the yale men

n 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 fl uorescent 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 266 MORE MONEY THAN GOD after leaving Quantum—he was now running his own fi rm, 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 $420,000 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-soyoung members of the audience as Led Zeppelin’s lead singer, strutted onto the dance fl oor. 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 profi ts 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 scientifi c 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 T H E YA L E M E N 267 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 fi rm, 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 fi fths 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, diversifi cation 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 268 MORE MONEY THAN GOD 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—hedgefund 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 diversifi cation. 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 SUPPLICA NT WAS TOM STEYER, A ND 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 T H E YA L E M E N 269 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 offi ce 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 fi rm 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 270 MORE MONEY THAN GOD 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 fi led 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, fi led 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 profi t.10 With the Drexel transaction Steyer had scored a dazzling double. He had T H E YA L E M E N 271 profited from the mergers made possible by Drexel’s bonds, and he had profi ted again from Drexel’s implosion. Steyer had created what would later be known as an “event-driven” hedge fund. He specialized in events that caused existing prices to be wrong—moments when a disruption suddenly rendered the market’s settled view inoperative. The moment before a takeover bid, a company’s share price embodies the verdict of investors who have projected future earnings: The price is efficient in the sense that it has been analyzed to death already. The moment after the takeover bid, the old calculations are scrambled: Now the analysts have to look at the size of the takeover premium, the time until it is likely to be realized, the rate at which it should be discounted, and so on. In similar fashion, an event such as a bankruptcy scrambles yesterday’s consensus on the value of a company’s bonds. Again, the challenge is to look afresh at the cash flows that each busted bond seems likely to generate. Even before the Drexel coup, the news of Steyer’s performance had reached the ears of David Swensen. Steyer was making excellent money irrespective of whether the stock market was up or down—he offered diversification. Steyer was generating profits by focusing on occasions in which settled prices were scrambled; to a financial economist attuned to the limits of the efficient-market hypothesis, the success did not look merely lucky.11 These two factors were enough to make Swensen reconsider his initial refusal to invest in Farallon. But before he went further, Swensen had to take the measure of Steyer the man. He wanted partners with integrity, and he wanted something more as well. Beating the market was only possible for people with a sort of obsessive passion. “Great investors tend to have a ‘screw loose,’ pursuing the game not for profit, but for sport,” Swensen wrote later.12 As Yale did its due diligence, it found that Steyer had all the qualities that the endowment could hope for. This guy was not running a hedge fund because he craved luxury: You just had to look at his office to see that. This guy shared Swensen’s passion for pure compensation incentives: He insisted that Farallon employees keep their liquid savings in the fund 272 MORE MONEY THAN GOD so that they would feel the pain if they lost money.13 Steyer also embraced the convention of a “high-water mark,” meaning that if his fund was down he would take no further fees until he earned the money back for his investors.14 In the fall of 1989, Swensen flew to San Francisco. He visited Farallon’s scruffy office and approved of what he saw; but over a cheap lunch with Steyer and another Farallon partner, Fleur Fairman, Swensen repeated his earlier verdict that Yale would not invest with them. Hedge funds, he said bluntly, would stiff their clients if their strategies went wrong. Rather than working without compensation to earn the capital back, as the “highwater mark” promise suggested, hedge funds would simply close up shop, reopening under a new name with a fresh set of investors. “Look, the reason we don’t want to do this honestly is in this format, if you lose money, you won’t want to earn it back. You’ll