More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  At the end of 1999, Robertson’s tone began to telegraph that the end was indeed coming. He pleaded with his investors that a great technology can change people’s lives without necessarily generating profits for investors. He pointed out that the managers of the companies in Tiger’s portfolio were buying their stock back, suggesting that they regarded their own equity as cheap, whereas managers of tech firms were eagerly selling stakes in their own enterprises. “We are in wild runaway technology frenzy: meantime most other stocks are in a state of collapse,” he wrote in December. “I have never seen such a dichotomy. There will be a correction.”32 The next month Robertson uncorked his frustration at the behavior of an “irrational public.” “This is the public that in the month of December drove the unprofitable companies in the NASDAQ up some 38 percent. There has to be a day of reckoning.”33

  The day of reckoning did come, shortly after Robertson predicted it. On March 10, 2000, the NASDAQ crested, and over the next weeks the air whooshed out of one of history’s great bubbles. But the turn had come too late. By the time the NASDAQ began to fall, Robertson had made his decision to get out, and he was too beaten up to change it. On March 30, with the NASDAQ already 15 percent off its peak, Robertson broke the news to his investors. After months of assuring them that there would be light at the end of the tunnel, he confessed that he was sick of waiting for it. Rational measures of valuation had taken a backseat to “mouse clicks and momentum,” as Robertson put it, and he had no stomach for more punishment. Because of capital withdrawals by his investors, the market had stayed irrational longer than he had stayed solvent, just as Keynes had warned. It was time to bring the curtain down on Tiger.34

  WHILE TIGER SUFFERED THROUGH THE LAST PHASE OF the bubble, Quantum had enjoyed a nervous sort of victory. The terrific technology profits of late 1999 had rescued Druckenmiller from the humiliation of a down year, but anyone could see that the run would end eventually. At Quantum’s weekly research meetings, Druckenmiller would worry that the bubble could burst any time; and the discussion would revolve around how the bust might be anticipated. As if to reinforce his nervousness, the tech-heavy NASDAQ index fell sharply at the start of January, then turned around and vaulted to new heights; the volatility was hair raising. At one point in February, while watching a biotech firm called Celera Genomics skyrocket, Druckenmiller told a Quantum trader that the market was insane. He needed to get out quickly.35

  “I just want you to know, I’m selling everything out,” Druckenmiller told Soros. “This is fucking nuts.”

  “I’m really glad you’re doing it,” Soros replied. “I haven’t been comfortable with this.”36

  Druckenmiller duly dumped his tech holdings and focused on currencies. It was a potential moment of triumph: Quantum’s supremo had gotten out before the bubble burst, and he was back to focusing on his strong suit as a macro trader. But the markets conspired to taunt Druckenmiller almost as cruelly as they had tormented Robertson. First, Druckenmiller got stuck on the wrong side of Europe’s fledgling currency, the euro. Next, the NASDAQ stocks that he had sold continued to rush upward. Carson Levit and Diane Hakala, Quantum’s in-house new-economy enthusiasts, were still running technology subportfolios, surfing the bubble, and all of a sudden the big man’s anxieties shifted. Having earlier worried that the bubble might blow up in his face, he now worried about losing face: He had doubted the new economy and misjudged the euro, and now these kids and their radioactive stocks were making a fool of him. Not for the first time, Druckenmiller turned on a dime. He bought all his tech stocks back and gave Levit and Hakala room to run. For a while the good times rolled again.

  Then on March 10 the NASDAQ turned, and many of the stocks that Quantum held fell faster even than the market. Druckenmiller himself had been a huge buyer of a firm called VeriSign, which lost almost half its value in a month, plummeting so hard that it was difficult to sell out of it. “I knew I was dead,” Druckenmiller said later; and by the end of March Quantum had lost about one tenth of its capital.37 By pivoting aggressively one too many times, Druckenmiller had failed to escape before the party ended.

  Druckenmiller left the office for a vacation in Florida. One year earlier, he had led Quantum back from behind; now he lacked the will to do it. Like his friend Julian Robertson, he was too drained to go on; and although Robertson’s decision to pull the curtain down on Tiger seemed exquisitely mistimed, Druckenmiller realized that he envied Robertson’s new freedom. “Money is supposed to be enjoyed,” he told his wife, “but if I can’t enjoy two weeks with my kids, what’s the point of it all?”38 He had carried Quantum on his shoulders for twelve years, and that was enough for him.

