Legends

Even for the affluent residents of London's Holland Park, the arrival in the area last year of Gerard Griffin, head of Tisbury Capital, was big news. Curtains twitched as a multi-million-pound refurbishment of his house began. Rather than buy furniture or even appoint an interior designer, Griffin and his wife Sarah commissioned top artists to produce original work specifically for their home.

Soon the Griffins boasted a dining-room chandelier by glass artist Deborah Thomas, two installations by potter-sculptor Edmund de Waal (including a complete room of more than 600 porcelain vessels), and an architectural version of a Morandi painting in the gallery by ceramist Julian Stair. It was, Mrs Griffin modestly told one visiting reporter, "simply an extension of collecting on a domestic scale".

To the neighbours, the house had been "hedged" - snapped up and spruced up by a rich hedge fund manager. These flash Wunderkinder are branching out, and surpassing toffs, lawyers and even footballers' wives with their reputation for ostentatious opulence.

As head of Tisbury, a $2.7bn (£1.35bn) event-driven fund founded in 2003, Griffin was the archetypal hedge fund manager: aggressive, arrogant and nearly always right. He audaciously took large positions in big public companies including ICI, J Sainsbury, EMI and Alliance Boots, and was listened to by their managements despite being smaller than other shareholders.

But just a year on from the refurbishment of his Holland Park house, this pillar of London's hedge fund industry is on shaky ground. The latest bite of the credit crunch has caught Griffin offguard and Tisbury offside with some of its biggest investments. The fund was down 8 per cent in the first two months of the year, according to Tisbury's monthly letter - and losses are getting worse.

The financial crisis in full

Hamstrung by the lack of liquidity and savaged by increasing redemptions, Griffin has had to negotiate new terms with his prime brokers, beg for patience from investors and offered his business for sale to bigger rivals, including GLG Partners.

One insider said: "Tisbury has gone from darling to disaster is a short space of time. Griffin is losing staff and probably won't get much for the sale. It's been amazing turn of fortunes."

Griffin is not alone. Some of the most successful players in the industry also have serious problems. The past month has been littered with high-profile calamities.

At the end of February, Peloton Partners, the award-winning fund run by ex-Goldman Sachs star Ron Beller, imploded. Focus Capital, another EuroHedge fund of the year, wound up days later. Then came the biggest casualty so far: the spectacular collapse of Carlyle Capital Corportation after a $16bn debt default.

Last week, it was the turn of John Meriwether, the man behind the collapse a decade ago of Long Term Capital Market. His bond fund at JWM Partners is struggling with losses of 28 per cent this month.

One industry expert told The Sunday Telegraph: "This is just beginning. Somewhere been 40 and 100 hedge funds will liquidate shortly. It's a bloodbath and it will get worse."

Already investors are showing their fury. One said: "I thought volatility was what hedge funds lived for? Making money, or at least preserving cash, during volatile times is certainly what we pay them for. They have been poncing around during the good times and are now found wanting at the first sign of trouble. It's a debacle out there."

Worse, the sector is being vilified for the first time in years. Hedge funds have been blamed for all market woes from the implosion of Bear Stearns three weeks ago, the collapse of HBOS's share price days later and now the weaknesses of the entire Icelandic economy.

Away from the credit crunch, Pentagon Capital Management, a London-based fund, last week said it was winding up its $2bn funds after being embroiled in the SEC investigation into market timing.

Pentagon Capital and Lewis Chester's losing battle

Suddenly, there's a new fear surrounding the sector. Just a few months ago these were the best brains in finance. Now they are being exposed as average fund managers at best, and potential market manipulators at worse. How many more pretenders are there out there and how much more chaos will their demise bring to the rest of the markets?

Six years ago, as financial markets hit rock bottom, David Prosser, chief executive of Legal & General, one of Britain's biggest life and pension funds, demanded a regulatory review of the way hedge funds influenced stock markets. He was joined by other corporate leaders, but they were dismissed as dinosaurs who were panicking because they didn't understand the practice of short selling.

Hedge funds morphed from being American, secretive and peripheral to becoming one of the most important influences on global markets. Assets grew from about $200m in 1998to an estimated $1.5 trillion at the end of last year.

Mayfair became the new hedge fund capital and a new openness was heralded with both more activism and public flotations. RAB Capital floated in 2004, Cheyne Captial followed and then GLG Partners last year.

At the same time, hedge funds shed their pariah image and developed cult status. With legendary brains - and pay packets to match - they started attracting celebrities and politicians.

Meet the Hedgies

Goldman Sachs, for instance, lost rainmakers Emmanuel "Manny" Roman to GLG and Ron Beller, who hit headlines when he failed to notice that his secretary Joyti De-Laurey had stolen £1m from him, to Peloton.

Lord Lamont, the former Chancellor, was made chairman of RAB Capital, while Clareville Capital attracted Eddie Jordan, the motor racing supremo, and Charles Dunstone, founder of Carephone Warehouse as non-executives.

With their dominance came increasingly displays of hubris and extravagance. Two years ago Albourne Partners, a hedge fund adviser, hired Knebworth and staged Hedgestock - the "alternative conference for the alternative investment industry" - one of the most extravagant and bizarre business meetings ever organised.

There were talks and meetings like any normal business conference, except the grounds were decked out as if it were a 1960s music festival, with the additions of a polo field, laser clay pigeon shooting range, hot-air balloon station and remote-controlled duck racing, while 4,000 delegates were dressed as hippies and danced to a live performance by rock giants The Who.

Meanwhile, London's annual Ark dinner, the industry charity night, became the biggest fund-raising night in the world.

