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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

 

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

For the quarterly period ended September 30, 2010

or

 

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

For the transition period from                      to                     

Commission File Number: 001-33294

Fortress Investment Group LLC

(Exact name of registrant as specified in its charter)

 

Delaware   20-5837959

(State or other jurisdiction of incorporation

or organization)

 

(I.R.S. Employer

Identification No.)

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

(212) 798-6100

(Registrant’s telephone number, including area code)

 

 

 

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

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

Indicate by check mark whether the registrant 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    No  ¨

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

 

Large accelerated filer  ¨

  Accelerated filer  x  

Non-accelerated filer  ¨

(Do not check if a smaller reporting company)

  Smaller reporting company   ¨

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

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

Class A Shares: 168,916,882 outstanding as of November 3, 2010.

Class B Shares: 300,273,852 outstanding as of November 3, 2010.

 

 

 


Table of Contents

 

FORTRESS INVESTMENT GROUP LLC

FORM 10-Q

INDEX

 

     PAGE  
   PART I. FINANCIAL INFORMATION   

Item 1.

  

Financial Statements

  
  

Consolidated Balance Sheets as of September 30, 2010 (unaudited) and December 31, 2009

     1   
  

Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2010 and 2009

     2   
  

Consolidated Statement of Equity (unaudited) for the nine months ended September 30, 2010

     3   
  

Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2010 and 2009

     4   
  

Notes to Consolidated Financial Statements (unaudited)

     5   

Item 2.

  

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

     39   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     71   

Item 4.

  

Controls and Procedures

     74   
   PART II. OTHER INFORMATION   

Item 1.

  

Legal Proceedings

     75   

Item 1A.

  

Risk Factors

     75   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     106   

Item 3.

  

Defaults upon Senior Securities

     106   

Item 4.

  

(Removed and Reserved)

     106   

Item 5.

  

Other Information

     106   

Item 6.

  

Exhibits

     107   

SIGNATURES

     108   


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 credit PE funds, depending on which measure management fees are being calculated upon at a given point in time, which in connection with private equity 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, including the Value Recovery Funds which pay fees based on realizations (and on certain managed assets); 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.


Table of Contents

 

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.

The Company acknowledges that, notwithstanding the inclusion of the foregoing cautionary statements, it is responsible for considering whether additional specific disclosures of material information regarding material contractual provisions are required to make the statements in this report not misleading.


Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

FORTRESS INVESTMENT GROUP LLC

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

 

     September 30,
2010
(Unaudited)
    December 31,
2009
 

Assets

    

Cash and cash equivalents

   $ 233,724      $ 197,099   

Due from affiliates

     148,069        64,511   

Investments

     907,456        867,215   

Deferred tax asset

     459,015        440,639   

Other assets

     117,736        90,803   
                
   $ 1,866,000      $ 1,660,267   
                

Liabilities and Equity

    

Liabilities

    

Accrued compensation and benefits

   $ 184,898      $ 131,134   

Due to affiliates

     341,516        345,976   

Deferred incentive income

     252,885        160,097   

Debt obligations payable

     355,900        397,825   

Other liabilities

     76,729        25,921   
                
     1,211,928        1,060,953   
                

Commitments and Contingencies

    

Equity

    

Class A shares, no par value, 1,000,000,000 shares authorized, 168,916,882 and 145,701,622 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively

     —          —     

Class B shares, no par value, 750,000,000 shares authorized, 300,273,852 and 307,773,852 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively

     —          —     

Paid-in capital

     1,362,359        1,029,536   

Retained earnings (accumulated deficit)

     (1,039,184     (767,994

Accumulated other comprehensive income (loss)

     (2,015     (325
                

Total Fortress shareholders’ equity

     321,160        261,217   

Principals’ and others’ interests in equity of consolidated subsidiaries

     332,912        338,097   
                

Total equity

     654,072        599,314   
                
   $ 1,866,000      $ 1,660,267   
                

See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(dollars in thousands)

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2010     2009     2010     2009  

Revenues

        

Management fees: affiliates

   $ 107,752      $ 106,926      $ 327,182      $ 321,003   

Management fees: non-affiliates

     8,628        1,748        17,513        3,522   

Incentive income: affiliates

     7,487        7,638        53,892        14,596   

Incentive income: non-affiliates

     371        279        8,679        1,264   

Expense reimbursements from affiliates

     36,745        24,952        100,606        58,660   

Other revenues (affiliate portion disclosed in Note 6)

     1,242        2,140        5,871        6,021   
                                
     162,225        143,683        513,743        405,066   
                                

Expenses

        

Interest expense

     3,549        4,451        11,043        20,242   

Compensation and benefits

     184,107        132,033        523,029        354,725   

Principals agreement compensation

     239,975        239,975        712,101        712,101   

General, administrative and other

     26,620        18,461        71,970        56,680   

Depreciation and amortization

     3,361        2,719        9,337        8,121   
                                
     457,612        397,639        1,327,480        1,151,869   
                                

Other Income (Loss)

        

Gains (losses) (affiliate portion disclosed in Note 3)

     2,025        20,189        (10,360     37,157   

Tax receivable agreement liability adjustment

     —          —          1,317        (55

Earnings (losses) from equity method investees

     16,941        40,345        42,972        56,553   
                                
     18,966        60,534        33,929        93,655   
                                

Income (Loss) Before Income Taxes

     (276,421     (193,422     (779,808     (653,148

Income tax benefit (expense)

     4,545        3,116        (4,641     4,831   
                                

Net Income (Loss)

   $ (271,876   $ (190,306   $ (784,449   $ (648,317
                                

Principals’ and Others’ Interests in Income (Loss) of Consolidated Subsidiaries

   $ (177,221   $ (131,704   $ (513,259   $ (477,964
                                

Net Income (Loss) Attributable to Class A Shareholders

   $ (94,655   $ (58,602   $ (271,190   $ (170,353
                                

Dividends declared per Class A share

   $ —        $ —        $ —        $ —     
                                

Earnings Per Class A share - Fortress Investment Group

        

Net income (loss) per Class A share, basic

   $ (0.57   $ (0.41   $ (1.70   $ (1.50
                                

Net income (loss) per Class A share, diluted

   $ (0.62   $ (0.43   $ (1.75   $ (1.53
                                

Weighted average number of Class A shares outstanding, basic

     168,907,106        143,627,823        163,920,012        118,638,707   
                                

Weighted average number of Class A shares outstanding, diluted

     469,180,958        454,064,379        466,666,392        430,159,270   
                                

See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC

CONSOLIDATED STATEMENT OF EQUITY (Unaudited)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2010

(dollars in thousands)

 

    Class A Shares     Class B Shares     Paid-In
Capital
    Retained
Earnings
(Accumulated

Deficit)
    Accumulated
Other
Comprehensive

Income (Loss)
    Total
Fortress
Shareholders’
Equity
    Principals’ and
Others’ Interests in
Equity of
Consolidated
Subsidiaries
    Total
Equity
 

Equity - December 31, 2009

    145,701,622        307,773,852      $ 1,029,536      $ (767,994   $ (325   $ 261,217      $ 338,097      $ 599,314   

Contributions from principals’ and others’ interests in equity

    —          —          —          —          —          —          70,670        70,670   

Distributions to principals’ and others’ interests in equity

    —          —          (1,068     —          —          (1,068     (121,049     (122,117

Conversion of Class B to Class A shares

    7,500,000        (7,500,000     7,351        —          (163     7,188        (7,188     —     

Net deferred tax effects resulting from acquisition of Fortress Operating Group units

    —          —          5,951        —          —          5,951        —          5,951   

Net deferred tax effects resulting from exchange of Fortress Operating Group units

    —          —          6,977        —          —          6,977        —          6,977   

Director restricted share grant

    210,302        —          194        —          —          194        367        561   

Capital increase related to equity-based compensation, net

    15,504,958        —          302,380        —          —          302,380        579,103        881,483   

Dilution impact of Class A share issuance

    —          —          11,038        —          (710     10,328        (10,328     —     

Comprehensive income (loss) (net of tax)

               

Net income (loss)

    —          —          —          (271,190     —          (271,190     (513,259     (784,449

Foreign currency translation

    —          —          —          —          239        239        23        262   

Comprehensive income (loss) from equity method investees

    —          —          —          —          (1,056     (1,056     (3,524     (4,580
                     

Total comprehensive income (loss)

                  (788,767
                                                               

Equity - September 30, 2010

    168,916,882        300,273,852      $ 1,362,359      $ (1,039,184   $ (2,015   $ 321,160      $ 332,912      $ 654,072   
                                                               

