NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the Long-term Issuer Default Ratings (IDRs) of Fortress Investment Group LLC and its related entities (collectively Fortress) at 'BBB' and affirmed the Short-term IDRs at 'F2'. The Rating Outlook is Stable. A complete list of ratings follows at the end of this release.
Today's rating actions have been taken as part of a periodic peer review of the Alternative Investment Manager (IM) industry, which comprises seven publicly rated global firms. Fitch's outlook for the sector is stable; reflecting the relative stability of core operating fundamentals, given the locked-in nature of a large portion of fee revenue, modest but increased leverage levels, manageable near-term obligations relative to available liquidity resources, increasing asset under management (AUM) diversity and investors' increasing allocation to alternative investments, particularly those managed by alternative IMs with strong franchises, such as those included in Fitch's peer review.
Fee-earning AUM (FAUM) growth has slowed considerably for the rated peer group, as numerous strategies have record levels of uncalled capital to invest. Fundraising is expected to moderate to some extent, as a result, but management fees are expected to retain their resiliency as capital not-yet-earning management fees (shadow AUM) remains elevated and realizations of legacy investments have declined. While an increase in market dislocations would impact the valuations and realization of existing investments, it could also result in stronger management fee growth, as uncalled capital would be invested at a faster pace. However, Fitch does not expect a widespread distress cycle to emerge over the near term.
The variable cost structure of the alternative IMs has contributed to relatively steady cash flows through cycles. Fee-related earnings before interest, taxes, depreciation, and amortization (FEBITDA) margins rebounded modestly in 2015 and 2016 as many alternative IMs have begun to realize the scale benefits of follow-on funds and adjacent strategies. The FEBITDA margin for 'A' category alternative IMs averaged 41.6% for the trailing-12-months (TTM) ended Sept. 30, 2016; this compared to a 35.6% average for 2015 and Fitch's quantitative benchmark range of 30% to 50% for 'A' category alternative IMs. Still, dispersion in the group is significant, with a more than 25 percentage point differential between the highest and lowest performer, driven by differences in strategy and product mix. Fitch believes higher margins provide enhanced operating flexibility through cycles.
Gross realized incentive income has steadily declined, since peaking in 2014, driven by the length of time valuations have been at elevated levels, a less supportive IPO environment, and a reduction in the average age of fund investments. Exit activity has declined in 2016 and is likely to moderate further, which points to likely reductions in distributable earnings. However, incentive income accruals remain strong and Fitch believes realized incentive income may be less volatile than pre-crisis experience given the increased diversity of product platforms.
Leverage levels have increased across the industry, as issuers have taken advantage of the low interest rate environment to issue long duration funding for the purpose of funding balance sheet co-investments, acquisitions, and, in some instances, to pre-fund maturities. Average leverage, defined as debt divided by FEBITDA, was 3.16x for 'A' category firms for the TTM ending Sept. 30, 2016; this compares to Fitch's quantitative benchmark range of 0.5x to 2.5x for 'A' category alternative IMs. Fitch believes the issuances have been largely opportunistic and views the reduction in refinancing risk favorably. Over time, Fitch expects leverage levels to generally decline to the benchmark range, as FEBITDA growth is driven by cost controls, increased scale, continued fundraising, and the gradual deployment of FAUM that earns fees on invested capital.
Counterbalancing the up-tick in leverage is the maintenance of strong liquidity profiles. Several firms remain in a negative net debt position and 2016 saw the introduction of perpetual preferred issuances by two issuers in the sector, with proceeds, to date, used to improve operating flexibility and liquidity. Debt maturities are negligible for the sector in 2016 - 2018. Payout ratios remain relatively high, but Fitch believes alternative IMs retain the ability to reduce shareholder distributions, as necessary, to meet obligations. While several share repurchase programs were announced over the last 12 months, execution of the programs is expected to remain opportunistic and is not expected to impair the sector's overall liquidity.
