Regulatory, investor demands to favour hedge M&A

MONACO (Reuters) - After years of unprecedented growth in the hedge fund industry, tough market conditions and investor defections are pushing some funds into closure while others may be forced to merge to survive, industry experts say.

Increased investor expectations and a higher regulatory burden will have the greatest impact on smaller funds, whose only source of income this year is likely to be a management fee of one or two percent of assets.

"I think there will be a number of managers in the alternative space which will not survive," Stephen Zimmerman, Newsmith Asset Management said at the GAIM conference this week, adding some previously viable funds risked being swamped by rising costs.

Many factors are driving these costs, with investors asking for ever more detail on how funds are managed, and asking for processes that are transparent and comprehensive. Business costs are rising and many smaller funds may be unable to afford them, Randall Dillard of Liongate told Reuters.

At the same time, fund management companies could see income fall as management fees are taken off a reduced asset base, while performance fees remain in limbo until funds recoup last year's losses and investors negotiate lower fees.

In other times management companies might have sought to raise money via a public offering, but in a tough economic climate investor appetite may be weak. The only option to closure may be to merge funds in order to obtain critical mass.

"It's unlikely we'll see a sudden rush of hedge funds going to the public market. I think there'll be attrition and some consolidation," said Peter Clarke, chief executive of Man Group MAN.L.

For Kevin Pakenham, managing director of investment banking at Jefferies International, the issue is less clear cut. "(Consolidation is) fine in theory but much more difficult in practice because of uncertainties about valuation," he said.

Even so, if regulators impose requirements for more extensive reporting and tighter risk management systems, something that has been mooted in both the European Union and the United States, the processes of consolidation and attrition may be accelerated.

Surprisingly, the largest fund managers have not raised their voices in protest, and some may secretly welcome tighter regulation, which could make high-performing smaller funds an easy target.

"The largest hedge funds aren't opposing regulation, they're encouraging it," Pierre-Paul Benoit, chief executive of SocGen spinoff Aldea Capital, told Reuters on Thursday. "They see it as a barrier to entry, and it could also allow them to pick off the best emerging managers cheaply."

(Additional reporting from Laurence Fletcher; Editing by Andrew Macdonald)

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