See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

SEPTEMBER 30, 2010

(dollars in thousands)

 

     Nine Months Ended September 30  
     2010     2009  

Cash Flows From Operating Activities

    

Net income (loss)

   $ (784,449   $ (648,317

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

    

Depreciation and amortization

     9,337        8,121   

Other amortization and accretion

     2,423        7,988   

(Earnings) losses from equity method investees

     (42,972     (56,553

Distributions of earnings from equity method investees

     5,630        2,156   

(Gains) losses

     10,360        (37,157

Deferred incentive income

     (53,493     —     

Deferred tax (benefit) expense

     391        (12,428

Tax receivable agreement liability adjustment

     (1,317     55   

Equity-based compensation

     881,200        878,808   

Allowance for doubtful accounts

     (2,303     —     

Other

     (46     (55

Cash flows due to changes in

    

Due from affiliates

     (85,937     (66,712

Other assets

     (5,076     (8,166

Accrued compensation and benefits

     111,229        (58,861

Due to affiliates

     (9,009     (18,087

Deferred incentive income

     146,281        —     

Other liabilities

     36,200        26,548   
                

Net cash provided by (used in) operating activities

     218,449        17,340   
                

Cash Flows From Investing Activities

    

Contributions to equity method investees

     (48,857     (43,322

Distributions of capital from equity method investees

     45,955        28,740   

Purchase of fixed assets

     (1,574     (1,972

Acquisitions, net of cash received

     (13,474     —     
                

Net cash provided by (used in) investing activities

     (17,950     (16,554
                

Cash Flows From Financing Activities

    

Repayments of debt obligations

     (41,925     (317,241

Payment of deferred financing costs

     —          (4,162

Proceeds from public offering

     —          230,000   

Costs related to public offering

     —          (10,500

Principals’ and others’ interests in equity of consolidated subsidiaries - contributions

     653        92   

Principals’ and others’ interests in equity of consolidated subsidiaries - distributions

     (122,602     (55,326
                

Net cash provided by (used in) financing activities

     (163,874     (157,137
                

Net Increase (Decrease) in Cash and Cash Equivalents

     36,625        (156,351

Cash and Cash Equivalents, Beginning of Period

     197,099        263,337   
                

Cash and Cash Equivalents, End of Period

   $ 233,724      $ 106,986   
                

Supplemental Disclosure of Cash Flow Information

    

Cash paid during the period for interest

   $ 9,228      $ 11,160   
                

Cash paid during the period for income taxes

   $ 7,833      $ 8,266   
                

Supplemental Schedule of Non-cash Investing and Financing Activities

    

Employee compensation invested directly in subsidiaries

   $ 70,124      $ 7,976   
                

Investments of receivable amounts into Fortress Funds

   $ 8,127      $ —     
                

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

   $ 11,821      $ —     
                

Distributions declared but not yet paid on other non-controlling interests

   $ 4,898      $ —     
                

Contingent consideration in purchase of Logan Circle Partners L.P.

   $ 4,000      $ —     
                

See notes to consolidated financial statements

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(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) Credit funds:

 

  a) Credit 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 which include non-Fortress originated funds for which Fortress has been retained as manager as part of an advisory business; and

 

  b) Credit 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, 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), and two Asia funds, a Japan real estate fund and an Asian investor based global opportunities fund.

 

  4) Principal investments in the above described funds.

Financial Statement Guide

 

Selected Financial Statement Captions

   Note
Reference
  

Explanation

Balance Sheet      
Due from Affiliates    6    Generally, management fees, expense reimbursements and incentive income due from Fortress Funds.
Investments    3    Primarily the carrying value of Fortress’s principal investments in the Fortress Funds.
Deferred Tax Asset    5    Relates to potential future tax benefits.
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.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

Selected Financial Statement Captions

   Note
Reference
  

Explanation

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.
Statement of Operations      
Management Fees: Affiliates    2    Fees earned for managing Fortress Funds, generally determined based on the size of such funds.
Management Fees: Non-Affiliates    2    Fees earned from managed accounts and our traditional fixed income asset management business, generally determined based on the amount managed.
Incentive Income: Affiliates    2    Income earned from Fortress Funds, based on the performance of such funds.
Incentive Income: Non-Affiliates    2    Income earned from managed accounts, based on the performance of such accounts.
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 Investments    N/A    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 Adjustment    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 the Fortress Funds resulting from its principal investments.
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.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

Selected Financial Statement Captions

   Note
Reference
  

Explanation

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.
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 FASB has recently issued or discussed a number of proposed standards on such topics as consolidation, financial statement presentation, revenue recognition, leases, financial instruments, hedging, contingencies and fair value. Some of the proposed changes are significant and could have a material impact on Fortress’s reporting. Fortress has not yet fully evaluated the potential impact of these proposals, but will make such an evaluation as the standards are finalized.

The accompanying consolidated 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, 2009 and notes thereto included in Fortress’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 1, 2010. Capitalized terms used herein, and not otherwise defined, are defined in Fortress’s consolidated financial statements for the year ended December 31, 2009.

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

2. MANAGEMENT AGREEMENTS AND FORTRESS FUNDS

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.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

Management Fees, Incentive Income and Related Profit Sharing Expense

Fortress recognized management fees and incentive income as follows:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010     2009  

Private Equity

          

Private Equity Funds

          

Management fees - affil.

   $ 36,341       $ 32,048       $ 103,313      $ 108,638   

Incentive income - affil.

     5,436         —           32,862        —     

Castles

          

Management fees - affil.

     11,425         12,358         34,279        35,698   

Incentive income - affil.

     —           —           —          —     

Management fees - non-affil.

     579         596         1,953        1,936   

Liquid Hedge Funds

          

Management fees - affil.

     16,732         18,566         52,013        61,063   

Incentive income - affil.

     671         6,431         528        6,575   

Management fees - non-affil.

     2,879         —           5,883        25   

Incentive income - non-affil.

     371         —           371        —     

Credit Funds

          

Credit Hedge Funds

          

Management fees - affil.

     32,397         31,815         105,406        89,030   

Incentive income - affil.

     —           —           (129     —     

Management fees - non-affil.

     262         277         1,074        686   

Incentive income - non-affil.

     —           279         8,308        1,264   

Credit PE Funds

          

Management fees - affil.

     10,857         12,139         32,171        26,574   

Incentive income - affil.

     1,380         1,207         20,631        8,021   

Management fees - non-affil.

     —           875         —          875   

Other (A)

          

Management fees - non-affil.

     4,908         —           8,603        —     

Total

          

Management fees - affil.

   $ 107,752       $ 106,926       $ 327,182      $ 321,003   

Management fees - non-affil.

   $ 8,628       $ 1,748       $ 17,513      $ 3,522   

Incentive income - affil. (B)

   $ 7,487       $ 7,638       $ 53,892      $ 14,596   

Incentive income - non-affil.

   $ 371       $ 279       $ 8,679      $ 1,264   

 

(A) Related to Logan Circle.

 

(B) See “Deferred Incentive Income” below.

Deferred Incentive Income

Incentive income from certain Fortress Funds, primarily private equity funds and credit 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.

Incentive income from certain Fortress Funds is earned based on achieving annual performance criteria. Accordingly, this incentive income is recorded as revenue at year end (in the fourth quarter of each year), is generally received subsequent to year end, and has not been recognized for these funds during the nine months ended September 30, 2010 and 2009. If the

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

amount of incentive income contingent on achieving annual performance criteria was not contingent on the results of the subsequent quarters, $69.4 million and $1.8 million of additional incentive income from affiliates would have been recognized during the nine months ended September 30, 2010 and 2009, respectively. 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.

During the nine months ended September 30, 2010 and 2009, Fortress recognized $20.6 million and $8.0 million, respectively, of incentive income distributions from its credit PE funds which represented “tax distributions.” These tax distributions are not subject to clawback and reflect a cash amount equal to the amount expected to be paid out by Fortress for taxes or tax-related distributions on the allocated income from such funds.

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

 

     Distributed-
Gross
     Distributed-
Recognized (A)
    Distributed-
Unrecognized (B)
    Undistributed net of
intrinsic clawback

(C) (D)
 

Deferred incentive income as of December 31, 2009

   $ 503,415       $ (343,318   $ 160,097      $ 168,686   

Share of income (loss) of Fortress Funds

     —           —          —          209,321   

Distribution of incentive income

     146,281         —          146,281        (146,281

Recognition of previously deferred incentive income

     —           (53,493     (53,493     —     
                                 

Deferred incentive income as of September 30, 2010

   $ 649,696       $ (396,811   $ 252,885      $ 231,726   
                                 

 

(A) All related contingencies have been resolved.