close down and start a new fund. That’s the problem with the whole format.” Steyer might have argued back, but Fairman beat him to it. “That’s a bunch of bullshit!” she exclaimed, and Swensen could see that she was furious. “If you think that’s who we are then we don’t want your money anyway!” Fairman carried on. “You have no idea who we are! It’s just ridiculous that you’d say that!”15 This was a better response than Swensen could possibly have wished for. He had found the integrity he sought: Fairman took her decency so seriously that she flew off the handle when you questioned it. In January 1990, Yale invested with Farallon. The university injected $300 million into Steyer’s fund, boosting his capital to a total of $900 million and kick-starting a gradual change in the social impact of hedge funds. SWENSEN’S PARTNERSHIP WITH STEYER BEGAN THE REpositioning of Yale, ultimately affecting the investment style of nearly all endowments. Until the Farallon deal, Yale had a smattering of holdings in private equity and “real assets” such as real estate, but nothing in hedge funds. Half a decade later, in 1995, the allocation to hedge funds had jumped to 21 percent, with another 31 percent in private equity and T H E YA L E M E N 273 real assets.16 Other universities followed, with a lag: For a typical university endowment, the allocation to hedge funds rose from nothing in 1990 to 7 percent in 2000.17 In the years after the dot-com crash, endowments that experimented with hedge funds were rewarded particularly well: From July 2000 through June 2003, the S&P 500 lost 33 percent of its value while the HFR index of hedge funds gained 10 percent. Yale itself was up 20 percent over this period, and a couple of years later, when the university celebrated the twentieth anniversary of Swensen’s arrival, his investment decisions were celebrated for generating $7.8 billion of the $14 billion in the Yale endowment—that was the amount by which he had outperformed the average university fund during his tenure. Fully $7.8 billion: It was a staggering number! With Swensen eclipsing storied education philanthropists such as Harkness and Mellon, hedge funds became more than just vehicles for the rich to get richer. By 2009 roughly half the capital in hedge funds came not from individuals but from institutions. The rush of endowment money into hedge funds ensured that there was no need at all to write an epitaph for the industry. At the start of 2000, when Soros proclaimed that the hedge-fund era was over, hedgefund assets had stood at $490 billion. By the end of 2005, they stood at $1.1 trillion. Soros’s epitaph was at least partially apt for his own type of trader: The first years of the new century were a relatively lean time for macro hedge funds. But event-driven funds such as Farallon made up for that.18 Farallon’s assets ballooned from $8 billion in 2002 to $16 billion in 2006, and imitators crowded in. Och-Ziff, created by another veteran of the Robert Rubin arbitrage group at Goldman Sachs, grew from $6 billion to $14 billion over the same period. Perry Capital, another Rubin offshoot, grew from $4 billion to $11 billion. This “Rubin three” soon exceeded the Commodities Corporation three in terms of asset size. By 2006, Caxton, Tudor, and Moore marshaled a combined total of $35 billion, $6 billion less than the total for Farallon, Perry, and Och-Ziff; and a host of other products of the Rubin arbitrage group, including Frank Brosens of Taconic Capital, Eric Mindich of Eton Park, and Edward Lampert of ESL Investments, were flourishing. In the hedge-fund family tree, perhaps only Julian Robertson had more offspring. 274 MORE MONEY THAN GOD It was not just that returns earned by event-driven funds were impressive. From the point of view of endowment managers, who reported to oversight committees that asked skeptical questions, the returns were pleasingly explicable. Macro traders like Paul Tudor Jones might talk about Kondratiev waves and breakout points: To the average investment committee, this was hocus-pocus. But event-driven funds like Farallon involved no mystery at all. These guys studied legal labyrinths. They understood the odds that a given merger would go through. They could judge how a particular slice of subordinated debt was likely to be treated by a particular bankruptcy judge in a particular court. With this sort of edge, of course they would make money! Besides, the endowment oversight committees could grasp that event-driven funds succeeded because others were hobbled. Institutional investors had rules that forced them to sell the bonds of companies in default, so they were required to cede profits to Steyer and his imitators. The more endowments displaced rich individuals as the chief investors in hedge funds, the more it mattered that hedge-fund strategies could be understood. A rich investor can bet his