For many investors putting money to work in hedge funds, bigger is better, leaving some smaller asset management firms with little alternative but to merge with other funds.
Investors such as pension funds and high-net-worth individuals added a net total of $23.3 billion to the funds in the first half of this year and all of it went to funds with more than $5 billion under management, according to Hedge Fund Research, which tracks the alternative investments industry.
Some funds with less than $5 billion are attracting new money, but "for everyone that's grown, there's someone else that's lost money," said Kenneth Heinz, HFR's president.
The preference for brand-name firms could drive consolidation in an industry that, even after the shakeout of the past few years, still consists of thousands of different alternative asset management companies.
"Assets beget assets," said Ron Geffner, a partner at Sadis & Goldberg LLP. He said hedge funds feel it's necessary to reach a certain size that will allow them to support the management team and develop and maintain adequate operations in order to attract even more capital.
Charles McDonald, a senior consultant with Towers Watson, said investors are not throwing money blindly at the biggest funds.
"Bigger has happened in part because of better," he said. "During the liquidity crisis, some firms managed risk well, so they didn't sustain big losses. They also managed their clients well, so there were no large redemptions. Other firms that had some combination of both problems — and got smaller as a result — are viewed as having been mismanaged."
Though it may look like money is just flowing to the largest firms, "there's also been a grading of how funds weathered the financial crisis," McDonald said.
McDonald said institutional investors are still mindful that a fund's size can affect its performance, but they are giving more consideration now to factors such as operational controls and whether asset claims can be verified independently.
"You're always weighing these things against each other, but the weight toward security or risk avoidance is greater now," he said.
Adding to the difficulty for small funds is the expected rise in compliance costs.
Scott MacLeod, a partner with Holland & Knight, said under new rules, virtually every hedge fund manager will have to register as an investment adviser. In the past, many small hedge funds were exempt from registration, but "the net is being cast wider."
The cost of registering can easily run to $50,000 or more, MacLeod said, and the ongoing costs of being a registered investment adviser could run into six figures. "You have to build a compliance system, buy a manual from someone, hire somebody to write procedures for you, and none of that includes [the cost of] hiring a separate chief compliance officer."
An expected change in the tax treatment of carried interest, the share of investor returns that hedge fund managers keep, is another squeeze on profits that will impact smaller funds disproportionately, MacLeod said.
To date, the number of hedge fund mergers is relatively small, and some of tie-ups taking place are between big players who already have economies of scale, such as Man Group PLC's $1.6 billion deal to acquire GLG Partners, which will create a group with a $63 billion in assets under management.
"Either one of them could have acquired smaller asset managers relatively easily," Heinz said. He said the fact that they chose to partner with one another suggests there were other considerations, such as the breadth of product offerings and global distribution.
Finding a partner to merge with may not be the only answer for small hedge funds; some may be able to attract "seed" capital.
SkyBridge Capital, a hedge fund advisory firm with $7.5 billion under management, is raising money for a new fund to seed other managers. Victor Oviedo, a partner with SkyBridge, said some of the money will be invested with start-ups, but the firm is also looking for candidates that already have a capital base and a track record but are having trouble raising additional funds.
"It won't all be day-one launches," he said. "It could be a fund with $100 million that's been around for five years and are looking to partner with someone to put themselves on the map."
Oviedo said there are also candidate funds that had great returns but lost significant assets during the financial crisis, because their liquidity policies were too permissive. "A fund that's gone from $500 million to $200 million has just lost 60% of its capital base, but it has an infrastructure in place and people it wants to keep on board, and it's looking for someone to stabilize that business."