 

(B) Reflected on the balance sheet.

 

(C) At September 30, 2010, the net undistributed incentive income is comprised of $315.0 million of gross undistributed incentive income, net of $83.3 million of intrinsic clawback (see next page). The net undistributed incentive income amount represents the amount that would be received by Fortress from the related funds if such funds were liquidated on September 30, 2010 at their net asset values.

 

(D) From inception to September 30, 2010, Fortress has paid $174.6 million of compensation expense under its employee profit sharing arrangements (Note 7) in connection with distributed incentive income, of which $27.9 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 $315.0 million of gross undistributed incentive income were realized, Fortress would recognize and pay an additional $116.4 million of compensation expense.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

The following tables summarize information with respect to the Fortress Funds, other than the Castles, and their related incentive income thresholds as of September 30, 2010:

 

Fund

(Vintage)

(A)

   Maturity
Date (B)
     Inception to
Date
Capital Invested
     Inception to
Date
Distributions
    Net
Asset  Value
(“NAV”)
    NAV
Surplus
(Deficit)

(C)
    Current
Preferred
Return
Threshold (D)
     Gain to
Cross Incentive
Income
Threshold (E)
     Undistributed
Incentive
Income (F)
     Distributed
Incentive
Income (G)
     Distributed
Incentive
Income
Subject to
Clawback (H)
     Gross
Intrinsic
Clawback (I)
     Net Intrinsic
Clawback (I)
 

Private Equity Funds

                                

NIH (1998)

     Indefinite       $ 415,574       $ (798,947   $ 25,417        N/A      $ —           N/A       $ —         $ 94,513       $ —         $ —         $ —     

Fund I (1999) (J)

     Apr-10         1,027,871         (2,744,046     126,745        1,842,920        —           N/A         11,225         304,204         —           —           —     

Fund II (2002)

     Feb-13         1,974,296         (3,045,345     297,204        1,368,253        —           N/A         18,441         250,811         49,320         —           —     

Fund III (2004)

     Jan-15         2,762,993         (1,307,375     1,464,620        9,002        900,732         891,730         —           66,903         66,903         66,903         45,108   

Fund III Coinvestment (2004)

     Jan-15         273,648         (90,925     183,091        368        118,409         118,041         —           —           —           —           —     

Fund IV (2006)

     Jan-17         3,639,561         (119,640     2,608,871        (911,050     1,068,754         1,979,804         —           —           —           —           —     

Fund IV Coinvestment (2006)

     Jan-17         762,696         (12,676     545,253        (204,767     231,309         436,076         —           —           —           —           —     

GAGACQ Fund (2004)

     Nov-09         545,663         (595,401     N/A        N/A        N/A         N/A         N/A         51,476         N/A         N/A         N/A   

FRID (2005)

     Apr-15         1,220,228         (505,605     394,209        (320,414     433,847         754,261         —           16,447         16,447         16,447         10,041   

FRIC (2006)

     May-16         328,754         (17,460     147,020        (164,274     122,419         286,693         —           —           —           —           —     

FICO (2006)

     Jan-17         724,525         —          (8,510     (733,035     248,147         981,182         —           —           —           —           —     

FHIF (2006)

     Jan-17         1,493,486         (63,154     1,313,052        (117,280     445,091         562,371         —           —           —           —           —     

Mortgage Opportunities Fund III (2008)

     Jun-13         193,861         (39,354     116,119        (38,388     —           38,388         —           —           —           —           —     
                                                              
                     $ 29,666       $ 784,354       $ 132,670       $ 83,350       $ 55,149   
                                                              

PE Funds in Investment Period

                                

Fund V (2007)

     Feb-18       $ 3,613,917       $ (2,594   $ 2,109,275      $ (1,502,048   $ 704,502       $ 2,206,550       $ —         $ —         $ —         $ —         $ —     

Fund V Coinvestment (2007)

     Feb-18         936,145         (126     486,691        (449,328     202,917         652,245         —           —           —           —           —     

FECI (2007)

     Feb-18         982,779         (144     728,817        (253,818     267,635         521,453         —           —           —           —           —     
                                                              
                     $ —         $ —         $ —         $ —         $ —     
                                                              

Credit PE Funds

                                

Long Dated Value Fund I (2005)

     Apr-30       $ 267,325       $ (45,656   $ 254,243      $ 32,574      $ 66,233       $ 33,659       $ —         $ —         $ —         $ —         $ —     

Long Dated Value Fund II (2005)

     Nov-30         270,783         (50,548     250,508        30,273        54,292         24,019         —           412         —           —           —     

Long Dated Value Fund III (2007)

     Feb-32         334,665         (76,224     324,922        66,481        —           N/A         10,447         1,983         —           —           —     

LDVF Patent Fund (2007)

     Nov-27         39,294         (9,631     51,126        21,463        —           N/A         1,480         484         —           —           —     

Real Assets Fund (2007)

     Jun-17       $ 353,671       $ (131,791   $ 269,330      $ 47,450      $ —           N/A         6,113         1,316         —           —           —     
                                                              
                     $ 18,040       $ 4,195       $ —         $ —         $ —     
                                                              

Credit PE Funds in Investment Period

                                

Assets Overflow Fund (2008)

     May-18       $ 90,500       $ (57,070   $ 51,643      $ 18,213      $ —           N/A       $ 1,155       $ 662       $ —         $ —         $ —     

Credit Opportunities Fund (2008)

     Oct-20         3,890,474         (3,503,137     1,666,204        1,278,867        —           N/A         131,200         122,172         87,997         —           —     

FTS SIP L.P. (2008)

     Oct-18         850,294         (728,519     389,650        267,875        —           N/A         16,420         37,044         32,218         —           —     

Credit Opportunities Fund II (2009)

     Jul-22         731,606         (33,057     751,521        52,972        —           N/A         10,767         —           —           —           —     

Net Lease Fund I (2010)

     Jan-23         30,529         (1,175     32,567        3,213        —           N/A         636         —           —           —           —     

FCO MA LSS (2010)

     Jun-24         48,635         (334     50,330        2,029        —           N/A         399         —           —           —           —     

FCO MA II (2010)

     Jun-22         120,281         (327     127,469        7,515        —           N/A         1,429         —           —           —           —     

Japan Opportunity Fund (2009)

     Jun-19         497,558         (187,219     400,554        90,215        —           N/A         18,988         —           —           —           —     
                                                              
                     $ 180,994       $ 159,878       $ 120,215       $ —         $ —     
                                                              

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

     Incentive Income
Eligible NAV (K)
     Gain to Cross
Incentive Income
Threshold (L)
     Percentage of
Incentive Income
Eligible NAV Above
Incentive Income
Threshold (M)
    Undistributed
Incentive Income (N)
     Year to date
Incentive Income
Crystallized (O)
 

Liquid Hedge Funds

             

Macro Funds (P)

             

Main fund investments

   $ 2,241,687       $ 784         96.5   $ 16,519       $ 1,193   

Sidepocket investments (Q)

     101,036         60,181         N/A        347         —     

Sidepocket investments - redeemers (R)

     217,490         118,123         N/A        987         —     

Managed accounts

     600,747         —           100.0     7,279         —     

Fortress Commodities Funds (S)

             

Main fund investments

     888,589         25,352         15.4     216         1   

Managed accounts

     172,680         2,878         64.3     —           371   

Credit Hedge Funds

             

Special Opportunities Funds (S)

             

Main fund investments

   $ 2,866,287       $ —           100.0   $ 41,386       $ —     

Sidepocket investments (Q)

     153,389         1,947         N/A        3,285         —     

Sidepocket investments - redeemers (R)

     217,852         68,404         N/A        228         —     

Main fund investments (liquidating) (T)

     1,705,698         219,103         61.8     11,550         —     

Managed accounts

     40,416         5,875         0.0     —           265   

Fortress Partners Funds (S)

             

Main fund investments

     210,401         60,916         35.2     1,486         —     

Sidepocket investments (Q)

     101,070         22,499         N/A        389         —     

Worden Funds

             

Main fund investments

     140,204         —           100.0     2,704         —     

 

(A) Vintage represents the year in which the fund was formed.

 

(B) Represents the contractual maturity date including the assumed exercise of all extension options, which in some cases may require the approval of the applicable fund advisory board. Private equity funds that have reached their maturity date are included in the table to the extent they have generated incentive income.