personal fortune on a mysterious genius if he so chooses. Endowment committees must protect their backs with PowerPoint presentations. Along with profits and transparency, the event-driven merchants promised consistency. They used very little leverage, which in the wake of Long-Term’s blowup was a selling point in itself; partly as a result, their returns were almost miraculously steady.19 Farallon’s consistency was legendary: Between 1990 and 1997, there was not a single month in which the fund lost money. As a result, Farallon’s Sharpe ratio, a measure of returns adjusted for risk, was roughly three times higher than that of the broad stock market, making it an overwhelmingly attractive place for endowments to park savings.20 Even during the height of the dot-com madness, Steyer sailed along serenely. He did not ride the bubble like Stan Druckenmiller. He did not get run over by it like Julian Robertson. Instead, he applied his methods to analyzing the epic takeover battles of the era, hedging out the market risk as he did so. Naturally, this strategy looked good when the market collapse sank both Druckenmiller and Robertson. T H E YA L E M E N 275 In sum, the event-driven hedge funds were producing understandable, unvolatile returns—returns, moreover, that reflected pure investment skill and were uncorrelated with the market index. This was the holy grail, the elixir that endowment consultants called alpha, and institutional capital flooded into their coffers. And yet the triumph of the event-driven hedge funds was not bereft of risk. Even the stars like Farallon had vulnerabilities that few suspected. BY THE LATE 1990S, FAR A LLON WAS OPER ATING OUT OF a fashionable skyscraper in yuppie downtown San Francisco. The commander’s work space was modest as always, but there was a Henry Moore sculpture outside and a lawn where beautiful people ate organic sandwiches. From this bastion of serenity, Steyer’s small operation was venturing to ever farther-flung frontiers. In 1998 it launched a merger-arb operation in London, arriving within a few months of its rivals, Och-Ziff and Perry Capital. It bought a stake in Alpargatas, a bankrupt Argentine textile and shoe maker. It installed new managers at Alpargatas and restructured the firm’s debt; soon some two thousand idled workers found themselves employed again, and Farallon had proved that it could do well by doing good in a frontier economy.21 But nothing could match what was about to follow. In November 2001, Farallon set out to buy the biggest bank in Indonesia. Farallon’s target, Bank Central Asia, had been founded by Liem Sioe Liong, who had been Indonesia’s richest man and a firm friend of the country’s modernizing dictator, Suharto. Liem’s empire was said to account for 5 percent of Indonesia’s output, and the secret of his success was best illustrated by the flour business. Playing on his connections to Suharto, Liem arranged for Indonesia’s government to sell him imported wheat at a subsidized price and then to buy it back from his fl our mills at a markup—nice work if you can get it.22 Untroubled by competitive pressure, Liem’s flour mill in Jakarta grew to be the largest in the world; the second-largest, in Surabaya, belonged to Liem also. And although the mills were supposed to sell their flour back to the government, an 276 MORE MONEY THAN GOD impressive quantity found its way to another Liem enterprise, Indofood, which consequently controlled 90 percent of Indonesia’s instant-noodles market. In similar fashion, Liem prospered mightily in coffee, sugar, rubber, cement, rice, and cloves. Naturally, a man of his standing needed his own bank. Naturally, the bank was the nation’s largest. By the time Farallon came on the scene, Liem’s empire had imploded. The patriarch had hedged his political risk by awarding Suharto relatives large stakes in his firms.23 But the currency crisis that cost Soros and Druckenmiller a fortune triggered a slow-motion revolution in Indonesia, culminating in the fall of the Suharto government. From that moment on, Liem’s political insurance policy became a target painted on his chest— friends of the fallen president were now enemies of the people. Rioters broke into Liem’s compound, set his cars ablaze, and smashed his Chinese vases. Shorn of their political protection, Liem’s businesses went bust, and since many of their loans had come from Bank Central Asia, they threatened to bring the bank down with them. To stem depositors’ understandable panic, the government rescued it. Farallon was used to event-driven investing, but the collapse of the Suharto regime was a more extreme event than the average takeover announcement. Millions of people were driven into poverty; thousands of demonstrators died in clashes with the police; hundreds of businesses were looted. Many Indonesians blamed the calamity on Western hedge funds, and