Hedge funds get hitched

LONDON (CNNMoney.com) -- The $1.7 trillion hedge fund industry has seen a hotbed of merger activity in recent years, as Wall Street firms have pushed into the booming business.

Now the tumult in the financial markets, while scaring away some investors, may spur opportunistic buyers to swoop in and buy funds at reduced prices. The result: even more consolidation.

As a group, the returns of hedge funds have been pummeled lately. Funds lost 1.3 percent in August - their worst monthly performance since May 2006, according to Chicago-based industry tracker Hedge Fund Research.

The recent market volatility may put some buyers on edge, but it's unlikely to derail the wave of strategic deals and other investments in alternative asset managers currently under way.

Big financial institutions, with the aim of providing their clients with more investment opportunities, have been keen to buy hedge funds.

For fund managers, linking up with a big brokerage or bank often nets them a hefty payout, as well as an opportunity to grow the amount of assets they manage. That's become of greater importance as the ballooning number of players in the industry has increased competition for investment money.

"If you want to be one of the elite performers, you want to be one of the biggest funds, and the largest funds tend to generate the biggest fees," said Ferenc Sanderson, senior hedge fund analyst for Lipper.

Merger activity, which has been going strong for some time, reached a fever pitch in the spring. Among the major deals was Citigroup's (Charts, Fortune 500) purchase in April of Old Lane Partners, a hedge fund run by former Morgan Stanley (Charts, Fortune 500) executive Vikram Pandit.

In addition to buying fund managers outright, a flood of deals have seen investors purchase minority stakes in fund managers. In May, Merrill Lynch (Charts, Fortune 500) bought stakes in GSO Capital Partners and Sterling Stamos Capital Management. Lehman Brothers (Charts, Fortune 500) has acquired an interest in a number of fund managers, including a stake in high-profile hedge-fund firm D.E. Shaw it bought in March.

"Banks know there's a huge amount of talent on Wall Street at independent firms. In some circumstances, if you decide not to build a business or can't hire the guys yourself, you align yourself with them," said David Nissenbaum, a partner at law firm Schulte Roth & Zabel, which has several hedge fund clients and represented Lehman in the D.E. Shaw deal.

The recent market volatility is likely to put a temporary hold on financial institutions buying fund managers. Some fear that there's more bad economic news to come and anxious investors, such as wealthy individuals and endowments, will abandon hedge funds in favor of less risky investments. A massive outflow of investment money could collapse some funds.

But alternative asset managers are still attractive targets for Wall Street firms.

"No one is abandoning the effort," said Andre Weiss, also a partner at Schulte Roth. "Investors are just taking a more cautious approach and want to see that fund managers are able to weather the current situation."

A short-term let up in deals could actually create opportunities for aggressive acquirers because prices would decline. Financial terms of hedge-fund sales often aren't disclosed, but prices have been boosted in recent years by the brisk amount of M&A activity in the sector.

"It's a double-edged sword," said Lipper's Sanderson. The value of target firms may decline, but buyers - if using their own equity for purchases - may also see the value of their equity go down, he said.

A recent survey of partners at 300 hedge funds conducted by accounting firm Rothstein Kass showed that two-thirds of managers expect large financial institutions to keep buying hedge-fund firms over the next three years.

The survey was conducted before the market volatility hit the industry. But hedge funds are known for carving out opportunities during periods of uncertainty, Howard Altman, co-managing principal at Rothstein Kass, noted.

"Market volatility is actually helpful to hedge funds - some funds actually tend to thrive in this environment," he said.