 

(C) Represents the gain needed to cross the incentive income threshold (as described in (E) below), excluding the impact of any relevant performance (i.e. preferred return) thresholds (as described in (D) below). The aggregate “NAV deficit,” net of surpluses, of the private equity funds was $1.5 billion as of period end.

 

(D) Represents the gain needed to achieve the current relevant performance thresholds, assuming the gain described in (C) above is already achieved.

 

(E) Represents the immediate increase in NAV needed for Fortress to begin earning incentive income, including the achievement of any relevant performance thresholds. It does not include the amount needed to earn back intrinsic clawback (see (I) below), if any. Incentive income is not recorded as revenue until it is received and any related contingencies are resolved (see (H) below).

 

(F) Represents the amount of additional incentive income Fortress would receive if the fund were liquidated at the end of the period at its NAV.

 

(G) Represents the amount of incentive income previously received from the fund since inception.

 

(H) Represents the amount of incentive income previously received from the fund which is still subject to contingencies and is therefore recorded on the consolidated balance sheet as Deferred Incentive Income. This amount will either be recorded as revenue when all related contingencies are resolved, or, if the fund does not meet certain performance thresholds, will be returned by Fortress to the fund (i.e., “clawed back”).

 

(I) Represents the amount of incentive income previously received from the fund that would be clawed back (i.e., returned by Fortress to the fund) if the fund were liquidated at the end of the period at its NAV, excluding the effect of any tax adjustments. Employees, former employees and affiliates of Fortress would be required to return a portion of this incentive income that was paid to them under profit sharing arrangements. “Gross” and “Net” refer to amounts that are gross and net, respectively, of this employee/affiliate portion of the intrinsic clawback. Fortress remains liable to the funds for these amounts even if it is unable to collect the amounts from employees/affiliates. Fortress withheld a portion of the amounts due to employees under these profit sharing arrangements as a reserve against future clawback; as of September 30, 2010, Fortress held $41.9 million of such amounts on behalf of employees related to all of the private equity funds.

 

(J) Fund I undistributed and distributed incentive income amounts are presented for the total fund, of which Fortress is entitled to approximately 50%. Distributed incentive income subject to clawback for Fund I is presented with respect to Fortress’s portion only.

 

(K) Represents the portion of a fund’s NAV that is eligible to earn incentive income.

 

(L) Represents, for those fund investors whose NAV is below the performance threshold Fortress needs to obtain before it can earn incentive income from such investors (their “incentive income threshold” or “high water mark”), the amount by which their aggregate incentive income thresholds exceed their aggregate NAVs. The amount by which the NAV of each investor within this category is below their respective incentive income

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

threshold varies and, therefore, Fortress may begin earning incentive income from certain investors before this entire amount is earned back. Fortress earns incentive income whenever the assets of new investors, as well as of investors whose NAV exceeds their incentive income threshold, increase in value.

 

(M) Represents the percentage which is computed by dividing (i) the aggregate NAV of all investors who are at or above their respective incentive income thresholds, by (ii) the total incentive income eligible NAV of the fund. The amount by which the NAV of each fund investor who is not in this category is below their respective incentive income threshold varies, and may vary significantly. This percentage represents the performance of only the main fund investments relative to their respective incentive income thresholds. It does not incorporate the impact of unrealized losses on sidepocket investments that can reduce the amount of incentive income earned from certain funds. See footnote Q below.

 

(N) Represents the amount of additional incentive income Fortress would earn from the fund if it were liquidated at the end of the period at its NAV. This amount is currently subject to performance contingencies generally until the end of the year or, in the case of sidepocket investments, until such investments are realized. Main Fund Investments (Liquidating) pay incentive income only after all capital is returned.

 

(O) Represents the amount of incentive income Fortress has earned in the current period from the fund which is no longer subject to contingencies.

 

(P) Represents the Drawbridge Global Macro Funds and Fortress Macro Funds. The Drawbridge Global Macro SPV (the “SPV”), which was established in February 2009 to liquidate illiquid investments and distribute the proceeds to then existing investors, is not subject to incentive income and is therefore not presented in the table. However, realized gains or losses within the SPV can decrease or increase, respectively, the gain needed to cross the incentive income threshold for investors with a corresponding investment in the main fund. The impact of the unrealized gains and losses within the SPV at September 30, 2010, as if they became realized, was immaterial to the amounts presented in the table for the Macro main fund.

 

(Q) Represents investments held in sidepockets (also known as special investment accounts), which generally have investment profiles similar to private equity funds. The performance of these investments may impact Fortress’s ability to earn incentive income from main fund investments. For the credit hedge funds, realized and unrealized losses from individual sidepockets below original cost may reduce the incentive income earned from main fund investments. For the Macro Funds, only realized losses from individual sidepockets reduce the incentive income earned from main fund investments. Based on current unrealized losses in Macro Fund sidepockets, if all of the Macro Fund sidepockets were liquidated at their NAV at September 30, 2010, the undistributed incentive income from the Macro main fund would be decreased by approximately $1.2 million.

 

(R) Represents investments held in sidepockets for investors with no corresponding investment in the related main fund investments. In the case of the Macro Funds, such investors may have investments in the SPV (see (P) above).

 

(S) Includes onshore and offshore funds.

 

(T) Relates to accounts where investors have provided return of capital notices and are subject to payout as underlying fund investments are realized.

Private Equity Funds and Credit PE Funds

During the nine months ended September 30, 2010, Fortress formed new private equity funds or credit PE funds which had capital commitments as follows as of September 30, 2010 (based on September 30, 2010 foreign exchanges rates):

 

Fortress’s commitments

   $ 18,914   

Fortress’s affiliates’ commitments

     23,700   

Third party investors’ commitments

     656,429   
        

Total capital commitments

   $ 699,043   
        

Liquid Hedge Funds and Credit Hedge Funds

During the nine months ended September 30, 2010, Fortress formed, or became the manager of, hedge funds with net asset values as follows as of September 30, 2010:

 

     Liquid      Credit  

Fortress

   $ —         $ 220   

Fortress’s affiliates

     —           —     

Third party investors

     —           140,204   
                 

Total NAV (A)

   $ —         $ 140,424   
                 

 

(A) Or other fee paying basis, as applicable.

Redemption notices received, and redemption payments which are made in periods after notices are received, including affiliates, have been as follows:

 

     Liquid Hedge Funds      Credit Hedge Funds  

Nine Months Ended September 30,

   Redemption Notices
Received
     Redemptions Paid
During the Period
     Redemption Notices
Received
     Redemptions Paid
During the Period
 

2010

   $ 692,730       $ 1,450,098       $ 789,619       $ 1,055,462   

2009

   $ 1,427,563       $ 4,159,798       $ 1,548,060       $ 423,319   

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(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. In some cases, including all of the credit hedge funds, these agreements allow for delayed payment. In particular, the redemptions within the flagship credit hedge fund in 2008 and 2009, and the redemptions within the flagship liquid hedge fund in the fourth quarter of 2008 which related to illiquid investments, were subject to delayed payment.

Traditional Asset Management

In February 2010, Fortress announced that certain of its consolidated affiliates had agreed to acquire 100% of the equity of Logan Circle Partners, L.P. (“Logan Circle”) and its general partner, Logan Circle Partners GP, LLC, for approximately $19 million, with the potential for an additional payment at the end of 2011. The closing of the transaction occurred on April 16, 2010. The additional payment, or contingent consideration, is contingent on the growth and performance of Logan Circle’s business (but not contingent on the continued employment of any employees). The contingent consideration is payable in cash or Class A shares, at Fortress’s option, and had an estimated fair value of approximately $4 million at closing (maximum payment of $28 million). In addition, Fortress may make payments to the prior owners of Logan Circle, contingent upon the settlement of certain liabilities subject to pending litigation, of up to $2 million as of the date of acquisition. Fortress attributed a nominal fair value to these possible additional payments to the prior owners of Logan Circle. The total purchase price was approximately $23 million, which has been allocated approximately as follows: $14 million to goodwill (all expected to be tax deductible), $8 million to amortizable intangible assets, and $1 million to miscellaneous net assets.

The goodwill and other intangible assets have been recorded in Other Assets. The intangible assets are being amortized over their estimated useful lives, which range from 1 to 8 years. The contingent consideration is measured at fair value with changes in fair value being recorded as a gain (loss). This fair value is measured based on the expected performance of Logan Circle in 2011 and a discount rate, and therefore is considered a Level 3 valuation (Note 3). During the period from April 16, 2010 through September 30, 2010, the fair value of the contingent consideration decreased by approximately $28,000, which is recorded in Gains (Losses).