  “I’m tired, exhausted. I fought out of the hole last year; I just can’t do it,” Druckenmiller told Soros.39

  Soros looked at Druckenmiller and recognized the desperation he had once felt himself. Years earlier, when he had run Quantum almost alone, Soros had come to hate the all-consuming nature of the task; he had compared himself to a sick person with a parasitic fund swelling inexorably inside his body. Druckenmiller had been saying for some time now that he wished Quantum were not so large, that he needed some kind of exit, that he could not go on forever. In the end, Soros reflected, Druckenmiller had only been able to free himself by blowing up the fund. It was an expensive method of escape, but it was certainly effective.40

  On April 28, Soros convened a press conference. He announced that Quantum was down 21 percent for the year and that assets at Soros Fund Management had fallen by $7.6 billion since August 1998, when they had reached their high-water mark of $22 billion. He explained that Stan Druckenmiller was leaving after a dozen years; Quantum would henceforth be managed as a sedate, low-risk endowment. Within the space of just one month, the two largest and most storied hedge funds had pulled down the shutters. “We have come to realize that a large hedge fund like Quantum Fund is no longer the best way to manage money,” Soros said sadly. “Markets have become extremely unstable.”41

  With that, Soros appeared to draw a line under an industry that he had helped to invent. But he could not have been more wrong. It was too early to write an epitaph for hedge funds.

  12

  THE YALE MEN

  On June 1, 2001, 2,920 people showed up for dinner at the Jacob Javits Convention Center on the western edge of Manhattan. They had come to participate in what had become one of the great rites of the summer: the annual gala of the Robin Hood Foundation, the charity conceived by Paul Tudor Jones in the wake of the crash of 1987. After thirteen years in operation, Robin Hood had distributed over $90 million to organizations that fought poverty, teen pregnancy, and illiteracy in New York City, and the gathering in 2001 promised to take the crusade to the next level. The guests filed into a cocktail area that mixed the vibe of a disco with a sort of rain-forest aesthetic: Hundreds of green poles rose nearly twenty feet into the air; an image of green treetops was projected onto the wall; a constantly shifting green light scanned the room for celebrities. There was the actress Meg Ryan, the baseball personality Keith Hernandez, and the newsman Tom Brokaw—and there were many, many hedge-fund managers. The caterers went about their business with paramilitary intensity. Traffic cops armed with fluorescent batons directed servers around the kitchen.1

  The Robin Hood dinner was proof that Soros’s epitaph for hedge funds had been delivered prematurely. Stan Druckenmiller himself was a sponsor of the event, having returned to the markets almost immediately after leaving Quantum—he was now running his own firm, Duquesne Capital Management. A who’s who of the titans turned out at the gala, paying $5,000 per ticket and bidding lustily in the auction. One guest forked over $540,000 for the privilege of lunch with a leading financial mogul. Another shelled out $260,000 for the “Be a Star” package, which included a part as an extra in Russell Crowe’s A Beautiful Mind, a walk-on in Drew Barrymore’s The Duplex, and dinner with the Hollywood power couple Catherine Zeta-Jones and Michael Douglas. Paul Tudor Jones’s wife, Sonia, bid $4
20,000 to attend a yoga lesson taught by Madonna and Gwyneth Paltrow—“Come on, people, you can’t stretch by yourselves!” the comedian Jerry Seinfeld urged as he auctioned off this item. Once the selling was over, a slice of the wall around the dining room dropped away. Cannons spewed confetti on the guests. Robert Plant, known to not-so-young members of the audience as Led Zeppelin’s lead singer, strutted onto the dance floor.

