future cash flows using various factors depending on the investment, including assumed growth rates (in cash flows), capitalization rates (for determining terminal values) and appropriate discount rates based on the investment to determine a range of reasonable values. The valuation based on the inputs determined to be the most probable is used as the fair value of the investment.
Liquid Hedge Funds
The majority of the investments in our liquid hedge funds are valued based on quoted market prices, including broker quotations in illiquid or inactive markets which include disclaimers stating they are not “actionable” and are therefore included in level 3A as described below. Investments valued based on other observable market parameters in our liquid hedge funds include (i) interest rate swaps and swaptions, equity swaps and foreign exchange swaps which are valued by the independent fund administrator using models with significant observable market parameters, and (ii) funds managed by third parties for which we receive value information from the fund managers. The fair value of interest rate swaps and swaptions is calculated using the current market yield of the relevant interest rate durations and an appropriate discount rate to determine a present value. The fair value of equity swaps and foreign exchange swaps is calculated using the market price of the underlying stock or foreign exchange pair, plus the financing cost of carrying the transaction. The fair value of these investments is also confirmed independently with the counterparty to the transaction. Investments valued using methods, including internal models, with significant unobservable market parameters consist primarily of investments in other funds and certain illiquid securities. Counterparty risk is also considered.
Hybrid Hedge Funds
In our hybrid hedge funds, investments are valued using quoted market prices, to the extent available. Independent valuation agents are used by our hybrid hedge funds to provide estimates of the fair value of investments, other than investments in other funds, for which quoted market prices are not available. For these investments, we understand that the independent valuation agents use some or all of the following methods and techniques to estimate the fair value of the relevant type of investments:
Private loans — The most common method used to value private loans is a discounted cash flow analysis. In this method, the estimated future payments to be made by the borrower under the loan agreement are discounted to the present using a discount rate appropriate to the risk level of the borrower and current market interest rates.
If it is likely that a borrower will not be able to repay a loan in full, the loan may be valued by estimating how much the borrower will be able to repay based on obtaining refinancing from a new lender. Under this method, the borrower’s business must be examined in detail, and then compared to known loans in the market to estimate how much the borrower will likely be able to borrow, and therefore repay under the existing loan. If the amount likely to be able to be refinanced is less than the total payments due under the loan, the fair value of the loan will be reduced.
Another method used to value loans that may not be repaid in full is to value the total amount of assets of the borrower that might be sold to raise proceeds to repay the loan (and debt, if any, that has a higher claim against assets) if necessary. Under this method, all assets of the borrower must be analyzed and valued. If the total value is less than the total payments due under the loan (and debt, if any, that has a higher claim against assets), the fair value of the loan will be reduced.

 

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Asset-backed securities and collateralized debt obligations for which there are no quoted market prices are valued using a discounted cash flow analysis based on the estimated cash flows to be generated by the relevant underlying assets and the appropriate interest rate based on the nature of the underlying assets.
Real estate is usually valued based on sales of comparable property. The value of real estate which is net leased is also influenced by the credit quality of major tenants, as their ability to make lease payments is relevant to the value of the property under lease.
Investments in other funds are valued primarily based on the net asset values provided by the fund managers of those funds. Adjustments to such net asset values are made for liquidity or to other factors if deemed material and necessary.
Investments valued using methods, including internal models, with significant unobservable market parameters consist primarily of investments in other funds and certain illiquid investments.
Hybrid PE Funds
Investments held within these funds are valued in a consistent manner with either the private equity funds or hybrid hedge funds, as applicable depending on the nature of the investment.
Sensitivity
Changes in the fair value of our funds’ investments would impact our results of operations as described in Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”
As discussed above, the determination of investment fair values involves management’s judgments and estimates. The degree of judgment involved is dependent upon the availability of quoted market prices or observable market parameters. The following table summarizes the investments held by the Fortress Funds by valuation methodology as of March 31, 2009.
The categories displayed below correspond directly with the disclosures which are required under SFAS 157. Note that negative percentages represent net short positions.
                                         
    Private Equity     Liquid Hedge     Hybrid Hedge     Hybrid PE     Total Investment  
Basis for Determining Fair Value   Funds     Funds     Funds     Funds     Company Holdings  
1. Quoted market prices (A)
    6 %     13 %     0 %     1 %     3 %
 
                                       
2. Other observable market parameters
    2 %     33 %     1 %     0 %     4 %
 
 
3A. Third party pricing sources with significant unobservable market parameters (B)
    3 %     52 %     93 %     87 %     58 %
 
                                       
3B. Internal models with significant unobservable market parameters
    89 %     2 %     6 %     12 %     35 %
 
                             
 
 
Total
    100 %     100 %     100 %     100 %     100 %
 
                             
     
(A)   For liquid hedge funds, includes gross long positions of 23% and short positions of (10%).
 
(B)   Primarily represents valuations based on third party pricing services, certain broker quotes, and third party fund managers. The result is skewed for the liquid hedge funds due to the offsetting net short positions in Level 1 and net long positions in Level 2.
As of March 31, 2009, $7.1 billion of investments in our private equity funds, $0.04 billion of investments in our liquid hedge funds, $0.6 billion of investments in our hybrid hedge funds, and $0.5 billion of investments in our hybrid PE funds are valued by internal models with significant unobservable market parameters. A 10% increase or decrease in the value of investments held by the Fortress Funds valued at level 3 (A or B) would have had the following effects on our results of operations on an unconsolidated basis for the three months ended March 31, 2009, consistent with the table above:
                                 
    Private Equity     Liquid Hedge     Hybrid Hedge     Hybrid PE  
    Funds   Funds   Funds   Funds  
Management fees, per annum on a prospective basis
  $3.2 million or   $2.0 million   $15.7 million   $1.0 million or
 
  ($3.3 million) (A)                   ($1.3 million) (A)
 
                               
Incentive income
    N/A (B)   $0.0 million     N/A (C)     N/A (B)
 
                               
Earnings from equity method investees
  $40.9 million   $0.5 million   $23.0 million   $7.0 million
Note: The tables above exclude non-investment assets and liabilities of the funds, which are not classified in the fair value           hierarchy. Such net assets may be material, particularly within the hedge funds.

 

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(A)   Private equity fund and hybrid PE fund management fees would be generally unchanged as, for investments in non-publicly traded securities, they are not based on the value of the funds, but rather on the amount of capital invested in the funds. However, if the NAV of a portfolio company of certain private equity funds or hybrid PE funds is reduced below its invested capital, there would be a reduction in management fees. As of March 31, 2009, $3.1 billion of such private equity fund or hybrid PE fund portfolio companies valued at level 3 (A or B) were carried at or below their invested capital and are in funds which are no longer in their commitment period. Management fees are generally calculated as of certain reset dates. The amounts disclosed show what the estimated effects would be to management fees over the next year assuming March 31, 2009 is the current reset date.
 
(B)   Private equity fund and hybrid PE fund incentive income would be unchanged as it is not recognized until received and all contingencies are resolved. Furthermore, incentive income would be based on the actual price realized in a transaction, not based on a valuation.
 