Fortress will test the Logan Circle goodwill and other intangible assets for impairment annually in the fourth quarter of each calendar year, or whenever events or circumstances indicate that it is more likely than not that Logan Circle’s fair value has declined below its carrying value. Logan Circle’ fair value will be estimated based on the following key assumptions: expected retention rate of existing investors, growth expectations, estimated future fee rates, and estimated operating margin. These assumptions are determined primarily based on Logan Circle’s past experience, Logan Circle’s historical and recent investment performance, current industry trends, and general economic expectations. These assumptions, particularly those relating to investor retention and growth expectations, are highly subjective and are subject to significant uncertainty with respect to future events. Continued challenging credit market conditions could adversely impact the value of Logan Circle.

In connection with the acquisition of Logan Circle, Fortress established a compensation plan for former Logan Circle employees who became employees of Fortress (the “Logan Circle Comp Plan”). The Logan Circle Comp Plan is further described in Note 7. From the date of acquisition through September 30, 2010, Logan Circle generated approximately $9 million of revenues (primarily management fees from non-affiliates, recorded in Other Revenues) and $(9) million of net (loss). This net (loss) does not include the above referenced change in fair value of the contingent consideration, but does include approximately $4 million of allocated corporate overhead.

Logan Circle is a fixed income asset manager with approximately $11.4 billion in assets under management as of the date of acquisition. With this acquisition, Fortress has expanded its investment management business to offer fixed income products to investors worldwide. Logan Circle is initially being reported in the “unallocated” section of Fortress’s segments until such time as it becomes material to Fortress’s operations.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

3. INVESTMENTS

Investments consist primarily of investments in equity method investees and options in these investees. The investees are primarily Fortress Funds.

Investments can be summarized as follows:

 

     September 30,
2010
     December 31,
2009
 

Equity method investees

   $ 855,748       $ 809,757   

Equity method investees, held at fair value

     50,761         56,710   
                 

Total equity method investments

     906,509         866,467   

Options in equity method investees

     947         748   
                 

Total investments

   $ 907,456       $ 867,215   
                 

Gains (losses) from investments can be summarized as follows:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Net realized gains (losses)

   $ (637   $ (408   $ (292   $ (1,180

Net realized gains (losses) from affiliate investments

     581        315        (601     301   

Net unrealized gains (losses)

     (3,116     —          (3,753     —     

Net unrealized gains (losses) from affiliate investments

     5,197        20,282        (5,714     38,036   
                                

Total gains (losses) from investments

   $ 2,025      $ 20,189      $ (10,360   $ 37,157   
                                

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)     Fortress’s Equity in Net Income (Loss)  
     September 30,      December 31,      Three Months Ended
Sept 30,
    Nine Months Ended
Sept 30,
 
     2010      2009      2010     2009     2010     2009  

Private equity funds, excluding NIH (A)

   $ 539,865       $ 506,383       $ 4,326      $ 22,197      $ 21,012      $ 18,366   

NIH

     1,867         2,486         388        300        207        144   

Newcastle (B)

     3,180         2,144         N/A        N/A        N/A        N/A   

Eurocastle (B)

     2,238         2,616         N/A        N/A        N/A        N/A   
                                                  

Total private equity

     547,150         513,629         4,714        22,497        21,219        18,510   

Liquid hedge funds

     12,480         12,296         245        1,285        266        3,254   

Credit hedge funds

     224,275         220,511         9,603        11,299        20,958        25,641   

Credit PE funds

     117,157         115,896         2,399        5,307        (1,537     8,806   

Other

     5,447         4,135         (20     (43     2,066        342   
                                                  
   $ 906,509       $ 866,467       $ 16,941      $ 40,345      $ 42,972      $ 56,553   
                                                  

 

(A) Includes Fortress’s 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 the fair value option for financial instruments.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

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

 

     Nine Months Ended September 30, 2010  
     Private Equity     Liquid     Credit              
     NIH     Other Funds (A)     Castles (B)     Hedge Funds     Hedge Funds     PE Funds     Other     Total  

Investment, beginning

   $ 2,486      $ 506,383      $ 4,760      $ 12,296      $ 220,511      $ 115,896      $ 4,135      $ 866,467   

Earnings from equity method investees

     207        21,012        N/A        266        20,958        (1,537     2,066        42,972   

Other comprehensive income from equity method investees

     (15     —          N/A        —          —          (4,838     —          (4,853

Contributions to equity method investees

     —          21,728        —          10,295        1,034        37,995        466        71,518   

Distributions of earnings from equity method investees

     (207     (55     N/A        (174     (14     (4,465     (715     (5,630

Distributions of capital from equity method investees

     (604     (2,596     N/A        (10,203     (18,214     (25,898     (505     (58,020
                                                                

Total distributions from equity method investees

     (811     (2,651     N/A        (10,377     (18,228     (30,363     (1,220     (63,650
                                                                

Mark to fair value - during period (C)

     N/A        (3,699     836        N/A        N/A        N/A        N/A        (2,863

Translation adjustment

     —          (2,908     (178     —          —          4        —          (3,082
                                                                

Investment, ending

   $ 1,867      $ 539,865      $ 5,418      $ 12,480      $ 224,275      $ 117,157      $ 5,447      $ 906,509   
                                                                

Ending balance of undistributed earnings

   $ —        $ 126        N/A      $ 12      $ 7,238      $ 3,234      $ 1,661      $ 12,271   
                                                                

 

(A) Includes Fortress’s 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 the fair value option for financial instruments.

 

(C) Recorded to Gains (Losses).

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. NIH, the Castles, GAGFAH and Other are not presented as they are insignificant to Fortress’s investments.

 

     Private Equity Funds excluding NIH  
     September 30,
2010
    December 31,
2009
 

Assets

   $ 11,637,348      $ 10,993,214   

Debt

     (490,651     (705,432

Other liabilities

     (213,376     (275,702
                

Equity

   $ 10,933,321      $ 10,012,080   
                

Fortress’s Investment (A)

   $ 539,865      $ 506,383   
                

Ownership (B)

     4.9     5.1
                
     Nine Months Ended September 30,  
     2010     2009  

Revenues and gains (losses) on investments

   $ 705,106      $ 1,864,675   

Expenses

     (172,722     (188,682
                

Net Income (Loss)

   $ 532,384      $ 1,675,993   
                

Fortress’s equity in net income (loss)

   $ 21,012      $ 18,366   
                

 

(A) Includes Fortress’s 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)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

     Liquid Hedge Funds     Credit Hedge Funds     Credit PE Funds (B) (C)  
     September 30,
2010
    December 31,
2009
    September 30,
2010
    December 31,
2009
    September 30,
2010
    December 31,
2009
 

Assets

   $ 5,719,045      $ 9,641,111      $ 12,106,558      $ 11,048,076      $ 5,859,279      $ 6,243,776   

Debt

     —          —          (3,838,424     (2,938,213     (593,143     (1,767,331

Other liabilities

     (1,899,355     (6,187,965     (654,860     (667,604     (255,180     (95,807

Non-controlling interest

     —          —          (9,320     (16,600     (2,713     (153,016
                                                

Equity

   $ 3,819,690      $ 3,453,146      $ 7,603,954      $ 7,425,659      $ 5,008,243      $ 4,227,622   
                                                

Fortress’s Investment

   $ 12,480      $ 12,296      $ 224,275      $ 220,511      $ 117,157      $ 115,896   
                                                

Ownership (A)

     0.3     0.4     2.9     3.0     2.3     2.7
                                                
     Nine Months Ended September 30,     Nine Months Ended September 30,     Nine Months Ended September 30,  
     2010     2009     2010     2009     2010     2009  

Revenues and gains (losses) on investments

   $ 242,814      $ 899,569      $ 1,170,760      $ 1,307,348      $ 871,615      $ 1,559,414   

Expenses

     (104,125     (130,254     (224,101     (216,459     (214,131     (98,119
                                                

Net Income (Loss)

   $ 138,689      $ 769,315      $ 946,659      $ 1,090,889      $ 657,484      $ 1,461,295   
                                                

Fortress’s equity in net income (loss)

   $ 266      $ 3,254      $ 20,958      $ 25,641      $ (1,537   $ 8,806   
                                                

 

(A) Excludes ownership interests held by other Fortress Funds, the Principals, employees and other affiliates.

 

(B) Includes one entity which is recorded on a one quarter lag (i.e., the balances reflected for this entity are for the periods ended June 30, 2010 and 2009, respectively) and two entities which are recorded on a one month lag. They are recorded on a lag because they are foreign entities and do not provide financial reports under U.S. GAAP within the reporting timeframe necessary for U.S. public entities.

