What Dan Loeb Has Learned As An Investor

1. His style of investing has evolved and adapted to the investment environment, his process has evolved significantly. Importance of process itself on running an investment management firm. Leadership is very important. Most firms fail from dysfunctional process, or leadership of the firm.

2. Areas of focus and interest: if spending all your time reading research reports and only looking at screen, you will fail. Be well-rounded, travel, study things outside of the narrow topics of finance. If investing was just about numbers, any young accountant could do this. More than industry analysis, need to understand why you make decision, when it’s right to be contrary, when its not. Santa Fe institute has good ideas.

3. Importance in today’s world of political analysis. You can be right about financials, but if you don’t understand what the next move is by our politicians, you can get it wrong.

4. Looking at portfolios, think deeply about process over outcome. If you do something the right way enough times, you’ll win. Look at risk in an intelligent way, look at Alpha generation, not just how much money you make.


On Value Investing: Let's not delude ourselves; some of us are just buying really crappy companies at low prices. Don't make excuses for making bad investments at apparently cheap valuations. He'd rather pay up for a better business that has some growth.


On Managing Risk: He was down 30% in 2008, went from 6B in assets to 1.4B in assets, so he knows that everyone says they’re long term investors, but they still don’t want to lose money in any given year. He’s back up to 9B in assets now. He doesn’t want to lose money in any given year. Tries to have things in different sectors, and asset classes. Has 1.8B mortgage portfolio now for example. Uses tail-risk hedges, and shorts to hedge risk. To have a sustainable, growing business, managing volatility is important.


On “Stinky Feet Stocks”: When your first reaction to a pitch is that’s a terrible stock or industry, those have often been some of their best investments. He considers that a positive when it’s something in an out of favor industry. Auto parts in 2009, European banks in beginning of this year.

They use private investigators on shorts, to know the situation better than the rest of the world. Be sure to also check out Dan Loeb's recommended reading list.

Investors hunt strategies in era of ‘repression’

“Financial repression” is here. And it is causing a headache for investors.
It may be little more than a buzz phrase in the markets but a growing number of strategists believe it accurately encapsulates how sovereign debt markets are being distorted by central bank and government policies that keep interest rates at historic lows.

Real bond yields, those adjusted for inflation, are at their lowest since the 1970s in the US and UK. And if the effect of central bank action is to prevent market mechanisms from responding to inflation, an element of the repression, then this poses big questions for investors’ asset allocation strategies.
Andreas Utermann, chief investment officer at Allianz Global Investors, is unequivocal: “We are clearly in a phase of financial repression. The central banks are clear about it: they are manipulating the capital markets,” he says. “It will mean continual uncertainty.”
For banks, the big worry is that they become the captive buyers of sovereign debt. Indeed, the evidence from Spain and Italy after the European Central Bank’s provision of cheap loans in December and February suggests that is already the case. Much of the billions of euros in cheap ECB money was used to buy eurozone government debt, leading to a fall in bond yields.
At the same time, the search for haven assets, combined with “quantitative easing” in the US and UK, means that yields are well below inflation rates in the government bond markets of America and Britain, as well as Germany. Allianz, the German insurer, holds, largely for regulatory reasons, 90 per cent of its assets in debt instruments, with only 6 per cent in equities.
But, rather than keep pouring money into low-yielding debt, as encouraged by central banks and governments, investors can escape the repression, say strategists. One way out is to opt for equities or corporate credit, so-called risky assets.
“There is a strong argument that when real yields are negative, people look for assets where they can at least get a real return. You want to get closer to real assets rather than IOUs,” says Hans Lorenzen, credit analyst at Citi.
The problem for such a strategy is whether it makes sense over the mid to long term. Mr Lorenzen argues that looking at the last big period of financial repression from the post-war era when there were strong equity returns and low credit spreads in the 1950s and 1960s could be misleading. “For me it is the difference in growth. It was a very different world. Repression wasn’t a problem for returns in risk assets like credit and equities as growth was strong and default rates were low,” he says of that era.
The world today is different. Growth in all developed countries, but especially in Europe, is expected to be mediocre at best while deleveraging or debt reduction is far more widespread through the economy than it was after the war. That may not bode well for risky assets.
Didier Duret, chief investment officer of ABN Amro Private Banking, says an unconsidered move into risky assets is dangerous. “You need to move away from the crowded trades,” he argues. He has been trimming exposure to US equities, investment grade corporate debt – where yields are close to all-time lows – as well as government bonds.
Rather, he suggests assets such as Asian corporate bonds. “You get the same credit rating but you have an additional spread of 30-50 basis points,” he says. In equities he suggests a “barbell” strategy, with cylicals such as Taiwanese companies balanced by defensives such as Malaysian stocks.
Mr Utermann proposes a “simple” two-pronged strategy. The first part is to focus on equities that have strong cash flows and dividends. While critics of this trade point to the large number of strategists recommending it, Mr Utermann says most equity portfolios are constructed at the moment with an anti-dividend bias.
Companies that have maintained dividends have performed poorly – banks and utilities for example – while the best performers such as technology groups have a bad track record on payouts, Apple’s recent announcement notwithstanding. So he recommends ensuring investors have real exposure to dividend companies.
His second piece of advice is to invest in emerging markets equities and bonds without hedging to participate in what he anticipates will be an appreciation of their currencies. “If you believe capital markets will normalise, it will require a fundamental realignment in currencies,” he says, arguing developed countries will see theirs weaken.
The uncomfortable truth for many investors, however, is that financial repression is likely to be a long-winded process with many ups and downs. Mr Lorenzen argues that the two most likely outcomes are a prolonged bout of inflation such as came in the 1970s after the last period of financial repression, or a Japan-style scenario of low growth and choppy markets.
“You can be in a long-term bearish trend but in the periods when monetary policy is being loosened very aggressively you can have these very strong rallies,” he says.
“The difficulty for investors is understanding the relationship between the poor fundamentals and strong liquidity injections. In the long run fundamentals will dominate but at times the liquidity will take over.”