  By the end of that evening in 2001, Jones’s foundation had pulled in $13.5 million, demonstrating that hedge-fund wealth had become a social force of some significance. Meanwhile, George Soros’s Open Society Institute, the oldest and largest of the hedge-fund philanthropies, was disbursing $450 million per year; and in 2002 Arki Busson, who fed capital to Paul Jones and others from investors in Europe, created ARK—Absolute Return for Kids—which became the Robin Hood equivalent in London. And yet the greatest philanthropic impact of hedge funds lay elsewhere—not so much in the charities that they bankrolled as in the profits that accrued to the endowments that invested with them. By the early 2000s, billions of dollars of hedge-fund earnings had flowed into the coffers of universities, boosting their ability to finance everything from scientific research to scholarships for students from poor families. And just as this bonanza changed the outlook for learning, so it changed the character of hedge funds too. As they took in institutional money, hedge funds grew larger, slicker, and more methodical in style. They were emerging as a real industry.

  The pioneer of this alliance between endowments and hedge funds was David Swensen of Yale University. He was tall, angular, ascetic, and cerebral—a “stiff-backed midwesterner,” one friend called him—and he was possessed above all by a fierce sense of moral purpose. Growing up in River Falls, Wisconsin, he founded a recycling club through a church group; his mother and sister were Lutheran ministers; and his ambition was to follow in the state’s progressive political tradition and be elected to the Senate. But after enrolling in Yale’s economics PhD program, Swensen took a different turn. He befriended the future Nobel laureate James Tobin. He got to know Wall Street’s preeminent bond firm, Salomon Brothers, which provided market data for his dissertation. He developed a passion for finance and for the Yale environment.

  When Swensen completed his doctorate in 1980, Salomon immediately hired him, and he thrived on the competitive culture of Wall Street. He helped to make financial history the following year by playing a role in the creation of the first currency swap, a deal between IBM and the World Bank that allowed the technology company to hedge its exposure to Swiss francs and German marks; and in 1982 he was lured away by Lehman Brothers to run the bank’s fledgling swaps desk.2 But in 1985, when his former professors lobbied him to take over Yale’s troubled endowment, Swensen accepted happily. He gave up investment-banking bonuses for a book-lined office on the university campus, taking a pay cut of 80 percent. Years later, a Wall Street admirer remarked that Swensen could have been a billionaire if he had applied his talents to running a hedge fund. “What’s the matter with you?” the admirer asked. “A genetic defect,” Swensen responded.3

  When Swensen took over the endowment at Yale, more than four fifths of its assets were invested in U.S. stocks, bonds, and cash, with only a tenth in so-called alternative investments—in short, it resembled most other college endowments. For a young man returning from the innovative world of Wall Street, this seemed a little tame; besides, it was an affront to the research of Swensen’s mentor, James Tobin, who had helped to advance the idea that portfolio diversification is the one free lunch in economics. In a modern financial system, Swensen reasoned, diversification should mean more than simply holding a broad mix of U.S. bonds and equities: Assets such as foreign equities, real estate, private equity, oil, gas, and timber all offered ways to add equity-type returns while diversifying risk substantially. Then there was another kind of asset that took Swensen’s fancy. He called it “absolute return,” and over the next years the term entered the investment lexicon. It was a synonym for hedge funds.

  The moralist in Swensen had no desire to help hedge-fund managers earn fortunes. But the economist in Swensen was impressed by the design of hedge-fund incentives. He knew that the larger an investment fund, the harder it was for a fund manager to generate returns, so he disliked fees that were tied to the volume of capital a manager amassed, preferring the performance fees that accounted for most hedge-fund revenues. He recognized that performance fees alone can encourage too much risk—hedge-fund managers get a fifth of the upside but pay no equivalent penalty if they blow up—so he sought out hedge-fund managers who had their own savings in their funds and was encouraged to discover many of them. But what really interested Swensen was the scale and source of hedge-fund profits. Hedge funds promised equity-sized returns that were uncorrelated with the market index, offering the free lunch of diversification.

  It took a little while for Swensen to recognize the potential in hedge funds. In 1987, two years after he assumed the helm at the endowment, he received a visit from a Yale alumnus who had heard of his appointment at a homecoming football game. The visitor said he had a small fund out on the West Coast; perhaps Yale might want to invest with him? Swensen and his deputy, Dean Takahashi, listened to the pitch.

  “We’re not interested,” they told the supplicant. “We’ll never be interested.”

