FEATURE: Fortress' slippery slope

It was the height of the credit bubble of 2006 and Fortress Investment Group, the New York-based private equity, hedge fund and real estate group, had just completed the $2.8 billion acquisition of Canadian ski and golf resort company Intrawest in a highly leveraged buyout.

Wes Edens, the Fortress chairman and co-founder, had hand-picked a team of senior Fortress executives to oversee Intrawest. This team travelled to Opus, a small boutique hotel in downtown Vancouver, to meet Intrawest's development and property sales force.

Skiing from the peak

According to a source who attended the meeting, Edens and the other Fortress executives in suits filed into a small meeting room accompanied by more than a dozen senior Intrawest managers. Also in the room was Richard Georgi, the former head of Goldman Sachs' Whitehall funds in Europe and founder of Grove International, which agreed to co-invest in the Canadian company alongside Fortress.

In contrast to the mood now afflicting the hospitality industry, the private equity GPs were in full swagger.

According to the source, Edens told the assembled Intrawest sales executives: “We have only ever had two deals not perform.” The Fortress team also explained that it expected to deliver 20 percent-plus returns to its investors.

In order to do this, says the source: “The Intrawest development group would produce and sell in the order of 1,000 condominium units each year.”

Unbeknown to Edens and his crew, the assembled sales force doubted the target could be achieved. Very recent sales of condos at Intrawest's resorts had been inflated by property speculators, not by core customers – holidaymakers who traditionally want to buy a condo to stay in for a couple of weeks and let out at other times of the year. “Frankly, the idea that you could sell 1,000 units a year was the poster child of bubble itself,” the source says.

Castle hassles

Two years later and Intrawest has indeed proved to be a massive challenge for Fortress. Last year the resort only just managed to refinance its debt by an October deadline.

Fortress' real estate problems are largely to blame for the collapse of its New York Stock Exchange share price. Shares in the New York-based firm are currently valued at just $1.46 at press time. When the firm debuted on Wall Street, those same shares were valued at $30. At the end of last year, the firm told shareholders it would not be paying a dividend.

According to the Fortress 2007 annual report, real estate (along with transportation and senior living accommodation) represented the largest investments in Fortress' private equity portfolio.

In North America, a year before Intrawest, the firm had bought Brookdale Senior Living via a series of funds including Fortress Investment Fund II. Fortress then bought senior living company Holiday Retirement Corporation in 2007.

Fortress also made significant bets on European property over the past few years. In particular, the firm invested heavily in Germany.

One of its boldest moves was to establish Eurocastle Investment, a publicly traded alternative investment vehicle which the firm refers to as a “castle”. However, this castle's foundations seem shaky.

Fortress listed Eurocastle on the Amsterdam stock exchange at the end of 2005 and in Frankfurt 18 months later with a broad mandate to invest in real estate across Germany.

Eurocastle owns about 580 offices, shops and other properties, many of which are in Frankfurt, the epicentre of finance in Germany. Shares in the company have mirrored those of Fortress itself, having seen almost all the value erode. They currently trade as low as €0.50 and €0.30 on the Frankfurt and Amsterdam exchanges, respectively, whereas they swapped hands in 2007 at €35 in Frankfurt and €45 on the Amsterdam bourse.

Wes Edens

Fortress' issues in Germany are particularly acute in the form of property firm Gagfah.

Fortress made a heavy bet on German residential property in 2004 when it acquired Gagfah for €3.5 billion out of Fortress Investment Fund III. In order to do so, the firm took on €1.4 billion of debt. It floated the company in 2006 and won plaudits for its timing and strategy, but the credit markets have once again been cruel. Recently Fortress needed to pay down $35 million of margin debt in Gagfah in addition to finding more cash for Eurocastle and another property-related investment, the US loan-servicing company Nationstar Mortgage bought in 2006.

According to reports, Fortress has taken the unusual step of asking limited partners whether they would consider making additional investments into Fortress Investment Fund III to help the group pay down debts on these investments. Bloomberg reports that Fortress has asked for a total of $80 million from LPs because the firm has already committed the capital from Fortress Investment Fund III, which raised $4 billion in 2004.

There has been a human cost of the credit crunch at Fortress too. Some 11 percent of the Fortress workforce has been axed in recent months. In Europe, one member of a large private equity firm remarked that two real estate acquaintances at Fortress had returned to the US.

Over at Intrawest, it has been a slightly different story, though. Fortress began cost-cutting almost immediately after acquiring the resort firm. The investors recognised that operating efficiency could be improved by reducing staff numbers.

It also identified other costs that could be stripped out, such as Intrawest corporate offsite days, conventions and entertainment surrounding business meetings at the resorts.

That is not to say that it has been easy getting to grips with the company.

Slope practice

As one insider told PERE, Fortress took quite some time to get its “head around” Intrawest because it had a very complicated structure.

In the early months, the Intrawest sales force was doing its best to achieve the magical 1,000-a-year target. Often they would contact Fortress people in New York about its clients potentially buying real estate at the resorts but that did not harvest many deals. The synergies were not quite as beneficial as originally hoped for.

In general, the source said his impression was that Fortress people were not that interested in the operation of Intrawest. Rather they were into financial engineering. “They are very good at operating efficiencies – and Intrawest is an example of that – but obviously the whole LBO strategy doesn't work unless everything is perfect and real estate prices continue to go to the moon. At the end of the day, the real estate part of Intrawest was a small niche market that was always going to be subject to market cycles. But they saw value there. The mountains, the resorts, they connected with it.”