Financial Services

Of Note:

“He could take a pile of napkins and figure out how to make money.”

Making money seemed to be simple for Fortress.

Fortress, like its peers, charged rich fees. A management fee of between 1 and 3 percent of the total assets under management, as well as “incentive fees”—20 to 25 percent of any profits.

“Many hedge-fund managers forgot the cardinal rule of hedge-fund investing, which is to protect investor capital during
down markets.”

“If I make a lot, you pay me. If I lose a lot, I don’t give anything back.”

Are hedge funds just a legal scam, in which investors pay through the nose for something that isn’t what it’s cracked up
to be?

The hedge-fund king is dead. Long live the hedge-fund king.


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Notes From a Cyber Trader


Over the Hedge

The five hotshots who took Fortress Investment Group public were worth billions at first. Today they look like arrogant showboats, and their story helps explain why hedge funds are imploding by the thousands—and why there’s still a truckload of money to be made.

by Bethany McLean April 2009

Fortress founders Randal Nardone, Wesley Edens, and Robert Kauffman

Fortress founders Randal Nardone, Wesley Edens, and Robert Kauffman, who, along with the two other principals, became paper billionaires in the company’s 2007 I.P.O. Photo illustrations by Darrow.

It used to be that to become a billionaire, rather than a mere millionaire, you had to inherit money, or build an empire that would last for a long, long time. But in the era that has just ended, you could become a billionaire just by managing other people’s money. You didn’t have to do so for very long—and, maybe, you didn’t even have to do so very well.

On February 9, 2007, a company called Fortress Investment Group began trading on the New York Stock Exchange. Fortress, which both runs hedge funds and makes private-equity investments, was part of the seemingly miraculous wave of money begetting more money, in which people who managed others’ fortunes made even greater fortunes for themselves. Those who thought they’d found a way to get in on the miracle snapped up Fortress’s shares. The stock had been priced at $18.50 the day before and promptly shot up to $35 when trading began in the morning. By the end of the day the five principals of Fortress—all youngish men who were present on that winter morning to ring the bell at the N.Y.S.E.—were worth a combined $10.7 billion.

The five Fortress guys hadn’t spent years toiling in obscurity to build their business. Fortress was founded as a private partnership only a decade ago by Wesley Edens, now 47, Randal Nardone, 51, and Robert Kauffman, 45. Edens, the C.E.O., is a cerebral, intense, very private wunderkind who made his reputation at Lehman Brothers—and a fortune for his firm—buying assets from the Resolution Trust Corporation. He made partner at Lehman when he was barely past 30. In 1993, he left “abruptly,” as the press described it, due to “philosophical differences with management.” He joined a prestigious money-management firm called BlackRock, split to spend a short year at the Swiss bank UBS, and then set up his own shop—Fortress.

In 2002, Edens, Nardone, and Kauffman were joined by Peter Briger Jr., 44, and Michael “Novo” Novogratz, 43. Both are Princetonians who became Goldman Sachs partners. Of Briger, someone who knows him says, “He could take a pile of napkins and figure out how to make money.” He is seen as a scrappy, tough trader type who knows how to play hardball in the often brutal world of distressed debt. His high-profile deals have included loans to both fallen New York real-estate mogul Harry Macklowe and Donald Trump’s struggling Chicago hotel project. As for Novogratz, a former college wrestler and army helicopter pilot, he’s the kind of guy who makes other guys “starry-eyed,” as a friend puts it. This is due to his great charm and his embrace of a lifestyle that more than one person calls “lunatic”—they mean it as a compliment—due to his love of partying. Indeed, sources say that, while Goldman Sachs wanted Novo’s considerable skills, the firm was nervous about his lifestyle issues, and the two parted ways.

