Small firms to play big role in hedge fund M&A

NEW YORK — The hedge fund industry is due for a big shake-up in the next couple of years as small firms with paltry assets under management exchange independence for infrastructure and distribution.

That's the view in a report on hedge fund merger and acquisition activity scheduled for release early next year by investment bank Freeman & Co. LLC, New York, which strongly suggests a surge in hedge fund consolidations.

By contrast, a pair of investment bankers who specialize in alternative investment management deals — Ted Gooden and Torjus Berge, vice presidents at Berkshire Capital Corp., New York — are less convinced the shake-up will manifest as outright consolidation among hedge funds. Instead, Messrs. Gooden and Berge predict that a range of partnership structures will be set up as larger hedge funds buy up revenue stakes in promising startups, firms take equity stakes in each other to gain distribution clout, and hedge fund-of-funds managers hit a brick wall in terms of profitability.

In fact, the Berkshire duo thinks it far more likely that consolidation will take place among unprofitable hedge fund-of-funds managers than between hedge funds themselves.

But in Freeman's latest report, authors Eric C. Weber, principal, Olga Freidzon, associate, and Frank Reynolds, analyst, think hedge fund consolidation will be sweeping in scale.

Seven hedge fund acquisitions, with $9 billion in total assets under management, occurred in 2004, compared with 2003, when only three hedge funds changed hands.

The deal flow, still admittedly just a trickle, will likely trend sharply upward, said the report's authors, as small hedge fund managers come to terms with their limited chances of commercial success and sell their firms to gain scale and liquidate their ownership.

In fact, small is the norm at this stage in the hedge fund industry's development, according to the report, which estimates that 70% of the world's approximately 8,000 hedge funds manage less than $100 million.

The problem is that hedge fund companies that can't attract sufficient assets are very vulnerable to performance volatility, which is compounded by a lack of investment strategy diversification, according to the report.

By way of example, the authors note that a hedge fund that charges investors a management fee of 1% of total assets and 20% of profits, and returns 10%, receives two-thirds of its annual revenue from performance.

"This high dependency puts a small firm under extreme pressure if performance is low or negative," the report stated. "Small hedge funds that face even two difficult years may witness their revenues erode significantly and may not be able to cover their operating expenses or retain talented professionals. This will force many to consider partnering with a larger organization that will be able to support the manager until performance returns."

Further compounding the problem for smaller firms is that negative performance and a subsequent decline in assets under management will make it even harder to raise more capital from new or existing investors. Because most small hedge fund companies offer one investment approach, they are left at the mercy of the markets when their strategy is out of favor.

Other problems unique to smaller hedge funds, according to Freeman researchers, include:

• Compensation challenges for key personnel, especially during cash-flow crunches;

• Operational issues such as scarcity of resources to support marketing, compliance, administration, systems and technology and investment research;

• Rising costs for compliance when new Securities and Exchange Commission regulations become effective in February 2006; and

• Investor concerns about small hedge funds, ranging from lack of infrastructure to name-brand recognition to operational and compliance risks.

With hedge funds of funds now controlling an estimated 40%, or $478 billion, of total hedge fund industry assets, Freeman researchers decided to use these firms as a kind of proxy for institutional investors and asked 20 firms about their comfort level with hedge fund size.

Freeman's survey found that 40% of hedge fund-of-funds respondents start to lose confidence in hedge fund managers managing less than $50 million; and a much smaller group, 15%, said they would not invest in a hedge fund managing between $50 million and $100 million. Hedge funds of funds surveyed only invested an average of 4% of their assets in funds managing less than $50 million. Just more than 80% of those surveyed said they were worried about the lack of infrastructure; more than 60% are concerned that small hedge fund portfolio managers have to devote significant attention to business operations; and 50% said they were concerned that smaller hedge funds are too dependent on key personnel.

The authors of the report also found that most hedge fund-of-funds managers are reasonably comfortable with merger and acquisition activity among smaller hedge funds, which is good, considering the merger mania the authors expect to see within the next few years.

Deals Freeman analysts expect to see among larger hedge funds include acquisitions of smaller firms that use different investment strategies in order to broaden their internal ability to offer multistrategy funds. Large financial service companies that don't currently offer hedge funds are also on the acquisition trail in order to add them to their product mix. Freeman researchers said they definitely expect larger financial institutions to follow the lead of JPMorgan Chase & Co., New York, which last year acquired hedge fund manager Highbridge Capital Management LLC, New York.

The investment bankers at Freeman also expect some consolidation among smaller hedge fund managers as multistrategy hedge fund platforms become more common and allow hedge fund managers to use pooled resources such as fund administration, marketing and information technology.

Rather than outright consolidation of the kind predicted by Freeman researchers, Berkshire's Messrs. Gooden and Berge predict that poor returns and the gradual institutionalization of the hedge fund industry will cause a huge increase in collaboration among hedge fund managers.

While many industry observers predict consolidation among hedge fund companies, Mr. Gooden said what's happening "very under-the-radar-screen because these are private deals" is "partnering" between the talented investors at hedge fund startups and larger, more established hedge fund managers.

"Bigger firms are redeploying some of their capital to gain revenue shares in smaller funds with different skill sets. It's really the capital side of the business at work: Smaller firms want trading capital that can help them get up to that critical $150 million under management, the magic number where institutional and other investors will start to look at them," said Mr. Gooden.

Mr. Berge said Berkshire is in talks with many companies on both sides of these revenue-sharing deals.

In addition, he said, larger hedge fund firms are striking cooperative deals with other hedge fund managers that have different skills sets, mainly to gain access to each other's client lists. While these deals are structured in many ways, Mr. Berge said most long-term deals involve an exchange of equity.

The hedge fund-of-funds niche is the one area where true consolidation is inevitable, Mr. Berge said. "The hedge funds-of-funds world is about to change dramatically," he said.

By Berkshire's estimates, hedge funds of funds with less than $2 billion under management are likely destined for extinction because of fee pressures and lack of scale. Berkshire estimates that at least 500 hedge funds of funds are simply not viable concerns going forward.

"Let's say you've got a $1 billion hedge fund of funds, with 40 employees necessary to do all the due diligence, research, compliance and sales and marketing needed to sell the funds. You simply aren't going to make enough money to cover all the overhead. You have a job, but you don't have a going concern," Mr. Berge said.

Messrs. Gooden and Berge said they've seen an enormous increase in the amount of dialogue between hedge fund-of-funds managers on all continents as they realize that they require scale to survive. "We expect a lot of consolidation activity in this space in the next two to three years," said Mr. Gooden.