DEALTALK-Hedge fund predators on the prowl for stragglers

(For more Reuters columns on deals, click on [DEALTALK/])

* Early days for deals; plenty of opportunity seen

* Ideal target seen as small funds of funds unable to grow

By Lionel Laurent and Laurence Fletcher

PARIS/LONDON, Jan 27 (Reuters) - Hedge funds are prowling the post-crisis landscape looking to buy small, weakened rivals that are struggling to grow.

The most vulnerable targets are so-called funds of hedge funds, essentially a basket of stakes in individual funds, which have been among the hardest-hit by client outflows.

"Consolidation will potentially be the only way to survive for smaller funds," said Aureliano Gentilini, global head of hedge fund research at Lipper, a Thomson Reuters company. "It will be a trend that cannot be averted."

Funds of hedge funds are also seen as easier targets because they are typically run by a team rather than a single, star manager who could be difficult to replace.

"Funds of hedge funds are more sellable than single-manager funds," said Antoine Haddad, founder of Bainbridge Partners, a $950 million firm that is keen to make acquisitions.

"They are usually managed by a team and are not star-driven; you're selling a business process."

Fund executives say the ideal acquisition target is a small fund of hedge funds with assets below $300 million, a size that makes asset growth almost impossible.

These funds are missing out on new clients who are investing instead in multi-billion-dollar funds, seen as having better risk management and more robust governance.

Having returned just 5.6 percent in 2010 -- barely half the level of the wider hedge fund industry -- funds of funds are also missing out on performance fees. With a smaller asset base to collect annual management fees on, many small firms are facing a tough choice: find a buyer or risk going under.

"There is no other way forward for a lot of these businesses," said Fabrizio Ladi Bucciolini, Reyl Asset Management's head of alternative investment, who has been looking at options like a purchase or merger.

"All the talk of the last six to 12 months is turning into things actually happening," he said. [ID:nLDE66Q14D]

Man Group's (EMG.L) $1.6 billion purchase of GLG last year was the industry's flagship deal, but smaller deals have seen Goldman Sachs (GS.N) take a minority stake in Mount Lucas Management and Orix Corp (8591.T) take a majority stake in Mariner Investment. [ID:nN27234181] [ID:nLDE6B11R9]

Cheyne Capital bought smaller fund of funds firm Altedge in 2009, while RAB Capital RAB.L took on staff and assets from Park Place Capital. [ID:nSGE69I0K3]

Michael Beattie, chief investment officer at fund of funds Tradex Global Advisors, told Reuters he hopes to do two or three deals over the next six months and one or two in the next 12 months, adding an extra $300 million to $500 million in assets.

RISKS ABOUND

Risks for the buyers are high.

Often by the time a fund puts itself up for sale, it is in very poor shape. "The danger is that funds will realise too late that they should sell," said Bainbridge Partners' Haddad. "I saw an example of that three months ago."

Looking over the books of small funds may bring up some unwanted surprises. Tradex is in serious talks with two funds but has found some things it doesn't like in one of them, CIO Beattie said.

Valuation is also tricky. The seller will want a premium for the assets being sold but the buyer might be reluctant to pay this in cash for a fund that depends on future investor sentiment and a potential restructuring of assets.

"All the time we're presented with potential targets," said Philippe Gougenheim, head of hedge funds at Unigestion, who said his firm is not currently looking for deals.

"The issue is that the people willing to sell businesses still have too high expectations ... (Also) there will be a lot of illiquid stuff. It's a lot of work to analyse. It's a big distraction with huge risk."

For Bainbridge's Haddad, the solution to valuation obstacles could be an earn-out structure that ties the full buyout payment to future performance. This would help cut down risk for the buyer, though it deprives the seller of a one-off cash lump sum.

(Editing by Sinead Cruise and and Erica Billingham)