Financial Repression Has Come Back to Stay: Carmen M. Reinhart

By Carmen M. Reinhart - Mar 11, 2012

As they have before in the aftermath of financial crises or wars, governments and central banks are increasingly resorting to a form of “taxation” that helps liquidate the huge overhang of public and private debt and eases the burden of servicing that debt.

Such policies, known as financial repression, usually involve a strong connection between the government, the central bank and the financial sector. In the U.S., as in Europe, at present, this means consistent negative real interest rates (yielding less than the rate of inflation) that are equivalent to a tax on bondholders and, more generally, savers.

In the past, other measures also included directed lending to the government by captive domestic entities (such as pension funds or banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter coordination between governments and banks, either explicitly through public ownership of some institutions or through heavy “moral suasion” by officials.

Central banks in both developed and developing countries are being subjected to complementary pressures. Emerging markets may increasingly look to financial regulatory measures to keep international capital “out” (especially given the expansive monetary policy stance pursued by the U.S. and Europe). Meanwhile, advanced economies have incentives to keep capital “in” and create a domestic captive audience to absorb the financing for the high existing levels of public debt.

Common Cause

Concerned about potential overheating, rising inflationary pressures and the related competitiveness issues, emerging- market economies may continue to welcome changes in the regulatory landscape that keep financial flows at home. Indeed, this trend is already well under way. This concern means advanced and emerging-market economies are finding common cause in increased regulation and/or restrictions on international financial flows and, more broadly, the return to more tightly regulated domestic financial environments.

This scenario entails both a process of financial deglobalization (the reappearance of home bias in finance) and the re-emergence of more heavily regulated domestic financial markets.

-- Public and Private Debt Overhang: Elevated levels of public debt in the U.S. and elsewhere will probably be the most enduring legacy of the post-2007 financial crises. For the advanced economies, public debts had not approached these levels since the end of World War II.

Figure 1 (attached), which traces the evolution of average gross public debt for the 22 advanced economies from 1900 to 2011 demonstrates the magnitude of the policy challenges now facing many (if not most) of these countries. However, these numbers significantly understate the magnitude of the debt surge in recent years by excluding record private borrowing -- particularly by banks -- which remains a major possible contingent liability of governments.

Throughout history, debt-to-GDP ratios have been reduced in five ways: economic growth, substantive fiscal adjustment or austerity plans, explicit default or restructuring of private and/or public debt, a surprise burst in inflation, and a steady dose of financial repression that is accompanied by an equally steady dose of inflation. It is critical to note that the last two options -- inflation and financial repression -- are only viable for domestic-currency debts (the euro area is a special hybrid case).

Closed Channels

Some of these channels have been used in combination during historical episodes of debt reduction. Fiscal adjustment, however, is usually painful in the short run and politically difficult to deliver. Debt restructuring leaves a troublesome stigma and is also often associated with deep recessions. Pretending that no restructuring will be necessary doesn’t make the debt overhang disappear. For many, if not most, advanced countries, concerns about those debt burdens will shape policy choices for many years to come.

In this setting, monetary policy in the advanced economies is likely to remain “overburdened” for some time.

Complicating the situation is the fact that the debt overhang isn’t limited to the public sector, as it was immediately after World War II. There is now a high degree of leverage in the private sector, especially in the financial industry and households. In addition, the recent buildup in external leverage was greater than in past crises. This debt overhang and the financial fragility it creates are a common feature of most advanced economies, along with stubbornly high unemployment. Concerns that higher real interest rates and deflation will worsen an already precarious situation will probably impose added constraints on monetary policy.

-- Negative Real Interest Rates, 1945-1980 and Post-2008: One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things being equal, reduces governments’ interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates and reduces or liquidates existing debts, it is a transfer from creditors (savers) to borrowers and, in some cases, governments.