 

(C) Includes certain entities in which Fortress has both a direct and an indirect investment.

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 nine months ended September 30, 2010 which caused a change in Fortress’s accounting, except as described below.

The following table sets forth certain information as of September 30, 2010 regarding entities formed during the nine months ended September 30, 2010 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.

 

     Fortress is not Primary Beneficiary       

Business Segment

   Gross Assets      Financial Obligations (A)      Fortress Investment (B)      Notes

Credit Hedge Funds

   $ 152,719       $ 6,018       $ 294       (C) (D)

Credit PE Funds

   $ 280,325       $ 189,314       $ 728       (C)

 

(A) Represents financial obligations at the fund level, which are not recourse to Fortress. Financial obligations include financial borrowings, derivative liabilities and short securities. In many cases, these funds have additional debt within unconsolidated subsidiaries. Of the financial obligations represented herein as of September 30, 2010, $189.3 million represent financial borrowings which have weighted average maturities of 0.2 years for the credit PE funds.

 

(B) Represents Fortress’s maximum exposure to loss with respect to these entities, which includes direct and indirect investments in the funds. In addition to the table above, Fortress is exposed to potential changes in cash flow and revenues attributable to the management fees and/or incentive income Fortress earns from these entities.

 

(C) Fortress is not the primary beneficiary of these entities, which represent investing vehicles and master funds, because the related funds and feeder funds (which are not consolidated) are more closely associated with these funds than Fortress based on both a quantitative and qualitative analysis. The investing vehicles and master funds were formed for the sole purpose of acting as investment vehicles for the related funds.

 

(D) Fortress’s investment includes $74,000 and $16,000 of other receivables from the credit hedge funds and credit PE funds, respectively.

In June 2009, the FASB issued new guidance on consolidation which became effective for Fortress on January 1, 2010. This guidance changes the definition of a variable interest entity (“VIE”) and changes the methodology to determine who is the primary beneficiary of, or in other words who consolidates, a VIE. Generally, the changes are expected to cause more entities to be defined as VIE’s and to shift consolidation to those entities that exercise day-to-day control over the VIE’s, such as investment managers. In February 2010, the FASB updated this guidance to defer its application to certain managed entities, particularly investment companies and similar entities. As a result, this guidance had no material impact on Fortress’s financial position, results of operations or liquidity.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

The following table sets forth certain information regarding VIEs in which Fortress held a variable interest. The September 30, 2010 amounts presented below include VIEs formed during the period (as shown in the immediately preceding table) 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.

 

     Fortress is not Primary Beneficiary       
     September 30, 2010      December 31, 2009       

Business Segment

   Gross Assets      Financial
Obligations (A)
     Fortress
Investment (B)
     Gross Assets      Financial
Obligations (A)
     Fortress
Investment (B)
     Notes

Private Equity Funds

   $ 335,766       $ 192,266       $ 2,130       $ 352,787       $ 197,791       $ 2,740       (C) (D)

Castles

     10,581,680         10,538,557         18,464         11,150,750         12,066,365         13,335       (C) (D)

Liquid Hedge Funds

     4,604,576         1,741,280         3,940         7,773,895         5,090,344         7,170       (C) (D)

Credit Hedge Funds

     2,415,765         153,509         14,738         2,153,220         598,216         3,132       (C) (D)

Credit PE Funds

     550,589         189,314         1,254         268,919         5,300         3,710       (C) (D)

 

(A) Represents financial obligations at the fund level, which are not recourse to Fortress. Financial obligations include financial borrowings, derivative liabilities and short securities. In many cases, these funds have additional debt within unconsolidated subsidiaries. Of the financial obligations represented herein as of September 30, 2010, $192.3 million, $9,891.5 million, $118.0 million and $189.3 million represent financial borrowings which have weighted average maturities of 0.6, 3.7, 2.5, and 0.2 years for the private equity funds, Castles, credit hedge funds and credit PE funds, respectively. Of the financial obligations represented herein as of December 31, 2009, $197.8 million, $11,438.7 million, $551.4 million, and $5.3 million represent financial borrowings which have weighted average maturities of 1.4, 4.5, 3.2, and 0.5 years for the private equity funds, Castles, credit hedge funds, and credit PE funds, respectively.

 

(B) Represents Fortress’s maximum exposure to loss with respect to these entities, which includes direct and indirect investments in these funds. In addition to the table above, Fortress is exposed to potential changes in cash flow and revenues attributable to the management fee and/or incentive income Fortress earns from those entities.

 

(C) Fortress is not the primary beneficiary of the Castles and NIH because it does not absorb a majority of their expected income or loss based on a quantitative analysis. Of the remaining entities represented herein, which represent investing vehicles, intermediate entities and master funds, Fortress is not the primary beneficiary because the related funds, intermediate entities and feeder funds (which are not consolidated) are more closely associated with these funds than Fortress based on both a quantitative and qualitative analysis. The investing vehicles, intermediate entities and master funds were formed for the sole purpose of acting as investment vehicles for the related funds.

 

(D) As of September 30, 2010, Fortress’s investment includes $7.7 million, $12.1 million, and $0.2 million of management fees receivable from the Castles, credit hedge funds, and credit PE funds, respectively, as well as $0.7 million in incentive income receivable from the liquid hedge funds. As of September 30, 2010, Fortress’s investment also includes $0.2 million, $4.4 million, $1.4 million and $1.2 million of expense reimbursements and other receivables from the private equity funds, Castles, liquid hedge funds and credit hedge funds, respectively. As of December 31, 2009, Fortress’s investment includes $4.1 million, $0.5 million, and $1.0 million of management fees receivable from the Castles, credit hedge funds, and credit PE funds, respectively, as well as $3.7 million and $0.9 million in incentive income receivable from the liquid hedge funds and credit hedge funds, respectively. As of December 31, 2009, Fortress’s investment also includes $0.2 million, $3.7 million, $1.5 million, $0.6 million and $0.7 million of expense reimbursements and other receivables from the private equity funds, Castles, liquid hedge funds, credit hedge funds and credit PE funds, respectively. In addition, Fortress has remaining capital commitments to certain credit PE funds which are VIEs which aggregated $0.9 million at September 30, 2010.

In March 2010, Fortress determined that a reconsideration event had occurred with respect to an operating subsidiary (“FCF”) of one of its private equity funds. FCF provides operating services to all of Fortress’s private equity funds and is reimbursed for related costs by the private equity funds based on a contractual formula. Therefore, FCF by design does not produce net income or have equity. Historically, Fortress has provided temporary advances to FCF as a result of certain funds having insufficient current liquidity to make their required reimbursements on a timely basis; these advances were deemed fully collectable. In March 2010, Fortress determined it would make advances to FCF related to a fund from which reimbursement was subject to significant uncertainty. Management determined that these advances would represent the provision of financial support to FCF. As a result of this reconsideration event, FCF was deemed to be a VIE and Fortress, as a result of directing the operations of FCF through its management contracts with the private equity funds, and providing financial support to FCF beginning in March 2010, was deemed to be its primary beneficiary. Therefore, Fortress consolidated FCF beginning in March 2010, which resulted in a gross up of reimbursement revenues, compensation and miscellaneous expenses, receivables, and payables, but had no impact on Fortress’s net income or equity. As of September 30, 2010, FCF’s gross assets were approximately $36.2 million, primarily comprised of affiliate receivables. Fortress’s exposure to loss from FCF is limited to its outstanding advances, which were approximately $13.5 million at September 30, 2010, plus any future advances. Subsequent to Fortress’s consolidation of FCF, these advances are eliminated in consolidation. FCF’s creditors do not have recourse to Fortress’s other assets.

 

17


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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

Fair Value of Financial Instruments

The following table presents information regarding Fortress’s financial instruments that are recorded at fair value. Investments denominated in foreign currencies have been translated at the period end exchange rate. Changes in fair value are recorded in Gains (Losses).

 

     Fair Value     

Valuation Method

     September 30, 2010      December 31, 2009       

Assets

        

Newcastle and Eurocastle common shares

   $ 3,536       $ 2,662       Level 1 - Quoted prices in active markets for identical assets

GAGFAH common shares

   $ 45,343       $ 51,950       Level 1 - Quoted prices in active markets for identical assets

Eurocastle convertible debt (A)

   $ 1,882       $ 2,098       Level 3 - Binomial lattice-based option valuation models, adjusted for non-option

Newcastle and Eurocastle options

   $ 947       $ 748       Level 2 - Lattice-based option valuation models using significant observable inputs

Liabilities

        

Logan Circle Contingent Consideration

   $ 3,972       $ —         Level 3 - Internal model using significant unobservable inputs

Derivatives

   $ 3,753       $ —         Level 2 - See below

 

(A) The debt bears interest at 20% per annum and is perpetual, but ECT may redeem the securities after June 2011 at a premium of 20%. As of September 30, 2010, it had a face amount of €1.2 million ($1.6 million) and was convertible into ECT common shares at €0.30 per share. The fair value was determined using the market value approach.

