GP Consolidation Part Two

I posted last week about the consolidation of the venture capital industry. Whitney Tilson recently pointed out that this is also happening in the hedge fund world. LP’s will increasingly gravitate towards brand where they also have the added benefit of being able to deploy larger sums into larger funds  (versus a lot of smaller allocations). This creates an interesting barrier to entry for new, emerging managers.

Big Hedge Funds Get Bigger, Leaving Less for Small Rivals
April 19, 2007; Page C1
The largest and best-known hedge funds are elbowing out their smaller and newer rivals for the cash pouring into the business.

The change is making it harder for smaller funds to attract deep-pocketed investors and is reducing the temptation for some Wall Street stars to leave to start their own funds.

Firms like D.E. Shaw & Co., Fortress Investment Group LLC, Farallon Capital Management LLC, Och-Ziff Capital Management Group, Tudor Investment Corp. and Citadel Investment Group LLC now manage between $13 billion and $31 billion each. At the beginning of 2004, each of these firms had less than $10 billion.

The 100-largest hedge funds now control about 70% of the money in the hedge-fund world, up from less than 50% at the end of 2003, according to Morgan Stanley’s prime-brokerage unit, which caters to funds. And the 300 hedge funds with $1 billion or more control about 85% of all the money in the business.

Many of the biggest hedge funds are examining public offerings of their stock, hiring employees from smaller firms and taking steps to try to transform themselves into organizations that can rival Wall Street’s investment banks. But despite a deluge of cash that continues to come into the business, many smaller funds — even those with top pedigrees and enviable track records — are finding the environment more challenging. Last year, new hedge funds raised $10.5 billion, well below the $18.7 billion they were hoping to bring in, according to Morgan Stanley.

"Larger, longer-established funds are increasingly capturing capital — squeezing smaller funds and making it difficult for new start-ups to raise capital," says Robert Discolo, managing director at AIG Global Investment Group, a unit of insurer American International Group Inc. that invests about $8 billion in hedge funds.

As recently as five years ago, the largest funds didn’t attract that much more money each year than their smaller competitors. Instead they usually relied on stellar returns to expand their firms. Investors are moving to bigger funds because their bulk often can create advantages like lower trading fees and financing costs and better risk management. These funds also are providing investors with a variety of trading strategies, becoming one-stop shops. Some of the biggest funds also are expanding because they have been able to generate enviable returns.

For example, funds managed by Citadel, Farallon and Fortress generated returns of 20% or more last year, according to investors.

But blowups at huge funds, such as last year’s heavy losses at Amaranth Advisors, a multistrategy fund handling $9.2 billion at its height, are reminders that big doesn’t always mean best.

Some academic research suggests the best returns come from younger hedge funds.

Large funds often have to pass on certain prime opportunities, such as companies with low market values and illiquid debt, because they need to deploy big chunks of cash to create returns that make a difference for their funds.

Still, over the past year, funds with $1 billion that focus on stocks outperformed rivals with less than $500 million by almost 2%, according to Rick Pivirotto, Morgan Stanley’s head of capital introduction, largely because the big funds do a better job betting against stocks.

A new problem for smaller hedge funds: The Securities and Exchange Commission recently proposed changing its rules to require that investors in hedge funds have at least $2.5 million in investible assets, as opposed to $1 million in net worth.

That could reduce the universe of investors who might be interested in a smaller hedge fund.

At the same time, there are some indications that wealthy individuals, who often stick with smaller hedge funds, are becoming less enamored with the entire hedge-fund sector.

When Ralph Rosenberg, a former star at Goldman Sachs Group, launched a hedge fund, R6 Capital Management, last year, he was expected to raise billions of dollars. Even though the firm has generated impressive returns, R6 still manages only about $250 million.

Mr. Rosenberg had expressed hope to some investors that the firm would be bigger because he invested heavily in building the firm.

A person close to the firm says R6 is taking advantage of its size to focus on sometimes overlooked investments.

The biggest reason for the change: Pension plans, endowments and charities have been moving into hedge funds in recent years, and these investors favor funds with extensive rules-compliance and risk-management operations. And funds of hedge funds, which invest in a range of hedge funds and have themselves become much bigger, are focusing on larger funds.

"Today it is institutions that are going into hedge funds, and they’re looking for the biggest funds," says AIG’s Mr. Discolo.

A big, well-known hedge fund also can be seen as a safe choice for investors without much experience in the business.

But don’t shed tears for smaller hedge funds just yet. The generous fees charged by these private partnerships allow even small funds to do well if their performance is good. And while raising money has gotten harder, there are still more investors looking to get in compared with five years ago.

Mr. Discolo says AIG, which focuses on larger funds because it manages so much money, is spending more time lately finding up-and-coming hedge-fund managers at small firms, arguing that there is "more talent out there that is overlooked" as larger funds enamor investors. He argues that more investors could rediscover the attraction of smaller funds.

In fact, some hedge fund managers predict that institutions investing in brand-name hedge funds will move to smaller funds after they have developed sufficient knowledge of the business.