American financiers in the country had been known to receive death threats. But the more Farallon studied Indonesia, the more the opportunities in the country seemed too good to pass up. Indonesia’s government was the classic noneconomic seller. The International Monetary Fund was goading it to off-load the chunks of the private sector that it had been forced to rescue, and to do so at almost any price; precisely because most fi nancial players would not set foot in the country, Farallon could expect limited competition in bidding for distressed assets. During the crises of 1997, hedge funds had profited by betting against governments that set illogically high prices for their currencies. In the hangover from those crises, hedge funds would profit by betting against governments that set illogically low prices for the broken jewels of their economies. T H E YA L E M E N 277 By the fall of 2001, Farallon had amassed $1 billion worth of holdings in Indonesia.24 It had bought stakes in PT Semen Cibinong, Indonesia’s third-largest cement company, and PT Astra International, the largest automaker; it bought the Jakarta Container Port Terminal and sold it on to Hong Kong–based Hutchison. Then one day Ray Zage, Farallon’s point man in Indonesia, got an unusual message from a government contact. Bank Central Asia would be reprivatized soon. Perhaps Farallon would like to bid for it? It was an astonishing proposal: A small San Francisco fund would take over the commanding heights of the world’s largest Muslim country. Farallon boasted no more than a few dozen employees; Bank Central Asia had eight million accounts and eight hundred branches. Farallon was the product of the Goldman arb culture plus a dollop of California cool; Bank Central Asia had been the embodiment of Indonesia’s crony capitalism. Andrew Spokes, a dapper English banker whom Steyer had recruited from the Goldman Sachs office in Hong Kong, later conceded that the deal was a stretch. “We were a little off piste,” he conceded, coolly inspecting his cuffs.25 He sounded like a vintage James Bond who skis an avalanche in a tuxedo.26 By the time the Bank Central Asia opportunity arose, the September 11 terrorist attacks had made Indonesia dicier than ever. A country torn by economic disaster and political revolution seemed vulnerable to Islamist extremism. The huge California state retirement fund, CalPERS, was getting ready to announce that it would not invest in Indonesia, period; even the intrepid Goldman Sachs tightened the limits on the Indonesian exposure that it would tolerate.27 The Farallon team began to behave differently on its periodic visits to the country, especially when it found itself in concentrated clumps of foreigners. Ray Zage viewed the area between the customs checkpoint and the taxi rank at the airport as a natural kill zone. “I remember Ray observing it would be great not to be mowed down there,” Spokes recalled matter-of-factly.28 Farallon proceeded to weigh up the case for buying Bank Central Asia. The discipline of event-driven investors is to zone out the chatter and the panic and focus on value—when market prices cease to be a guide, you decide what to pay for an asset based on the cash flows it will generate. 278 MORE MONEY THAN GOD Spokes pushed past Bank Central Asia’s reputation as the center of Liem’s crony-capitalist empire and focused on three facts. Since nationalization, the bank’s rotten loans to Liem’s enterprises had been replaced with special recapitalization bonds, so that instead of depending on repayments from busted crony companies, BCA depended on repayments from the Indonesian state: BCA was really less a bank than a government bond fund. Moreover, BCA enjoyed access to cheap capital from retail depositors: Unlike most other bond funds, BCA came bundled with bargain- basement leverage.29 Finally, if the local economy picked up, the bank could start making profitable loans to businesses: BCA was a bond fund, plus bargain-basement leverage, plus a free option on Indonesia’s recovery. As to the political risk, Spokes had an answer to that too. Precisely because the world viewed Indonesia as scary, the post-Suharto leadership could not afford to treat Farallon capriciously. If they cheated a foreign investor in a high-profile deal, their reputation would be mud indefi nitely. After some spirited debate, the Spokes argument for off-piste investing convinced Steyer and the other partners. Only a year or so earlier, Farallon had had no track record in Indonesia; now it would be bidding for Bank Central Asia—and going up against a consortium led by Standard Chartered, a venerable lender with deep roots in the region. In late 2001, Farallon duly submitted an offer of $531 million, and in March 2002 the government announced that it had won: A hedge fund from latte land had bought control of the top bank in the nation. The