Making money seemed to be simple for Fortress. And no wonder. While the five principals are seen by their colleagues as extremely smart—“these are not B-team guys,” says one—in recent years it was hard to lose, and Fortress, like its peers, charged rich fees. For instance, its hedge funds, which were run by Novogratz and Briger, cost investors a management fee of between 1 and 3 percent of the total assets under management, as well as “incentive fees”—20 to 25 percent of any profits. At Fortress, such fees for all of its businesses totaled over $1 billion in 2007, more than double than in 2005.

Peter Briger Jr. and Michael “Novo” Novogratz, who
joined Fortress in2002. Both are Princetonians and
former Goldman Sachs partners.

While the $10.7 billion the five principals made with the I.P.O. was only paper wealth, that didn’t really matter, because they’d already made fortunes from the business before they sold it to the public. They did so in three ways. First, they borrowed money, used $250 million of it to pay themselves a dividend, and used part of the I.P.O. proceeds to pay back the loan. Second, they sold a 15 percent stake to the Japanese bank Nomura for $888 million right before the I.P.O. Last, from 2005 until the date of the I.P.O., they distributed to themselves hundreds of millions from the accumulated fees that investors had paid. In other words, each man got an average of $400 million in cash even before the I.P.O. But the Fortress men are big believers in their own prowess. They say they took all that money—and more—and put it into the funds and investments they managed. And they still own 77 percent of the company’s stock. “We have invested more than we have taken out,” says Edens, in a rare interview. “We have bet on ourselves more than anyone else has.”

To go with their bravado, they lived a normal lifestyle—that is, “normal” by the rarefied standards of those who made their fortunes in finance. Edens has had an apartment on Manhattan’s Central Park West since his Lehman days, owns land in Montana, and bought an $18 million house on Martha’s Vineyard from J. Crew C.E.O. Mickey Drexler. Kauffman, who runs Fortress’s European business, bought into Michael Waltrip’s nascar team, valued recently at $86 million. Novogratz purchased Robert de Niro’s Tribeca duplex for $12.25 million—and then bought the apartment underneath to make a triplex. Briger built a 12,000-square-foot home in East Hampton in 2007 to add to his residence in Manhattan. A helicopter that is partially owned by Fortress, purchased before the company went public, sometimes shuttles Novogratz and Briger to and from the firm’s Manhattan offices. (The men say they reimburse Fortress for the expense.)

There are few better measures of the end of the era of easy money than the chart of Fortress’s stock, which went almost straight down after the I.P.O. On Wednesday, December 3, 2008, it plummeted 25 percent, to $1.87—a 95 percent drop from its opening-day high—after Fortress told investors that they would not be allowed to withdraw the $3.5 billion they had invested in Fortress’s Drawbridge Global Macro fund, which is run by Novogratz. By the end of October, the fund was 26 percent below its high-water mark; Briger’s fund had also suffered double-digit losses. The redemption requests, combined with the investment losses, would have brought down Novogratz’s fund, which had $8 billion in assets on September 30, to just $3.65 billion. The firm also canceled its dividend for the last two quarters of 2008. Bad jokes about “cracks in the Fortress” and “pulling up the Drawbridge” are now making the rounds on the Street.

Truth be told, in the hedge-fund universe, about the only thing that makes Fortress unusual is its publicly traded stock. The entire industry is reeling as investors pull billions from funds that have lost billions. (While private equity has its own severe problems—maybe more severe—investors don’t expect to get their money back for years, thereby delaying the day of reckoning.) According to the Chicago-based firm Hedge Fund Research, 2008 was by far the worst year for hedge funds since it began tracking the industry, in 1990. The average fund fell 18 percent—and for many top names, the numbers are even worse. The flagship hedge fund run by Steve Mandel of Lone Pine Capital, one of the most respected managers, was down 32 percent last year. “So many ‘smart’ guys had their heads handed to them,” comments one knowledgeable observer. Or as famous hedge-fund manager George Soros told Congress in testimony last fall, “Many hedge-fund managers forgot the cardinal rule of hedge-fund investing, which is to protect investor capital during down markets.”