(C)   Hybrid hedge fund incentive income would be unchanged as it is not recognized until all contingencies are resolved in the fourth quarter. Incentive income is generally not charged on amounts invested by hybrid hedge funds in funds managed by external managers.
Income Taxes
FIG Corp. has recorded a significant deferred tax asset, primarily in connection with the Nomura transaction and the IPO. These transactions resulted in the basis of Fortress Operating Group’s net assets being in excess of its book basis, which will result in future tax deductions. A substantial portion of this asset is offset by a liability associated with the tax receivable agreement with our Principals.
The realization of the deferred tax assets is dependent on the amount of our future taxable income before deductions related to the establishment of the deferred tax asset. The deferred tax asset is comprised of a portion that would be realized in connection with future ordinary income and a portion that would be realized in connection with future capital gains.
We project that we will have sufficient future taxable ordinary income in the normal course of business without any projected significant change in circumstances to fully realize the portion of the deferred tax asset that would be realized in connection with future ordinary income. Our projections do not include material changes in AUM or incentive income from the current levels which, due to the market crisis, have declined from historical levels. However, the projections do contain an estimated marginal growth assumption in years beyond 2009. Based on our historical and projected taxable income, we have concluded that the realization of the portion of the deferred tax asset that would be realized in connection with future taxable ordinary income is more likely than not. If our estimates change in the future and it is determined that it is more likely than not that some portion, or all, of this portion of the deferred tax asset will not be realized, a valuation allowance would be recorded for that portion. However, in most cases, any tax expense recorded in connection with the establishment of a valuation allowance or the reversal of a deferred tax asset would be partially offset by other income recorded in connection with a corresponding reduction of a portion of the tax receivable agreement liability (see below). The following table sets forth our estimated federal taxable ordinary income for 2007 and 2008 before deductions relating to the establishment of the deferred tax assets, excluding deferred tax assets arising from equity-based compensation, as well as the average of such amount needed over the approximate period of the deductibility (approximately 15 years from the date of establishment, based on the amortization period of the tax basis intangible assets recorded) in order to fully realize the portion of the deferred tax asset that would be realized in connection with future ordinary income (in millions):
         
2007
  $ 74.9  
 
 
2008: Estimated
  $ 47.9  
 
 
2009 - 2015: Average Required
  $ 55.4  
 
 
2016 - 2021: Average Required
  $ 79.1  
As of December 31, 2008, based on the effects of the continuing credit crisis, particularly the fourth quarter declines in equity investment values, we revised our assessment of the realizability of the portion of the deferred tax asset that would only be realized in connection with future capital gains. We have established a full valuation allowance for this portion of the deferred tax asset as management does not believe that the projected generation of material taxable capital gains is sufficiently assured in the foreseeable future. In addition, the establishment of the valuation allowance resulted in a reduction of the obligations associated with the tax receivable agreement and a corresponding reduction of the deferred tax asset.
For further information on our effective tax rate, and the tax receivable agreement, see Note 5 to our financial statements in Part I, Item 1, “Financial Statements — Income Taxes and Tax Related Payments.”
Our effective tax rate for GAAP reporting purposes may be subject to significant variation from period to period.
The amount of income taxes that we may be required to pay could increase significantly if legislation introduced in Congress is passed in its proposed form. For more information on the proposed legislation, see Part II, Item 1A, “Risk Factors -Risks Related to Taxation — Legislation has been introduced that would, if enacted, preclude us from qualifying for treatment as a partnership for U.S. federal income tax purposes under the publicly traded partnership rules. Our structure also is subject to potential judicial or administrative change and differing interpretations, possibly on a retroactive basis.”

 

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Equity-Based Compensation
We currently have several categories of equity-based compensation which are described in Note 7 to Part I, Item 1, “Financial Statements — Equity-Based Compensation.” The aggregate fair value of each of the RSU grants that are subject to service conditions is reduced by an estimated forfeiture factor (that is, the estimated amount of awards which will be forfeited prior to vesting). The estimated forfeiture factor is based upon historic turnover rates within our company adjusted for the expected effects of the grants on turnover, if any, and other factors in the judgment of management. The estimated forfeiture factor is updated at each reporting date.
The volatility assumption used in valuing certain awards, as described below, was based on five-year historical stock price volatilities observed for a group of comparable companies, since we do not have sufficient historical share performance to use our own historical volatility, adjusted for management’s judgment regarding our expected volatility. Since our IPO in February 2007, our actual volatility has exceeded the volatility assumption used. To the extent that this trend continues, and management’s judgment concerning volatility is changed, we would adjust the volatility assumption used. The risk-free discount rate assumptions used in valuing certain awards were based on the applicable U.S. treasury rate of like term. The dividend yield assumptions used in valuing certain awards were based on our actual dividend rate at the time of the award; the dividend growth rate used with respect to one type of award was based on management’s judgment and expectations.
The following elements of the accounting for equity-based compensation are subject to significant judgment and estimation:
    the estimated forfeiture factor;
 
    the discount related to RSUs which do not entitle the recipients to dividend equivalents prior to the delivery of Class A shares. This discount was based on the estimated present value of dividends to be paid during the service period, which in turn was based on an estimated initial dividend rate, an estimated dividend growth rate and a risk-free discount rate of like term;
 
    the discount related to RSUs with no service conditions which are subject to the delayed delivery of Class A shares, which occurs in periods subsequent to the grant date. This discount was based on the estimated value of a put option on such shares over the delayed delivery period since essentially this would be the value of owning, and being able to trade, those shares during the delayed delivery period rather than having to wait for delivery. This estimated value was in turn derived from a binomial option pricing model based on the following assumptions: volatility, term, dividend rate and risk-free discount rate; and
 
