Fitch Ratings says the recent wave of consolidation in the hedge funds industry leaves just a handful of candidates for large scale acquisitions.

In their quest for size, alternative multi-managers now focus on organic growth.

The same number of deals has taken place in the year to date in the European fund of hedge fund industry as in the whole of 2011.

The most notable include Man Group/FRM, Gottex/Penjing AM Kenmar/Olympia and UBP/Nexar. In all cases, the rationale for acquisition has been primarily mutualisation of costs, economies of scale but also diversification of revenues and investor base.

Few medium to large scale fund of hedge funds i.e. with assets under management in excess of EUR2bn remain to be acquired, in Fitch's opinion. The notable exceptions are EIM and Gottex.

Smaller players (i.e. with AUM below EUR1bn or EUR2bn) remain targets for acquisitions but obstacles exist such as poor financial condition, legacy issues, key person risk, in addition to the usual risks related to asset retention and cultural differences.

In this context, many fund of hedge funds focus on organic growth, enhancing their core value proposition to raise assets. Fitch says there are two main avenues.

First, traditional fund of hedge funds endeavoor to position themselves as true alpha providers, in an industry tarnished by lacklustre performance. For this, they need to demonstrate their skills in the selection of managers providing distinct, concentrated sources of alpha. Sourcing and research therefore now tend to focus on increasingly smaller, nimbler hedge funds which, in many instances, operate below the radar of large pension funds. Furthermore, re-engineered portfolio construction aims to maximise uncorrelated source of alphas while creating downside risk protection at portfolio level. Therefore, Fitch expects fund of hedge fund managers to manage a concentrated portfolio (by number of managers) but more diversified (by risk factors).

Second, fund of hedge fund managers work on becoming service providers to meet investor's demand for flexible and transparent investment solutions: advisory, managed account platforms, co-management of mandates, transparent client risk reporting are among the new services offered. These activities have lower fees than traditional fund of hedge fund management so that scale is needed to reach profitability.

Investors will judge fund of hedge fund managers on their ability to re-establish appealing risk-return profiles and provide a greater level of flexibility in new services. This may be the last chance for many managers to achieve critical mass and ultimately remain in an industry that is still under severe pressure.


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