LONDON Many small European funds of hedge funds could close or be forced into a merger or sale as falling asset bases hit a sector whose reputation is already badly damaged in the eyes of investors and hedge funds alike.
Having seen $130 billion (84.5 billion pounds), or more than a fifth of assets, leave since the start of last year, firms are still finding asset-raising tough, as witnessed by Eddington Capital's recent decision to shut down and return clients' cash.
And with negative returns so far this year hardly likely to encourage a flood of new investors, a sector that many say is overcrowded will have to face up to lower incomes and higher costs, through closure or deals, or by changing their focus.
"There will be attrition," said Mark Wightman, hedge fund industry commentator and head of strategy for Asia-Pacific at specialist technology group SunGard.
"I'd expect M&A and consolidation in the sector because a lot of guys are doing similar things," said Wightman who closely advises funds of funds on corporate issues.
Last year Cheyne Capital bought smaller fund of funds firm Altedge, while last month Swiss private bank Reyl Group's fund of funds unit told Reuters it was looking at options such as a merger or acquisition to help it bulk up.
Some funds are even slashing fees in order to attract assets and make themselves more attractive to potential buyers or merger partners, said one fund of hedge funds executive, who asked not to be named.
"Private equity is quite keen to do some deals. They're definitely sniffing around, money is burning a hole in their pocket. They're looking to come in, we've had a fair amount of enquiry," the executive said.
SMALL FIRMS VULNERABLE
Funds of funds hold a range of underlying hedge funds, and try to avoid blow-ups while spotting top talent. They have been hit by a wave of bad news, much of which has eroded their unique selling points.
Some like UBP and Man Group's (EMG.L) RMF unit were caught short by Bernard Madoff's ponzi scheme, while the financial crisis served to open up many individual hedge funds to more investors, who no longer needed funds of funds to gain access.
Some potential clients such as big pension funds now buy hedge funds directly, although not all can do it due to the costs of doing due diligence, while wealthy individuals' exit from the industry has hit European funds of funds in particular.
Firms with $1-2 billion or less look particularly vulnerable as they try to meet higher due diligence costs since Madoff, with institutional investors expecting much more.
"I think there will be a risk of closures amongst smaller groups -- they are always the most vulnerable," said another industry executive who asked not to be named.
Clients may also opt for bigger firms on concerns a smaller firm may not survive.
"If two funds were doing the same things with similar returns and one was ten times the size of the other, you'd go with the larger as it's a better counterparty," said SunGard's Wightman.
However, even bigger firms have been affected and may have to look at ways to restore profitability.
Financial Risk Management, for instance, saw assets fall from a peak of $15 billion in 2008 to $9 billion currently. An FRM spokesperson said the company had remained profitable in 2009, and was cash-rich and free of bank debt.
Funds of funds underperformed the average hedge fund, both during 2008's crisis and particularly in 2009's bull market. They are down 0.47 percent in the first seven months of the year while hedge funds are up 1.52 percent, according to Hedge Fund Research.
Anecdotal evidence suggests that a sector that became notorious for pulling out money from hedge funds very quickly during the crisis is finding it difficult to invest with some managers.
To turn things around, some say funds of funds will have to become more specialised, focusing on a particular sector or geographical region.
"I certainly think small funds of funds can survive but they have to be in a niche," said Marcus Jordi, head of fund of hedge funds Cosmos Capital, whose company manages or advises on assets of $140 million.
"What we are seeing now is a growing number of managers with a specific focus, either by geography or by strategy."
(Editing by Sitaraman Shankar)
(Additional reporting by Martin de Sa'Pinto in Zurich and Cecilia Valente in London)