    the estimated fair value of the LTIP awards, which was estimated using a Monte Carlo simulation valuation model, with the following assumptions: volatility, term, dividend rate, and risk-free discount rate.
Each of these elements, particularly the forfeiture factor and the volatility assumptions used in valuing certain awards, are subject to significant judgment and variability and the impact of changes in such elements on equity-based compensation expense could be material. Increases in the assumed forfeiture factor would decrease compensation expense. Increases in the volatility assumption would (i) decrease compensation expense related to RSUs with no service conditions since the discount for delayed delivery would have increased, and (ii) increase compensation expense related to the LTIP since the value of the LTIP would have increased. Increases in the assumed risk-free rate would (i) decrease compensation expense related to RSUs which do not entitle recipients to dividend equivalents since the estimated value of the foregone dividends would have increased, thereby increasing the discount related to their non-receipt, (ii) decrease compensation expense related to RSUs with no service conditions since the discount for delayed delivery would have increased, and (iii) increase compensation expense related to the LTIP since the value of the LTIP would have increased. Except for the forfeiture factor, changes in these assumptions will only affect awards made in the future and awards whose accounting is impacted by changes in their fair value (generally those to non-employees, known as “liability awards”).
Recent Accounting Pronouncements
In December 2007, the FASB issued SFAS No. 160 “Accounting for Noncontrolling Interests.” SFAS 160 clarifies the classification of non-controlling interests in consolidated statements of financial position and the accounting for and reporting of transactions between the reporting entity and holders of such non-controlling interests. SFAS 160 applies to reporting periods beginning after December 15, 2008. SFAS 160 had the following effects on Fortress’s financial statements: (i) reclassification of Principals’ and Others’ Interests in Equity of Consolidated Subsidiaries from the “mezzanine” section of the balance sheet (between liabilities and equity) to equity, (ii) removal of Principals’ and Others’ Interests in Income of Consolidated Subsidiaries from the calculation of Net Income (Loss) on the statement of operations, and disclosure thereof below Net Income (Loss), and (iii) with respect to potential future transactions in which Fortress could acquire Fortress Operating Group units from the Principals pursuant to their exchange (along with Class B shares) for Class A shares (or otherwise), these transactions would be accounted for as equity transactions rather than as a step acquisition of Fortress Operating Group (as would be required under prior accounting principles). There is no effect from the adoption of SFAS 160 on the equity which pertains to Class A shareholders, or net income (loss) allocable to Class A shareholders, or on Fortress’s liquidity.

 

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In September 2008, the FASB issued exposure drafts of two proposed standards, “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” and “Amendments to FASB Interpretation No. 46(R).” These proposed standards would fundamentally change the requirements to consolidate (or deconsolidate) special purpose and variable interest entities and would be effective for us in 2010. We are currently evaluating the potential impact of these proposed standards on us. To the extent they result in changes to the entities included in our consolidated financial statements, the impact could be material to our gross assets, liabilities, revenues and expenses but would not be material to our net income or equity.
In April 2009, the FASB issued three FSPs related to fair value and impairment, FSP FAS 107-1 and APB 28-1 “Interim Disclosures about Fair Value of Financial Instruments,” FSP FAS 115-2 and FAS 124-2 “Recognition and Presentation of Other-Than-Temporary Impairments,” and FSP FAS 157-4 “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” These FSPs (i) require disclosures about the fair value of financial instruments on an interim basis, (ii) change the guidance for determining, recording and disclosing other-than-temporary impairment, and (iii) provide additional guidance for estimating fair value when the volume or level of activity for an asset or liability have significantly decreased. These FSPs will be effective for Fortress in the second quarter of 2009. We anticipate that they will have a small impact on our disclosures, a potential impact on future impairment determinations for distributable earnings purposes (if any), but no material impact on our financial condition, liquidity, or results of operations upon adoption.
Market Risks
Our predominant exposure to market risk is related to our role as investment manager for the Fortress Funds and the sensitivities to movements in the fair value of their investments on management fee and incentive income revenue, as well as on returns on our principal investments in such funds. For a discussion of the impact of market risk factors on our financial instruments refer to Part I, Item 3 “Quantitative and Qualitative Disclosures About Market Risk” and “— Critical Accounting Policies — Valuation of Investments” above.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements.
Contractual Obligations
As of March 31, 2009, our material contractual obligations are our capital commitments to our funds, our lease obligations and our debt obligations as described above. Furthermore, we have potential clawback obligations with respect to our private equity deferred incentive income received to date.
Our future contractual obligations decreased from $1.5 billion as of December 31, 2008 to $1.4 billion as of March 31, 2009.
Our debt obligations payable decreased from $777.7 million as of December 31, 2008 to $646.4 million as of March 31, 2009, including estimates for interest payments. This decrease was primarily attributable to our March 13, 2009 amendment to our credit agreement. In connection with the amendment, we repaid (i) $50.0 million of outstanding revolving debt and (ii) $75.0 million of outstanding term loans.
Our outstanding capital commitments, including our commitments to our funds, have decreased from $140.9 million as of December 31, 2008 to $132.4 million as of March 31, 2009. The decrease is primarily attributable to a $14.4 million contribution we have made to Fund V in the three months ended March 31, 2009. This decrease in outstanding capital commitments was partially offset by the net effect of recallable capital distributions from the Real Assets Fund and the Credit Opportunities Fund, which increased our outstanding commitments by $6.5 million.
The amount of clawback that would be due based on a liquidation of the related Fortress Funds at their net recorded asset value as of March 31, 2009, which we refer to as intrinsic clawback, was $136.0 million as compared to $130.3 million at December 31, 2008.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our predominant exposure to market risk is related to our role as investment manager for the Fortress Funds and the sensitivities to movements in the fair value of their investments on management fee and incentive income revenue and investment income (loss).
The fair value of the financial assets and liabilities of the Fortress Funds may fluctuate in response to changes in the value of securities, foreign exchange, commodities and interest rates. Fluctuations in the fair value of the Fortress Funds will continue to directly affect the carrying value of our investments in the Fortress Funds and thereby our earnings (losses) from equity method investees, as well as the management fees and incentive income we record, to the extent that they are earned based on fair value or NAV.
Risks are analyzed across funds from the “bottom up” and from the “top down” with a particular focus on asymmetric risk. Management gathers and analyzes data, monitors investments and markets in detail, and constantly strives to better quantify, qualify and circumscribe relevant risks.
Although the Fortress Funds share many common themes, each segment within the investment companies runs their own investment and risk management process subject to the company’s overall risk tolerance and philosophy:
    the investment process of our private equity funds involves a detailed analysis of potential acquisitions, and asset management teams assigned to oversee the strategic development, financing and capital deployment decisions of each portfolio investment;
 
    our hybrid funds and Castles perform credit and cash-flow analysis of borrowers, tenants and credit-based assets, and have asset management teams that monitor covenant compliance by, and relevant financial data of, borrowers, tenants and other obligors, asset pool performance statistics, tracking of cash payments relating to investments, and ongoing analysis of the credit status of investments; and
 
    our liquid hedge funds continuously monitor a variety of markets for attractive trading opportunities, applying a number of traditional and customized risk management metrics to analyze risk related to specific assets or portfolios, as well as fund-wide risks.
Each segment has an institutional risk management process and related infrastructure to address these risks. The following table summarizes our financial assets and liabilities that may be impacted by various market risks such as equity prices, interest rates and exchange rates as of March 31, 2009 (in thousands):
         
Assets
       
Equity method investees
  $ 759,980  
Options in affiliates
    72  
 
     
 
  $ 760,052  
 
     
 
       
Liabilities
       
Debt obligations payable
  $ 604,041  
 
     
Since Fortress’s investments in the various Fortress Funds are not equal, Fortress’s risks from a management fee and incentive income perspective (which mirror the funds’ investments) and its risks from an investment perspective are not proportional.
Fortress Funds’ Market Risk Impact on GAAP Management Fees
Our management fees are based on either: (i) capital commitments to a Fortress Fund, (ii) capital invested in a Fortress Fund, or (iii) the NAV of a Fortress Fund, as described in our historical consolidated financial statements. Management fees will only be impacted by changes in market risk factors to the extent they are based on NAV. These management fees will be increased (or reduced) in direct proportion to the impact of changes in market risk factors on our investments in the related funds and would occur only in periods subsequent to the change, as opposed to having an immediate impact. The proportion of our management fees that are based on NAV is dependent on the number and types of Fortress Funds in existence and the current stage of each fund’s life cycle. As of March 31, 2009, approximately 49% of our management fees earned were based on the NAV of the applicable funds.
    For private equity funds and hybrid PE funds, management fees are charged on committed capital during the investment period of a new fund, and then generally on invested capital after the investment period, with the exception of funds formed after March 2006. For funds formed after March 2006 that are no longer in the investment period, management fees are earned on the NAV of investments in publicly traded entities. Reductions in net asset value below invested capital for any fund investment will also cause reductions in management fees.
 
