Bryan Kloster sends:
-Blackstone (BX) has an IPO at $30 earlier this year and has plummeted since then nearly 30%.
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-Fortress Investment Group (FIG) has had similar issues, starting trading on its IPO day at $35; shares closed at half that price today.
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Following months of weakness in the alternative asset managers, I believe that investor sentiment has improved recently on the heels of a
partial recovery in the credit markets. While BX has bounced back from its lows, I continue to view it as attractive at current levels and believe it has the potential to outperform in the near-term. Shares of both BX and FIG have struggled over the last 3 months, as investors have grappled with concerns over a deteriorating financing environment for the private equity business as well as potential tax increases. While I acknowledge both of these concerns, they have not had much of an impact on how I view the shares, as I have taken a longer-term approach to valuation, valuing both BX and FIG using a DCF on the basis of expected dividends over the next 10 years and a perpetuity growth rate thereafter. I am certain that the assumptions in my DCF reflect both the risk around taxation (I’m effectively building in a 50% likelihood of a tax rate change) and more normalized returns in private equity that I believe both companies can achieve over the life of an investing cycle. Nevertheless, even though current events do not necessarily impact my valuation methodology, I certainly recognize that they can drive short-term stock price performance. And while the aforementioned concerns have been putting pressure on the stocks over the last few months, sentiment has recently improved on the heels of a partial recovery in the credit markets.

Both BX and FIG have bounced back from their lows on September 7, up 21% and 30%, respectively, since then versus a 6% gain in the S&P 500. I still view both stocks as attractive at current levels, and given the positive change in sentiment, they have the potential to outperform in the near-term.
Overall the credit markets are healing, though not fixed, at this point. The $9.4 billion sale of leveraged loans related to First Data last week at $0.96 on the dollar is an encouraging sign that the credit markets are slowly starting to re-open - but slowly is the keyword here. The $9.4 billion represents less than half of the $24 billion in debt related to that LBO that ultimately needs to get sold. Just a few months ago, even a deal of this size would have been much easier absorbed by the market. Furthermore high yield issuance has slowly started to increase again. In a surprising move, the Fed cut the federal funds rate to 4.75% recently, demonstrating that it is willing to actively fight the risk of a recession. As a result overall interest rates, such as the benchmark LIBOR rate have come down significantly, which should benefit borrowers such as private equity firms.

Demand for Alternative Asset Management Remains Strong
In July, Fortress announced the closing of the Fortress Investment Fund V and Fortress Co-investment Fund V, with a final total of $5 billion in third party capital commitments. Other private equity firms have continued to see demand for their funds as well. In September, Carlyle closed its Carlyle Europe Partners III fund at 5.35 billion ($7.6 billion). Several firms, including Apollo, Carlyle and KKR, are currently on the road to raise buyout funds in excess of $10 billion. Furthermore, the firms are modifying the investment approach across their businesses to accommodate a shifting investing climate. In response to current shifts, the firms are looking to source investment opportunities that expand beyond traditional private equity. This could include loans and capital infusions to companies that are having difficulty getting financing in this difficult funding market, as well as distressed debt securities. Several distressed debt funds have been set up across the industry recently. I believe that the appetite for hedge funds remains strong as well. As an example, Man Group just announced last week that asset inflows have been remaining strong over the last few months. Lastly, I believe that both BX and FIG are well positioned to react quickly to a changing investing climate, due to their significant amount of proprietary investment funds, which are the result of their recent IPOs.

Potential for Tax Rate Change
I do not believe that the risk around a potential tax rate change for the industry has changed significantly over the last few months. To reiterate, I already reflect a 50% likelihood that tax rates will rise in my earnings models for both BX and FIG. However, I believe that the industry potentially entering a slow patch could shift the attention of lawmakers to different issues for the time being.

Valuation Methodology:
I have valued Fortress using a DCF on the basis of expected dividends over the next 10 years and a 4% perpetuity growth rate thereafter. I am using a 12% discount rate to get to my price target of $35. The $33 price target implies 24.1x my 2008 distributable EPS forecast of $1.42.

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