Buy-out houses are doing smaller deals, borrowing less money and are more involved in hands-on management, as the crisis pushes them back to the roots of their industry.

And for hedge funds too, managers will be harshly measured by their market outperformance now that banks are much less willing to lend them money to boost returns in a manner reminiscent of their humble origins in the 1940s.

Private equity firms will have to be more hands on than they have been in the past, investment director for private equity at Scottish Widows Investment Partnership (LLOY.L: Quote, Profile, Research, Stock Buzz), Billy Gilmore told this week's Reuters Hedge Funds and Private Equity Summit in London.

That is what is going to make the difference in the next cycle, the ability to really set the agenda, not at the strategic level -- which private equity has been quite good at -- but at the operating level, said Gilmore.

For hedge funds -- a freewheeling sector that ballooned into a $2.6 trillion asset class just before the crisis -- the focus is now on alpha -- returns down to a manager's skill.

Following record 19 percent performance losses last year, investors withdrew $150 billion in the fourth quarter, according to Hedge Fund Research, and with more outflows forecast after the Bernard Madoff scandal, poorer-quality managers who got their returns by riding the bull market are set to be found out.

Why have hedge funds performed so poorly? said Mark Kary, chief executive of Polar Capital (POLR.L: Quote, Profile, Research, Stock Buzz).

People just flooded into it at all levels, the investor level, the fund of funds level and at the manager level. It all happened exceedingly quickly ... and I just don't think there's enough talent around to be able to do that.

Hugh Hendry, partner at Eclectica Asset Management, who identifies with the spirit and descriptions of hedge funds in the 1970s, said he hopes the industry shrinks further.

The hedge funds we came to understand in the last few years, who manage billions and billions, they're financial institutions. Madoff reintroduced the notion of risk, that you could lose everything.

NO MEGADEALS

For the time being at least, large heavily-leveraged private equity deals are not happening, but equity-heavy deals that require little or no debt are going ahead, as are those with some degree of vendor financing, BC Partners managing partner Andrew Newington said.

The proof is in the pudding and we will see how often it gets eaten this year, Newington said. But I do think that will increasingly become a feature of the market.

Less debt financing also means smaller deals, and as a result, Gilmore does not expect the megadeals such as Terra Firma's TERA.UL acquisition of EMI, or KKR's KKR.UL deal for Alliance Boots to come back for some time.

And to be perfectly honest, I'm not sure that's what investors want, said Gilmore.

I think private equity is at its best when it's buying companies that are in need of some energy injections -- it's not just applying a leverage structure to a company that's already quite successful.

The mid-market will be where the action is for some years, British Private Equity and Venture Capital chief executive Simon Walker said.

It will be about finding those companies with good assets but bad balance sheets and applying managerial and operational skills to try and turn those companies around, Walker said, adding he believes bosses in large private equity firms have the hands-on skills to meet the task.

Hedge funds, meanwhile, are now in a different leverage world, according to CQS chief executive Michael Hintze.

Managers now accept that strategies that relied on the alchemy of cheap leverage to turn wafer-thin margins into lucrative returns in areas such as credit will struggle.

I think there are some strategies that have no future, said Hugh Hendry Complicated strategies, anything that is systematic.

(Editing by Rupert Winchester)

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