The smoldering hedge fund

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.

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.

The period of 2005--08 may go down in history as the easiest in which to raise money in America. If you had the words "hedge fund" anywhere in your prospectus, it seemed, investors would fall over themselves to give you great wads of cash. It's no surprise that investors handed Plainfield $1 billion within months of its founding in May 2005.

Holmes, now 49, was a logical enough recipient -- a pedigreed investing veteran. He'd risen from modest beginnings in Plainfield, N.J. -- the inspiration for his firm's name. The son of a proofreader at the Newark Star-Ledger and a mother who was a librarian and high school German teacher, Holmes worked his way to an elite education: Harvard College, and both law and business degrees from Columbia University.

Holmes spent a few years as a big-firm lawyer, then switched to investment banking and rose fast at Drexel and then Salomon Brothers. During the '90s the Wall Street Journal once described him as the "bard of bankruptcies." By 2002 he had landed at hedge fund D.E. Shaw, where he excelled: The distressed-investing unit he ran returned 40.6% in 2003 and 34.6% in 2004.

Perhaps befitting the lawyer he once was, Holmes is analytical. "He was a very astute problem solver who looked at every angle," says a former Plainfield colleague. Where other hedge fund honchos enjoy flaunting their riches, and some former Drexelites seem to revel in their street-fighter images, the bookish Holmes craves intellectual legitimacy: Since 1993 he has taught a popular course on bankruptcy at New York University's Stern School of Business. And a year ago he proposed a solution for the financial crisis in a New York Times op-ed.

Despite his reserved demeanor, Holmes made clear that the buck stopped with him at Plainfield. He circulated "maxims," the most prominent of which was Investors are putting money in Max Holmes.

Holmes's firm first opened Plainfield Special Situations Master Fund, which would buy distressed investments and high-yield bonds and also make loans to businesses. Holmes knew a distressed fund wasn't going to excel in a booming economy. He hoped he could make large sums lending to businesses while biding his time until his big opportunity came during the next recession. He didn't know when that would happen, but he wanted to be ready. A year later he opened a second fund, Plainfield Direct, which would make more loans and, in theory, could later be taken public to provide liquidity.

Initially money flowed in, and for the first few years the Master Fund generated solid, though far from spectacular, results: In 2005, 2006, and 2007, it returned 2.8%, 15.5%, and 9.7%, respectively. Plainfield Direct generated 12.4% in 2006, then slumped to an anemic 2.4% in 2007.

Early on, a pattern of shoddy due diligence emerged, say two former Plainfield employees and three investment bankers who worked with the fund. Before long, Plainfield Direct saw two investments -- one tiny, one more substantial -- explode in public fashion.

The first was a scam dubbed "Vati-con" in the tabloid press. Raffaello Follieri -- who garnered as much attention for his then-romance with actress Anne Hathaway as he did for his alleged investing prowess -- claimed he would use his supposed Vatican connections to get sweetheart prices on church-owned land. Plainfield lost $3 million in the failed hopes of acquiring a church property located on, of all places, the Strip in Las Vegas. Plainfield hoped to turn it into a casino. But the fund rolled craps, and Follieri is now in prison.

That stumble was dwarfed by Plainfield's loss on Pay by Touch, a startup whose technology was intended to allow consumers to make purchases by swiping a finger over a biometric scanner. That company went bankrupt in 2007 after burning through hundreds of millions in financing; founder John P. Rogers was accused of blowing huge sums on parties and drugs. (Rogers's lawyer Steven Joffe denies any wrongdoing on his client's part and asserts that Plainfield contributed to the problems of Pay by Touch.)

After the controversy came news that Rogers had lost a suit for not paying employees in a previous business. He had also pleaded guilty to disorderly conduct in 1997. Plainfield's bottom line: $67.5 million of its investors' money reduced to a shrunken combination of equity and debt in the company. Plainfield and two investors have taken control and renamed the company YTAC Holdings.

Meanwhile, there were the disasters that didn't make the newspapers -- such as the miasma of the Bahamas land deal (which a source close to Plainfield argues was a good investment because the package came with a potentially lucrative casino license). Or the tens of millions Plainfield sank into a company called Green River Biodiesel, which ended in bankruptcy liquidation. Or the $11.2 million it loaned in 2007 to one William Lucia so that he could acquire property to develop. Lucia was later arrested on charges of racketeering and fraud, though his lawyer says the case was ultimately dropped. (Plainfield foreclosed on the property and is now trying to sell it at a deep discount.)

