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* Hedge fund boss McCaffery says industry to consolidate
* Fund of hedge funds face falling assets, fees
By Tommy Wilkes
LONDON, Sept 20 (Reuters) - Aberdeen Asset Management said there will be a further wave of consolidation in the fund of hedge funds industry, with managers who run less than $3 billion facing a struggle to survive amid shrinking assets and rising costs.
Once a fast-growing source of capital for hedge funds, fund of funds - which try to pick the best managers and reduce risk by holding a basket of funds - have been hurt by criticism about their high fees and poor returns.
Many in the $627 billion sector are still to recover from redemptions in the financial crisis, forcing a round of dealmaking as bigger players snap up smaller, struggling rivals.
On Wednesday, U.S.-based K2 Advisors became the latest player to sell out after Franklin Resources said it would buy a majority stake.
That followed private equity group Kohlberg Kravis Robert's buyout of Prisma Capital Partners in June, and Man Group's May purchase of FRM.
"What you have is a number of businesses over the years which have been quite successful, have very good revenues, and now they are finding their performance is being compromised and their high-water mark is out here," Andrew McCaffery, Global Head of Hedge Funds at Aberdeen, told Reuters in an interview.
High-water marks are the level at which these investors can start to charge their clients much-needed performance fees, and McCaffery was indicating that many funds are some way from returning to these levels.
"Business models when you have got $1, $2, $3 billion are severely compromised when you are a single company."
Aberdeen runs more than $4.5 billion in fund of hedge fund assets, much of it gained after the FTSE 100-listed group bought the non-core asset management business from Britain's Royal Bank of Scotland in 2010.
Like many managers, hedge fund are a relatively small part of its overall business - Aberdeen runs 182 billion pounds ($295 billion). It is keen to expand into alternative assets as investors turn away from traditional bonds and stocks.
With fund-of-funds on the ropes - many have also been hit by outflows as large clients choose to invest directly in hedge funds, thus cutting out a layer of fees - McCaffery said owners now needed to accept lower valuations for their businesses.
He described Man's purchase of FRM as a potential "game-changer". Under the deal Man pays nothing upfront, with the price dependent on asset retention and performance fees earned.
"In some cases the problem is there may be no price for a deal, because if they carry on like that they undermine the business...if people leave, assets leave, and if they both leave together it's a very different situation," he said.
Among those mulling a sale is celebrity financier Arpad Busson, but EIM, the hedge fund investor he founded in the 1990s, could struggle to find buyers.
McCaffery said Aberdeen's future growth - he aims to grow hedge fund assets by 50 percent over the next three to four years - will likely come from institutions demanding tailored services versus the high-net worth clients who buy readymade products.
Aberdeen's flagship fund of hedge funds have struggled to attract inflows since it bought them from RBS, which tended to market them to the client base at its private bank, Coutts.
The Aberdeen Orbita Global Opportunities Strategy has lost around 25 percent of its assets since 2010, for example, but McCaffery said the focus is now on getting its funds on more wealth manager platforms and private bank lists.
"The business wasn't really out there being marketed or managing money in an extensive way, but that's starting to change," he said.