The fall of a hedge-fund wunderkind

NEW YORK (Fortune) -- It was the sort of boom-era project that a developer had to love: 385 scenic acres in the Bahamas that would be transformed into a casino, hotels, luxury residences, a marina, and a golf course designed by Greg Norman.

For the developer, a Floridian named Roger Stein, and the main investors, a Greenwich, Conn., hedge fund called Plainfield Asset Management, it seemed like an exciting opportunity, with the added frisson of Norman's celebrity cachet.

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Max Holmes, founder, Plainfield Asset Management

Over the Martin Luther King Jr. holiday weekend in January 2008, as Norman showed up with his then-fiancée, Chris Evert, to celebrate the opening of the course, Stein held a gala dinner to mark the occasion and hobnobbed with Bahamian dignitaries and guests. The Plainfield team spent the next day on the links with Norman.

Despite the glamour of the moment, Plainfield's involvement seemed incongruous. The fund was founded in 2005 by Max Holmes, a prominent veteran of Drexel Burnham Lambert and D.E. Shaw who specializes in bankruptcy (and has taught the subject for years at New York University) and high-yield debt.

What was his fund doing using $88 million of investors' money to buy land in the Bahamas -- never mind doing so at the height of the real estate bubble with a developer who had never undertaken a project of such magnitude?

Two years later the property languishes, largely abandoned. The golf course is closed and the mortgage holder is foreclosing, raising the likelihood that the entire investment will be lost. The hedge fund is now locked in a bitter arbitration with its erstwhile partner over who is to blame for the fiasco.

Unfortunately for Plainfield, it's just one among many fiascoes. The firm, which a few years ago managed $5 billion, has faced a wave of withdrawal requests, which it contained only by invoking a contract clause and refusing to let investors withdraw their money.

Plainfield is now reporting that it oversees $3.3 billion. But about $2.74 billion of that represents money from those investors who weren't permitted to leave. That portion is being slowly wound down, and the investors will be released by 2012.

In other words, Plainfield is managing only $560 million from people who actually want the firm to run their money (and some of that consists of the assets of Plainfield employees). Plainfield continues to charge even the captive investors 1.25% or 2% management fees.

Plainfield is hardly the only hedge fund to struggle in the downturn; its flagship fund's 21.5% decline in 2008 was far from the worst. Unlike many of its peers, though, Plainfield failed to make a dramatic recovery in 2009, and its mediocre results only further piqued angry investors. The firm's woes show how, even for some sophisticated professional investors, the effects of the great financial crisis of 2008 will continue rippling forward for years.

Meanwhile, Plainfield is fending off suits from borrowers. Nine companies that received loans from Plainfield charge it with using underhanded tactics to force the companies into default and take control of their assets. Plainfield denies any wrongdoing. (So far, four of the cases have settled; five are still pending.) But the subject has reached the Manhattan district attorney, which is investigating Plainfield's lending practices.

Plainfield declined to comment on the record for this article. But interviews with 45 people, among them current and former employees, business partners, and investors in the fund, reveal that in many ways Plainfield is a casualty of the very investment boom that created it.

Despite its expertise in buying cheap, it launched in 2005 when asset prices were soaring, vacuumed up billions -- and then had to find something to do with the cash. Not only did Plainfield buy at the top of the market, it compounded that error by holding huge quantities of illiquid assets and striking some ill-conceived deals.

So when investors clamored to cash out, Plainfield was effectively forced to hold their money hostage. Holmes's best hope -- a dramatic turnaround that wins back his investors' favor -- hasn't come close to happening so far. The result is a slow, smoldering fuse that threatens Plainfield's future.

Read the full story of how Max Holmes' firm became a distressed asset.