If you look at the headline numbers you would be excused for thinking that 2008 was one of those blips that happen in every industry and asset class, namely a correction within a long term bullish trend. According to Hedge Fund Research (HFR), global hedge fund assets (including funds of hedge funds) reached $1.9 trillion in 2010, with net new flows of $56 billion.

The first part of 2011 wasn’t bad either. However, as we predicted, this trend inverted again in the second half of 2011. For starters, mean hedge fund performance for 2011 was a disappointing negative 4%, while the S&P500 was up 2.11% for the year (although the Eurostoxx was down over 8%). Even the UCITS Alternative Indices that track the performance of UCITS FoHFs was 5.25% in the red in 2011, having also had a marginally negative 2010. The big question is how last year’s lacklustre performance will translate into future asset flows, and also where will assets go to and come from.

Between 2003 and 2007 global hedge fund assets grew at a CAGR of 23% with the strongest component being funds of hedge funds (FoHFs) which were growing at a rate of 31% over the same period. During the two years after 2008 this trend inverted, with FoHFs becoming a much lower portion of total hedge fund assets, falling from 43% of the total stock in 2007 to below 30% in 2011. In addition, it is clear that even among hedge funds, the resurrection of growth hasn’t been across the spectrum, but concentrated in the largest funds which have been getting bigger and bigger. To illustrate, of the net flow of $56 billion in 2010, $44 billion (or 79%) went to funds with over $5 billion AUM.

Additionally, InvestHedge’s “Billion Dollar Club” featured 150 FoHFs at the end of 2007, with total combined AUM of about $1.1 trillion. As of the middle of this year, there were 111 FoHF managers with at least $1 billion of AUM, but the consolidated total was $655 billion, testifying to the contraction of the fund of funds industry. Year end numbers from InvestHedge show that the ‘stock’ is now down to about $620bln. Moreover, the top 20 managers in 2007 represented 48% of the Club, while this proportion is now up to 54%.

Even more significant than looking at these consolidated numbers, is the empiric, non-scientific research that we have undertaken over the past few months among managers, distributors and clients. Here the results continue to show a clear chasm between the fortunes of large and small-medium-sized FoHF managers.

Three clear trends emerge: First of all, and this shouldn’t surprise anyone, the FoHF model was badly hurt in 2008 by the combined ‘nuclear strikes’ of the application of various kinds of gates and side pockets and the Madoff fraud. Investors have lost trust in the liquidity of these vehicles and their due diligence skills. This trust has, by and large, not come back in any significant measure, especially for the managers that were affected by these forced circumstances.
Second, different investor types reacted in different ways to 2008. If we divide the investor universe into private banking clients, insurance and endowments, and family offices, we see different reactions. Private banking clients were promised equity-like returns with bond-like risk by investing in FoHFs. They were put off in a big way, and haven’t really returned to the asset class. Insurance companies and endowments have by and large stuck to their investments, but have mainly directed new flows to direct hedge funds thus bypassing FoHFs, with a few exceptions for large FoHF managers untainted by 2008. Family offices are tending to go for an investment strategy through managed accounts where they have direct control of their investments and are not dependent on decisions made by others with regards to, for example, liquidity, or gating.

Finally, in the context of this ‘customisation’ of hedge fund investment, which is now done through managed accounts and the like, new managers have entered the fray. These include pension consultants who realised that they had a lot of the same expertise as the FoHF managers but were paid a capped fee which is a fraction of what a FoHF can charge. Some have therefore evolved into ‘applied consultants’ that advise their clients on allocations, strategies, risk, liquidity, due diligence, and then also offer ‘cheaper’ execution. The problem with this model is that the skills to make decisions, as opposed to merely advising, are quite different, and these “applied consulting” mandates may end up being risky for consultants, who, in the event of performance mishaps, could risk the consultancy and the management mandate together.

The combined effect of these trends for FoHFs has been a great dispersion of success for the larger funds and sustainability for the small to medium-sized managers.

The largest managers, composed of a couple of dozen global players with assets under management (AUM) of over $5 billion, have been attracting the vast majority of new inflows from the investors that still allocate in this fashion (as shown above these inflows represent over 79% of net flows in 2010). Competition at that level is low, and their businesses have benefited from this. However, small to mid-sized groups, that pre-2008 had between $500 million to $3 billion of AUM, have now shrunk by up to 70-80% and have not recovered from 2008. This is confirmed by HFR’s data (although this data aggregates hedge funds and FoHFs) which estimates that funds with between $500m to $1 billion have actually lost $2.8 billion of AUM in 2010, while the ones below $500m have attracted a net $8 billion, which seems to indicate that there were a good number of new launches, many from ex-prop traders of major banks which have retrenched their risk business.

With regards to FoHFs, we estimate the number of firms with AUM of $250 million – $1 billion to be about three quarters of the industry in numbers, and their business model is at risk. Of course, some will recover based on a good product or a breakthrough on the distribution side, but most of them could slowly wane, absent a business combination.

As we have been arguing for a long time, the FoHF industry was too fragmented and needed to consolidate. A combination of wishing for a better deal and personal ‘chemistry’ issues has contributed to a very low rate of consolidation. This was true in the good times, because we were all hoping for continued growth and higher values, and in the more difficult recent past, when combinations were hindered by a lack of coming to terms with the much lower real valuations.

In this instance, it is also the respectiveblemishes in track record, due diligence or both that made managers wary of inheriting someone else’s problems, specifically when they were already dealing with their own.

Two possible scenarios are now in front of us. The first, based on the factors discussed above, is that the industry will continue to go through a slow rate of attrition based on the survival of the fittest. Large firms will continue to grow, but small ones will continue to get smaller in absolute and relative terms and will not be able to compete for the mandates on offer. Over time, biological age factors, lifestyle, and opportunities elsewhere for the managers themselves will conspire against many of these sub-$1 billion managers, which will slowly wither away.

The second alternative is one where a wave of consolidation starts taking place in the ‘belly of the curve’, i.e. among those managers with $500 million to $1 billion of remaining funds. This is where consolidation makes most sense for reasons of both survival and growth. Entities that will champion or sponsor a combination of two or more managers to reach the minimum critical mass of $2-3 billion will be able to inherit the better track record of the combined firms, while at the same time being able to afford state of the art technology and a credible investment team. These are the minimum ingredients to be able to compete for the serious institutional mandates which are today the only real area of growth in the industry.

Over the last twelve months we have begun to see a few more transactions of this type, involving both European and US-based managers. A couple of good examples are the Olympia-Kenmar recently announced merger, and Nexar’s acquisition of Ermitage. What is more interesting is that there are now several players that have made ‘repeat’ deals, albeit in small sizes. Based also on the investment returns and continued, albeit slower, contraction in AUM, it is quite possible that this trend will accelerate in the months to come.