ft.com/alphaville

That is Roger Ehrenberg’s assessment of the Fortress IPO. The former head of Deutsche Bank’s fund of hedge funds, and blogger at Information Arbritrage, wasn’t planning to write another post on the Fortress offering but felt forced back to the keyboard after events of last week.

“The response to the Fortress offering was, well, demonstrably insane,” he writes, pointing to reports that put Fortress, after Friday’s close, trading at 40 times last year’s earnings, compared to Goldman Sachs at 11 times, and Legg Mason at 24 times.

“It is a great firm run by top pros (as I’ve written many times), but the profit dynamics of the business simply don’t support that kind of a multiple,” he says. The firm basically has two components, Ehrenberg writes:

Annuitized cash flows relating to management fees. This is a function of fee level, asset level, asset growth, tenor of lock-up and the probability of assets being redeemed. I would afford this type of stream a high multiple - say 20-25x earnings - due to its persistence, stability and growth potential. 

Variable cash flows relating to performance fees. This is a function of fee level, asset level and performance. FIG’s performance variability is cushioned by the fact that it runs a highly diversified portfolio, likely offering benefits of non-correlated returns similar to a fund-of-funds. That said, correlations generally rise in market downdrafts and fees are driven by absolute - not relative - performance. Therefore I’d afford this stream a lower multiple of earnings - say 12-18x earnings - due to the risks involved but greater diversification than, say, Goldman Sachs.

“So how does one get to 40x earnings? Probably if you expect FIG’s AUM to grow for a long time at its 5 year historic rate of 97%. Is this realistic?” asks Ehrenberg. “FIG isn’t a business that scales like Google….Investment management at FIG isn’t just a model business…- it’s a people business. People require management… It’s hard and it poses a risk. Doubling in size every year will place such dramatic stress of the FIG management structure (not to mention infrastructure) that something will break. It has to. And it will tarnish returns.”