By Porter Stansberry in the S&A Digest:

"Maybe what we should have done was not bought it," said Steve Feinberg, co-founder of hedge fund Cerberus Capital Management, in regard to his firm's ill-fated 2007, $7 billion purchase of Chrysler. Longtime readers will recall my sarcastic quarterly letters from the "chairman" of General Motors from exactly the same period. Using the satiric voice of the "chairman," I explained a serious fact: GM couldn't afford the $5 billion in interest it owed on its debts each year. And as its credit rating fell, its interest expenses would rise, resulting, inevitably, in a bankruptcy filing.

Although you had to be able to read financial statements to determine these facts, it didn't take much more than common sense to realize a company that hadn't earned enough money to pay the interest on its debts since 1992 and had added to its debt pile in 19 of the last 20 years probably wasn't going to make it. Here's the incredible part: Chrysler's debt load was even larger. It would have to earn $10 billion a year, just to pay the interest on its obligations.

With the Cerberus-Chrysler story in the back of your mind... allow me to share two secrets I know to be true about hedge funds. First, they are all destined to fail. And second, the entire industry consumes capital. Thus, while you might make money on a given fund, in total, hedge-fund investors are destined to lose money.

Why? Hedge funds are doomed by the Peter Principle. The Peter Principle, you'll recall, is that in the corporate world people tend to be promoted to the point of incompetence. Someone who is a really good salesman isn't necessarily a good manager. Someone who is a good manager isn't necessarily a good corporate executive. And someone who is a good corporate executive isn't necessarily a good CEO. But nobody knows where they'll top out in ability before it's too late. The same thing is true with hedge funds - with catastrophic financial consequences.

In the case of Cerberus, Steve Feinberg was a great distressed (junk) bond investor. Michael Milken trained him. He has an unbelievably high I.Q. and beat almost anyone in chess - blindfolded. This gave him a valuable edge in the debt market and attracted a large and powerful group of investors. They promoted Feinberg, in terms of capital and influence, into the top rung of the hedge-fund world - where he failed miserably. He reached his Peter level. And his investors lost $6 billion last year. While I don't know it for a fact, my guess is that's more money than Cerberus earned, in total, to date.

Here's how it happens: These fund managers pile their gains up and reinvest their capital in their next big trade. But... sooner or later they reach a level of capital under management that requires them to move into new areas. And eventually, they blow up. I know of only one hedge-fund manager who cashed out of his entire fund near the top in 2007. Only one.

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