By DEBORAH PRUTZMAN

With pension fund allocations to hedge funds increasing over the past two years, institutional investors are refining asset allocation investment philosophies into risk-based approaches. A risk-based approach, however, is only as good as its methodology. For an investor considering private equity and hedge funds, this raises two questions: What is an appropriate risk-based approach; and what risks does it consider?

Until recently, issues other than investment performance of alternatives played a secondary role for institutional investors and their consultants. With the 2008 financial crisis and resulting scandals, investors shifted to back-office risks in areas such as custody, valuation and audit. Today, operational due diligence teams are just as important in vetting managers as investment teams.

Despite these changes, due diligence efforts still minimize legal and regulatory risks. In many cases, regulatory risks are weighed only after a scandal erupts. This backward-looking mindset leaves significant risks unrecognized — until the next scandal breaks — and creates risks for pension fund investors.

Alternatives investment managers have gone from being relatively unregulated to heavily regulated. Additionally, the glare of regulatory scrutiny has only intensified. Indeed, activity by one regulator will typically draw the focus of others both in the U.S. and international markets…

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