Today, the burning question for most hedge-fund managers isn’t whether their industry will contract but, rather, by how much. Soros told Congress that the amount of money hedge funds manage would shrink by 50 to 75 percent.

The industry’s problem isn’t just bad performance. Regulators in both the U.S. and the U.K. made headlines by charging that short-selling by hedge funds—in which a manager bets that a stock will decline in value—helped cause the market’s crash. There’s also outright fraud, for which the poster boy is Bernie Madoff. While his operation wasn’t actually a hedge fund, the scandal has infused another dose of what-are-they-actually-doing-with-my-money fear into investors. Add to that Arthur Nadel, the Florida hedge-fund manager who allegedly bilked investors out of $300 million before fleeing. (The not-so-reassuring headline in Forbes: poof! another fund manager disappears.) While fraud may not be exactly the norm, the underlying paranoia is this: Are hedge funds just a legal scam, in which investors pay through the nose for something that isn’t what it’s cracked up to be?

There are many managers who argue that the industry’s problems are at least in part of its own making. Says Leon Cooperman, who founded the $3 billion hedge fund Omega Advisors in 1991, after a 25-year career at Goldman Sachs, “Hedge funds have shot themselves in the foot. They have not treated investors correctly.” Atop his list of sins: refusing to allow investors to take their money out, which is known in the industry as “gating” investors. Cooperman is not alone. Says Brooke Parish, senior managing director at the $9 billion hedge fund York Capital Management, “Someone worked hard for that money, and it’s someone else’s money. You give their money back when you promised it. I’m upset with the hubris, the lack of humility, the arrogance. It gives this industry a black eye, and it will take a long period of time to work through.”

Another manager tells me a story about Morgan Stanley’s annual hedge-fund conference at the Breakers, in Palm Beach, which was held the last week of January. In years past, every hedge-fund manager wanted a plum spot on a panel, so they could present themselves to prospective investors. This year, Morgan had to beg its clients to participate. Managers were reluctant not because they didn’t want—or need—the money, but because “no one wanted to be subject to a Q&A from strangers about why we all suck so bad,” as this manager put it. And those who worried were right to do so. “It was open warfare,” he says. He adds that the attitude from wealthy families was “Who are these bourgeois pigs who ripped us off?”

Another manager describes the mood at the Breakers as “pure, unbridled anger.” A source says one foreign investor at the conference declared, “These hedge-fund managers are like the Somali pirates!”—and he wasn’t kidding.

The Compensation Scheme

Contrast the Breakers with a scene from just a few years ago, when Goldman Sachs held its annual conference, this one aimed at so-called emerging managers—those who were supposed to be the industry’s new rock stars—in Miami, Florida. Over cocktails at the pool, there was chatter by those who had never run hedge funds of raising billions for their start-ups. After all, Eric Mindich, who made partner at Goldman Sachs at 27 before quitting that plum perch to start a hedge fund called Eton Park, had begun with $3.5 billion. The air at the conference, says one attendee, was a mixture of “money lust, arrogance, and am-I-going-to-get-mine anxiety.” (This year, Goldman Sachs canceled its conference.)
Citadel founder Kenneth Griffin’s net worth was
estimated at $3 billion in 2007. His firm’s two
main funds lost about 55 percent in 2008.

While hedge funds all manage money, they do so in very different ways. Some may invest solely in stocks, while others make bets on the direction of currencies around the globe. Many don’t actually “hedge” at all. What unites them is the way that managers are paid. Like Fortress, all hedge funds charge investors a certain percentage of assets under management, plus a cut of the net profits. The standard is “2 and 20,” or 2 percent of assets annually plus 20 percent of any profits. (As recently as five years ago, the standard was 1 and 20.) Some charge much more. Citadel, a well-known Chicago-based hedge fund, used to charge not 2 percent but whatever its expenses were, which could be as high as 8 or 9 percent of assets, plus 20 percent of profits. (Even after these fees, however, investors got an annualized return of 22 percent from 1998 through the end of 2007.)