outcome was so improbable that conspiracy theories blossomed. Was Farallon a front for the U.S. government? Was it a Trojan horse for Liem, who dreamed of reviving his old empire? Despite the fervid whispers, Farallon’s investment was a blessing for Indonesia. Farallon installed a new chairman, brought in some consultants, and patiently coaxed the bank out of the Suharto era. By 2006, when Farallon sold most of its stake to an Indonesian partner, BCA’s share price had risen 550 percent since the purchase; just as with the Argentine shoe company, Farallon had shown it could do well by doing good in a tough country. But Farallon’s investment had another effect too. The T H E YA L E M E N 279 spectacle of a swashbuckling hedge fund dashing into Indonesia turned heads in New York and London, and institutional investors began to give the country a sympathetic second look. In the year leading up to the BCA purchase, a mere $286 million of net portfolio investment had trickled into Indonesia; but the following year almost $1 billion of foreign capital came in, and the year after that brought more than $4 billion.30 Farallon had scrambled the market’s settled view on all Indonesian assets, setting the stage for a rebound. An event-driven fund had created an event, helping to turn the economic tide for a nation of 240 million people.31 AS FAR A LLON WAS BIDDING FOR BA NK CENTR A L ASIA, another adventure half a world away was proceeding less smoothly. Steyer had gone into business with a Colorado rancher named Gary Boyce, a flamboyant horse trainer and dreamer of wild dreams about the wealth in the valley of his childhood. Boyce had approached Farallon with a plan to buy land in the valley and pump water from the aquifer beneath—the water could supply Boulder, Colorado Springs, and even Denver. Farallon’s alliance with the Yale endowment made it alert to the potential of “real assets” like water. Steyer and his team invested. Southern Colorado’s valleys were as remote in their own way as Jakarta’s back alleys. To get to Gary Boyce’s homestead, the Farallon people had to fly to Denver, then drive south for four hours to Alamosa, a small town with a True Grits Steakhouse, a TropArctic Lube Center, and a store plastered with posters announcing Tecate Imported Beer, Extra Gold Lager, and new Bud Light Lime—lattes had some competition in this neighborhood. After Alamosa, the visitor pressed on into the San Luis Valley, past lonely trailer homes, over pancake-flat land covered in harsh scrub, under cotton-candy clouds that sat motionless on distant mountains. At the far edge of the valley lay Gary Boyce’s ranch house: a handsome adobe structure with hollow walls to keep out the heat. Boyce wore shirts with mother-of-pearl studs on the pockets. On the desk in his study lay a pair of ornate pistols. 280 MORE MONEY THAN GOD You could see why Steyer and his team took this man for the perfect local partner. Boyce grew up poor in the San Luis Valley, then became the three-time winner of the Colorado dirt-biking championship. He was a veteran of the politics of water: During a fight over an earlier venture to tap the San Luis aquifer, he had founded a newspaper called the Needle to pierce the developer’s bubble.32 And while Boyce was a true local, he was also worldly: He had grown wealthy training horses for upper-crust Virginians, and wealthier still by marrying an MGM heiress. Confi dent that Boyce had the moxie to get a new version of the water project launched, Steyer created a partnership to finance his ambitions. Half the capital came from Farallon and the other half came from Yale, though Yale played no role in managing the project. Backed by Farallon’s money, Boyce duly bought a ranch in the San Luis Valley in 1994, outbidding the Nature Conservancy, which wanted to turn the land into a national park. He spent $3 million on an environmental study that showed water could be extracted without damaging the local soils. He hired lobbyists to plead for the project in the Colorado legislature. Meanwhile, Boyce spent half a million dollars on collecting signatures to get two referenda in front of Colorado’s voters. The first measure required valley farmers and ranchers to place consumption meters on their wells; the second forced farmers to pay user fees for some types of water. Both measures were essential to Boyce’s scheme, since they would establish a fair price for the resource he would be selling. Boyce spent another $400,000 on advertisements to build support for his ballot initiatives, assuring his partners at Yale and in San Francisco that they would be voted through. Steyer went out to the valley to visit, bringing his mother along for a vacation. She bonded happily with Boyce and tried her hand at elk hunting.33 Not everyone was happy, however. The farmers in the valley revolted against Boyce’s proposals: They were