It's not denial. I'm just selective about the reality that I accept.
Bill Watterson, author of Calvin and Hobbes cartoon series

Many private-equity and hedge fund managers are facing a perfect storm of economic and credit challenges that threaten to destroy their businesses. Unfortunately for their investors, rather than face these challenges head-on, many of these managers are choosing to emulate their lenders and pretend that these problems don't exist or are just a temporary bump in the road.

This strategy of hope and denial by private-equity and hedge fund investment managers does not benefit their limited partners and in many cases does not benefit the manager in the long run; it will lead investors to pull out their money and never return to those managers who lose credibility.

There is a better way for managers to handle the crisis that they're facing, but first let's examine the severity of the problem.

Nearly all leveraged private-equity funds and hedge funds that were focused on leveraged buyouts or leveraged real estate investments are facing enormous losses in their funds. That includes, to name just a few: Blackstone ( BX), Fortress Investment Group ( FIG), Farallon, Lubert Adler, Broadway, Whitehall, Perry, D.E. Shaw, D.B. Zwirn, The Carlyle Group, KKR, Cerberus, et al. I am not singling out any of these firms. Every private-equity fund and hedge fund that entered levered real estate and corporate buyouts for the last several years is facing the same situation.

The problem is that during this down cycle the interests of the managers and the limited partners are no longer aligned. Managers want to hide losses and hope the values of their bad investments recover so that they don't have to face the wrath of investors for losing so much of their money.

Unfortunately, this strategy of denial makes the problems and losses even worse because it makes it impossible for the manager to take the appropriate and necessary steps to recover value for the investors. Managers can't do the right things to fix the problems if they keep denying that the problems exist.

Further, down markets present problems that require expertise many current fund managers do not have because they were set up to take advantage of the long bull market in credit and assets. Many private-equity and hedge fund managers were experts at financial engineering, deal structuring and bull market-oriented exit strategies such as the quick flip, but they are not as experienced or nearly as capable when it comes to workouts, distressed situations, minimizing losses and slowly recovering value in a bear market environment.

This lack of capacity to deal with problems has been made even worse by managers as they try to cut overhead costs by reducing staff because they are not making new investments.

Many investment managers are now trying to handle hundreds of millions or even billions of dollars of distressed real estate and corporate buyouts with only a skeleton staff. This is nearly impossible to do correctly and is clearly not in the best interests of the limited partners in these funds.

Another operational problem facing managers is that they often have several different funds with completely different sets of problems that they are trying to manage at the same time with limited staffing and internal expertise. The problems with a real estate fund are completely different than the problems with a corporate-buyout fund or a credit strategies fund.

In the current environment, managers are focused on their survival and not likely to pay close attention to the unique problems facing each of their multiple funds with completely different strategies in different asset classes. Human nature will lead managers to focus on what makes money for them, which at this point is raising a new fund because the carried interest in the old funds is wiped out and does not have any realistic chance of ever being worth anything.

Unfortunately again, for their current limited partners, none of this behavior by the manager is going to help them maximize recovery of their investment in the current funds that are distressed.

Many limited partners are very frustrated with the performance of their investment managers, but they are reluctant to do anything that would create a hostile situation and try to remove the manager by force. However, a change of management doesn't need to be hostile. Limited partners can raise these operational issues facing managers and suggest that supplementing their expertise and staffing with either a co-manager or a subadviser would benefit all parties.

The limited partners could feel that there is an independent group with new expertise looking out for their interests, and the existing manager will be relieved of some of the work and responsibility for dealing with the problem funds. In some cases, the current manager may want to exit entirely to pursue other opportunities and would welcome handing off the responsibility of liquidating a troubled investment fund to another group that is acceptable to the limited partners.

Limited partners need to start thinking more creatively and strategically if they expect to receive any significant liquidity from their investments in illiquid hedge funds and private equity in the short term. In the long term, it may be many years before the value of private equity and hedge fund investments start to recover any significant value. Hoping that the real estate or corporate buyout market recovers in two years, even if the economy turns around, is not realistic. The last down cycle lasted more than six years, and our current economic situation is even worse.

Some of these investments could never recover value because there was just too much leverage involved. Limited partners need a plan to either change or supplement existing management in these troubled funds if they want to be assured of having the best chance to recover value from their investments. This would also create an orderly transition between the current management structure and a new one that is focused specifically on recovering value for investors rather than maximizing profit and minimizing costs for the fund manager.

Action Alerts PLUS

As far as publicly traded fund managers such as Blackstone, Och-Ziff Capital Management Group ( OZM) and Fortress, their stock prices already tell the story of what is happening to their businesses. Although their executives talk publicly about how this is a great environment for them to make new investments and they will be back stronger than ever in a few years, the evidence does not exist to support those statements. These companies should not be public at all, and will probably be taken private again by the principals at fire-sale prices at the bottom of this bear market.

As a public shareholder of this business, you are really just making a bet on the return of expansionary credit and asset appreciation. You can make this bet in many other ways without paying the hefty fees that these managers charge their investors or being diluted by the enormous compensation that they pay their executives.

Investors are better off buying an S&P or Russell index ETF such as the S&P 500 Depositary Receipts ( SPY), which holds shares in AT&T ( T), Exxon Mobil ( XOM) and Procter & Gamble ( PG). Another choice is the iShares Russell 2000 ( IWM) ETF, which holds shares in Waste Connections ( WCN) and Myriad Genetics ( MYGN). If you believe the real estate markets will recover, you may even consider the REIT index ETF such as iShares Dow Jones US Real Estate ( IYR), which owns shares in Vornado Realty Trust ( VNO) and Equity Residential ( EQR).
At the time of publication, Grey had no positions in stocks mentioned.

Christopher Grey is a managing partner and co-founder of Third Wave Partners, a leading restructuring adviser, distressed situations expert and turnaround operating company focused on the real estate industry. Previously, Grey was a managing director in the California office of Emigrant Realty Finance, the real estate group of Emigrant Bank, a New York-based financial institution with $17 billion of assets. Founded in September 2005, the California office of Emigrant Realty Finance completed and managed on balance sheet $2.5 billion of debt investments.

Grey is a founding member of the Capital Markets Forum II of the National Association of Office and Industrial Properties and the Stanford Real Estate Network. He is a graduate of Stanford University with a degree in economics and holds a California real estate broker's license.