For investors, it was supposed to make sense to pay so much more than the 1 percent of assets that a mutual fund might charge, because hedge funds were supposed to offer something that a mutual fund couldn’t. The macho hedge-fund men scorned the mutual-fund boys, who measured themselves by the wimpy “relative return”—how their numbers stacked up against the S&P 500. In contrast, hedge funds, including Fortress, aimed for “absolute return”—positive numbers no matter what the S&P 500 did. The idea was that a hedge fund limited your “exposure to market risks,” as Fortress puts it in financial filings. The setup was supposed to make so much sense that another industry—“fund of funds”—sprang up. Funds of funds sold investors a collection of hedge funds, and charged another layer of fees—usually 1 and 10—on top of the manager’s fees.

Some hedge-fund managers defend the loss of 18 percent of investors’ money as trouncing the S&P 500, which lost 37 percent in 2008. True, but that wasn’t supposed to be the goal. Cooperman calls hedge-fund compensation an “asymmetric fee structure”: “If I make a lot, you pay me. If I lose a lot, I don’t give anything back.”

Do the math,” says another veteran Wall Streeter. What he means is this: Assume you give a manager $100 million and he doubles it. The manager gets $20 million. The next year, he’s down 50 percent. Your $100 million is now $90 million, but the manager has $20 million.

Unfortunately, in flush times few did that particular math, and so, for wealthy investors, endowments, and pension funds, hedge funds became the new luxury must-have. And for smart youngsters—or those who thought they were smart—coming out of Harvard Business School, or with a few years on Wall Street, well, how else could you get rich so quickly? “The shocking thing was how easy it was to get in from 2002 to 2006,” says one longtime manager. “All you had to do was raise your hand and say I’ll take 2 and 20. That was the barrier to entry. It boggled my mind.”

In mid-2008, there were some 10,000 hedge funds, according to Hedge Fund Research—more than five times the number of companies listed on the New York Stock Exchange, and up from just 3,000 funds a decade earlier. Assets mushroomed from around $400 billion to about $2 trillion. Everyone wanted to be the next Eric Mindich—or the next Kenneth Griffin, who started trading when he was a sophomore at Harvard, and after graduation founded Citadel with $1 million of backing from a wealthy investor. At its peak, Citadel had some $20 billion in assets; Griffin’s estimated net worth of $3 billion made him 117th on the 2007 Forbes Four Hundred.

Such wealth didn’t make Griffin unique—on the contrary. By 2006 you needed to make at least $50 million to make Trader Monthly’s list of the top 100 traders, ranked by pay, on the Street. You needed $1 billion in annual earnings to crack the top five—and the top five were all hedge-fund managers. That year, the magazine—which suspended operations this February—gave up capping the number of hedge-fund managers who could make the list, because, the editors wrote, “we could no longer ignore the ever-widening chasm between hedge fund traders and the rest of the pack.” By the following year, the bottom-of-the-list haul had risen to $75 million. “The size of paychecks as they relate to performance got out of control, particularly in the last few years,” says Brad Balter, who runs a hedge-fund advisory firm called Balter Capital Management. “The numbers in many cases were staggering, and this is particularly frustrating in cases where performance ceased to matter.” As Balter points out, if a fund with billions under management took the standard 2 percent fee on those dollars, managers could earn fortunes regardless of their returns.

One requisite toy of the newly rich hedge-fund managers was expensive art. Steven Cohen, who runs the multi-billion-dollar fund SAC Capital, became the trendsetter when he paid $8 million in 2004 for British artist Damien Hirst’s shark in formaldehyde. He also owns two de Koonings that he bought from DreamWorks co-founder David Geffen for $63 million and $137.5 million, respectively, as well as works by Picasso, Warhol, Pollock, and Munch.