This amounts to a tax that has interesting political- economy properties. Unlike income, consumption or sales taxes, the “repression” tax rate is determined by factors such as financial regulations and inflation performance, which are opaque -- if not invisible -- to the highly politicized realm of fiscal policy. Given that deficit reduction usually involves highly unpopular spending cuts and/or tax increases, the “stealthier” financial-repression tax may be a more politically palatable alternative.

Bretton Woods

Liberal capital-market regulations and international capital mobility had their heyday before World War I, when the gold standard was in force. However, the Great Depression, followed by World War II, put an end to laissez-faire banking. It was in this environment that the Bretton Woods arrangement of fixed exchange rates and tightly controlled domestic and international capital markets was conceived.

The result was a combination of very low nominal interest rates and inflationary spurts of varying intensities across the advanced economies. The obvious results were real interest rates -- whether for Treasury bills (see attached Figure 2), central bank discount rates, deposits or loans -- that were markedly negative from 1945 to 1946.

For the next 35 years or so, real interest rates in both advanced and emerging economies were, on average, negative. Binding interest-rate ceilings on deposits (which kept real ex- post deposit rates even more negative than real ex-post rates on Treasury bills) “induced” domestic savers to hold government bonds. In addition to the effect of capital controls, leakages by investors in search of higher yields elsewhere were limited because the incidence of negative returns on government bonds and on deposits was, more or less, a universal phenomenon at this time.

The frequency distributions of real rates for the period of financial repression (1945 to 1980) and the years following financial liberalization, shown in Figure 2, highlight the universality of lower real interest rates prior to the 1980s and the high incidence of negative real interest rates.

A striking feature of Figure 2, however, is that real ex- post interest rates (shown for Treasury bills) for the advanced economies have, once again, turned increasingly negative since the outbreak of the crisis, and this trend has been intensifying.

Real rates have been negative for about half of the observations and below 1 percent for about 82 percent of the observations. This turn to lower real interest rates has occurred even though several sovereign borrowers have been teetering on the verge of default or restructuring (with the attendant higher risk premiums). Real ex-post central bank discount rates and bank deposit rates have also become markedly lower since 2007.

Negative Rates

Critical factors explaining the high incidence of negative real interest rates after the crisis are the aggressively expansive stance of monetary policy and heavy central bank intervention in many advanced and emerging economies.

This raises the broad question of whether current interest rates are more likely to reflect market conditions or whether they are determined by the actions of official large players in financial markets. A large role for non-market forces in interest-rate determination is a central feature of financial repression.

In the U.S. Treasury market, the increasing role of official players (or conversely the shrinking role of “outside market players”) is made plain in Figure 3, which shows the evolution from 1945 through 2010 of the share of “outside” marketable U.S. Treasury securities plus those of so-called government-sponsored enterprises, such as the mortgage companies Fannie Mae and Freddie Mac.

The combination of the Federal Reserve’s two rounds of quantitative easing and, more importantly, record purchases of U.S. Treasuries (and quasi-Treasuries, the government-sponsored enterprises, or GSEs) by foreign central banks (notably China) has left the share of outside marketable Treasury securities at almost 50 percent, and when GSEs are included, below 65 percent.

These are the lowest shares since the expansive monetary policy stance of the U.S. regularly associated with the breakdown of Bretton Woods in the early 1970s. That, too, was a period of rising oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher inflation.

A similar situation prevails in the U.K., where the Bank of England’s quantitative-easing policies since the crisis -- coupled with the requirement (since October 2009) that banks hold a higher share of gilts in their portfolios to satisfy tougher liquidity standards -- have reduced the share of “outside” gilts to about 70 percent. If foreign official holdings (by central banks) were included in this calculus, the share of outside gilts would be considerably lower.

ECB Purchases

The European Central Bank’s purchases of the bonds of Greece, Ireland and Portugal amounted to about 76 billion euros ($100.9 billion) from May 2010 to March 2011 and account for about 12 percent of the combined general government debts of those three countries.

To summarize, central banks on both sides of the Atlantic (and the Pacific, for that matter) have become even bigger players in purchases of government debt, possibly for the indefinite future. Meanwhile, fear of currency appreciation continues to drive central banks in manyemerging markets to purchase U.S. (and, increasingly, European) government bonds on a large scale. That means markets for government bonds are increasingly populated by nonmarket players, calling into question the information content of bond prices relative to their underlying risk profile -- a common feature of financially repressed systems.

-- Modern Financial Repression, 2008-2012: Advanced economies face the common policy challenge of finding prospective buyers for their abundance of government debt. Huge purchases of such debt by central banks around the world have played a clear role in keeping nominal and real interest rates low. In addition, the Basel III rules provide for the preferential treatment of government debt in bank balance sheets.