Fortress’s interests in instruments measured at fair value using Level 3 inputs changed during the nine months ended September 30, 2010 as follows:

 

     Assets     Liabilities  

Balance at December 31, 2009

   $ 2,098      $ —     

Total gains (losses) included in net income (including foreign currency translation)

     (216     28   

Issuance of Logan Circle contingent consideration (Note 2)

     —          (4,000
                

Balance at September 30, 2010

   $ 1,882      $ (3,972
                

See Note 4 regarding the fair value of Fortress’s outstanding debt.

Derivatives

Fortress is exposed to certain risks relating to its ongoing business operations. The primary risk managed by Fortress using derivative instruments is foreign currency risk. Fortress enters into foreign exchange forward contracts to economically hedge the risk of fluctuations in foreign exchange rates with respect to certain foreign currency denominated assets. Foreign exchange forward contracts involve the purchase and sale of a designated currency at an agreed upon rate for settlement on a specified date. Fortress entered into four foreign exchange forward contracts in June 2010 which were not designated as hedges for accounting purposes. Gains and losses on these contracts are reported currently in Gains (Losses).

Fortress’s derivative instruments are carried at fair value and are generally valued using models with observable market inputs that can be verified and which do not involve significant judgment. The significant observable inputs used in determining the fair value of our Level 2 derivative contracts are contractual cash flows and market based parameters such as foreign exchange rates.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

Fortress’s derivatives are recorded as follows:

 

     Balance Sheet
Location
     Fair Value
September 30, 2010
    Notional Amount
September 30, 2010
     Gains/(Losses) Nine
Months Ended
September 30, 2010
    Maturity
Date
 

Foreign Exchange forward contracts (not designated as hedges)

     Other Liabilities       ($ 3,753   20,000       ($ 4,284     June 2011   

The counterparty on this derivative is Citibank N.A.

4. DEBT OBLIGATIONS

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

 

                         September 30, 2010  
     Face Amount and                   Weighted     Weighted  
     Carrying Value            Final      Average     Average  
     September 30,      December 31,      Contractual     Stated      Funding     Maturity  
Debt Obligation    2010      2009      Interest Rate     Maturity      Cost (A)     (Years)  

Credit agreement (B)

               

Revolving debt (C)

   $ —         $ —           LIBOR + 2.50% (D)        May 2012         —          —     

Term loan

     350,000         350,000         LIBOR + 2.50%        May 2012         3.53     1.42   

Delayed term loan (C)

     5,900         47,825         LIBOR + 2.50%        May 2012         2.97     0.04   
                                       

Total

   $ 355,900       $ 397,825              3.52     1.40   
                                       

 

(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 0.25%.

 

(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 $65.7 million was undrawn on the revolving debt facility as of September 30, 2010. The revolving debt facility includes a $25 million letter of credit subfacility of which $9.3 million was utilized. Lehman Brothers Commercial Paper, Inc., which is committed to fund $7.2 million (including $0.9 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, $59.5 million of the undrawn amount was available.

 

(D) Subject to unused commitment fees of 0.50% per annum.

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 approximately equal to its face amount at September 30, 2010.

Fortress was in compliance with all of its debt covenants as of September 30, 2010. The following table sets forth the financial covenant requirements as of September 30, 2010 (dollars in millions).

 

   

September 30, 2010

(dollars in millions)

        
   

Requirement

     Actual      Notes  

AUM

 

³$

     20,000       $ 43,992         (A

Consolidated Leverage Ratio

 

£

     3.50         1.10         (B

Required Investment Assets

 

³$

     378       $ 1,018         (C

Fortress Fund Investments

 

³$

     151       $ 683         (C

Total Investments

 

³$

     227       $ 844         (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 changes in clawback reserves or gains and losses, including impairment, on investments.

 

(C) Impacted by capital investments in funds and the valuation of such funds’ investments.

In October 2010, Fortress entered into a new credit agreement and repaid its existing credit agreement in full (Note 11).

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

5. INCOME TAXES AND TAX RELATED PAYMENTS

For the nine months ended September 30, 2010, an estimated annual effective tax rate of (1.74)% 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 September 30,     Nine Months Ended September 30,  
     2010     2009     2010     2009  

                     Current

        

Federal income tax expense (benefit)

   $ (3,134   $ (232   $ (505   $ 387   

Foreign income tax expense (benefit)

     631        433        1,723        1,424   

State and local income tax expense (benefit)

     6        1,951        3,032        5,786   
                                
     (2,497     2,152        4,250        7,597   
                                

                     Deferred

        

Federal income tax expense (benefit)

     (3,047     (1,956     (2,518     (5,227

Foreign income tax expense (benefit)

     14        (127     45        219   

State and local income tax expense (benefit)

     985        (3,185     2,864        (7,420
                                
     (2,048     (5,268     391        (12,428
                                

Total expense (benefit)

   $ (4,545   $ (3,116   $ 4,641      $ (4,831
                                

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

 

     September 30, 2010     December 31, 2009  

Total deferred tax assets

   $ 565,487      $ 545,253   

Valuation allowance

     (106,472     (104,614
                

Net deferred tax assets

   $ 459,015      $ 440,639   
                

Total deferred tax liabilities (A)

   $ 535      $ 456   
                

 

(A) Included in Other Liabilities

For the nine months ended September 30, 2010, a deferred income tax benefit of $1.0 million was credited to other comprehensive income, primarily related to the equity method investees. A current income tax benefit of $0.7 million was credited to paid-in capital, related to (i) dividend equivalent payments on RSUs (Note 8), and (ii) distributions to Fortress Operating Group restricted partnership unit holders (Note 7), which are currently deductible for income tax purposes.

The exchange by the principals of Fortress Operating Group units and Class B shares for Class A shares during the second quarter (as described in Note 8) increased FIG Corp’s ownership percentage in the underlying Fortress Operating Group entities. As a result of the increased ownership, the deferred tax asset was increased by $7.2 million with an offsetting increase of $2.8 million to the valuation allowance. In addition, the deferred tax asset was increased by $8.2 million related to a step-up in tax basis due to the share exchange which will result in additional tax deductions, while the liability for the tax receivable agreement was increased by $5.7 million to represent 85% of the expected cash tax savings resulting from the increase in tax basis deductions. The establishment of these net deferred tax assets, net of the change in the tax receivable agreement liability, as well as a $6.0 million increase to the deferred tax asset relating to the vesting of RSUs, also increased paid-in capital.

Tax Receivable Agreement

Although the tax receivable agreement payments are calculated based on annual tax savings, for the nine months ended September 30, 2010, the payments which would have been made pursuant to the tax receivable agreement, if such period was calculated by itself, were estimated to be $11.8 million.

In April 2010, $14.7 million was paid out under the tax receivable agreement related to prior periods.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(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           Credit              
    Funds     Castles     Liquid Hedge
Funds
    Hedge Funds     PE
Funds
    Other     Total  

                    September 30, 2010

             

Management fees and incentive income (A)

  $ 59,170      $ 7,653      $ 723      $ 14,762      $ 11,392      $ —        $ 93,700   

Expense reimbursements (A)

    1,046        3,196        2,077        7,851        3,258        —          17,428   

Expense reimbursements - FCF (B)

    34,489        —          —          —          —          —          34,489   

Dividends and distributions

    —          —          —          —          —          —          —     

Other

    78        432        —          —          2        1,940        2,452   
                                                       

Total

  $ 94,783      $ 11,281      $ 2,800      $ 22,613      $ 14,652      $ 1,940      $ 148,069   
                                                       
    Private Equity           Credit              
    Funds     Castles     Liquid Hedge
Funds
    Hedge Funds     PE
Funds
    Other     Total  

                    December 31, 2009

             

Management fees and incentive income (C)

  $ 17,116      $ 4,087      $ 7,557      $ 4,038      $ 11,200      $ —        $ 43,998   

Expense reimbursements (C)

    5,471        3,750        1,802        4,752        3,010        —          18,785   

Dividends and distributions

    —          —          —          —          —          —          —     

Other

    88        179        —          —          1        1,460        1,728   
                                                       

Total

  $ 22,675      $ 8,016      $ 9,359      $ 8,790      $ 14,211      $ 1,460      $ 64,511   
                                                       

 

(A) Net of allowances for uncollectable management fees and expense reimbursements of $11.5 million and $1.2 million, respectively.

