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Hedge Funds Headed for M&As: Institutional Investors Looking for Large, Established Firms

The hedge fund industry will consolidate through mergers and acquisitions, as the funds continue to proliferate and gain popularity among institutional investors, experts predict.

"This is absolutely going to happen," said Joel Press, a managing director with the prime brokerage division of Morgan Stanley, speaking to an audience at The National Investment Company Service Association's "Alternative Investments Conference" in New York last month.

"While it hasn't started yet, it is the logical next step for the industry," concurred Ted Dougherty, a partner at Deloitte Tax, a Deloitte & Touche subsidiary.

Hedge funds are not required to register with a government agency, but currently there are estimated to be 9,550 hedge funds globally, up 7% from last year's 8,900, according to New York-based Hennessee Group's recent annual hedge fund manager survey, which polled 605 hedge funds from 178 management companies representing over $342 billion in assets.

The hedge fund industry continues to grow at a phenomenal rate, with industry assets reaching $1.5 trillion in 2006, up 26% from $1.2 trillion in 2005, according to Hennessee Group.

Nonetheless, it is increasingly difficult for funds to grow their assets and get to the next asset tier, said John Hedge, chief compliance officer at Partner Capital Group of Nashville, Tenn.

The M&A trend among hedge funds will most likely parallel what happened in the mutual fund industry, he said. A lot of mutual funds consolidated with other funds to get to a critical mass status, he noted.

How it might work, Press suggested, is that five hedge funds with powerful and successful strategies will merge into one hedge fund to create a large talent pool.

The task of merging funds together, however, will be difficult and challenge hedge fund entrepreneurs to run their business more formally. Consolidating would force hedge fund industry professionals to think of themselves as a business, Press explained. They will have to consider the role of the chief compliance officer and compliance risks, for instance. Additionally, more professional managers will be hired to help run the business, he said.

"The hard thing will be how to delegate all the egos that would come together," he said.

Two smaller hedge funds that merge together will have to be very comfortable with each other and make certain that their principles align, Dougherty said. A transition period would have to be worked through and a clear delineation of duties and responsibilities would have to be set, he said. Also, there would be a lot of synergies and dual roles, he added.

Merger and acquisition activity has been thriving in the hedge fund arena, just not with hedge funds consolidating with each other. In the past few years, traditional asset management firms have been acquiring hedge funds to establish a footprint in the growing area, said Ferenc Sanderson, a senior analyst at New York-based Lipper. Currently, private equity firms are looking into acquiring hedge funds, he noted.

Activity will start occurring as the industry becomes increasingly institutionalized. Five years ago, institutional money in hedge funds was minimal, but that has since changed and now it is the bulk of money flowing into hedge funds, experts said. Pension funds and endowments are looking to place their money with large, reputable and well-known hedge funds, experts agreed.

Consequently, startups and newer hedge funds are having difficulty bringing in assets to the company. Plus, the pending new rule that would require hedge fund investors to have a minimum of $2.5 million in investable assets, excluding real estate and closely held company stock, from the current $1 million requirement, is going to affect smaller hedge funds, as well.

In addition, the landscape of the industry is changing. Five years ago, the bulk of hedge funds had assets under $100 million, five people in the office and a single U.S. based strategy, Press said. Today, the majority of hedge funds have $100 million to $1 billion in assets, employs 25 to 50 professionals and more sophisticated infrastructure with complex trading strategies, he noted.

Another reason hedge funds might merge is because it is very expensive for smaller firms to maintain business, Sanderson said. Infrastructure is costly, particularly as compensation for hiring and maintaining staff has risen, he said.

Bigger hedge funds also have more bargaining power and typically are able to receive lower transaction costs from prime brokerages, Sanderson noted.

However, all do not agree that M&A activity will happen among small hedge funds or even be feasible. Ben Phillips, a managing director at Putnam Lovell NBF Securities, believes that it would be too difficult for small hedge funds to merge together, and it would be counterproductive for business. Also, hedge fund success is based on performance, not how large the company is, he added.

As Phillips sees it, what will likely happen is that large funds will acquire smaller hedge funds, as it is a way for large shops to bring in new clients in a controlled manner, he said.

Dougherty agreed that large funds looking to add a new strategy might look to buy a specialized hedge fund instead of hiring new people to implement the strategy.

The merging of hedge funds raises a red flag, said Jacob Zamansky, a partner with Zamansky & Associates of New York. Before a merger sometimes insider trading can occur and it is a concern for investors because hedge funds are largely unregulated companies, he said.

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