Smaller hedge fund firms hard hit by the current tighter credit conditions may be bought by larger, more traditional fund houses or may simply fold, law firm Eversheds told Reuters.
"There's bound to be a shake-out of hedge funds after the credit crunch. There are a lot around ... and it's got a lot more difficult for them to stay in business," Mark Brady, a partner at Eversheds who specialises in alternative investments, said in a recent interview.
"There are buyers around who are sitting on significant amounts of excess cash and are willing to look at smaller acquisitions. Hedge fund assets are still very attractive to traditional fund houses."
The $2.5 trillion hedge fund industry has seen its assets boom in recent years, with investors such as pension funds and wealthy individuals, attracted by the ability to make money in all market conditions, putting money with large firms and start-ups alike.
However, sharp volatility in credit and equity markets this summer -- caused by fears a surge in defaults in the U.S. subprime sector will lead to a wider financial crisis -- has proved a difficult environment for some, particularly in an industry where investors are quicker to pull their assets out if they fear large losses.
The average portfolio lost 1.53 percent in August after a flat July, according to the Credit Suisse/Tremont Hedge Fund Index, with some high-profile funds recording double-digit losses.
The industry has already seen acquisitions by more traditional firms -- for instance, last year Schroders announced it was buying fund of hedge funds firm NewFinance Capital -- and Brady said the motivation behind such deals is primarily investment talent.
"You don't buy smaller firms because of their assets under management. With smaller managers you're buying individual talent," he said.
Some May Fold
However, Brady said some boutiques would simply go out of business, which would also benefit the larger players.
"Over the last 10 years it hasn't been an especially difficult environment in which to run a hedge fund. But we've never really had anything like this (credit squeeze).
"Some hedge funds firms will fold -- firms managing up to $1 billion are particularly susceptible, especially if they haven't built the necessary infrastructure ... A lot of the assets of smaller hedge funds will drift away, and are more likely to go to bigger hedge fund managers."
Brady said the failure by some hedge fund firms to negotiate hard on terms with their prime brokers, who provide services such as financing for trading and settlement of trades, would particularly hit smaller firms in the current environment.
"Not all hedge fund managers have negotiated hard on the credit terms they get from their prime brokers. Trying to do so now is unlikely to be particularly fruitful, except for the larger hedge funds who have a more even relationship with their service providers."
Last week Fidelity International star fund manager Anthony Bolton said mediocre hedge fund managers would be "wiped out" by the current market turmoil.