Other approaches to creating or expanding demand for government debt may be more direct. For example, at the height of the financial crisis, U.K. banks were required to hold a larger share of gilts in their portfolio. Figure 4 documents how Greek, Irish and Portuguese banks among others have already increased their exposures to domestic public debt.

Thus, the process where debts are being “placed” at below market interest rates in pension funds and other more captive domestic financial institutions is under way in several countries in Europe. Spain recently reintroduced a de facto form of interest-rate ceilings on bank deposits.

It is difficult to sort out the exact motivations, but as bank deposits have migrated from the periphery countries in Europe to Germany and Scandinavia, among others, the amount of disclosure, red tape and other requirements that are necessary to make such transfers has been on the rise. Although some of these requirements may be motivated by a government’s desire to curb money laundering and tax evasion, the measures also amount, in some cases, to administrative capital controls.

Similar trends are emerging in Eastern Europe. The pension reform adopted by the Polish parliament in March 2011 has been criticized by the Polish Confederation of Private Employers, which said the proposal is intended to hide part of the state’s debt by grabbing the money of the insured and passing the buck to future governments. Hungary has nationalized its prefunded pension plans and excluded the cost of the reforms from public debt figures. Bulgaria has taken similar measures.

Faced with a private and public domestic debt overhang of historic proportions, policy makers will be preoccupied with debt reduction, debt management, and, in general, efforts to keep debt-servicing costs manageable.

In this setting, financial repression in its many guises (with its dual aims of keeping interest rates low and creating or maintaining captive domestic audiences) will probably find renewed favor and will likely be with us for a long time.

Dan Zwirn's Fall a Horror Story of Doing Right: William D. Cohan

Feb. 29 (Bloomberg) -- On the lengthy list of things Dan Zwirn has lost, a few items jump out. There's the $17 million condo on Central Park South, the summer place in Quogue, N.Y., and the $18 million Gulfstream IV jet. Then there's D.B. Zwirn & Co., the hedge fund that once managed $12 billion in assets, employed 275 people in 14 global offices, and created the roughly $700 million in personal wealth that made so many of Zwirn's spectacular purchases possible. Zwirn, 40, misses his money and the things it afforded him. But what he misses most, he said, is his "beautiful machine."

That's Zwirn's term of endearment for his now-defunct hedge fund. The beautiful thing about it was its discipline. D.B. Zwirn abstained from the directional or leveraged bets that other hedge funds make. Instead the firm provided capital to about a thousand companies with few other financing options -- companies such as a small New York-based Spanish-language radio group and a company that leased slot machines to casinos on Indian reservations. The one and only strategy was to learn everything about the prospective borrowers, figure their odds of repayment, crank up the interest rate to the proper pain point, and grind out 1 percent a month in profits.

For 49 straight months, Zwirn, who aspired to be the hedge fund world's scrappy singles hitter, got paid like a home run champ. The D.B. Zwirn Special Opportunities Fund had gross returns of 21.8 percent in 2003, 21.6 percent in 2004, 18.9 percent in 2005, 24 percent in 2006, and 16 percent in 2007. As machines go, Zwirn's was a Ferrari.

Kafkaesque Fight

Seated behind the desk in his personal office in midtown Manhattan, Zwirn, who's built with the compact force of a small linebacker, reaches for what have become the most prized possessions of his new life: two Lucite tombstones. They could be from any number of deals he did in his early career as an investment banker and private equity investor. Instead, each contains a replica of a letter from the Securities and Exchange Commission. The first, dated Feb. 23, 2011, absolves Zwirn -- after a four-year investigation -- of any personal blame for the implosion of his firm. The second, dated April 7, 2011, clears D.B. Zwirn of any wrongdoing. This past summer, Zwirn settled most of the outstanding civil litigation against him. "For the first time in five years, I have not been thinking of catastrophic personal downside," he says, managing a faint smile.

After a Kafkaesque fight with his firm's auditors, PricewaterhouseCoopers, and the SEC, Zwirn said the tombstones give him hard-won proof of his innocence. What the letters can't restore are his firm or the roughly 98.6 percent of his fortune that vanished over the past five years. They also don't say that he's without his share of responsibility.

Gulfstream Loan

In April 2005, Zwirn decided he needed a Gulfstream IV. He was 33 and the boss of a rapidly growing global financial behemoth. He didn't ask anyone's permission. He just gave the order, and it fell to Harold Kahn, the fund's chief operating officer, to arrange the financing.

Merrill Lynch agreed to provide 90 percent of the $18 million purchase price on a non-recourse basis and required only a $1.9 million letter of credit from Zwirn's management company to close the deal. Citibank initially agreed to provide the letter of credit; after a series of delays in obtaining the Citi loan, Zwirn still needed $3.8 million in September 2005 (including cash collateral) to meet what Merrill required to get the jet. For a firm the size of D.B. Zwirn, it was a tiny sum. Zwirn could have just written a check, but that's not particularly creative or cost-effective for a specialist in the art of using other people's money. In any event, Zwirn says he was not aware that difficulties had emerged in getting the final piece of financing.

