Hedge funds are expected to become more open about their businesses to meet the needs of financial institutions which account for a significant amount of the total invested in the industry, analysts said. Many hedge funds are also looking at improving disclosure before listing or selling themselves to bigger institutions.
Analysts reckon about 25 percent of the $1 trillion estimated to be invested in hedge funds comes from institutions like pension funds and insurance companies, up from around 10 percent of $500 billion 5 years ago.
"Pension fund interest in hedge funds is massive," Jamie Murray, head of marketing at HSBC Republic Investments said.
"Their process is very different from private banking clients and underlying requirements are different ... The hedge fund industry will have to change the way it works and provide an institutional level of reporting."
By 2006, institutions are expected to account for about 40 to 50 percent of between $1.5 trillion to $2.0 trillion invested in hedge funds.
If hedge funds want to manage some of that institutional money, they will have to tell investors how their businesses are run, decision-making and investments.
Unlike wealthy individuals, who only have to please themselves, institutions are accountable to investors and need transparency because they are normally regulated and often listed on stock exchanges.
"Institutions want more reports, access and relatively predictable return profiles to reduce risk," Gavin Rankin, head of investment analysis at Citigroup Private Bank Europe, said. "When hedge fund assets reach a certain point, they start to institutionalise ... (They develop) a business infrastructure, risk reporting, risk management and accountability."
More transparency means investors will be able to understand the product more clearly, gauge its quality and risks. But analysts do not expect risk-adjusted returns to drop because of more openness about investments.
Some successful hedge funds whose assets come primarily from private investors are likely to resist change and analysts say the drive for openness is coming from funds of hedge funds, which invest in a variety of hedge funds.
Funds of hedge funds were estimated to control more than half of the total invested in the industry, with much of that coming from institutions like pension funds which do not normally invest directly in hedge funds.
They tend to use funds of hedge funds, which carry out the due diligence and monitor the business and investment risks. "New buyers insist on filling in due diligence forms ... Due diligence people have the ultimate veto," Tim Haywood, chief investment officer Julius Baer Investments, said. "The idea of a hedge fund as a two-man shop is becoming a thing of the past."
Haywood said hedge funds which attract investors nowadays are those which can give investors decent risk-adjusted returns. "They have proper segregation of assets, auditing, accountability, division of labour and risk management systems."
Analysts agree these changes are a sign of a maturing industry, triggered by institutional interest in hedge funds.
Other reasons for growing transparency include what are known as exit strategies - realising value either by listing or by selling to investment banks or traditional fund managers.
Some think that the appetite for listings or stake sales may have diminished given recent weak returns from the industry, but many say they are still on the agenda of hedge fund managers who want a way out without closing down the business. "Hedge funds selling themselves or stakes is quite a significant movement," Arie Assayag, global head of hedge funds at Societe Generale Asset Management said. "
"They get a stamp of approval and access to institutions who want to invest in hedge funds."
Examples include US investment bank J.P. Morgan's purchase of a majority stake in hedge fund firm Highbridge last year and more recently Lehman Brothers, which bought a 20 percent stake in hedge fund firm Ospraie.
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