KEY RATING DRIVERS - IDRs AND UNSECURED DEBT
The rating affirmations reflect Fortress' established position as a global alternative IM, experienced management team, stable cash flow generation, decreasing balance sheet co-investment, modest leverage and adequate liquidity profile. Ratings are constrained by limited revenue diversity relative to more highly rated peers, investment concentrations within its private equity fund and vehicles, higher management fee exposure to net asset value (NAV) relative to peers and recent underperformance in certain funds and business segments. Fitch views the firm's fully unsecured funding profile as increasing potential funding flexibility but notes its sources of funding remain limited. Ratings are also constrained by 'key man' risk, which is institutionalized throughout many limited partnership agreements and reputational risk, which can impact the company's ability to raise future funds.
Fortress' fee earning assets under management (FAUM) remained steady at $70.2 billion as of June 30, 2016 (2Q16) compared to $70.5 billion at Dec. 31, 2015 (YE15) and were down 2.6% compared to $72.0 billion the year prior. The year-on-year decline was driven by redemptions in liquid hedge funds and distribution in PE funds, partially offset by capital inflows in credit hedge funds and credit private equity funds. At 2Q16, approximately 35% of the management fees that Fortress earned on alternative funds (not including Logan Circle AUM) were based on the NAV of applicable funds. Fitch believes the larger exposure to NAV-based fees creates more volatility in Fortress' earnings over time relative to other diversified alternative investment managers whose fees are primarily based on invested capital.
In 4Q15, following consecutive years of negative performance and redemptions in the flagship liquid hedge funds, Fortress Macro Funds, and the departure of the business' founder and CIO, Michael Novogratz, Fortress closed the macro funds and returned all remaining capital ($1.8 billion as of 3Q15) to investors by YE15. In 2016, Fortress continued to reduce its liquid hedge funds business, transferring its interests in the Fortress Convex Asia Funds to a third party during 2Q16 and announcing that it would close the Fortress Centaurus Global Funds. In Fitch's view, the diminished hedge fund business is a negative from a franchise perspective but together these strategies represented less than 1% of total Fortress AUM and contributed negative distributable earnings (DE) in 1H16 so their closure is not expected to have a material financial impact. At 2Q16, the liquid hedge fund business included $4.6 billion in total FAUM, primarily comprised of $4.1 billion managed by Graticule Asset Management Asia, L.P., an independent manager which spun out of Fortress in January 2015 and in which Fortress held an equity stake of 30% in 2015 and 2016, declining to 27% in 2017.
Fortress' operating performance for TTM 2Q16 was solid but lower than in 2015 and 2014. Pre-tax distributable earnings were $364 million, down 6.8% compared to 2015 with the decline primarily attributable to lower incentive income, partially offset by lower compensation expense. On a TTM 2Q16 basis, management fees were $580 million, in line with 2015, reflecting consistent FAUM levels. Management fees as a percentage of average FAUM have been declining in recent years primarily due to growth in Logan Circle AUM, which garners lower management fees due to its focus on traditional investment management strategies primarily in the fixed income space. However, the pace of the decline has slowed with a fee rate of 0.83% on a TTM 2Q16 basis, in-line with 0.84% in 2015 but below the five-year average of 0.97%.
Incentive income on a TTM 2Q16 basis declined 8.9% compared to FY 2015, primarily driven by lower returns in permanent capital vehicles, partially offset by strong performance and realization activity in credit private equity funds. Fitch expects stable operating performance in the near-term with a supportive exit environment providing potential opportunities to realize some of the $1.2 billion of embedded incentive income across the funds and permanent capital vehicles.
FEBITDA, adjusted for deferred management fees, was up 7.2% to $172.0 million for TTM 2Q16, from $165.1 million in 2015, driven by a combination of steady management fees and lower base compensation expense. The FEBITDA margin was 29.6% for TTM 2Q16, which is below the peer average of 33.4% but at the high end Fitch's quantitative earnings benchmark of 20% to 30% for alternative IMs in the 'BBB' rating category.
