Bigger may be better as smaller hedge funds give up

By Svea Herbst-Bayliss

BOSTON (Reuters) - Bigger may really be better for hedge funds at a time the $2 trillion (1 trillion pound) industry's smaller players face tough choices of either merging or being forced out of business.

In the first six months of 2008, more than a dozen smaller funds have already agreed to let larger players own a piece of them, and investors and managers expect that pace to quicken.

Man Group (EMG.L), the world's largest publicly traded hedge fund group, has taken stakes in Ore Hill Capital and Nephila Capital, while Goldman Sachs' (GS.N) Petershill unit has taken stakes in Capula Management, Claren Road Asset Management and Trafalgar Asset Managers.

"What we are finding is that managers of varying sizes are either merging with or selling a stake in their businesses to larger institutions," said Ron Geffner, who works with hedge funds as a partner at law firm Sadis & Goldberg. "And in many cases the primary reason is to gain access to better infrastructure and distribution."

While many hedge funds once operated with only a few people out of a basement or garage, bigger investors who have helped double the industry's assets to $2 trillion in the last three years are demanding more for their money.

Risk management, legal departments and top-notch back office operations are must haves for big name investors like the Massachusetts state pension fund, trustees and fund officials said. That fund plans to put more money into hedge funds in the months ahead.

For smaller funds managing only a few million dollars these types of costs can put them out of business very quickly, several small fund managers said.

"The costs of entry into the hedge fund industry have always been very low, but the costs of remaining in business are very high," Philip Duff, chief executive officer of Duff Capital Advisors said, adding "the odds are probably as good as running a restaurant in Manhattan."

Duff announced plans last week to integrate hedge fund North Sound Capital, the first of a string of expected joint ventures this year. For years Duff wooed hedge fund teams to FrontPoint Partners but then sold that company to Morgan Stanley in 2006.

Adding fresh pressure to small fund managers these days are industry studies that show big investors tend to prefer more seasoned and larger hedge funds over the start-ups even though other data show new funds tend to outperform older ones.

"There seems to be a change of allocation strategy among some institutional investors to larger hedge fund firms as global investors who have been rattled by the markets sense these bigger funds offer more perceived security," Sadis & Goldberg's Geffner said.

But there may also be a silver lining for bigger funds as they consider growing by integrating smaller players: there arelots to choose from.

"The environment for recruiting investment talent is the best it has been in 20 years," Duff Capital's Duff said.