Triple Major

To close the deal, Kahn sent e-mails to Perry Gruss, Zwirn's chief financial officer, and an accountant at the firm named Li Anne Law. Gruss authorized that almost $1.8 million be taken from the firm's domestic hedge fund and about $2 million from a $500 million account managed by Zwirn for Highbridge Capital Management. Zwirn got his jet. He says he didn't know or ask about how it was paid for.

Zwirn grew up in the Pittsburgh suburb of Mt. Lebanon, the only child of a hospital accountant father and a mother who was a teacher with a Ph.D. in literature. In 1993 he graduated from the University of Pennsylvania's dual-degree program with a B.S. in computer science and a triple-major in accounting, finance, and corporate control from the Wharton School. He then headed to Wall Street. (Zwirn and I worked together on a few deals at Lazard Frères between 1993 and 1995.) After getting an MBA at Harvard Business School in 1998, Zwirn used a connection with a Lazard partner to get a job at the hedge fund Davidson Kempner Capital Management. He bounced from fund to fund before partnering with hedge-fund mogul Glenn Dubin at Highbridge Capital, later acquired by JPMorgan Chase. In 2004, Highbridge spun Zwirn out with his own fund to manage.

'Rare Ability'

Like many people who live at the nexus of complex math and high risk, Zwirn is disarmingly intense and, by common acclaim, brilliant. "Dan has the rare ability to see the next asset class to invest in much sooner than others," said Anthony Gellert, founder of Livingston Capital, who worked with Zwirn at Lazard. "He has the ability to see around corners. I know that's a cliché, but it's absolutely true." What he's not is detail-oriented about such things as the back-office operation of his business. Zwirn saw himself at the wheel of the Ferrari; he hired other people to work under the hood.

Hiring Gruss

One of those people was Perry Gruss. A graduate of SUNY Oneonta in upstate New York, Gruss, now 44, worked for more than a decade at Nomura Securities in New York in its distressed debt and real estate businesses. In early 2002, when Zwirn was still part of Highbridge but doing his own investing, he hired Gruss to be his fund's CFO. Near the end of 2003, Gruss was being recruited by Wachovia to be chief financial officer of a 1,000- person division. Zwirn and Highbridge persuaded him to stay. "Every data point was that his old colleagues loved him," Zwirn said. "He was a big kind of EQ type of guy."

Gruss completed the purchase of Zwirn's jet quietly. By Nov. 10, 2005, the delayed Citibank loan had closed, allowing Gruss to repay what he'd borrowed from the Highbridge account and the domestic fund.

The jet was a relatively simple transaction, but D.B. Zwirn was an increasingly complicated operation. Zwirn started his firm with $500 million under management in 2004. Within a few years he had $5 billion. "Dan had a core group of people who were competent for a $500 million firm but not necessarily for a $5 billion firm," said Lawrence Cutler, who joined D.B. Zwirn as chief compliance officer in 2005 and continues to work part- time for what remains of the Zwirn management company. "Within a few months of being spun off from Highbridge, Dan upgraded the senior staff and brought in a number of experienced people to overhaul the firm's infrastructure."

SEC Registration

It was already too late. In a shift in federal policy, all hedge funds were required to register with the SEC by February 2006. As D.B. Zwirn prepared to file, all sorts of improper paperwork surfaced, including the financing documents for the G IV. According to court documents, Tim Wong, who had been hired as the firm's controller in December 2005, told Cutler and general counsel David Proshan that he noticed money from the domestic fund and the Highbridge managed account "had been improperly used to finance the purchase" of the plane. The funds had been repaid after a month, but without interest, and management fees had been taken earlier than contractually agreed-a violation of the Investment Advisers Act of 1940.

'Inadvertent Mistakes'

At first, Cutler was unconcerned. "I've seen or heard of inadvertent mistakes in the industry frequently over the years," he said. "Errors occur, and they are corrected, and as long as they don't continue, things are OK." Cutler said he asked: "We're not doing this anymore, correct?" He was told the firm was not. Cutler then asked Wong to get all the documentation for the transfers so he could figure out whether the mistake needed to be disclosed to investors and the SEC. Cutler also alerted the hedge fund's outside counsel, Schulte Roth & Zabel.

When Cutler first arrived at D.B. Zwirn, the firm didn't have a unified record of the bank accounts, the signatory authorities, or of who owed what money to whom. Cutler says he advised the team: "You can't keep opening up new funds. We've got to get this cleaned up."

When Cutler, Kahn, and Gruss briefed Zwirn, the CEO agreed to ease up. "It will be the summer of digestion," Zwirn said, coining a phrase that spread around the firm to explain the slowdown in activity. In the meantime, Zwirn asked Schulte Roth & Zabel to investigate the financing of the G IV. Zwirn says he expected they'd find "some sort of clerical issue" and that he "wanted to make sure it was dealt with in as draconian a manner as possible to set an example for other young guys."