    For Castles, management fees are not calculated based on NAV but instead a fee is charged based on the funds’ contributed capital.
 
    For hedge funds, management fees are based on their NAV, which in turn is dependent on the estimated fair values of their investments.

 

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Changes in values of investments could indirectly affect future management fees by, among other things, reducing the funds’ access to capital or liquidity and their ability to currently pay the management fees.
Fortress Funds’ Market Risk Impact on GAAP Incentive Income
Our incentive income is generally based on a percentage of profits of the various Fortress Funds subject to the achievement of performance criteria. Our incentive income will be impacted by changes in market risk factors. However, several major factors will influence the degree of impact: (i) the performance criteria for each individual fund in relation to how that fund’s results of operations are impacted by changes in market risk factors, (ii) whether such performance criteria are annual or over the life of the fund, (iii) to the extent applicable, the previous performance of each fund in relation to its performance criteria, and (iv) whether each fund’s incentive income is subject to contingent repayment. As a result, the impact of changes in market risk factors on incentive income will vary widely from fund to fund, as summarized below, and is heavily dependent on the prior performance of each fund, and is therefore not readily predicted or estimated.
    Incentive income from our private equity funds and hybrid PE funds is not recorded as revenue but instead is deferred under GAAP until the related clawback contingency is resolved. Deferred incentive income, which is subject to contingencies, will be recognized as revenue to the extent it is received and all the associated contingencies are resolved. Assuming that the deferred incentive income earned to date would be equal to what would be recognized when all contingencies are resolved, a 10% increase or decrease in the fair values of investments held by all of the private equity funds and hybrid PE funds where incentive income is subject to contingencies at March 31, 2009 would increase or decrease future incentive income by $21.3 million or ($8.8 million), respectively; however, this would have no effect on our current reported financial condition or results of operations.
 
    Incentive income from the Castles is not impacted by changes in the fair values of their investments, except to the extent they represent impairment, since these changes do not impact the measure of current operating results (i.e. FFO in excess of specified returns to the company’s shareholders) upon which the incentive income is calculated. The definition of FFO excludes unrealized changes in the values of the Castles’ investments (primarily real estate, loans and securities), except for minor items (for example, the unrealized gain or loss on non-hedge derivatives which make up only an immaterial portion of their assets).
 
    Incentive income from our hedge funds is directly impacted by changes in the fair value of their investments. Incentive income from certain of our hedge funds is earned based on achieving quarterly or annual performance criteria. For the hedge funds with quarterly performance criteria, a 10% decrease to the NAV of the fund on March 31, 2009 would have resulted in a loss to investors for the quarter. In future quarters, this loss would create or cause the fund to fall further below a “high water mark” (minimum future return to recover the loss to the investors) for our funds’ performance which would need to be achieved prior to any incentive income being earned by us. For the hedge funds with annual performance criteria, a 10% decrease to the NAV of the fund on March 31, 2009, assuming that NAV is constant for the rest of the current year, would result in no incentive income recorded as revenue at year end (in the fourth quarter of the year).
Fortress Funds’ Market Risk Impact on GAAP Investment Income
Our investments in the Fortress Funds, other than the Castles, are accounted for under the equity method. To the extent they are investment companies, our investments are directly affected by the impact of changes in market risk factors on the investments held by such funds, which could vary significantly from fund to fund.

 

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Market Risk — Quantitative Analysis
The following table presents information on the impact to Fortress of a 10% change in the fair values of all of the investments held by the Fortress Funds at March 31, 2009 (in millions).
                                                 
    10% Positive Change  
    GAAP Revenues     Segment Revenues (A)  
                    Earnings from                    
    Management     Incentive     Equity Method     Management     Incentive     Investment  
    Fees (B)     Income     Investees (C)     Fees (B)     Income     Income  
Private Equity
                                               
Funds
  $ 3.9     $ N/A (E)   $ 42.5     $ 3.9     $ N/A (E)   $ N/A  
Castles (D)
    N/A       N/A       N/A       N/A       N/A       N/A  
Liquid Hedge Funds
    7.1       0.6       1.9       7.1       0.6       1.7  
Hybrid
                                               
Hedge Funds
    9.4       N/A (G)     17.0       9.4             9.0  
PE Funds
    1.1       N/A (E)     8.9       1.1       N/A (E)     N/A  
 
                                   
Total
  $ 21.5     $ 0.6     $ 70.3     $ 21.5     $ 0.6     $ 10.7  
 
                                   
                                                 
    10% Negative Change  
    GAAP Revenues     Segment Revenues (A)  
                    Earnings from                    
    Management     Incentive     Equity Method     Management     Incentive     Investment  
    Fees (B)     Income     Investees (C)     Fees (B)     Income     Income  
Private Equity
                                               
Funds
  $ (4.0 )   $ N/A (E)   $ (42.5 )   $ (4.0 )   $ N/A (E) (F)   $ N/A (F)
Castles (D)
    N/A       N/A       N/A       N/A       N/A       N/A (F)
Liquid Hedge Funds
    (7.1 )           (1.9 )     (7.1 )           (1.7 )
Hybrid
                                               
Hedge Funds
    (9.4 )     N/A (G)     (17.0 )     (9.4 )           (9.0 )
PE Funds
    (1.3 )     N/A (E)     (8.9 )     (1.3 )     N/A (E) (F)     N/A (F)
 
                                   
Total
  $ (21.8 )   $     $ (70.3 )   $ (21.8 )   $     $ (10.7 )
 
                                   
     
(A)   See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Segment Analysis” for a discussion of the differences between GAAP and segment basis revenues.
 
(B)   Changes in management fees represent an annual change for the one year period following the measurement date assuming there is no change to the investments held by the funds during that period. For private equity funds and hybrid PE funds, it assumes that the management fees reset as of the reporting date. Private equity fund and hybrid PE fund management fees would be generally unchanged as, for investments in non-publicly traded securities, they are not based on the value of the funds, but rather on the amount of capital invested in the funds. However, if the NAV of a portfolio company of certain private equity funds or hybrid PE funds is reduced below its invested capital, there would be a reduction in management fees. As of the reporting date, $3.5 billion of such private equity fund or hybrid PE fund portfolio companies were carried at or below their invested capital and are in funds which are no longer in their commitment period.
 
