Shares of Fortress Investment Group (FIG) are trading higher today after comments made at the Goldman Sachs (GS) US Financial Services conference. The private equity company has benefited from the equity market rebound and the return of liquidity to the global investment universe. As I write, the stock is up more than 7% after CEO Daniel Mudd spoke at the conference this morning and told investors that they are seeing more demand for their private investment funds.

Fortress has seen its stock plummet over the past year as funds that the company managed took on losses while at the same time, investors pulled capital out due to the poor returns. This is the nature of private equity – it can often be a boom and bust business model even though funds are usually structured to be absolute return vehicles. When a fund or family of funds are performing well, the company recognizes very attractive incentive allocations (FIG gets to keep a portion of it’s investor’s profits) and at the same time, new capital comes pouring in.

However, when these funds face a few months of poor performance, investors pull capital out resulting in a smaller pool of capital available to generate gains. At the same time, the poor performance puts the funds below their “high water mark” and that level must be reached again before the fund can charge any incentive fees on investors who are simply making their money back. So even in a rebounding market environment, companies like FIG will see their profitability lag because it takes time to make up past losses on their investments.

But we are likely in the early stages of another boom in the private equity market and for Fortress particularly. There are two factors feeding this new wave of profitability which could quickly lead to a sharply higher stock price. First, the company isseeing new investment capital come in the door. Keep in mind that this capital does not have a high water mark. Gains on these new investments will immediately lead to FIG taking a portion of the returns as their own profit. In the past few months, FIG raised $500 million in a portfolio designed to invest in the Japanese real estate market. Other new fund launches will likely allow the company to substantially increase their Assets Under Management (AUM)

The second factor is that existing funds are nearing their high water marks. So while the funds have been struggling to make up past losses, these assets have basically been adding very little to FIG’s profits. But once the magical high water mark is hit, immediately new gains will tie directly to increased profits. As expectations ramp higher, the stock price will likely get a lift and potentially run several hundred percent higher.

Currently, analysts are expecting FIG to earn 28 cents in 2009 and 45 cents in 2010. This means that the stock is currently trading below 10 times next year’s expected earnings. To be fair, these earnings estimates are not very reliable. It’s extremely difficult to handicap exactly how well the company’s funds will do and what type of incentive allocations will be generated. But I do think that the Wall-Street analysts are excessively conservative given the difficulty we have experienced over the last year.

FIG is not an investment that you should make with your “safe” capital. In many ways, this is a risky bet that could go bust, or could pay off big. If the market experiences another decline (which I think is possible) its likely that the funds will be better prepared to handle the turbulence. But there’s no guarantee that they won’t lose money in the funds resulting in much lower revenue. However, there is a good chance that FIG will have some of its funds make wise investment decisions (short or long) which will yield significant profits and push earnings up significantly. A little confidence could go a long way and if FIG realized a multiple of 20 on earnings of 75 cents we would have a return of roughly 275%.

So consider taking a shot at FIG – buy a few speculative shares and tuck them away for 6 to 12 months. The potential is great and you are only risking roughly $4.20 per share.

FD: Author does not have a position in FIG

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