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When Hedge Funds High-Flyers Crash

Date: Thursday, March 5, 2009
Author: DealBook, The New York Times

Not that long ago, hedge fund managers oozed money and power, snapping up contemporary art like chewing gum and basking in attention from investors eager to part with their cash.

It’s a different world now. In the latest issue of Vanity Fair, Bethany McLean looks at how hedge funds have lost their luster, racking up huge losses as their super-secret trading strategies proved no match for markets gone wild.

Once revered as the smartest guys in the room, many of these fund managers have become targets of scorn; the article describes “pure, unbridled anger” at the exclusive Breakers hotel in Palm Beach.

Not all hedge fund firms are floundering, of course. But the pain is widespread, with even well-established fund managers being forced to halt redemptions to avoid a fire sale of their assets.

And the recent flurry of frauds, like the one Bernand L. Madoff is said to have done, aren’t helping the industry’s reputation any. Ms. McLean writes:

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?

Meanwhile, the huge fees that hedge funds collected in the good times don’t need to be returned. That’s because the traditional hedge-fund fee structure is asymmetric. Leon Cooperman, who founded Omega Advisors in the early 1990s, described it to Vanity Fair this way: “I make a lot, you pay me. If I lose a lot, I don’t give anything back.”

We now know that much of the success enjoyed by hedge funds in recent years wasn’t because of above-average investing skills. With the market buoyant and debt cheap, running a fund seemed almost as easy as raising one’s hand and asking for money. Borrowing additional cash allowed hedge-fund managers to amplify tiny gains into enormous ones — at least until the markets went haywire, and all these me-too funds started selling the same securities at the same time.

The article uses Fortress Investment Group as its main example of this shift, in part because, as one of the few publicly traded hedge fund firms, its troubles are particularly easy to see.

The founders of Fortress, including Wesley Edens, the firm’s chief executive, became paper billionaires overnight when the firm sold its shares to the public. But the stock has basically traced a steady decline since then, much to the chagrin of Fortress’ shareholders — and the founders, who own much of its stock.

“We have invested more than we have taken out,” Mr. Edens tells Vanity Fair. “We have bet on ourselves more than anyone else has.”