(C)   Presented on a gross basis, before Principals’ and others’ interests in income of consolidated subsidiaries. The changes presented do not include any effect related to our direct investment in GAGFAH common stock. A 10% increase (decrease) in the equity price of GAGFAH’s common shares would affect our unrealized gains and losses by $2.8 million.
 
(D)   Our investments in the Castles are held at fair value, based on the market value of the shares we own. Gains (losses) on our shares in the Castles and options granted to us by the Castles are affected by movements in the equity price of the shares. A 10% increase (decrease) in the equity price of the shares would affect unrealized gains and losses by $0.1 million. Furthermore, the Castles’ management fees and incentive income are not directly impacted by changes in the fair value of their investments (unless the changes are deemed to be impairment, which would impact incentive income).
 
(E)   For GAAP Revenues, private equity fund and hybrid PE fund incentive income would be unchanged as it is not recognized until received and all contingencies are resolved. Furthermore, incentive income would be based on the actual price realized in a transaction, not based on a valuation. For Segment Revenues, private equity fund and hybrid PE fund incentive income is based on realizations.
 
(F)   A reduction in the fair value of investments could impact our conclusion regarding the potential impairment of our investments or a potential segment basis incentive income reserve for funds which are subject to clawback.
 
(G)   For GAAP Revenues, hybrid hedge fund incentive income would be unchanged as it is not recognized until all contingencies are resolved in the fourth quarter. Incentive income is generally not charged on amounts invested by hybrid hedge funds in funds managed by external managers.
Interest Rate Risk
Fortress Operating Group has debt obligations payable that accrue interest at variable rates. Interest rate changes may therefore impact the amount of interest payments, future earnings and cash flows. Based on debt obligations payable as of March 31, 2009, we estimate that interest expense relating to variable rate debt obligations payable would increase $6.0 million on an annual basis in the event interest rates were to increase by one percentage point.
Exchange Rate Risk
Our investments in Eurocastle and GAGFAH are directly exposed to foreign exchange risk. As of March 31, 2009, we had a $0.4 million investment in Eurocastle and a $28.2 million investment in GAGFAH which are accounted for at fair value. In the event of a 10% change in the applicable foreign exchange rate against the U.S. dollar on March 31, 2009, we estimate the gains and losses for the three months ended March 31, 2009 in relation to the value of the shares and options would increase or decrease by $2.9 million.

 

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ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. The Company’s disclosure controls and procedures are designed to provide reasonable assurance that information is recorded, processed, summarized and reported accurately and on a timely basis. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective.
Changes in Internal Control Over Financial Reporting
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the most recent fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We may from time to time be involved in litigation and claims incidental to the conduct of our business. Our industry is always subject to scrutiny by government regulators, which could result in litigation related to regulatory compliance matters. As a result, we maintain insurance policies in amounts and with the coverage and deductibles we believe are adequate, based on the nature and risks of our business, historical experience and industry standards. We believe that the cost of defending any pending or future litigation or challenging any pending or future regulatory compliance matter will not have a material adverse effect on our business. However, increased regulatory scrutiny of hedge fund trading activities combined with extensive trading in our liquid hedge funds may cause us to re-examine our beliefs regarding the likelihood that potential investigation and defense-related costs could have a material adverse effect on our business.

 

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Item 1A. Risk Factors
We face a variety of significant and diverse risks, many of which are inherent in our business. Described below are certain risks that we currently believe could materially affect us. Other risks and uncertainties that we do not presently consider to be material or of which we are not presently aware may become important factors that affect us in the future. The occurrence of any of the risks discussed below could materially and adversely affect our business, prospects, financial condition, results of operations or cash flow.
Risks Related to the Financial Services Industry and Financial Markets
We do not know what impact the U.S. government’s various plans to attempt to stabilize the economy and the financial markets will have on our business.
In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the U.S. government enacted the Emergency Economic Stabilization Act of 2008, or EESA, on October 3, 2008. Pursuant to the EESA, the U.S. Treasury has the authority to, among other things, purchase up to $700 billion of mortgage-backed and other securities from financial institutions for the purpose of stabilizing the financial markets. In addition, the U.S. government also made preferred equity investments in a number of the largest financial institutions, including Citigroup, Bank of America and AIG. In addition, on March 3, 2009, the U.S. Department of the Treasury and the Federal Reserve announced the launch of the Term Asset-Backed Securities Loan Facility, or TALF, which provides up to $200 billion (which may be increased to up to $1 trillion) of financing to certain U.S. entities to purchase qualifying AAA-rated asset-backed securities. Such financing is subject to various conditions, has a term of three years and accrues interest at specified rates. It is not clear what impact the various plans to attempt to stabilize the economy and the financial markets will have on our business.
In March 2009, the US Treasury announced plans for the Public Private Investment Partnership Program (or “PPIP”) for legacy assets, which is intended to generate purchasing power to help facilitate the purchase of various loans and securities held by financial institutions. As part of the PPIP, the Treasury accepted applications from investment managers to become pre-qualified to manage assets of to-be-formed investment funds that would invest in legacy securities on behalf of the government and private investors. We applied in April of this year to be pre-qualified as an investment manager under this program, and have not yet been informed of whether we have been selected as one of the managers by the Treasury. We do not currently anticipate that the PPIP will have a material impact on our business irrespective of whether we are selected as a manager. The details of the TALF, PPIP and other initiatives are subject to change, and it is unclear whether we and/or our funds will be eligible to participate directly in these programs (whether as an investment manager, as a recipient of financing or otherwise) and, therefore, these initiatives may not directly benefit us. If any of our competitors are able to benefit from these programs, they may gain a competitive advantage over us. In addition, the government may decide to implement these programs in unanticipated ways that have a more direct impact on our funds or our businesses. For example, the government may decide that it will not purchase or finance certain types of loans or securities, which may adversely affect the price of those securities. If we own such securities in our funds, such price impacts may have an adverse impact on the liquidity and/or performance of such funds.
Risks Related To Our Business
The terms of our credit agreement may restrict our current and future operations, particularly our ability to respond to certain changes or to take future actions.
Our credit agreement contains a number of restrictive covenants and requires significant amortization payments over the next several years, which collectively impose significant operating and financial restrictions on us, including restrictions that may limit our ability to engage in acts that may be in our long-term best interests. Although we recently amended our credit agreement to, among other things, make the financial covenants less restrictive, the terms of our credit agreement still impose significant operating and financial restrictions on us. Our credit agreement includes financial covenants that we:
    not exceed a total leverage ratio;
 