Fortress is focusing on reducing the size of its balance sheet by opportunistically monetizing its co-investment portfolio, which measured $1.0 billion at June 30, 2016. As a result of an increasingly balance sheet light strategy, usage of debt has remained low, but increased year-on-year to $260 million from $75 million due primarily to the issuance of a $155.7 million promissory note in November 2015 to fund the repurchase of Class A shares from Mr. Novogratz.
Leverage, as measured by gross debt to FEBITDA, was a modest 1.52x for TTM ending 2Q16, below Fitch's quantitative leverage benchmark of 2.5x to 4.0x for 'BBB' category alternative IMs. With low leverage and an attractively priced revolver (LIBOR plus 2.5%), interest coverage was strong at 21.2x for TTM 2Q16, above Fitch's quantitative benchmark of 4.0x to 8.0x for alternative IMs in the 'BBB' rating category. Leverage and interest coverage are considered moderate drivers of the overall ratings and help to offset elevated risks associated with portfolio concentrations and the business model. Fitch expects leverage to decline by year-end 2016 and interest coverage to improve thereafter as a $78 million amortization payment on the promissory note comes due in November 2016.
At June 30, 2016, balance sheet cash amounted to $278.9 million, which was more than sufficient to cover the $166.3 million of unfunded fund commitments and $78 million of debt maturing in 2016. Fitch believes that Fortress has significant discretion over the timing and funding of unfunded commitments. In addition, the company had $170 million of available revolver capacity at 2Q16.
Fortress' dividend policy, adopted in 2014, involves distributing substantially all of the after-tax distributable earnings from all sources including net management fees, net incentive income, and balance sheet investment realizations. Fitch notes that this policy is consistent with some of the larger alternative IM peers and views Fortress' conservative debt usage, modest leverage and adequate liquidity as sufficient mitigants to this payout policy.
FIG LLC is the debt issuing subsidiary of Fortress, which is where the company's bank credit facility is housed. Debt issued from FIG LLC is joint and severally guaranteed by the other fee generating entities within the Fortress operating group, thereby subordinating all general partner interests to those of debtholders. The unsecured debt rating is equalized with Fortress' IDR reflecting average recovery prospects given the absence of secured debt in Fortress' funding profile.
The Stable Rating Outlook reflects Fitch's expectations for stable net fund flows, management fees, and FEBITDA generation, which should yield moderate leverage and adequate debt service for the rating category.
RATING SENSITIVITIES - IDR and SECURED DEBT
Positive rating momentum could result from continued FAUM growth, operating consistency, further revenue diversity, and additional funding flexibility through further access to unsecured debt, while maintaining conservative leverage and liquidity postures.
Conversely, negative rating pressure could be driven by a reduction in management fees resulting from significant redemption activity, material declines in asset values, and/or an inability to raise follow-on funds, a diminished liquidity profile, or materially higher leverage.
The secured debt rating is equalized with Fortress' IDR and therefore, would be expected to move in tandem with any changes to Fortress' IDR.
Fortress, a Delaware incorporated limited liability company, is a global alternative IM specializing in private equity, credit funds, permanent capital vehicles and hedge funds. As of June 30, 2016, AUM amounted to $70.2 billion. The company's stock is listed on the NYSE under the ticker 'FIG'.
Fitch has affirmed the following ratings:
Fortress Investment Group LLC
--Long-term IDRs at 'BBB';
--Short-term IDRs at 'F2'.
FIG LLC
Fortress Operating Entity I L.P.
Principal Holdings I L.P.
--Long-term IDRs at 'BBB';
--Short-term IDRs at 'F2'.
--Unsecured debt at 'BBB'.
The Rating Outlook is Stable.
In addition, Fitch has withdrawn the 'BBB' senior unsecured debt rating for Fortress Investment Group LLC, which was previously assigned in error.
Additional information is available on www.fitchratings.com.
Applicable Criteria
Global Non-Bank Financial Institutions Rating Criteria (pub. 15 Jul 2016)
https://www.fitchratings.com/site/re/884128
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