The other was expensive offices. In New York, the place to be was “the Plaza District”—the area stretching from Park Avenue to Sixth Avenue, just south of Central Park. A view of the park was coveted: “The park means power,” says Ben Friedland, a senior vice president at the real-estate company CB Richard Ellis, who does most of his business with financial-services firms. And the higher the floor the better. Evan Margolin, a managing director at Studley, another real-estate firm, which helps tenants with their commercial-real-estate requirements, says that over the last four or five years rents increased between 50 and 100 percent or even more in the Plaza District, depending on the building. At the peak, the most coveted space rented for more than $200 per square foot. (By this measure, Fortress was relatively conservative. Its offices on the 46th floor of 1345 Avenue of the Americas, four blocks from the park, cost some $8.4 million in rent in 2007, but the building is considered more corporate than high hedge-fund style.) After the crash of last fall, however, the Manhattan rent increases of the last few years have been all but erased, says Friedland.

Bankers once lined up to pitch hedge funds on selling shares to the public. One successful manager says he had no fewer than nine investment banks urging him to do an I.P.O. Cooperman, for his part, says he gave some advice for those funds that did go public: “I said to all of them, within five years you will buy yourself back at 20 cents on the dollar.” Indeed, while the few other funds that followed in Fortress’s footsteps have fared a tiny bit better, they certainly haven’t fared well. Both the Blackstone Group, a private-equity firm, and the hedge fund Och-Ziff Capital Management have seen their stocks fall more than 80 percent from their highs.

For old-timers, it was all a shock. “When I started a hedge fund, people asked me what I did. I said, ‘I run a hedge fund,’ and they said, ‘What’s that?’ This included people on Wall Street,” says one manager, who started his now multi-billion-dollar fund over a decade ago. “We got to a period in the late 1990s where if someone said to me, ‘Do you work at a hedge fund?’ I would have said, ‘Not as you know it. We hedge.’”

Jamie Dinan, C.E.O. of York Capital Management, says that, when he started, most of his friends thought he was nuts. If you graduated from Harvard Business School, as he did, you worked as a banker, not as a low-class trader. Initially, he operated out of a windowless office and figured that if things went well he might one day net some $200,000 annually from his management and performance fees. “I never dreamed this,” he says.

The Secret Sauce

It all begs a fairly simple question, which is: How could there have been as many great investors as there were hedge funds being started?

The short answer is there weren’t.

In the later years of the hedge-fund explosion, there weren’t any serious tests of a manager’s prowess, because it was so easy to make money. In addition, David Kabiller, a principal at AQR Capital Management—a roughly $20 billion hedge fund founded by Goldman Sachs alums Kabiller, Cliff Asness, John Liew, and Robert Krail—points out that there isn’t any way to measure most hedge funds. While any investor in a mutual fund can glance at the S&P 500 to get a yardstick of how well his fund manager is doing, a hedge fund with a more esoteric strategy is harder to measure. “If there aren’t any benchmarks, then you can’t be discovered,” says Kabiller.

As money flooded in, even those managers who did something unique soon found billions of dollars copying them. That reduced the available returns. In response, some managers began to hunt off the beaten paths and buy more exotic stuff—stakes in private Chinese companies, or securities based on mortgages, for instance—that wasn’t as “liquid” (meaning it couldn’t be sold as easily) as a stock.

And there was a secret sauce that washed away all sins: debt. The cost of borrowing money was so insanely low that a hedge-fund manager could make a trade that would earn only a sliver of a return, and then juice that return by using a truckload of borrowed money. As the money rolled in, many young managers thought they were geniuses. Or as Keith McCullough, who sold a hedge fund he founded and then started a research site for investors called Research Edge, says, “Some of them actually thought it was due to their intelligence, and not just the cycle.”