    maintain a minimum AUM; and
    maintain a minimum amount of investment assets (and maintain specific amounts of certain types of investments).
The leverage ratio covenant is tested as of the end of each fiscal quarter while the AUM and investment asset covenants are applicable at all times. We have amended these and other covenants several times in the last year in order to provide sufficient flexibility to ensure compliance with the terms of our credit agreement. Our ability to comply with these and other covenants is dependent upon a number of factors, some of which are beyond our control but could nonetheless result in noncompliance. For example, our leverage ratio fluctuates depending upon the amount of cash flow that we generate, and the value of our AUM and investment assets fluctuates due to a variety of factors, including mark-to-market valuations of certain assets and other market factors. The ongoing global economic recession has negatively impacted the cash flow that we have generated and expect to generate in the future as well as the current and expected value of our investment assets and current and expected AUM. These negative conditions, in turn, negatively affect our ability to comply with these covenants. For example, the investment assets on our balance sheet include a limited number of concentrated positions in companies or other ventures whose liquidity, operating results and financial condition have been adversely affected by the ongoing recession. Our largest on-balance sheet investment relates to a portfolio company that has a large amount of debt that must be refinanced in the summer of 2009. The failure of the portfolio company to successfully refinance its debt (or a material default by any other portfolio company in which we have a material direct or indirect investment) would likely cause us to lose all, or nearly all, of the value of our investment, which would, in turn, decrease the amount of our investment assets and could result in our failure to comply with the investment asset covenant in our credit agreement. Our credit agreement also contains other covenants that restrict our operations as well as a number of events that, if they occurred, would constitute an event of default under the agreement.

 

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In addition, our credit agreement requires that we make the following amortization payments during the following time periods: $50 million in July 2009, $25 million in October 2009, an additional $100 million during 2010, an additional $75 million by January 2011, and the remaining balance at the maturity of the facilities in May 2012. Making these payments will require a significant amount of our available cash flow that could otherwise be applied to other purposes such as making investments.
A failure by us to comply with the covenants or amortization requirements — or upon the occurrence of other defaults or events of default — specified in our credit agreement could result in an event of default under the agreement, which would give the lenders under the agreement the right to terminate their commitments to provide additional loans under our revolving credit facility, to declare all borrowings outstanding, together with accrued and unpaid interest and fees, to be immediately due and payable. In addition, the lenders would have the right to proceed against the collateral we granted to them, which consists of substantially all our assets. If the debt under our credit agreement were to be accelerated, we may not have sufficient cash on hand or be able to sell sufficient collateral to repay this debt, which would have an immediate material adverse affect on our business, results of operations and financial condition. For more detail regarding our credit agreement, its terms and the current status of our compliance with the agreement, please see Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” and “—Debt Obligations,” and “—Covenants.”
We depend on Messrs. Briger, Edens, Kauffman, Nardone and Novogratz, and the loss of any of their services would have a material adverse effect on us.
The success of our business depends on the efforts, judgment and personal reputations of our principals, Peter Briger, Wesley Edens, Robert Kauffman, Randal Nardone and Michael Novogratz. Our principals’ reputations, expertise in investing, relationships with our investors and relationships with members of the business community on whom our funds depend for investment opportunities and financing, are each critical elements in operating and expanding our businesses. We believe our performance is strongly correlated to the performance of these individuals. Accordingly, the retention of our principals is crucial to our success. In addition, if any of our principals were to join or form a competitor, some of our investors could choose to invest with that competitor rather than in our funds. The loss of the services of any of our principals would have a material adverse effect on us, including our ability to retain and attract investors and raise new funds, and the performance of our funds. Two or more of our principals occasionally fly together, which concentrates the potential impact of an accident on our company. We do not carry any “key man” insurance that would provide us with proceeds in the event of the death or disability of any of our principals.
Each of our principals has entered into an employment agreement with us. The initial term of these agreements is five years from the date of our initial public offering in February 2007, with automatic one-year renewals until a non-renewal notice is given by us or the principal. If a principal terminates his employment voluntarily or we terminate his employment for cause (as defined in the agreement), the principal will be subject to eighteen-month post-employment covenants requiring him not to compete with us. However, if we terminate a principal’s employment without cause, the principal will not be subject to the non-competition provisions.
The principals have also entered into an agreement among themselves, which provides that, in the event a principal voluntarily terminates his employment with us for any reason prior to the fifth anniversary of the consummation of our initial public offering, the principal may be required to forfeit a portion of his Fortress Operating Group units (and the corresponding Class B shares) to the other principals who continue to be employed by the Fortress Operating Group. However, this agreement may be amended by the principals who are then employed by the Fortress Operating Group. We, our shareholders and the Fortress Operating Group have no ability to enforce any provision of this agreement or to prevent the principals from amending the agreement or waiving any of its obligations.
There is no guarantee that our principals will not resign, join our competitors or form a competing company, or that the non-competition provisions in the employment agreements would be upheld by a court. If any of these events were to occur, our business, prospects, financial condition and results of operation would be materially adversely affected.
Several of our funds have “key person” provisions pursuant to which the failure of one or more of our senior employees to be actively involved in the business provides investors with the right to redeem from the funds or otherwise limits our rights to manage the funds. The loss of the services of any one of such senior employees could have a material adverse effect on certain of our funds to which such key person provisions relate and in some circumstances on us.
Investors in most of our hedge funds may generally redeem their investment without paying redemption fees if the relevant key person ceases to perform his functions with respect to the fund for 90 consecutive days. In addition, the terms of certain of our hedge funds’ financing arrangements contain “key person” provisions, which may result, under certain circumstances, in the acceleration of such funds’ debt or the inability to continue funding certain investments if the relevant employee ceases to perform his functions with respect to the fund and a replacement has not been approved.

 

