Six months into 2015, the mergers and acquisitions in the private equity real estate industry just keep on coming. Whether it be take-privates of US REITs such as Brookfield Asset Management’s deal for Associated Estates and Lone Star Funds acquiring Home Properties, or takeovers of real estate asset management platforms like Sun Life Financial buying Bentall Kennedy, it has been a busy year for sure.
But Mount Kellett Capital Management’s merger with Fortress Investment Management, stands to be an M&A deal unlike any other this year. It’s not every day, after all, where a general partner willingly hands over his firm after making a series of money-losing investments.
The transaction, which was days away from closing at press time, is complicated and unconventional for multiple reasons, not the least of which is its structure. Although Fortress is assuming Mount Kellett’s funds and business, its acquisition of the New York-based hybrid hedge fund/private equity real estate firm isn’t a straightforward purchase.
Instead, Fortress, through some of its funds, is investing a total of $200 million across Mount Kellett’s three investment funds, and in doing so, is becoming a special limited partner of those vehicles. With this capital outlay, Fortress will become a co-manager of the funds and share investment decision-making with Mount Kellett. The two firms also will split management and performance fees.
Additionally, the majority of Mount Kellett’s employees will become part of Fortress, which will need investment professionals and other staff to help manage the Mount Kellett funds. Mount Kellett has been downsizing some 30 positions over the past few months, with approximately 70 employees expected to transfer to Fortress. The firm’s real estate team, however, is said to be largely unaffected by the staffing cuts.
Mount Kellett’s general partners, who include co-founder Mark McGoldrick and chief operating officer Jonathan Fiorello, will not become Fortress employees, but will continue working with the firm until the Mount Kellett funds have been harvested. Any potential role that the general partners may have at Fortress beyond that point has not yet been determined.
With this deal, McGoldrick, who doubles as managing principal and chief investment officer, is effectively shuttering the firm that he founded only seven years ago.
Bad energy bets
What precipitated this turn of events were the heavy losses that Mount Kellett’s funds sustained after oil prices began to dramatically decline late last year.
The energy investments stood to be unprofitable, which did not bode well for the performance of the firm’s three funds. Each fund, after all, had some energy exposure, and energy investments accounted for approximately 20 percent of the firm’s overall portfolio. The energy losses made it unlikely that the firm would be earning a promote or raising a new fund anytime soon – which raised the risk of its acquisition professionals leaving.
“When a firm isn’t growing, which was the reality that Mount Kellett faced, and a firm is not into their carry, they’re going to start to lose investment people as well as be perceived by the market as a wounded animal out on the savanna,” said Eric Dillon, chief investment officer and co-founder of Silver Creek Capital Management, a Seattle-based hedge fund of funds that is a longtime Mount Kellett investor leaving.
Mount Kellett, which has specialized in opportunistic investing and special situations involving companies that are undergoing a spinoff, restructuring or bankruptcy, therefore found itself in circumstances not unlike the troubled firms it often has targeted. Rather than continue operating Mount Kellett independently and have his firm’s positions be vulnerable to attack by distressed or opportunistic buyers, however, McGoldrick instead chose to take matters into his own hands, and called up his old friend, Fortress principal Peter Briger, in late February. Soon after, McGoldrick flew out to meet with Briger at the latter’s offices in San Francisco, and by May, the two had struck a merger agreement.
McGoldrick’s loss of his business stands in stark contrast to his days at Goldman Sachs, where he earned the nickname ‘Goldfinger’ for running one of the most profitable units at the investment bank, its special situations group. In fact, at one point during his tenure, he was one of the highest-paid employees at the company.
McGoldrick was hired by Briger to join Goldman in the 1990s, and together the two founded the special situations group in 1997. Although Briger left Goldman in 2002 to launch Fortress’ credit business, the two continued to make investments together, first through Fortress and Goldman, and later through Fortress and Mount Kellett, which McGoldrick founded with Jason Maynard, a fellow Goldman alumnus, and Blake Hutcheson, his former colleague at CIBC, in 2008. Hutcheson left Mount Kellett to head up the real estate arm of the Ontario Municipal Employees’ Retirement System in 2009, while Maynard retired from the firm last year.
Over its seven-year history, Mount Kellett raised three funds, including the $3 billion Mount Kellett Capital Partners Fund in 2009 and a $4 billion successor vehicle in 2012. The firm also had targeted $4 billion for Mount Kellett Capital Partners Fund III but fell short of its equity goal, partly because of the firm’s troubled energy investments.
Although Mount Kellett has made new acquisitions in recent months – including the purchase of the Astro Park office tower in Frankfurt, Germany in February – the firm primarily has been focusing on exiting its real estate investments, for example 55 West Monroe, a 40-story office tower in Chicago, to John Hancock in February, February, and a 50-property Extended Stay hotel portfolio in southern US to Starwood Capital Group in May. Mount Kellett has fully harvested its first fund and together with Fortress, will continue to harvest its second fund and invest its third.
In multiple ways, the merger between Fortress and Mount Kellett made sense, given the similarities in the two parties’ investment strategies, which are focused on special situations, particularly in credit and global real estate. The firms also overlap geographically, with both having offices in New York, London, Dallas and Hong Kong.
According to Dillon, Mount Kellett’s investment funds and operating platform will benefit from Fortress’ substantially greater scale as an investment manager. Fortress currently has $69.9 billion in total assets under management, and of that amount, $13.8 billion is invested in credit, which is one-third composed of real estate assets. Those assets under management are poised to grow further, as the investment management firm recently closed on a total of $1 billion for its latest property fund, Fortress Real Estate Opportunities Fund II, last month. By comparison, Mount Kellett manages approximately $5 billion in assets, with about half in property investments.
“The Fortress infrastructure, team, skill set and stability will greatly enhance the runoff value of Mount Kellett portfolio,” said Dillon. “From this point forward, what’s changed is that we have a better shot at higher residual values in these underlying investments due to the combination of the Fortress and the Mount Kellett teams.”
However, Fortress also stands to gain from the deal, primarily in acquiring additional manpower and expertise to bolster its 80-strong real estate team. PERE understands that while energy was a problem area for Mount Kellett, the firm was a strong performer in real estate. “The real estate portfolio and professionals are excellent,” said one person familiar with the firm. “The The returns are what you would see in the best real estate fund management companies.”
Facing the music
Dillon is quick to highlight McGoldrick’s personal integrity in his decision to voluntarily give up his firm in the best interests of both his investors and employees – a rarity in the investment world.
“It takes a lot of courage to face the music that this would be a better situation for your investments,” said Dillon. “I give him high character marks, which is counter to human nature. Human nature is to shade unpleasant situations and not realistically assess a situation, to be hopeful and even delusional about the future versus being very rational about what the right thing to do is, especially when your name’s on the door. It’s a real high character move.”
In Dillon’s view, McGoldrick’s ill-timed energy investments were aberrations in an otherwise long career as an excellent investor. Moreover, he adds: “Making a few bad investments over the course of a long career does not make one a bad investor, but the real mark of character is what you do when that happens.”