A source close to Plainfield defends the firm's due diligence, noting, for example, that plenty of others invested in Pay by Touch. "They're being paid to take risks, and they're going to make mistakes," the source says. "The goal is for the winners to be bigger than the losers." The source adds that most of the failed investments were small: "They didn't buy GMAC."

Not surprisingly, both of Plainfield's funds tumbled in 2008. Plainfield Direct dropped 33.4%. Given its troubles -- and the historic market collapse -- it's almost a miracle that Plainfield's flagship fund lost only 21.5% that year. Still, investors had already run for the exits.

Even as Plainfield's performance sagged, it began to face a rising tide of eerily similar lawsuits. Fortune reviewed nine such suits. The litigants were companies that had borrowed from Plainfield. The fund had entered the business of lending both to companies in distress and to healthy firms that are too high risk to get a loan from a traditional bank. Outfits like Plainfield, as lenders of last resort, typically charge 15% or more in annual interest.

The loans aren't for the faint of heart. Borrowers have to pledge the company's assets and often even the personal property of company executives. Hedge funds aren't in the habit of keeping the sorts of capital cushions banks retain to cover loan defaults.

Plainfield agreed to lend borrowers money. Then, the litigating borrowers charge, Plainfield ginned up pretexts to renege on its commitments. Different borrowers, for example, accuse the firm of announcing surprise audits with a single day's notice (and then deeming the borrower in default) or demanding tougher terms on a loan after the contract was signed. Such tactics put the companies under duress, the borrowers claim. After they defaulted, Plainfield swooped in and seized the company.

By contrast, Plainfield's legal papers allege that borrowers acted in bad faith, misappropriated or stole money, and misrepresented their finances. A source close to Plainfield says that those lawsuits account for only a small percentage of its loans and that most of its borrowers are satisfied.

Indeed, eight interviewed by Fortune echoed that view. "Plainfield is loyal," says Jeff Gural, chairman of Newmark Knight Frank, who partnered with Plainfield to start American Racing. "Our business lost $1 million a month for more than a year, yet Plainfield continued to fund us, and we stabilized."

Still, Plainfield's lending practices are now being examined by New York City's district attorney, according to five people who say they've been interviewed by investigators in the office. The case was sparked last year by Plainfield's borrowers, who hired Rob Seiden, a former assistant DA in New York who now specializes in financial-fraud probes at a private firm, Confidential Security & Investigations.

It's not clear what will result; spokesmen for the DA and for Plainfield declined to comment. Either way, Plainfield is managing to lend at sky-high interest -- and still lose money. Plainfield Direct, the fund that specializes in such lending, fell 9.8% through the first 11 months of 2009.

Perhaps Plainfield's biggest mistake was to be caught loaded with illiquid investments when the panic hit in 2008. According to the fund's audited financial statements, the flagship fund had 43% of its assets in hard-to-value investments at the end of 2007. (Part of that was a product of foresight: Holmes had begun reducing Plainfield's debt before the crash.)

By the fall of 2008, Plainfield faced a brutal squeeze: a market crash that was slashing the value of its assets even as panicked investors began trying to retrieve their money. (It didn't help that Plainfield had signed a $7.3-million-a-year lease at the top of the market -- about $80,000 in annual rent per employee -- for its Greenwich offices.)

Little was left for investors or borrowers -- by the end of 2008, 93% of Plainfield's assets were illiquid -- and Plainfield was compelled to prevent investors from leaving. For his part, Holmes was forced to endure the agony of being unable to invest during the big recession opportunity he had long awaited.

Plenty of hedge funds "gated" investors in the panic of 2008. But few continued charging the sorts of fees Plainfield is imposing. "A lot of managers have had total forbearance on fees while liquidating or while they have gates up," says Tanya Beder, whose firm advises institutional investors. Charging fees, she says, "isn't going to give investors a warm, fuzzy feeling."

Indeed, Plainfield has struggled to lure new money -- getting only about $95 million since June. To attract more, the fund will have to do well enough that people forget 2008. So far that's not happening. Its new fund (which opened on June 1) generated a 4.6% return through the end of 2009, compared with 19.7% for the S&P 500 during the same period. That means that for now, at least, Holmes is operating in his area of expertise: His own firm is a distressed asset.

--Reporter associate Doris Burke contributed to this article.