outraged at the prospect of a user fee, and they claimed that the valley’s sandy soils would clog the meters. As the arguments grew heated, Steyer began to wonder if he had chosen the right local partner after all.34 Being born locally was not the same as being respected locally; perhaps the mother-of-pearl shirt studs and decorative T H E YA L E M E N 281 pistols marked Boyce out as a poseur, not a regular local with Colorado credibility. When it came time to vote, in November 1998, Boyce’s water initiatives were defeated by a large margin. Steyer and his Yale partners had spent four years and more than $20 million on the project, but now they had no choice but to recognize its failure.35 Casting about for an exit, Farallon invited the Nature Conservancy to revive its old plan for a national park, and the two sides signed a deal at the end of 2001. But then an obstacle cropped up. Boyce blocked the path to the exit by filing a suit against Farallon. Boyce’s argument in court was that the water scheme was still viable. By bailing out prematurely, Farallon was damaging the value of Boyce’s stake in the project. The lawsuit delayed the sale to the Nature Conservancy, and soon various onlookers saw an opportunity to make mischief. Colorado senator Wayne Allard accused Yale of profiting at the expense of Colorado’s taxpayers, who would bankroll the Nature Conservancy’s purchase, and demanded that Yale lower its asking price of $31.3 million— even though Yale’s role was merely that of a passive investor.36 Allard suggested Farallon had misled Yale about the environmental costs of the project, even though Boyce’s referenda had failed because of the proposed user fees and meters, not because anyone had shown that his environmental study was faulty. For nearly all of its history, Farallon had tried to stay out of the headlines, and it was certainly not accustomed to public abuse from a senator. The involvement with Boyce was growing ever more uncomfortable. At the start of 2004, Farallon emerged victorious in its legal struggle against Boyce, and pressed to conclude the sale to the Nature Conservancy. To buy peace from the critics, Yale announced it would donate $1.5 million to subsidize the cost to Colorado’s taxpayers. But Farallon was soon ambushed by another surprise: A bizarre coalition of protesters announced itself on several college campuses. Its leaders declared that they were part of an “unFarallon campaign” aimed at forcing college endowments to withdraw their capital from Farallon. A protest soccer game at the University of Texas featured players dressed up as crony capitalists. A “transparency fairy” in a feathered mask waved her wand 282 MORE MONEY THAN GOD outside Swensen’s office at Yale, willing the endowment to be more open and accountable.37 The street theater drew attention to a new unFarallon Web site, which listed all manner of supposedly nefarious activities. It cited Farallon’s investment in a coal-fired power project in Indonesia: Coal was evil. It invoked Farallon’s investment in Argentina: The workers had suffered. It paraded the plight of the tiger salamander on a California golf course in which Farallon had invested: Unless the golf lords dug some ponds, the salamanders would be threatened.38 Indeed, Farallon was complicit in no less a crime than the Iraq war: It owned a $3 million stake in Halliburton, the oil-services firm once headed by Vice President Cheney. The activists demanded that Farallon’s secretive mastermind meet them to discuss “the ethics of Farallon’s investment practices.” “We are stakeholders in the investments you make with university money,” they lectured Steyer, apparently imagining an adversary with a monocle and top hat. “We do not want our universities to profit from investors that harm other communities.”39 Steyer did his best to stand up for himself. He wrote to the unFarallon campaign, pleading that he cared as much as anyone about strong business values. He wrote to Farallon’s investors, stating the obvious truth that the Web site was “factually inaccurate.” But the demonstrations continued. In April students held a rally in front of the office of Yale’s president. They staged a mock attempt to extract water from an aquifer under the campus, and they broke ground for a new coal-fired power plant. When the students showed up at a meeting of Yale’s Advisory Committee on Investment Responsibility, David Swensen’s patience was stretched even further.40 After sitting through a recital of complaints about the endowment’s failure to disclose the details of its investments, he decided it was time to engage his tormentors, and he approached them after the meeting: A tall, wiry figure in a fleece vest, towering over a group of grungy students, arguing intensely. The students’ demand for more transparency was simply impractical, he explained; in order to compete successfully