While some funds resisted the siren call of debt, Fortress, for the most part, wasn’t one of them. Its financial filings note that “the funds we manage may operate with a substantial degree of leverage.… This leverage creates the potential for higher returns, but also increases the volatility.”

As another hedge-fund manager tells me, Warren Buffett brilliantly predicted that there would be a day of reckoning: “You only learn who has been swimming naked when the tide goes out.

A Series of Unfortunate Events

Fortress’s stock, which had sunk to $10 by August 2008, should have been a sign that the tide was going out. But few hedge-fund managers were adroit enough to head for shore.

“You know the children’s books ‘A Series of Unfortunate Events’?” Jamie Dinan asks me. “Horrible, horrible things happen in those books. That’s how I feel about last fall.”

Another manager tells me that his fund was down 2 percent at the end of August. By October, he was down 26 percent. “We have great confidence in our analytical ability, and when the world is panicking, we stand up,” he says. “In retrospect, I should have panicked.

As the investment banks that provided the debt began to fight for their own survival, those hedge funds that depended on it were faced with margin calls. But even funds that weren’t debt-laden were hit with problems from the banking panic. To reduce their risk, many funds began to sell their positions and move to cash. For example, the stock holdings of Atticus Capital, whose co-chairman is Nathaniel Rothschild, fell from $8.1 billion at the end of June to just $510 million by the end of September. In addition, just as you wouldn’t want your money at a bank that goes under, hedge funds didn’t want to be trapped at a firm that went under, so they moved their money to banks they thought were safer. In order to do so, they had to sell their long positions and get out of the short positions, driving down the price of the former and driving up the price of the latter—thereby exacerbating the selling pressure.

In a way, hedge funds were eating one another alive. As managers sold their positions, some discovered, as one manager puts it, that “all our names were owned by the same guys. We had become the market. When I ran for the exits, all the buyers who should have been there were doing the same.” During the third quarter, a Goldman Sachs index which tracks stocks that are heavily owned by hedge funds lost 19 percent, more than twice the decline of the S&P 500, while another Goldman Sachs index that tracks stocks which hedge funds were likely to sell short actually gained 2.4 percent, according to a Cambridge Associates LLC report. “Hedge funds were shooting at each other,” says one manager, meaning that some funds would make bets against stocks that were heavily owned by other managers.

And then there was the September 2008 bankruptcy of Lehman Brothers. Not only did that roil the market further—it caused a particular problem for hedge funds. Because the U.S. actually has fairly strict rules about the amount of debt you can use, many funds had set up offshore accounts—sometimes with Lehman London—where the rules were far laxer. What they failed to understand was that bankruptcy rules are also different in London, and that they wouldn’t be able to get their money out. One manager estimates that roughly half of the hedge funds in existence had at least some exposure to Lehman London.

At the same time, hedge funds found themselves becoming a scapegoat for the problems in the market. “We are the whipping boys,” says one executive. The C.E.O.’s of investment banks including Bear Stearns, Lehman, and Morgan Stanley blamed short-selling by hedge funds for the declines in their stock—no matter that these banks had previously made a lot of money from the industry, and that Morgan Stanley’s C.E.O., John Mack, had once worked as the chairman of a hedge fund—Pequot Capital. On September 18, New York attorney general Andrew Cuomo announced an investigation into whether traders illegally spread rumors to drive down the stock prices of financial firms, and likened the activity to “looters after a hurricane.” On September 19, the S.E.C. temporarily banned short-selling in a list of almost 1,000 finance-related stocks. A few days later, the agency ordered more than two dozen hedge funds to turn over records as part of an investigation into whether traders were spreading rumors to manipulate share prices downward.