  THE SUPPLICANT WAS TOM STEYER, AND HIS HEDGE fund was called Farallon. Steyer sported a sweeping red-blond parting, jaunty sideburns, and faded woven wristbands; though he had grown up in New York, he exuded the vibe of his adopted home of San Francisco. He was ebullient, funny, and comfortable in his own skin; he could fill a conversation with mental and athletic juice, running with ideas like the soccer star that he had been in college. Steyer came equipped with another quality that would appeal to Swensen later on: He had an acute sense of right and wrong, which colored everything from his lifestyle to his approach to business. Long after Steyer built Farallon into one of the world’s biggest hedge funds, he was renowned for his beat-up car, his habit of flying commercial, and his utter indifference to fashion.4 His office consisted of a desk in the middle of an open-plan hallway. Behind him was a breathtaking panorama of San Francisco, except that Steyer kept the blinds down.5

  Steyer founded Farallon in 1985, the same year that Swensen took over the Yale endowment. He was motivated partly by a desire to escape Wall Street for a life on the West Coast and partly by that sense of justice. As a young analyst at Morgan Stanley, he had been upset to discover that investment-bank advisers can be paid for being wrong; sounding convincing mattered more than actually being right, since the objective was simply to extract fees from the clients. After a stint at Stanford’s business school, Steyer had worked at Goldman Sachs for the merger-arbitrage unit run by Robert Rubin, the future Treasury secretary. This suited him better: Goldman got paid in this business only when Goldman was right, though the distribution of the profits among employees sometimes generated arguments. The way Steyer saw things, setting up an independent fund was the logical next step. He had begun at a firm that took no responsibility for bad investment calls. He had moved to a firm that took responsibility collectively but that did not always recognize an individual’s contribution. Now, by starting a freestanding fund, Steyer would be out there on his own, with no buffer between the quality of his investment calls and the rewards he got from them.

  Steyer rented some cheap space in downtown San Francisco with a couple of desks, one for himself and one for a partner.6 He would ride the elevator up to his office at 5:30 in the morning, clutching his coffee and doughnut, ready to analyze the merger action at the start of the New York trading day. The investment style he practiced was the same one he had learned at Goldman Sachs. When a takeover bid was announced, the stock in the target company would move most of the way to the bid price: For example, if it had been trading at $30 and the bid was for $40, it might shoot up to $38. This presented Steyer with a choice. If he bought the stock and the merger was consummated, he
would pocket another $2 per share; but if the merger was called off and the stock fell back to its old price, he would forfeit $8. Knowing whether to risk $8 to make $2 required a special skill. You had to judge whether antitrust regulators would block the merger, or whether shareholders would revolt. You had to estimate the odds that another suitor might emerge stage left, perhaps pushing the stock above $40.

  Steyer pursued his work with a competitive passion that sometimes seemed overboard. When he took some losses in the crash of 1987, he started to show up at three in the morning, accompanied by his wife, who feared for his stability.7 But despite the hit in 1987, Steyer did extremely well: An arbitrageur who analyzes mergers from a desk at Goldman Sachs can analyze them pretty much as well from a desk in San Francisco, especially when his body and soul are tied up in his performance. By buying target companies in deals that would be consummated, Steyer eked out profits, month by month. And by shorting the acquiring firms, he hedged out the risk from general market movements.

  Toward the end of the 1980s, Steyer expanded his horizons. This was partly a survival strategy, since the takeover boom skidded to a halt when the junk-bond market collapsed in 1989, leaving merger arbitrageurs with few mergers to analyze. But Steyer was playing offense too: The junk-bond collapse created an opportunity to apply his analytical skills in a different context.8 The companies at the center of the junk-bond market filed for bankruptcy one by one; and an investor who could figure out which piece of busted debt to buy was likely to profit handsomely. To make matters even better, pension funds, mutual funds, and other institutional investors were forced sellers of junk: Their rules forbade them to hold the bonds of companies in default, so they were compelled to concede bargains to nimble players such as Farallon.9 When Drexel Burnham Lambert, the kingpin of the junk-bond market, filed for bankruptcy in 1990, Steyer bought a large slice of its debt at cents on the dollar; and when he sold his stake in 1993, Farallon’s portfolio chalked up a 35 percent profit.10 With the Drexel transaction Steyer had scored a dazzling double. He had profited from the mergers made possible by Drexel’s bonds, and he had profited again from Drexel’s implosion.