The hedge fund market is set to continue its rapid growth as institutions, under pressure to demonstrate more clearly that they can meet their future obligations, seek alternative investment products that deliver strong returns.

However, many institutions have a high degree of governance and oversight, not to mention close press scrutiny. To maintain their reputations, they cannot afford to be associated with debacles or scandals, which they see as a high risk with certain hedge funds.

As a result, with institutional-grade money comes the need for hedge funds to provide institutional-grade infrastructure, possible only with at least $2 billion in assets under management.

Equally, the diverse investment requirements of institutional investors, combined with the adverse impact of increased fund competition on yields, are driving convergence in asset classes, with some hedge funds increasing investment allocations in real-estate and private equity investments. As asset classes further converge, the increasing diversity of investment styles means broader platforms are needed.

Faced with all this growing complexity, hedge funds are facing profound challenges to the way they operate. To compete successfully for institutional money, they not only have to deliver strong and consistent absolute returns with single-digit volatility, they also have to place a greater emphasis on risk management, internal controls and governance.

To ease the burden, some hedge funds have outsourced IT and other support activities, and make use of third-party administrators. But the ultimate responsibility for risk management still lies with the advisor, which now has to consider not only its own risk management and internal controls, but also the quality of the provider's control environment and the risks associated with the inherent interdependencies between the provider and the fund. In this highly dynamic environment, rigorous due diligence has to be backed up with clear governance arrangements, strong controls, continuous oversight-including onsite reviews-and the setting and monitoring of appropriate key performance indicators.

The scale and sensitivity of institutional investors mean that they require high levels of data security and record retention, but at the same time, convergence of asset classes and the pressure for asset managers to report accurate and disaggregated performance data is placing huge demands on the IT infrastructure. One all-embracing IT system would be ideal, but it is not realistic in this fast-paced, increasingly complex environment.

It is also natural for institutions, worried about managing their portfolio risk, to look for appropriate levels of transparency with hedge funds. New and improved risk management tools can give them the transparency they want. However, these tools have to be fully embedded within the hedge funds' operations, including the investment management process and risk management framework.

For obvious reasons, valuations are core to the concerns of institutional investors. As a result, hedge funds have to demonstrate that they have models and processes that deliver accurate and realistic valuation figures. Above all, there needs to be consistency between portfolio pricing practices, administration practices and financial reporting.

While strong internal governance and risk management, accurate and justifiable valuations and effective compliance structures are essential to excelling in the rapidly evolving hedge fund marketplace, they also play another vital role: limiting regulatory intervention by maintaining the confidence of the regulators.

At this point, there is relatively little uniformity in the level of regulation. In some countries, regulation is being strengthened; in others, it is being eased. The U.S., where proposals to regulate hedge fund advisors were overturned, is lagging some of the more aggressive global regulators. But in the U.S., the President's Working Group on Financial Markets is going to suggest best practices for hedge funds, and some form of regulation appears to be inevitable. In any event, there is tight regulation of broker/dealers worldwide, which already gives regulators a good back-door perspective on the activities of the hedge funds.

Hedge funds need to address their compliance programs, and particularly any issues regarding disclosure. This means ensuring appropriate policies and procedures are in place to monitor potential risks and provide adequate transparency to clients. Implementing compliance diagnostics and risk assessments, including fraud risk diagnostics, can further bolster compliance programs.

So adopting a full spectrum of risk management best practices has multiple potential benefits for hedge funds. It is certainly the best way of maintaining a low regulatory profile and being prepared should any regulatory questions arise. It is a competitive advantage in the search to secure institutional clients. And it enables a rapid response to both market opportunities and market disruptions.

James Suglia and Francois Cooke are principals in KPMG's Advisory Services Practice.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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