 

(B) Represents expense reimbursements due to FCF, a consolidated VIE (Note 3).

 

(C) Net of allowances for uncollectable management fees and expense reimbursements of $13.8 million and $0.8 million, respectively.

As of September 30, 2010, amounts due from Fortress Funds recorded in Due from Affiliates included $59.0 million of past due management fees, excluding $11.6 million which has been subordinated to other liabilities of the related fund and has been fully reserved by Fortress, and $12.6 million of private equity general and administrative expenses advanced on behalf of certain Fortress Funds. Although such funds are currently experiencing liquidity issues, Fortress believes the unreserved fees will ultimately be collectable as the NAV’s of the respective funds exceed the amounts owed.

Due to affiliates was comprised of the following:

 

     September 30, 2010      December 31, 2009  

Principals

     

- Tax receivable agreement - Note 5

   $ 316,305       $ 326,467   

- Distributions payable on Fortress Operating Group units

     11,821         16,552   

- Distributions payable on other non-controlling interests

     4,898         —     

Other

     8,492         2,957   
                 
   $ 341,516       $ 345,976   
                 

Other Related Party Transactions

For the nine months ended September 30, 2010 and 2009, Other Revenues included approximately $5.1 million and $5.0 million, respectively, of revenues from affiliates, primarily dividends.

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 nine months ended September 30, 2010 and 2009, these expenses, mainly related to subscriptions to market data services, approximated $12.6 million and $12.5 million, respectively.

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

In February 2010, two employees terminated their employment at Fortress in order to form their own management company. Effective April 1, 2010, a subsidiary of Fortress entered into a sub-advisory agreement with them and their management company for the purpose of continuing to have them advise on an existing portfolio of illiquid investments in emerging markets on which they previously worked while they were employees. Pursuant to the terms of the agreement, the subsidiary will pay their management company an annual advisory fee and pay them a percentage of realized net proceeds from certain of such investments. As part of the agreement, the former employees have agreed to notify Fortress about certain investment opportunities in which they are involved. Through September 30, 2010, such payments have aggregated $1.1 million.

In April 2010, Fortress entered into a software sublicensing agreement on an “as is” basis with a subsidiary of several Fortress Funds. The software is designed to facilitate cash management, legal entity management and data reconciliation. Fortress paid a one-time licensing fee of $150,000. The license is perpetual and irrevocable and for the non-exclusive use of Fortress’s affiliates.

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:

 

     September 30, 2010      December 31, 2009  

Principals’ Fortress Operating Group units

   $ 290,612       $ 301,469   

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

     40,991         35,789   

Other

     1,309         839   
                 

Total

   $ 332,912       $ 338,097   
                 

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 September 30,     Nine Months Ended September 30,  
     2010     2009     2010     2009  

Principals’ Fortress Operating Group units

   $ (179,768   $ (133,712   $ (520,543   $ (482,261

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

     2,554        2,013        6,800        4,234   

Other

     (7     (5     484        63   
                                

Total

   $ (177,221   $ (131,704   $ (513,259   $ (477,964
                                

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

The purpose of this schedule is to disclose the effects of changes in Fortress’s ownership interest in Fortress Operating Group on Fortress’s equity:

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2010     2009     2010     2009  

Net income (loss) attributable to Fortress

   $ (94,655   $ (58,602   $ (271,190   $ (170,353

Transfers (to) from the Principals’ and Others’ Interests:

        

Increase in Fortress’s shareholders’ equity for the conversion of Fortress Operating Group units by the Principals

     —          4,100        7,188        4,100   

Increase in Fortress’s shareholders’ equity for the delivery of Class A shares primarily in connection with vested RSUs

     2,795        —          10,328        —     

Decrease in Fortress’s shareholders’ equity for the purchase of Fortress Operating Group units in connection with an equity offering

     —          —          —          (144,572
                                

Change from net income (loss) attributable to Fortress and transfers (to) from Principals’ and Others’ Interests

   $ (91,860   $ (54,502   $ (253,674   $ (310,825
                                

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 September 30,      Nine Months Ended September 30,  
     2010      2009      2010      2009  

Equity-based compensation, per below

   $ 57,070       $ 60,883       $ 169,100       $ 166,707   

Profit-sharing expense, per below

     32,286         8,949         111,720         20,798   

Discretionary bonuses

     54,932         31,396         133,611         77,545   

Other payroll, taxes and benefits

     39,819         30,805         108,598         89,675   
                                   
   $ 184,107       $ 132,033       $ 523,029       $ 354,725   
                                   

Equity-Based Compensation

The following tables set forth information regarding equity-based compensation activities.

 

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

Outstanding as of December 31, 2009

    44,941,811      $ 14.59        6,689,054      $ 13.42        216,367      $ 9.58        31,000,000      $ 13.75   

Issued

    8,630,101        4.59        1,004,551        4.70        210,302        3.50        —          —     

Converted to Class A shares

    (14,408,930     13.71        (938,390     13.40        —          —          —          —     

Transfers (C)

    5,345,717        12.50        (5,345,717     12.50        —          —          —          —     

Forfeited

    (1,875,052     12.65        (212,555     8.42        —          —          —          —     
                                                               

Outstanding as of September 30, 2010 (B)

    42,633,647      $ 12.69        1,196,943      $ 11.11        426,669      $ 6.58        31,000,000      $ 13.75   
                                                               

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2010      2009      2010      2009  

Expense incurred (B)

           

Employee RSUs

   $ 32,241       $ 29,431       $ 94,004       $ 78,696   

Non-Employee RSUs

     119         6,607         1,934         14,577   

Restricted Shares

     164         299         325         596   

LTIP

     1,733         1,733         5,143         5,143   

RPUs

     22,813         22,813         67,694         67,695   
                                   

Total equity-based compensation expense

   $ 57,070       $ 60,883       $ 169,100       $ 166,707   
                                   

 

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FORTRESS INVESTMENT GROUP LLC

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

SEPTEMBER 30, 2010

(dollars in tables in thousands, except share data)

 

 

(A) Represents the weighted average grant date estimated fair value per share or unit. The weighted average estimated fair value per unit as of September 30, 2010 for awards granted to non-employees was $3.59, 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 $493 million, with a weighted average recognition period of 2.45 years. This does not include contingent amounts or amounts related to the Principals Agreement.

 

(C) Relates to FCF employees who became employees of Fortress (see Note 3).

When Fortress records equity-based compensation expense, including that related to the Principals Agreement, it records a corresponding increase in capital. When Fortress delivers Class A shares as a result of the vesting of equity-based compensation, to the extent that it pays withholding taxes in cash (rather than through the sale of employee shares upon delivery) it will record a decrease in capital related to these payments.

In January 2010, Fortress granted 8.0 million RSUs to its employees and affiliates. These RSUs generally vest over two and a half years.

In April 2010, in connection with the acquisition of Logan Circle, Fortress created the Logan Circle Comp Plan (see Note 2). The Logan Circle Comp Plan provides for annual bonuses to a senior employee which may be paid partially in RSUs, as well as for potential Class A share awards to certain employees, including this senior employee, in the years 2015, 2016 and 2017. These awards are annual performance-based awards and depend on the future performance of Logan Circle in the specific years to which they relate. Furthermore, the amounts of RSUs or shares to be awarded are not fixed until the respective year is completed. As such, these awards are expensed in the year to which they pertain based on the estimated value of awards expected to vest in that year. No equity-based compensation expense relating to the Logan Circle Comp Plan has been recorded to date.

In September 2010, based on actual forfeitures experienced to date and their impact on management’s expectations, Fortress’s forfeiture assumptions for dividend-paying RSU awards granted prior to 2010 and non-dividend paying RSU awards granted prior to 2010 and during 2010 were changed to 24%, 43% and 17%, from 30%, 39% and 12% as of June 30, 2010, respectively. The forfeiture assumptions for dividend-paying and non-dividend paying RSU awards were 26% and 35%, respectively, as of December 31, 2009.

Profit Sharing Expense

Recognized profit sharing compensation expense is summarized as follows:

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2010      2009     2010      2009  

Private equity funds (A)

   $ 2,010       $ —        $ 2,010       $ (15

Castles (A)

     —           (55     —           (192

Liquid hedge funds

     4,927         6,723        8,773         12,173   

Credit hedge funds

     20,300         1,646        28,494         4,603   

Credit PE funds

     5,049         635        72,443         4,229   
                                  

Total

   $ 32,286