Some investors who paid $30 per share for

Fortress Investment Group

(FIG)

in early 2007 might be asking the following as its stock hovers near $1 today: Why didn't anyone ever advise me to sell?

Like other alternative-investment firms, Fortress faces incredible difficulty raising new capital as asset values have declined, returns have become more meager and investors are clinging to cash for dear life. A tidal wave of redemptions from existing clients forced Fortress to halt further investor withdrawals from its Drawbridge Global Macro Fund in December, about a month after the firm posted a third-quarter loss that fell far below Wall Street's profit expectation.

Fortress' liquid hedge-fund segment -- which includes Drawbridge Global Macro and Fortress Commodities Funds -- accounts for $9.1 billion worth of capital, and clients can ask for their money back at the end of every quarter. The most recent available figures show that clients demanded $5.6 billion of their cash back in 2008.

Fortress' other hedge-fund business -- a hybrid one that includes Drawbridge Special Opportunities Funds and Fortress Partners Funds -- accounted for $8.2 billion worth of capital. Although those funds have more strings attached to redemptions, clients still asked to withdraw $2.3 billion last year.

Jeffries & Co. analyst Daniel T. Fannon estimates that when all is said and done, assets under management in Fortress' hedge-fund group will fall by nearly 40% to $10.5 billion. As the hedge-fund world navigates through dire straits, Fortress' other business -- private-equity -- didn't lose any capital, but also has the luxury of long-term restrictions around its funds.

Fortress isn't alone in its struggle; the entire

hedge-fund

industry is shrinking as the recession has taken hold, asset values have declined and clients have demanded their money. Private-equity players are finding attractive investment opportunities, but lack the financing to get deals done.

Overall, Fortress showed relative strength as the bear market took shape, with its Drawbridge Global Macro fund down 13.5%, Drawbridge Special Ops fund down 5.7% and the Commodities fund up 7.2% through Nov. 30 -- better performance than the overall markets or many of its peers, according to a recent report by Fannon.

Banking on Strong Reputation

Fortress' reputation and relatively decent performance allowed the firm to raise $3.1 billion in new capital, net of redemptions requested, for the year ended Dec. 31. It was also able to refinance nearly all of the $7.2 billion worth of debt that was to mature in 2007 and 2008 at an average cost of 6.5% -- a phenomenal feat for an alternative-asset manager with a plummeting share price, in the midst of an unprecedented credit crisis.

Looking ahead, there are several factors that will determine Fortress' ability to survive. If the credit crisis calms down, Fortress' nearly $40 billion in outstanding debt may not overwhelm the firm in coming years. If investors' risk appetite returns, or Fortress proves its reputation is deserved, the company will find it easier to raise more capital. If liquidity is restored to the market, Fortress can make big bets and boost performance more easily as well.

But all of those are big "ifs." Fortress CEO Wes Edens highlighted "limited private equity realizations as well as zero or limited hedge fund profits" in coming quarters as key concerns for investors. The outlook has arguably worsened since that conference call on Nov. 13, and the firm will have to do something to entice new clients to place their funds with the firm and to keep existing investors happy while holding onto their cash.

If Fortress is unsuccessful in doing so, it could impact the companies in which it holds a stake. Ironically, companies whose stocks have performed the best may suffer the most, if Fortress is forced to liquidate holdings to return cash to clients. Top holdings include

Caterpillar

(CAT) - Get Report

,

General Electric

(GE) - Get Report

,

Goldman Sachs

(GS) - Get Report

,

Nike

(NKE) - Get Report

and Blackberry-maker

Research in Motion

( RIMM), according to Fortress' most recent filing on Sept. 30 about holdings in its various funds.

Goldman Sachs analyst Marc Irizarry believes that Fortress will have to reduce or waive management fees in light of weak performance and accelerating outflows. Eric Newman, a co-portfolio manager at the advisory firm TFS Capital, which operates two hedge funds and two mutual funds, believes that transparency will also be key, as Fortress works to maintain its reputation with clients and investors.

"Managers don't have a free pass anymore to say 'Trust me,'" says Newman. "Saying, 'We know better than you what to do with your money,' then halting redemptions as performance suffers, is not going to fly anymore."

Window of Opportunity

Whatever Fortress does to rebuild confidence, it is presently seated in a window of opportunity, with much of its debt pushed back to a later date, and a bullish sentiment from top investors like

Nomura

(NMR) - Get Report

,

Fidelity

,

Oppenheimer

,

Bank of America

(BAC) - Get Report

and

Legg Mason

(LM) - Get Report

, which all recently increased their holdings.

There are also fewer investors betting against Fortress, with short interest shrinking to around 5%, vs. a height above 10% in late September. The Street seems to be arguing that Fortress is a bargain. Analysts are targeting exponential increases to its value over the next 12 months -- with one believing it could sextuple, and just one recommending that clients sell the stock.

However, in a year that saw some of the mightiest financial stocks crumble to a fraction of their value, or become worthless, it's tough to imagine a good short-term outlook for Fortress. Investors once burned by keeping the faith in firms like

Bear Stearns

,

Lehman Brothers

,

AIG

(AIG) - Get Report

,

Freddie Mac

( FRE) and

Fannie Mae

( FNM), only to watch stock prices plummet and never return, may be twice warned -- particularly if Fortress's year-end report is bleak.

"If you had asked me 12 months ago, would I think that

General Motors

(GM) - Get Report

is going to go down to $2, $3 a share? And I would say no," says Newman. "Would Fortress go down to $1.25 a share? I would say no. Some of these are going to be great investments that turn around to $20 a share next year, but others are going to go under and I think it's a fool's game to figure out which one is which."

Another fund manager says he would be more of a buyer than a seller, because those leading Fortress are "very, very bright people" and "it's very possible that they could come back and live another day."

There are unsubstantiated whispers that Fortress' principals may just take the firm private, with a market cap hovering around a mere $120 million. Such a move would allow Fortress to take advantage of attractive opportunities without the added scrutiny of regulators and public investors, thus limiting its vulnerability to bear-market reputation risk. Such an outcome -- while always possible -- is still just speculation today, but the rumors helped spur a rally in Fortress' stock on Monday, driving shares up nearly 50% to $1.90.

Morningstar analyst Alan Rambaldini warns that lower fees, weak performance, difficulty raising capital and tough credit conditions will hamper Fortress' returns for the near term. He notes that redemptions could force Fortress to wind down, leaving shareholders in the lurch, but bets that the company's track record and strong management will allow it to weather the economic storm.

His outlook, however, provides little solace for investors who watched Fortress shares plummet in value, or clients whose funds are now locked up after watching returns slip into the red.

"Although we think Fortress will ultimately come through all right on the other side, it's unlikely to repeat its former success," Rambaldini said in a recent note, "and the near term could be a wild ride."