Although Cuomo was careful to single out illegal short-selling, some managers took it as a criticism of the industry. So one manager was surprised to get a call from Cuomo’s office, shortly after the announcement, inviting him to lunch at the Core Club (a Manhattan venue opened three years ago for “leaders” willing to part with a $50,000 initiation fee). The suggested campaign donation: $1,000. When he arrived, he battled for elevator space with other hedge-fund managers. “It was the hedge-fund community of New York,” he recalls. Cuomo told the assembled managers that, if he were an investor, he would have sold housing-related stocks short as well. He also told them that they needed a Washington lobbyist because the industry lacked a voice. (One manager who was at the event emphasizes that Cuomo had targeted only illegal short-selling, and was right to launch an investigation into that.)

By mid-October, rumors that Citadel—which also depended on debt—was in trouble began to sweep through the market. On October 24, more than 1,000 listeners crowded onto a conference call in which Citadel said that its two largest funds were down 35 percent due to the “unprecedented de-leveraging that took place around the world,” as C.F.O. Gerald Beeson described it. Citadel finished the year with its two main funds down over 50 percent (although smaller funds were up more than 40 percent), and it told investors it would suspend redemptions in them until the end of March, at which time it would re-evaluate market conditions. (Citadel did reimburse investors for most of the fees they paid in 2008.) Other big-name funds, including Thomas Steyer’s Farallon and Paul Tudor Jones’s BVI Global, also limited redemptions. Even Über-trader Steve Cohen’s SAC Capital put a chunk of investors’ money in a “side pocket,” meaning that they can’t take it out, although SAC did say it would try to get people their money in 2009.
SAC Capital founder and chief Steven Cohen,
whose fabulous art collection includes works by
Picasso and Pollock.

Managers who employ gates defend the practice on the grounds that it’s within their legal rights, and that selling their positions to meet redemption requests would be unfair to those investors who wanted to stay. But the widespread impression among investors is that managers broke a social contract and are doing it to save their own skins. And there may be another reason for the gates. Fortress’s documents, for instance, disclose that “our funds have various agreements that create debt or debt-like obligations … with a material number of counterparties. Such agreements in many instances contain covenants or ‘triggers’ that require our funds to maintain specified amounts of assets under management.” (The firm says it renegotiated those deals, and has already returned 70 percent of investors’ money. The rest of it will be paid out over the next 18 months.)

Other hedge-fund managers who do not employ gating are outraged, in part because the practice has hurt them. “It is the stupidest thing I have ever seen my industry do,” says Jim Chanos, who runs a well-known hedge-fund firm called Kynikos Associates, which specializes in short-selling. “It’s given rise to the worst fears—that hedge funds are a roach motel.” He also says that, while his fund was up more than 50 percent last year, he has gotten redemption requests for 20 percent of his assets—not because investors want to cash out, but because they can’t get money anywhere else. “I am an A.T.M. machine,” he says, in a comment that was repeated to me by many other managers.

Others in the industry also say that preventing investors from taking their money out is nothing short of an admission that the assets in the fund can’t be sold as they are currently valued. One manager tells me that he has a debt security that he is valuing at 50 cents on the dollar. He knows another fund that is marking the identical security at 90 cents on the dollar.

This means that the headline number for the industry—down 18 percent—may not be an accurate read. (In fairness, this is probably not an issue for hedge funds that deal mostly in actively traded securities.) One manager laughs when I ask him if 18 percent is really the right number. “It’s way worse,” he says. “Way worse.

Whether they’re down 18 percent or more, many managers are subject to so-called high-water marks, according to which they agree to waive performance fees until they have made back investors’ money. This can make it hard for a fund to stay in business, because there’s no money coming in to pay employees. As Fortress’s filings note, some of its funds “face particular retention issues with respect to investment professionals whose compensation is tied, often in large part, to performance thresholds.”

You might ask where these people are going to go. “There is a purge on Wall Street,” says York Capital’s Parish. “The new dream job is a salary, health care, and Jamie Dinan buys you lunch every day.”

“Five years ago, if you’d gone to start a fund, people would have fought over you,” says another manager. “Now they won’t return your phone call.”