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The loss or inability of Mr. Novogratz to perform his services for 90 days could result in substantial withdrawal requests from investors in our Drawbridge Global Macro funds and, in the event that a replacement is not approved, the termination of a substantial portion of the funds’ financing arrangements. Such withdrawals and terminations would have a material adverse effect on the Drawbridge Global Macro funds by reducing our management fees from those funds. Further, such withdrawals and terminations could lead possibly to the liquidation of the funds and a corresponding elimination of our management fees and potential to earn incentive income from those funds. The loss of Mr. Novogratz could, therefore, ultimately result in a loss of a material portion of our earnings attributable to our liquid hedge fund business segment.
The loss or inability of Mr. Briger to perform his services for 90 days could result in substantial withdrawal requests from investors in our Drawbridge Special Opportunities funds and, in the event that a replacement for him is not approved, the termination of a substantial portion of the funds’ financing arrangements. Such withdrawals and terminations would have a material adverse effect on the Drawbridge Special Opportunities funds by reducing our management fees from those funds. Further, such withdrawals and terminations could lead possibly to the eventual liquidation of the funds and a corresponding elimination of our management fees and potential to earn incentive income from those funds. The loss or inability of Mr. Briger to perform his services or devote an appropriate portion of his business time to the long dated value funds for 90 days would (unless approved by a majority of fund investors) prevent some of the Drawbridge long dated value funds from making additional investments. This could have a material adverse effect on such long dated value funds, resulting in us receiving reduced management fees. The loss of Mr. Briger could, therefore, ultimately result in a loss of a material portion of our earnings attributable to our hybrid hedge fund and hybrid PE fund business segments.
If either Mr. Edens or both of Mr. Kauffman and Mr. Nardone cease to devote certain minimum portions of their business time to the affairs of certain of our private equity funds, the funds will not be permitted to make further investments, and then-existing investments may be liquidated if investors vote to do so. Our ability to earn management fees and realize incentive income from our private equity funds therefore would be adversely affected if we cannot make further investments or if we are required to liquidate fund investments at a time when market conditions result in our obtaining less for investments than could be obtained at later times. In addition, we may be unable to raise additional private equity funds if existing private equity fund key-man provisions are triggered. The loss of either Mr. Edens or both of Mr. Kauffman and Mr. Nardone could, therefore, ultimately result in a loss of substantially all of our earnings attributable to our private equity funds.
In addition, the terms of certain of our existing funds may be amended over time to add additional key persons, and senior employees (including but not limited to Fortress principals) may also be deemed as key persons for funds that are formed in the future.
Any such events would potentially have a direct material adverse effect on our revenues and earnings (depending on the size of the particular fund to which a key person event relates), and would likely harm our ability to maintain or grow management fee paying assets under management in existing funds or raise additional funds in the future.
Our ability to retain our managing directors is critical to our success and our ability to grow depends on our ability to attract additional key personnel.
Our success depends on our ability to retain our managing directors and the other members of our investment management team and recruit additional qualified personnel. We collectively refer to these key employees (other than our principals) as our investment professionals. Our investment professionals possess substantial experience and expertise in investing, are responsible for locating and executing our funds’ investments, have significant relationships with the institutions which are the source of many of our funds’ investment opportunities, and in certain cases have strong relationships with our investors. Therefore, if our investment professionals join competitors or form competing companies it could result in the loss of significant investment opportunities and certain existing investors. As a result, the loss of even a small number of our investment professionals could jeopardize the performance of our funds, which could have a material adverse effect on our results of operations as well as our ability to retain and attract investors and raise new funds. Also, while we have non-competition and non-solicitation agreements with certain investment professionals, there is no guarantee that the agreements to which our investment professionals are subject, together with our other arrangements with them, will prevent them from leaving us, joining our competitors or otherwise competing with us or that these agreements will be enforceable in all cases. In addition, these agreements will expire after a certain period of time, at which point each of our investment professionals would be free to compete against us and solicit investors in our funds, clients and employees.

 

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Efforts to retain or attract investment professionals may result in significant additional expenses, which could adversely affect our profitability, and changes in law could hamper our recruitment and retention efforts. For example, we might not be able, or may elect not, to provide future investment professionals with equity interests in our business to the same extent or with the same tax consequences as our existing investment professionals. Therefore, in order to recruit and retain existing and future investment professionals, we may need to increase the level of cash compensation that we pay to them. Accordingly, as we promote or hire new investment professionals over time, we may increase the level of cash compensation we pay to our investment professionals, which would cause our total employee compensation and benefits expense as a percentage of our total revenue to increase and adversely affect our profitability. In addition, we may deem it necessary to maintain compensation levels to retain employees even during periods when we generate less revenues than in previous periods, which would reduce our profit margins. Also, if proposed legislation were to be enacted by the U.S. Congress to treat carried interest as ordinary income rather than as capital gain for U.S. federal income tax purposes, such legislation would materially increase the amount of taxes that we and our investment professionals that are compensated in part with carried interest would be required to pay, thereby adversely affecting our ability to recruit, retain and motivate our current and future professionals. See “—Our structure involves complex provisions of U.S. federal income tax law for which no clear precedent or authority may be available. Our structure also is subject to potential legislative, judicial or administrative change and differing interpretations, possibly on a retroactive basis.” Lastly, issuance of certain equity interests in our business to current or future investment professionals would dilute Class A shareholders.
Certain of our funds face particular retention issues with respect to investment professionals whose compensation is tied, often in large part, to performance thresholds, or “high water marks.” For example, several investment professionals receive performance-based compensation at the end of each year based upon their annual investment performance, and this performance-based compensation represents substantially all of the compensation the professional is entitled to receive during the year. If the investment professional’s annual performance is negative, the professional will not be entitled to receive any performance-based compensation for the year. Alternatively, certain other investment professionals are compensated in part based upon the performance fees earned by the fund during each quarter. The fund’s positive quarterly investment performance represents a high water mark, and neither the fund nor the investment professional is entitled to receive future performance-based compensation until the fund’s cumulative performance at the end of a subsequent quarter is greater than the previously set mark. In either compensation scenario, if the investment professional or fund, as the case may be, does not produce investment results sufficient to merit performance-based compensation, any affected investment professional may be incentivized to join a competitor because doing so would allow the professional to eliminate the burden of having to satisfy the high water mark before earning performance-based compensation. Similarly, many of our investment professionals in our private equity and hybrid PE fund businesses are compensated with grants of carried interest in our funds. During periods of economic volatility such as what we are currently experiencing, realization events in our private equity and hybrid PE fund businesses may be delayed, and it may therefore take significantly longer for investments to result in payments to such professionals. In addition, in the event that overall returns for any of our private equity funds or hybrid PE funds result in the generation of less incentive income than might have otherwise been anticipated, such professionals’ grants of carried interest in such fund will have similarly decreased value. To retain such professionals, the fund’s manager may elect to compensate the professional using a portion of the management fees earned by the manager, which would, in turn, reduce the amount of cash available to the public company, thereby reducing the amount available for distribution to our Class A shareholders or other liquidity needs. This retention risk is heightened during periods similar to those we are currently experiencing where market conditions make it more difficult to generate positive investment returns.
We have experienced rapid growth, which may be difficult to sustain and which may place significant demands on our administrative, operational and financial resources.
Our rapid growth in recent years has created significant demands on our legal, accounting and operational infrastructure, and increased expenses. The complexity of these demands, and the expense required to address them, is a function not simply of the amount by which our fee paying assets under management have grown, but of significant differences in the investing strategies of our different funds. In addition, we are required to continuously develop our systems and infrastructure in response to the increasing sophistication of the investment management market and legal, accounting and regulatory developments. Moreover, the strains upon our resources caused by our growth are compounded by the additional demands imposed upon us as a public company with shares listed on the New York Stock Exchange and, thus, subject to an extensive body of regulations that did not apply to us prior to our initial public offering.
Our future growth will depend, among other things, on our ability to maintain an operating platform and management system sufficient to address our growth and will require us to incur significant additional expenses and to commit additional senior management and operational resources. As a result, we face significant challenges:
    in maintaining adequate accounting, financial, compliance, trading and other business controls,
 
    implementing new or updated information, financial and disclosure systems and procedures, and
    in recruiting, training, managing and appropriately sizing our work force and other components of our business on a timely and cost-effective basis.
There can be no assurance that we will be able to manage our expanding operations effectively or that we will be able to continue to grow, and any failure to do so could adversely affect our ability to generate revenue and control our expenses.

