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Can hedge funds survive onslaught of bureaucrats?

The looming prospect of government regulation may not be the biggest challenge to the continued success of hedge funds.

A greater threat may come from hedge-fund customers -- specifically, pension funds and other institutions that have lately developed a taste for this specialized style of investing.

A new pack of proprietors is crowding into the picture too, led by big banks, brokerages and other titans of the financial-services establishment. From several directions at once, stand by for the assault of the administrators, a bureaucratic blitzkrieg.

Some of these thoughts are inspired by a study just published by Casey, Quirk & Acito LLC, a Darien, Conn., consulting firm specializing in the investment- management business, and the Bank of New York, under the headline "Institutional Demand for Hedge Funds."

"Five years ago, hedge funds derived virtually all of their assets from wealthy individuals," the study says. "Institutional capital will soon account for more than 50 percent of net new inflows into the hedge-fund industry."

Great news for hedge-fund managers, right? There are few richer sources of potential new business for this $850 billion industry than the trillions of dollars entrusted to investing institutions.

Yes, but that isn't the whole story. In addition to their deep pockets, institutional managers bring a special set of expectations and standards to the game.

Hedge funds got their start as freewheeling private partnerships for wealthy investors, using a wider array of strategies and sometimes taking bigger risks than is common with more conventional vehicles such as mutual funds.

Lately, the definition of a hedge fund has been expanded to include most any pool of money that seeks "absolute return" independent of over-all trends in the markets.

Also expanding has been the attention paid by the Securities and Exchange Commission, which wants hedge funds to submit to greater regulatory scrutiny. "The commission does not know as much as it needs to about this growing sector of the investment management industry," SEC Chairman William Donaldson said in a speech this week.

Compared with such rumblings, the growing presence of institutional customers may appear benign. Institutional managers are usually less prone to a get-richer-quick mentality than some wealthy individuals. "Institutions' hedge-fund return expectations are relatively modest at 8 percent annually," the study says.

The joker in the deck is the other demands to which institutions are prone. Wealthy individuals can afford to be patient with a hedge-fund manager they trust, and to grant that manager as much leeway in making decisions as the two parties agree.

Institutional managers, by contrast, have bosses, clients and maybe even regulators of their own to keep happy. When you layer in fund-of-funds managers, who put together packages of hedge funds, can increased bureaucracy be far behind?

Investment committees want to know details, lots of details, about how results are achieved and how risks are managed. The financial bureaucracy is fond of style boxes and other strictures that let them fit the managers they hire together like parts of a machine.

Now, everybody agrees that hedge funds boast some of the best money-management talent around. The question is, wasn't their great record of success to date achieved in a wide-open environment? Can they keep performing the same feats amid a thicket of green eyeshades?

The institutional crowd is also notorious for negotiating lower fees. That would stand to reduce hedge funds' allure as a magnet for talented managers. Meanwhile, the continuing influx of new money is bound to have its own dilutive effect on the talent pool.

Before long, you could have a hedge-fund business that looks less and less different from any other part of the money-management industry.

"Given that serving institutions will be a business necessity for the average hedge fund, we expect that this transition will have a dramatic impact," the CQA study says. "Though many hedge funds are making the appropriate adjustments, the great majority of today's hedge-fund managers are unlikely to meet the new stringent requirements."

While the special mystique hedge funds enjoy right now attracts swarms of institutional customers, it won't be enough to keep them. The institutions can be counted on to poke and pummel it with the sort of tireless energy only a large, well-paid force of bureaucrats can summon. Once the mystique is gone -- with or without SEC regulation

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Currier is a columnist for Bloomberg News. Comments regarding this column can be sent to editor@sddt.com. All letters are forwarded to the author.

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