Nor is it clear when the purge will be over. In the coming year, private-equity firms will ask investors to pony up more capital, which will force more redemptions from hedge funds. People may also try to redeem in order to pay their taxes. “No silver lining in any of this cloud,” says a hedge-fund trader. “The first quarter of 2009 is going to be another eyepopper for the industry.

As another manager says to me dryly, “The new $500 million is $50 million.

It isn’t clear what the future holds for Fortress. In my admittedly 100 percent unscientific survey of the industry, I found that redemption requests are usually unrelated to the size of a fund’s losses, and may have more to do with how investors feel about a particular manager, or about their need for cash.

While there are complaints that the Fortress principals are arrogant, there are clearly a lot of people who are willing to trust them with their hard-earned cash. Even during the meltdown of 2008, the firm raised a net $6.2 billion in new capital for its funds, a figure that includes $3 billion Briger raised during the tumultuous month of November.

Some of those familiar with Fortress say that while in the good times the people who worked there got along—who wouldn’t, when the money is flowing?—the culture has turned brutal. “Hell,” one hedge-fund manager puts it succinctly. Just before things turned truly rotten, Fortress committed more than $300 million to the film finance company, Grosvenor Park, which last summer released the genre spoof Disaster Movie. “I think they are starring,” jokes a former investor.

But, for now, it appears that the principals are sticking together. Fortress’s filings note that several of its funds have “keymanprovisions, meaning that if one or more of the principals ceased to be actively involved in the business, that could give investors the right to get their money out—and, in the case of some of the hedge funds, might result in the acceleration of the debt. There are rumors that the principals might, as Cooperman predicted, buy their company back from the public. But it isn’t clear how they’d repay the $675 million in debt on the balance sheet at the end of the third quarter.

Fortress, for its part, denies any issues. “I have known Pete [Briger] for 15 years. I talk to Pete 20 times a day,” says Edens. “Any notion of divisiveness or a split is absurd.” Nor, in truth, does Edens seem like the kind of guy who would give up easily. He comes in early in the morning, works until late at night, and often spends his weekends at the office. He’d be the first to say that he doesn’t cure cancer or teach kids to read, but as he puts it, “I do take pensioners’ money and try to give them back a good return.”

For those basking in Schadenfreude—and, oh, it’s hard not to—it is unlikely that hedge funds are going away. “Our cynicism has bounds,” says AQR’s Asness. “We don’t think that no one has skill. It’s just that skill is more scarce than the hedge-fund industry sold it as.” There are plenty of funds, from the well known to the not so well known, that did just what they promised, even last year. Star manager Bruce Kovner’s Caxton fund returned a reported 13 percent. The tiny Bearing Fund, which is managed by Kevin Duffy, returned 72 percent in 2007 and 134 percent in 2008—net of fees.

And even for the funds that did lose big sums, some have loyal investors who have made enough over time that they’re willing to forgive one bad year. One manager, who posted a loss of more than 20 percent last year, says that 82 percent of his investors have been with him for more than five years. “I have gotten more handwritten notes saying, ‘Hang in there,’” he says. Another manager points to Steve Mandel, of Lone Pine Capital, who lost money last year—but got requests for only a sliver of the capital he manages. “That says it all,” says another manager.

Says Cooperman, despite his criticism of the industry, “They weren’t the gods you made them into, but they aren’t the whale turds they’re being portrayed as now.”

It’s also worth noting that, despite all the problems in hedge-fund land and the clamor for more regulation (and there will be more regulation), you don’t see any hedge-fund managers in Washington with their hands outstretched for a piece of the bailout pie.

Some managers, like Edens, even argue that, for those who survive the current shakeout, the future is more golden than ever before. After all, many hedge funds are gone, as are the in-house trading desks at many Wall Street firms that served as competitors to hedge funds. Meanwhile, opportunity abounds.

The hedge-fund king is dead. Long live the hedge-fund king.

Bethany McLean is a Vanity Fair contributing editor.


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