'Heart Attack Moment'

In September 2006, Schulte reported the findings of its four-month, $2 million investigation to Zwirn, Cutler, and other senior executives in a tense Sunday evening meeting. Gruss was excluded, which should have been a signal to Zwirn of what was about to take place. But the meeting was two days before the birth of his first son and, Zwirn said, "in my mind I was thinking I'm going to see a 24-year-old who screwed something up."

Instead, Zwirn had a "heart attack moment." He learned that Gruss had arranged for the improper use of funds to finance the purchase of the jet. Among other things, he'd also taken management fees from investors before they were due and had borrowed money-without interest paid or documentation-from Zwirn's overseas fund to make it possible to do more deals in the domestic fund. Gruss had thrown sand into the gears of the beautiful machine, and Zwirn had no idea.

'Now I'm Terrified'

"In the six weeks after that day, I lost 18 pounds," Zwirn said. "I'm not saying I didn't need to, but not that way." His mind raced back to Martin Mayer's Nightmare on Wall Street, the 1993 book about Salomon Brothers CEO John Gutfreund's failure to report the 1991 scandal involving the firm's trading in Treasury securities. "Now I'm terrified," Zwirn recalls.

He decided at that moment to tell the SEC everything he'd just discovered. It was the right thing to do, and Zwirn also hoped that by self-reporting he could take advantage of an emerging legal precedent based on a case involving Seaboard Corp. in which firms that voluntarily admitted to wrongdoing could get swifter and more favorable treatment from the SEC. But Zwirn's decision turned out to have numerous unforeseen consequences. Frank Goldstein, a lawyer familiar with Seaboard at Severn, O'Connor & Kresslein in Frederick, Maryland, urges companies to have sensible expectations when self-reporting. "It's still a good way to go, but it doesn't work all the time and it can kill you in terms of timing," Goldstein says. "It's not a panacea."

Trading Lawsuits

Zwirn said he understood what he was doing and felt he had no choice but to go to the SEC. "The agony was that I knew that to do that would mean I was putting myself into a horrible position of being [mistakenly] accused."

The full scope of the accounting misdeeds at D.B. Zwirn came to light publicly in the second half of 2009, when Gruss and Zwirn traded lawsuits in federal court in New York seeking financial retribution from each other. On April 8, 2011, the day after Zwirn got his final absolution letter from the SEC, the commission added to the legal pile by filing its own a suit against Gruss. According to the SEC's 14-page complaint, on 25 occasions between March 2004 and July 2006, Gruss "knowingly misused the signatory and approval authority he had over the funds held in client accounts and directed and/or authorized more than $870 million in improper transfers of client cash, both between client funds and from client funds to the investment adviser" -- D.B. Zwirn -- "and third parties."

Early Payments

The SEC also noted that Gruss had authorized taking management fees before they were due. Without the early payments, the SEC says, the management company "would have faced severe liquidity constraints and might have been unable to fund its disbursements for operating expenses," a charge that, if true, reveals the extent to which the D.B. Zwirn funds lacked internal cash management and accounting controls. It's a rare hedge fund company with billions under management that finds itself stretched so thin that it cannot make payroll. But, according to the SEC complaint, the management company would have been short $2 million to $10 million at the end of 2005 and the beginning of 2006 if Gruss had not taken the fees early.

Still incredulous, Zwirn said he had no idea the management company was so short of cash; rather, he says, he thought the firm was flush from its steady profits and growing management fees. "Gruss has characterized what he did as, in effect, no harm, no foul," according to Zwirn's court filings. "Gruss has also admitted that he did not tell Zwirn or anyone in senior management about the practice."

'Improper' Transfers

Although the SEC hasn't accused Gruss of pocketing any D.B. Zwirn funds, it notes that the transfers were "improper," were not permitted by the Zwirn offering documents, were not disclosed to investors until after Gruss resigned in September 2006, and were violations of the Investment Advisers Act. Unless Gruss "is permanently restrained and enjoined," the SEC wrote in its complaint, "he will continue to engage in acts, practices and courses of business of similar type and object." All of which might be news to Gruss's current employer, the U.S. subsidiary of Babcock & Brown. After making and breaking six appointments to give his account of what happened at D.B. Zwirn, Gruss decided not to comment for this story. Babcock & Brown didn't return requests for comment.

Overseas Fund

At least a few people at D.B. Zwirn suspected Gruss was out of his depth. The first documented instance of Gruss's moving money between funds occurred during the first quarter of 2005. Silvia Wu, a senior accountant at the firm, received a funding request for an unspecified investment in the domestic fund and realized the fund didn't have the cash to cover it. She asked Gruss how to proceed, and Gruss told her to take the money from the overseas fund. According to the SEC, "Thereafter, a practice developed of using cash" from the overseas fund to cover the domestic fund's investments, with Gruss approving the transfers in e-mails.

