Concerns grow that small European funds of hedge funds are vulnerable

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Written by Ray Clancy

Thursday, 02 September 2010 08:10

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, it is feared.

Having seen $130 billion (£84.5 billion), 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. I’d expect M&A and consolidation in the sector because a lot of guys are doing similar things,’ said Mark Wightman, hedge fund industry commentator and head of strategy for Asia-Pacific at specialist technology group SunGard.

Last year Cheyne Capital bought smaller fund of funds firm Altedge, while last month Swiss private bank Reyl Group’s fund of funds said 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.

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 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 to $2 billion or less look particularly vulnerable as they try to meet higher due diligence costs since Madoff, with institutional investors expecting much more.

‘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.

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% in the first seven months of the year while hedge funds are up 1.52%, 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,’ he added.