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Follow the Money: Plundered Fortress

Principals strip the hedge fund firm clean before the IPO.

When it comes to hedge fund company

Fortress Investments


, one thing's for sure: Chief executive Wesley Edens and the other principals didn't get where they are today by leaving money on the table.

Fortress went public two weeks ago and doubled in price on the first day.But what investors may not realize is that the five principals pretty much stripped the company clean just before the IPO.

I don't mean they cleaned up the balance sheet. I mean they cleaned out the vault.Page five of the prospectus shows they withdrew $446.9 million from the company in "cash distributions" last year.

Plus another $409 million in January.

They collected a further $888 million on Jan. 17 by selling a small stake to Japanese bank


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Oh yes, and they pocketed a further $22.8 million in the final weeks before this month's IPO.

A table buried on page 94 of the prospectus shows the remarkable facts. Between January 2005 and this month's IPO, the five principals of Fortress -- Edens, Peter Briger, Robert Kauffman, Randal Nardone and Michael Novogratz -- cashed out $1.04 billion."That does not include the Nomura transaction," adds company spokeswoman Lilly Donohue.

Total withdrawn in the two years before they took it public: $1.9 billion. Most of that was in the final few months.

This isn't just every penny that the company earned over that period -- it's a lot more.By the time the owners opened the doors to the investing public this month, the company wasn't just out of cash -- it had negative book value. Liabilities actually exceeded assets by $507 million.

In other words, the owners didn't just clean out the vault. They left a pile of IOUs -- and used the new money to balance the books.

When the overallotment is finally calculated, ordinary investors will probably have put in $685 million.

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Let's be clear. Edens and his partners have done nothing illegal. Let's even go as far as saying they did nothing unethical.

They sold a stake in the company to the investing public on an "as is" basis. And all this was disclosed in the prospectus. (So, too, by the way, is the company helicopter).

Caveat emptor.

The big problem with Sarbanes-Oxley is that even though it makes companies disclose facts in their filings, it cannot force people to read those filings. Especially when they run to 200 pages or more of fine print.

The emptying of the vault isn't the only interesting thing the prospectus turns up.There are, for example, various obligations that the newly public company still owes to the five principals.

For example, Fortress Investments has indemnified them for up to $283 million in investment management fees they may not have earned.

Those are performance fees that the principals have already pocketed from Fortress' private-equity and hedge funds, based on forecast returns. If the funds fall short of those forecasts, the principals may have to give some or all of that money back.

Now, thanks to the IPO, the money will come from the public company.

The obligations don't end there.

Even after the IPO, the principals will still own somewhere between 68% and 78% of the business, in the form of special units in the operating company. When the principals exchange these units in the future for ordinary shares, Fortress ought to get a tax benefit. The new shares, after all, will have a much higher tax-cost basis.

But according to the prospectus, whenever an exchange occurs, Fortress Investments has to hand over 85% of any tax benefit to the principal.

In cash.

As no one knows the value that shares will have when this occurs, you can't put a number on that obligation right now. But a fascinating footnote reveals just how big it may be.

The Nomura transaction alone, on a pro forma basis, raised the cost basis by $945 million. And that involved exchanging units for just 55 million new shares.

The amount of equity still to be exchanged: six times as much.

All of which is great news for people at the top of the company. The five principals own stock that is today valued at around $10 billion. There's another 51 million shares being handed out to key employees in the IPO. Value today: another $1.6 billion.

In keeping with TSC's editorial policy, Brett Arends doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Arends takes a critical look inside mutual funds and the personal finance industry in a twice-weekly column that ranges from investment advice for the general reader to the industry's latest scoop. Prior to joining in 2006, he worked for more than two years at the Boston Herald, where he revived the paper's well-known 'On State Street' finance column and was part of a team that won two SABEW awards in 2005. He had previously written for the Daily Telegraph and Daily Mail newspapers in London, the magazine Private Eye, and for Global Agenda, the official magazine of the World Economic Summit in Davos, Switzerland. Arends has also written a book on sports 'futures' betting.