Wu resigned in June 2005 "because she was uncomfortable with the interfund transfer practice," according to court documents. Zwirn said Gruss told him she left because she wanted to have a baby. According to the SEC, Wu's replacement, Li Anne Law, "repeatedly expressed concern to Gruss about the practice of transferring cash between funds." On April 18, 2005, after Gruss had approved another transfer, Law wrote him an e-mail. "Is there a game plan? Or is this something that the back office must 'learn to accept?'?" Gruss's e-mail response: "What's our altwrnatives? [sic]" Law quit the company in June 2006 "for the same reason" as Wu, according to court documents, and told her successor "not to allow herself to get drawn into the practice of making interfund transfers." Law has moved to London and changed her name. Wu now lives in Asia. Neither could be reached for comment.

Gruss Seeks Dismissal

Gruss has filed a motion to dismiss the SEC's lawsuit. Nathaniel Akerman, Gruss's attorney, argues that interfund transfers "were permitted in general as part of the basic operations of both funds, and all of the monies that were advanced to the [domestic fund] were continuously returned to the [overseas fund] either in kind or in cash with only $108 million remaining to be paid as of October 2006," after Gruss left the company. According to Zwirn, these transfers were made without his authorization, despite what the documents might have permitted.

Strict 'Micromanager'

In his lawsuit, Gruss seeks more than $10 million for defamation and breach of contract from Zwirn and D.B. Zwirn. In his July 2009 federal court filing, Gruss argues that Zwirn was hardly the disconnected genius behind the beautiful machine. Zwirn was actually "a micromanager" who "paid strict attention to every detail of his business" and "was involved intimately in all aspects of the company's investment, legal, financial, managerial, and operational details." Zwirn was "such a micromanager," Gruss contends, that the CEO "spent endless hours poring over details and data and would constantly demand that reports be provided to him immediately, day or night, weekdays and weekends." Gruss says Zwirn "needed a scapegoat" and a "fall guy" for his firm's problems, which he described as "growing at an uncontrollable pace."

In his suit against Gruss, Zwirn and his management company have demanded $45 million from Gruss. The SEC's lawsuit against Gruss and the suits between Gruss and Zwirn are pending.

Following the Script

After Gruss tendered his resignation in September 2006, Zwirn hired lawyers. Gibson Dunn was brought in to investigate the interfund transfers, and Fried Frank was retained to represent D.B. Zwirn in its dealings with the SEC. Gibson Dunn hired Deloitte & Touche to do forensic accounting work. "Now the meter's really running," said Zwirn.

Following a carefully vetted script, Zwirn called each of his investors to explain what Schulte Roth had uncovered and what Gibson was setting out to do, and followed up with a memo on Nov. 3 reiterating his "chagrin" at the accounting errors. Zwirn relinquished all authority over the Gibson Dunn investigation to Cutler and David Lee, who was elevated to CFO of the hedge funds from his job as a Zwirn portfolio manager. Zwirn also forfeited his ability to claim any of his documents, actions, or conversations as privileged. "If David and I thought that something needed to be passed over to the lawyers that would put Dan in jail for 20 years, Dan had no say in it," Cutler said. "That's really scary, especially since David and I had no clue if there was a smoking gun."

Eight-Page Memo

On March 26, 2007, Zwirn shared Gibson's conclusions with his investors in an eight-page, single-spaced memo. "Although the cumulative impact to our fund's investment performance is not quantitatively material, the conduct identified is completely unacceptable to us and deeply embarrassing," Zwirn wrote, blaming the errors on "substantial growth over a relatively short period of time." A number of other infractions-such as miscalculating NAVs and the value of certain illiquid securities-were reported. The firm also announced that it had hired Warren Rudman, the former U.S. senator from New Hampshire, to advise it on "best practices" for governance and compliance.

Zwirn paid $8.5 million from his own pocket to the overseas fund to compensate it for the lost interest on the money that Gruss had transferred. He also paid an additional $35 million for the cost of the investigations. (Neither Gibson Dunn nor Schulte Roth would make their full investigative reports available; Zwirn said he was not given copies of them, only their conclusions.)

Pushing for Audit

When word of the accounting issues at D.B. Zwirn leaked in December 2006, Zwirn decided to stop accepting new money, though money was the least of his problems. D.B. Zwirn's real enemy was time. Zwirn kept pushing PricewaterhouseCoopers to produce the 2006 audit so Zwirn's investors could get their K-1s in order to file their tax returns. But the accounting firm would not start the 2006 audit until the Gibson Dunn report was completed in March 2007. Then Pricewaterhouse fielded a 90-person team, led by partner Scott Sulzberger, to comb through nearly every aspect of the business. Despite pressure from Zwirn to complete the audit swiftly, it wasn't finished until Dec. 24, 2007, at a cost of $23 million. Between September 2006 and November 2007 investors redeemed $1.4 billion, in large part because the slow- rolling audit meant a delay in giving investors their K-1s, which then impeded their ability to file their own tax returns. PricewaterhouseCoopers did not respond to requests for comment.

