Hedge Funds Merge to Survive Shake-Out

By Lisa Lee




[This article was originally published by Dow Jones Investment Banker. To find out more about the service please visit: http://www.dowjones/banker]

Expect to see an uptick in hedge fund consolidations — the buying and selling of management teams and assets — as the desire to survive pushes some hedge funds into the arms of stronger peers.

After the devastating losses of 2008 and outflow of funds from the hedge world, investors want the security of bigger firms and prime brokers are getting finicky about the funds they service. Selling out or merging can be a life-saver for smaller or less well-established managers.

A record 1,471 hedge funds liquidated in 2008, and 858 hedge funds burned out in the first nine months of 2009, estimates Hedge Fund Research Inc.

For stable firms, it is an opportunity to gain new offerings, diversify strategies and forge new LP relations. With rising markets, many funds have now surpassed their high-water marks, or are close to them, so they will be able to collect their share of profits. That allows them breathing room to consider growth moves.

Fortress Investment Group, the behemoth publicly traded hedge fund, recently announced a deal to buy Logan Circle Partners, which manages about $12 billion in bond investments, from Guggenheim Partners. With this purchase, Fortress adds fixed-income products to its menu and expands its client base.

In the current market, buyers have the edge and are asking targets to share in the risks, reducing immediate premiums and increasing the use of features such as earn-outs so sellers share in the risk of performance over the medium term.

In the Fortress-Logan Circle deal, for instance, Fortress will pay just $21 million in cash immediately. Then, based on performance metrics Fortress declined to reveal, there could be an additional payout next year.

During the crisis, when distressed mergers predominated, valuations slumped to 5x to 6x Ebitda, according to Karl D’Cunha of investment bank Houlihan Smith.

“Multiples were reduced after the crisis hit,” says Roger Hartley of Mitchell Hartley Advisers, an investment banking advisory firm focused on the investment management industry, adding “multiples have bounced back.”

Aaron Dorr of investment bank Jefferies Group concurs. “For managers that weathered the storms, the future growth opportunity is better than ever. As a result, valuations should be in the ballpark of where they’ve been historically.”

Still, sellers shouldn’t expect the 9x to 10x multiples seen at the height of the market in 2006 and 2007, D’Cunha says.

Sellers may not relish having to share their fees and carry with a new parent firm. But in some cases, it is a matter of survival. And some managers may appreciate not having to deal with the administrative headaches of managing money; plus, there can be cost savings to sharing overhead.

Ultimately, staying in business and being able to retain and raise money are usually the driving factors. Smaller firms may not have the risk management abilities of a larger $1 billion-plus fund, and that can put smaller funds at a disadvantage. “For smaller firms, the fund-raising environment has gotten more difficult,” says Dorr.




In 2008, net asset flow to hedge funds turned negative, an outflow of $154.5 billion reversing most of 2007’s inflow of $194.5 billion. Though the hedge fund industry as a whole posted positive returns last year, investors were nonetheless tight with their purse strings, resulting in net outflow of $131.2 billion, according to Hedge Fund Research.



In addition to full mergers, minority investments are also popular. Goldman Sachs, despite the possibility that the Volcker rules might ban banks from running hedge managers, this year said it will invest in two firms, Shumway Capital Partners LLC and Level Global Investors LP.



What types of firms are most attractive to buyers? Those with strategies that people can understand, says Hartley.



From the wall street journal published on April 19 2010