A trend of fund of hedge fund (FoHF) mergers is expected to continue as they vie to maintain and grow their share of the institutional investor client base.

“Funds of funds are going through a really tough time right now,” says one asset management executive in Hong Kong. “They’re not a dying breed, but they’re certainly an endangered species.”

Consolidation is becoming a means of survival for smaller FoHF firms, say industry practitioners, with five notable mergers announced globally since the beginning of the year – the same number of M&As in the sector for all of 2011.

“A lot of the small and medium-sized funds of funds are no longer a profitable business to run,” says Richard Johnston, head of Asia at Albourne Partners, a consultancy firm which advises investors on hedge fund investments. “Even the sub-$10 billion funds of hedge funds are getting squeezed.”

In May it was announced that Hong Kong-based Penjing Asset Management was being acquired by the $7.6 billion Swiss alternatives group Gottex Fund Management. The deal, subject to regulatory approvals in Hong Kong, marks the first M&A of an Asian FoHF by a major fund house.

Within a week of the Gottex-Penjing deal, Man Group of the UK announced it was buying Financial Risk Management Holdings, a London-based FoHF whose biggest clients are institutional investors in Asia.

And just last week KKR announced a planned acquisition of Prisma Capital Partners, a New York-based FoHF with $7.8 billion in assets. The deal is intended to expand the operations of KKR – which manages $62 billion – beyond private equity.

The institutionalisation of the client base is a key factor behind sector consolidation. Originally, FoHFs were a means for high-net-worth individuals to invest in what was then a largely unregulated hedge fund industry.

In the early 2000s, institutions such as pensions and endowments became a growing portion of the clientele after reasoning that they would need greater exposure to alternatives to generate higher returns.

Global FoHF assets reached a peak of $800 million in early 2008, according to data provider Eurekahedge. However, the turning point came later in the year with the Wall Street crash.

The Bernard Madoff scandal, in particular, did much to tar the image of FoHFs. Several had invested with Madoff, who was not running a hedge fund, but a Ponzi scheme. "Investors thought, ‘if they can’t do proper due diligence, then what were they doing?’” says an industry observer.

FoHF assets have not yet recovered to pre-crisis levels and now stand at about $600 billion. Last year, about $20 billion was redeemed by investors, according to Eurekahedge.

Acquisitions will give some FoHFs the scale they need to compete for institutional capital. “The big end of the industry is still relatively healthy,” notes Johnston.

Asian FoHFs see their value in being able to identify start-up funds that will grow into billion-dollar hedge funds. It is a crucial skill, as hedge funds nowadays need to scale up quickly to sizable AUM to sustain investor momentum and interest.

A medium-sized Asia fund of about $300 million in AUM is not very sustainable, says Albourne’s Johnston. “You are either on the way up or on the way down. It’s not an easy place to stay in the long term.”

As a result, FoHFs and institutional investors are trending towards Asia’s larger hedge funds. This is leading to a winnowing of smaller Asian hedge funds under $100 million, which have traditionally relied heavily on FoHF investments.

One Hong Kong-based fund executive, who is raising money for an Asia-focused hedge fund, is not holding his breath for FoHF capital. “Even though there are some that can allocate money, we’re not focusing on them.”

Family offices, endowments, pension funds and insurance companies would be targeted, he said, along with “any corporate pools of money”.

Smaller and poorer-performing FoHFs have been falling by the wayside in the post-crisis era as part of an industry shake-out which may eventually only leave large managers with big institutional investor bases left standing.

“Funds of hedge funds will still be around and will still be needed,” says Farhan Mumtaz, senior analyst at Eurekahedge. In terms of their assets, however, “it’s a big crunch time now to grow them back”.