'Not Absolving Dan'

Jason Papastavrou, the founder of Aris Capital, had between $10 million and $20 million invested in Zwirn's fund. "Look, we are not buddies," he said of Zwirn. "I am never going to go to lunch or dinner with him." Papastavrou said Zwirn's biggest mistake was hiring Gruss, but, "I am not absolving Dan for what happened. His name was on the door." Still, he doesn't think Zwirn deserves his fate. "Dan was beyond a workaholic. He was not some guy out in the Hamptons, chasing chicks in his Ferrari. Dan used to have 7 a.m. meetings on Saturdays in Central Park with his portfolio managers. Nobody worked harder."

After a total of $2 billion departed the funds, Zwirn decided in February 2008 to wind them down. Fifteen months later the remaining $2.5 billion in illiquid assets were transferred to an affiliate of Fortress Investment Group LLC, which continues to manage them. "My life's work is gone," Zwirn said.

Meanwhile, the SEC investigation churned on. According to Steven Witzel, Zwirn's counsel at Fried Frank, Zwirn could have made the decision "lawfully" not to self-report the incidents to the SEC because the amounts of money involved were nonmaterial. Instead Zwirn turned over more than 15 million documents, and the commission took sworn testimony from a dozen Zwirn employees and interviewed many others.

SEC Staffing

"Many cases take longer than we would like -- in fact that's typical," Witzel said. "The staff wants to make sure they are thorough. Here they had one staff attorney with supervision. Typically, we'd like to see it over sooner, but the SEC in this case didn't have the personnel to do it any faster."

Why the SEC didn't add more people to the investigation and ignored the Seaboard precedent is a question the commission hasn't answered. George Canellos, the director of the SEC's New York office and the most senior official involved with Zwirn's case, did not return phone calls seeking comment. The SEC made one of its lawyers available to discuss the Seaboard precedent but only on background and not in relationship to the Zwirn investigation or its active case against Gruss.

Changed View

Zwirn has been changed by his tribulations. His once- ubiquitous self-confidence is gone, and he's more cynical; he says he no longer believes the world is meritocratic or that doing the right thing always yields the right result. He reserves most of his anger for the SEC and PricewaterhouseCoopers, with a special citation for Robert Khuzami. Prior to D.B. Zwirn's assets being sold to Fortress, Zwirn tried to partner with Deutsche Bank to buy back his firm. Khuzami, then the bank's general counsel for the Americas, was one of the people Zwirn spoke with regularly. Zwirn says Khuzami knew about Gruss and the money transfers when he joined the SEC as its chief enforcement officer and could have helped bring about a faster resolution. But Khuzami recused himself. Khuzami didn't respond to a request for comment made in an e-mail to an SEC spokesman.

The two letters encased in Lucite have brought Zwirn a modicum of relief. Still, Zwirn and others at the now defunct firm are astonished at the way in which D.B. Zwirn vanished. As a result of all the delays, "he lost the support of his investors because he wasn't able to provide them [with] what they ultimately needed, which was enough information -- like the K-1s -- to keep them happy," said Cutler.

'Patient Was Dead'

"Dan went down because basically we as a firm decided to go public with the issues in the organization, which in hindsight is a difficult thing to do. We spent tens and tens of millions of dollars providing a tremendous amount of information to regulators. In the end, the resolution was great. But by then the patient was dead." Zwirn doesn't blame Gruss -- "Perry's activities didn't kill the business on their own," he says -- but he also doesn't hesitate when asked what he would have done differently: "Hired a different guy to be my CFO."

Zwirn is not impoverished. He has pieces of two small banks as well as a small commercial finance company and an office building in Beverly Hills. "It doesn't take a lot of my time," he says of his remaining investments, "but it's a fine thing."

He lives in a rental apartment on the Upper East Side of Manhattan with his wife, a fixed-income research analyst at Morgan Stanley, and their two young sons. He's thought about returning to school to get a Ph.D. in philosophy or foreign policy and considered turning his positions on the board of the Brookings Institution and as a member of the Council on Foreign Relations into full-time research gigs. He hopes to reclaim his reputation, noting that Google searches of his name do him no favors.

Potential Investors

Not surprisingly, Zwirn would also like to get back behind the wheel. He recently returned from visiting potential investors in London, flying business class on a commercial jet. "The macro environment for what I know how to do is exceptional and has prospects of being so for quite a long time," he said. "I got a lot of clarity from this process. It's what I am actually doing for 15 hours in a day that's important. And so there's lots of forms that could take as long as I'm able to do something that has the levers and buttons and control panel on it."