in markets, investors must protect proprietary secrets. If Yale wanted to reap the benefits of hedge funds, it had to promise not to leak information about their dealings: It T H E YA L E M E N 283 needed to ensure that it was “the highest-quality limited partner possible.” The students were unmoved. “I think it’s more important to look at Yale as the highest-quality global citizen,” one of them retorted.41 In picking on Swensen and Steyer, the students had chosen two of the least appropriate targets in the hedge-fund universe. Far from being a Cheney acolyte, Steyer was an open-fisted backer of the Democratic presidential candidate, John Kerry. Far from being a money-obsessed monster, Swensen had missed a chance to be a billionaire because of his “genetic defect.” But none of this mattered. Hedge funds had grown with the help of college endowments. They could not expect immunity from the vagaries of college politics. FARALLON CLOSED THE SALE TO THE NATURE CONSERvancy in September 2004. The water project had been a failure, but the land had gained value, so Steyer and his partners came out with a small profit. But the Colorado episode exposed a vulnerability—both in Farallon and in ambitious bargain-hunting funds more generally. Bargains often lurk in quirky places: in the details of the junk-bond market’s debris, in postcrisis Indonesia, in tangled feuds between ranchers and farmers in a remote Colorado valley. To invest successfully in these sorts of situations, you need to understand the traps in the terrain, and young hedge funds sometimes lack the manpower to survey it adequately. If Farallon’s people had spent more time in the San Luis Valley, they might have realized that Gary Boyce was an unsatisfactory partner.42 But in a fund that doubles its assets every four or five years, it can be hard to grow in-house expertise as fast as incoming capital. But the vulnerability in Farallon-style funds goes deeper than that. Their returns partly reflect a willingness to buy illiquid investments. If busted junk bonds represent value, it is probably because most investors are frightened to buy them—so if you decide you want to sell later, such assets will be hard to exit. If you buy a bank in Indonesia, the same argument applies; if you make a mistake, you can’t expect to get out easily. In ordinary liquid markets, prices are fairly efficient and second-guessing them 284 MORE MONEY THAN GOD is hard. In illiquid markets, by contrast, there are bargains aplenty—but mistakes can be extremely costly.43 Hedge funds that buy illiquid assets benefit from an accounting quirk that can flatter their performance. By definition, it is hard to know what an illiquid asset is worth—you lack the continually updated price discovery that comes with constant trading. As a result, hedge funds with illiquid assets don’t so much report their profi ts as estimate them—there is no objective price for much of what they hold, so they have to come up with a subjective value. In a few cases, hedge funds may take advantage of this murkiness to exaggerate their returns, though this game is not sustainable. But even if funds make every effort to report their results honestly, they cannot help but “smooth” them. A hedge fund may estimate the value of an illiquid asset every few weeks; if it rises 5 percent and then falls back within that period, it will be recorded simply as fl at—with the result that some sharp volatility along the way is not acknowledged. As a result, hedge funds with illiquid assets are not as stable as their numbers suggest. Their risk-adjusted returns look wonderful because some of the risk goes unreported. But the biggest danger for buyers of illiquid assets is that, in a crisis, these assets will collapse the hardest. In moments of panic, investors crave securities that can be easily sold, and the rest are shunned ruthlessly. LongTerm Capital’s apparently diverse portfolio concealed a single bet that the world would be stable: When this proved wrong, apparently unrelated positions collapsed simultaneously because many of them boiled down to an attempt to harvest a premium for holding illiquid assets. Likewise, apparently diversified event-driven funds may be taking a concentrated bet on illiquid investments. In 1998, Long-Term Capital paid the ultimate price for taking too much of this sort of risk. In 2008, buyers of illiquid assets paid heavily again, as we shall see presently. 