Organised by Arpad "Arki" Busson, the multi-millionaire French financier and former boyfriend of supermodel Elle Macpherson, more than 1,000 hedge fund managers and celebrities, including Jemima Khan, Bob Geldof and Liz Hurley, paid up to £50,000 for a table.

Last year, a speech by Bill Clinton, a private concert by Prince and an appeal from Madonna helped raise a record of £28m.

Even when the markets turned last year, the hedge funds' high jinks continued. Stephen Partridge-Hicks, the former Citibank debt guru and head of Gordian Knot, one of the big credit hedge funds and so hit first, tackled the crisis by splurging thousands of pounds on a show-stopping party.

In October, as his fund tanked, he chartered a plane to fly 150 mates to Morocco where he had hired Marrakech's upmarket Amanjena hotel for a James Bond-themed party. On top of the usual champagne and haute cuisine, Patridge-Hicks staged a James Bond scene - complete with actors, stunts, a real submarine and a fly-by from two Mig jets - starring himself as 007.

At the start of this year, hedge funds had been protected from the full impact of the credit crunch. While private equity houses experienced a sudden severance from lending, investment banks largely kept open for the hedge funds, which are smaller borrowers but crucial fee generators.

In recent weeks, this has changed. Scrambling to cope with the next stage of the credit crunch, bank bosses ordered their prime brokerage and repo departments to comb through their books again and slash risk exposure.

Lending lines have been cut, just as the funds needed them most to cope with the volatility. One prime broker said: "People representing top brass are coming round like the credit police. The mood is that of no mercy, even to the most important clients."

A new view of hedge funds has been revealed, particularly with regards to borrowing levels. In recent years, leverage in the funds has spiralled. While hedge funds have traditionally used two or three times leverage in their funds, this figure has been multiplied to eight or nine times in many cases - and even more in some.

One prime broker said: "Hedge funds have had it easy. Every man in a pink Cadilac has been able to raise money, start a fund and do really well. Frankly, those who have taken the biggest risks have come off best because markets have been so extraordinarily kind."

The leverage that magnified gains in the rising markets has had the same impact on the way down. Weaker funds were the first victims. But now the squeezing by the lenders has meant that a far bigger number have had no cushion or protection against short-term swings.

Beller wrote to his investors: "Because of their own well-publicised issues, credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has . . . made it impossible to meet margin calls."

In the aftermath, others have a different view. One observer says: "The only way to generate 90 per cent returns off AAA-rated bonds is if you are taking too much risk. Simple as that."

Another friend says that he often boasted that Peloton was sailing close to the wind. "I once asked Beller how he would cope if the market suddenly turned and he was forced to mark to market. He said he'd be in trouble but that would never happen."

Focus Capital, the fund that liquidated two weeks ago, was managed by Tim O'Brien and Philippe Bubb, who formerly worked at Pictet & Cie in Geneva. Focus won a EuroHedge industry award after returning more than 100 per cent in 2006. O'Brien and Bubb told investors that they had been the victims of the credit crunch and short selling. But observers disagree: "Focus took large stakes in very small, illiquid companies. In these markets that's a dangerous position to be in."

Two weeks ago funds were caught out when the so-called "box trade" - betting that 20-year bond and swap spreads would widen as seven-year spreads narrowed - moved against them. Endeavour Capital, run by former Salomon Smith Barney fixed-income traders, told investors that 27 per cent of the value of the $3bn fund had been wiped out. The fund is thought to have been 18 times leveraged.

Meanwhile, Platinum Grove, the $5.5bn New York-based hedge fund set up by former Long Term Capital Management co-founder Myron Scholes, fell 7 per cent when Japanese prices moved suddenly. Investors said that London-based London Diversified had lost between 4 per cent and 5 per cent, too. The fund's founders, led by David Gorton, famously took £55m in management fees after the fund's first year in 2004.

Already, the sector is starting to look very different. As well as the closures, hedge fund inflows have slowed dramatically. Recent figures collected by Absolute Return, the trade magazine, showed that total assets in the big US funds grew by 34 per cent last year, but only 10 per cent of this was in the second half. This year inflows across the sector have almost dried up.

Even so, the big funds say the fall-out will make the sector stronger. Notes one: "Hedge funds aren't dead, they have been far too successful for investors to lose faith in them. But it will be the ones that are looking more like grown-up institutional investment houses that will thrive and get bigger, leaving the pretenders behind."

Neil Wilson, editorial director of Hedge Fund Intelligence, says: "One broader concern going forward will be that some strategies will be less practical than others - and that we will probably see an increase in the shutdown rate of some types of funds. But if markets continue to be very volatile then we should also see some funds making big gains this year, such as the CTAs and Macro funds that did so well in January and February ".

Prime brokers say that the survivors are big funds with diversified portfolios and are not overleveraged. One said: "Over the next few months, there will be a shake-up of hedge funds and the ones that survive will be stronger and more robust - essentially, the new breed of hedge funds that take the sector to the next stage of development."

Behind the scenes many are thriving: GLG, Lansdowne and Brevan Howard stand out as winners still generating double-digit returns.

The sector is also taking on a far more sober outlook. This year the Ark dinner has been moved from Friday night to Thursday. The invitation reads: "We recognise that these are very difficult times for many of our supporters, but we are counting on your continued support to enable us to drive forward and implement our vital programmes for the benefit of so many children."

One said: "Hedge funds got carried away. Benevolent markets meant that anyone could be a superstar which couldn't be true. The current crisis will quickly show the pretenders and leave behind those that are genuine hedge funds - that can make money whatever the weather."