 

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Operational risks may disrupt our businesses, result in losses or limit our growth.
We face operational risk from errors made in the negotiation, execution, confirmation or settlement of transactions. We also face operational risk from transactions not being properly recorded, evaluated or accounted for in our funds. In particular, our liquid hedge and hybrid fund businesses are highly dependent on our ability to process and evaluate, on a daily basis, transactions across markets and geographies in a time-sensitive, efficient and accurate manner. Consequently, we rely heavily on our financial, accounting and other data processing systems. In addition, new investment products we introduce create (and recently introduced products created) a significant risk that our existing systems may not be adequate to identify or control the relevant risks in the investment strategies employed by such new investment products. If any of these systems do not operate properly, are inadequately designed or are disabled, we could suffer financial loss, a disruption of our businesses, liability to our funds, regulatory intervention and reputational damage.
In addition, we operate in an industry that is highly dependent on its information systems and technology. We believe that we have designed, purchased and installed high-quality information systems to support our business. There can be no assurance, however, that our information systems and technology will continue to be able to accommodate our operations, or that the cost of maintaining such systems will not increase from its current level. Such a failure to accommodate our operations, or a material increase in costs related to such information systems, could have a material adverse effect on us.
Furthermore, we depend on our headquarters, which is located in New York City, for the operation of our business. A disaster or a disruption in the infrastructure that supports our businesses, including a disruption involving electronic communications or other services used by us or third parties with whom we conduct business, or directly affecting our headquarters, may have an adverse impact on our ability to continue to operate our business without interruption, which could have a material adverse effect on us. Although we have disaster recovery programs in place, there can be no assurance that these will be sufficient to mitigate the harm that may result from such a disaster or disruption. In addition, insurance and other safeguards might only partially reimburse us for our losses.
Finally, we rely on third party service providers for certain aspects of our business, including certain financial operations of our hedge funds. In particular, we rely heavily on the services of third party administrators in our hedge fund businesses and on the general ledger software provider for a number of our funds. Any interruption or deterioration in the performance of these third parties could impair the quality of the funds’ operations and could impact our reputation and adversely affect our business and limit our ability to grow.
Our removal as the investment manager, or the liquidation, of one or more of our funds could have a material negative effect on our business, results of operations and financial condition.
We derive a substantial portion of our revenues from funds managed pursuant to management agreements that may be terminated or fund partnership agreements that permit investors to request liquidation of investments in our funds on short notice. The termination of certain management agreements or commencement of the dissolution of certain funds would constitute an event of default under our credit agreement.
The terms of our funds generally give either the general partner of the fund or the fund’s board of directors the right to terminate our investment management agreement with the fund. However, insofar as we control the general partner of our funds which are limited partnerships, the risk of termination of investment management agreement for such funds is limited, subject to our fiduciary or contractual duties as general partner. This risk is more significant for our offshore hedge funds where we do not serve as the general partner, which represent a significant portion of our hedge fund AUM.
With respect to our private equity funds formed as registered investment companies, each fund’s investment management agreement must be approved annually by the independent members of such fund’s board of directors and, in certain cases, by its members, as required by law. Termination of these agreements would reduce the fees we earn from the relevant funds, which could have a material adverse effect on our results of operations.
In addition, investors in any private equity fund or hybrid PE fund and certain hedge funds have the ability to act, without cause, to accelerate the date on which the fund must be wound down. We will cease earning management fees on the assets of any such fund that is wound down. In addition, the winding down of a material fund or group of funds within a short period of time could trigger an event of default under certain debt covenants in our credit facility. Our ability to realize incentive income from such funds therefore would be adversely affected if we are required to liquidate fund investments at a time when market conditions result in our obtaining less for investments than could be obtained at later times.
In addition, management agreements of our funds that are registered investment companies under the Investment Company Act of 1940 would terminate if we were to experience a change of control without obtaining investor consent. Such a change of control could be deemed to occur in the event our principals exchange enough of their interests in the Fortress Operating Group into our Class A shares such that our principals no longer own a controlling interest in us. We cannot be certain that consents required for the assignment of our investment management agreements will be obtained if such a deemed change of control occurs. In addition, the board of directors of certain hedge funds have the right under certain circumstances to terminate the investment management agreements with the applicable fund. Termination of these agreements would affect the fees we earn from the relevant funds, which could have a material adverse effect on our results of operations.
Under the terms of our credit agreement, if, subject to certain exceptions, we cease to serve as the investment manager of any fund that generates management and incentive fees during the previous twelve months — or which we expect to generate such fees within the next twelve months — in an aggregate amount of at least $25 million, such termination would constitute an event of default under our credit agreement. In addition, if any such fund commenced a process to dissolve, liquidate or otherwise wind-up the fund, such commencement would also constitute an event of default under our credit agreement. If either event of default occurred, it would give our lenders the right to terminate their commitments to lend us funds under our revolving credit facility and to require us to repay all outstanding term loans immediately (in addition to other remedies available under the credit agreement). If our lenders exercised their rights upon the occurrence of an event of default, doing so would likely have an immediate material adverse effect on our business, results of operations and financial condition.

 

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We are subject to third-party litigation risk that could result in significant liabilities and reputational harm, which could materially adversely affect our results of operations, financial condition and liquidity.
In general, we will be exposed to risk of litigation by our fund investors if our management of any fund is alleged to constitute gross negligence or willful misconduct. Investors could sue us to recover amounts lost by our funds due to our alleged misconduct, up to the entire amount of loss. Further, we may be subject to litigation arising from investor dissatisfaction with the performance of our funds or from allegations that we improperly exercised control or influence over companies in which our funds have large investments. By way of example, we, our funds and certain of our employees, are each exposed to the risks of litigation relating to investment activities in our funds and actions taken by the officers and directors (some of whom may be Fortress employees) of portfolio companies, such as risks relating to a portfolio company’s mortgage servicing activities and the risk of shareholder litigation by other shareholders of public companies in which our funds have large investments. The stock prices of several of our publicly traded portfolio companies and Castles have decreased significantly over the past two years (resulting in the delisting of one of our portfolio companies from the NYSE), which decreases may lead to securities class action claims or other suits against us. In addition, we are exposed to risks of litigation or investigation relating to transactions that presented conflicts of interest that were not properly addressed. In such actions we would be obligated to bear legal, settlement and other costs (which may be in excess of available insurance coverage). In addition, although we are indemnified by the funds we manage, our rights to indemnification may be challenged. If we are required to incur all or a portion of the costs arising out of litigation or investigations as a result of inadequate insurance proceeds or failure to obtain indemnification from our funds, our results of operations, financial condition and liquidity could be materially adversely affected. As a general matter, the litigation environment in the investment management business tends to become worse in times of extreme market volatility such as what we are currently experiencing. We have experienced negative performance over the past several months in several of our investment funds, which increases the likelihood that we will be sued by one or more of our investors.
In our liquid hedge funds, we are exposed to the risk of litigation if the funds suffer catastrophic losses due to the failure of a particular investment strategy or due to the tradin