13 The Code Breakers Not so many hedge funders have been to East Setauket. It is an hour’s drive from Manhattan, along the Long Island Expressway; it is separated from the hedge-fund cluster in Greenwich by a wedge of the Atlantic Ocean. But this sleepy Long Island township is home to what is perhaps the most successful hedge fund ever: Renaissance Technologies. Starting around the time that David Swensen invested in Farallon, Renaissance positively coined money; between the end of 1989 and 2006, its flagship fund, Medallion, returned 39 percent per year on average.1 By the mid-2000s, Renaissance’s founder, James Simons, had emerged as the highest hedge-fund earner of them all. He was not the world’s most famous billionaire, but he was probably its cleverest. Simons was a mathematician and code breaker, a lifelong speculator and entrepreneur, and his extraordinary success derived from the combination of these passions. As a speculator, he had dabbled in commodities since his student days, acquiring the trading bug that set him up for future stardom. As an entrepreneur, he had launched a string of businesses; the name of his company, Renaissance Technologies, reflected its origins in high-tech venture capital. As a code cracker, Simons had worked at the Pentagon’s secretive Institute for Defense Analyses, where he learned how to build a research organization that was closed toward outsiders but collaborative on 286 MORE MONEY THAN GOD the inside. As a mathematician, he had affixed his name to a breakthrough known as the Chern-Simons theory and won the American Mathematical Society’s Oswald Veblen Prize, the highest honor in geometry. In an expression of his diverse passions, Simons used a wedding gift to speculate successfully on soybeans, got fired from the Institute for Defense Analyses for opposing the Vietnam War, and drove from Boston to Bogotá on a Lambretta motor scooter—all while still in his twenties. Having grown to know Colombia at the end of that road trip, he teamed up with some local friends to launch a tile factory in the country. Simons’s early adventures in markets had little to do with mathematics. He traded commodity futures on the basis of hunches about demand and supply, riding the wild booms and busts of the 1970s. But the mathematician inside him yearned to substitute models for seat-of-the-pants judgment, and he loved the idea of a machine that would do his trading for him. Starting in the late 1970s, Simons recruited a string of outstanding mathematical minds to help create such a machine. There was Leonard Baum, a cryptographer who had worked with Simons at the Institute for Defense Analyses. There was James Ax, a winner of the American Mathematical Society’s foremost prize in number theory. And there was Elwyn Berlekamp, a Berkeley mathematician who was yet another veteran of the Institute for Defense Analyses. The names and ownership structures of Simons’s various ventures changed along with the collaborators he drew into his net. He had an investment fund in Bermuda and a company on the West Coast, as well as the operation on Long Island, where he had chaired the math department of Stony Brook University before quitting in 1977 to focus on his businesses. It was not just that Simons’s recruits were intellectually formidable. Their experiences in cryptography and other aspects of military communications were relevant to finance. For example, Berlekamp had worked on systems that send signals resembling “ghosts”—faint traces of code in seas of statistical noise, not unlike the faint patterns that hide in broadly random and effi cient markets. Soldiers on a battlefi eld need to send messages to air cover that are so wispy and translucent that they won’t betray their positions: Not only must the enemy not decode the messages; it must not THE CODE BREAKERS 287 even suspect that someone is transmitting. To Berlekamp, the battlefi eld adversaries fooled by such systems bore a striking resemblance to economists who declared markets’ movements to be random. They had stared at the ghosts. They had seen and suspected nothing.2 The Simons team took their experience with code-breaking algorithms and used it to look for ghostly patterns in market data. Economists could not compete in the same league, because they lacked the specialized math needed to do so. The early efforts of the Simons team were only moderately successful. Despite his preeminence as a mathematical modeler, Leonard Baum quickly tired of the quest for golden algorithms; he read the business papers and took a huge bet on the British pound, which paid off handsomely. James Ax stuck with the computer-trading project; but he was a volatile personality and his system’s returns could be volatile also. Still, by 1988 Simons had built the platform for his later success. Together with Ax he launched the Medallion Fund, named in honor of the medals the two men had won for geometry and number theory. Medallion traded commodity and financial futures on the basis of computer-generated signals; and although the heart of the system was unremarkable—it was a trend-following model not unlike the one built at Commodities Corporation more than a decade before—a small portion of the money was deployed according to a different set of rules. This was the kernel of the future Simons fortune.