The majority of institutional investors intend to increase their allocations to alternative investments over the next three years, carrying far greater influence over the shape of the industry as a result, concludes a KPMG International study titled "Transformation: The Future of Alternative Investments."

More than 50 percent of institutional investors surveyed said they intend to increase their allocations to alternatives, with some intending to allocate more than 10 percent of their total assets, according to the KPMG study, which surveyed 200 alternative investment managers, administrators and institutional investors in the U.S. and globally.

The study found that as investors increase their stake in alternative investments, they will expect institutional grade controls, increased transparency and flexible product strategies in order to invest their capital. That, in turn, is expected to drive changes to business models, fee arrangements and servicing agreements.

"The study clearly indicates that institutional investors will be gaining power over the investment managers and they want to see managers' interests more closely aligned with their own," said Mikael Johnson, lead partner for KPMG LLP's Alternative Investments practice in the U.S. The main changes will likely feature longer-term performance fee arrangements, increased capital investment from managers, and a move toward enhanced liquidity and transparency.

Regulation, Governance and Transparency are Top Challenges Facing the Industry

The KPMG International study said 97 percent of the administrators and 75 percent of the managers believe that regulation and governance are the most important challenges facing the alternative investment industry over the next 3 years. Seventy-eight percent of institutional investors cited transparency as the most important challenge. Sixty-seven percent of the investors cited regulation and governance as the second most important challenge.

Surprisingly, while regulation has been widely promoted as a way to protect investors, the study revealed that the majority of respondents are against increased regulation.

In North America, 67 percent of the institutional investors participating in the study said forthcoming regulations will have a negative impact on alternative investments. Forty-four percent of the U.S. investment managers agreed as did 32 percent of the U.S. administrators. They cited the belief that regulation will not produce any tangible benefits and will add costs and bureaucratic burden.

"The study certainly indicates that while investors are clearly looking for products with increased transparency and liquidity, they do not seem to be demanding regulated products," said Johnson.

Regulation could also reduce the number of new start-ups due to the increased costs and stall the industry's engine of creativity and limit choice, the report found.

Respondents See New Type of Manager

The study also revealed the creation of a new type of manager. From a legacy of boutiques (e.g. five people with one strategy working out of an apartment), to super boutiques (increased global reach and size), a new type of manager is emerging - the entrepreneurial-institutional (EI) manager.

According to the study, El's represents a change along the path of institutionalization. The study found they are more formalized and offer clients multiple products, including complementary services like financing, private placements, proprietary trading and structured products through multiple distribution channels.

Some of the other key findings in the KPMG survey included:

-- Larger institutional investors are moving to an allocation model with
a clear trend in favor of direct investment and managed account
platforms. At the same time, allocations to fund of funds are
falling.

-- Larger fund of fund managers with the resources to expand into managed
accounts will diversify their offerings in other ways, and use their
brand name to attract investment. Many smaller players, however, are
unlikely to be able to compete and the result could be a wave of M&A
activity.

-- Administrators are not immune from investor influence as demands for
reporting transparency and risk management support increase and force
greater standardization.

-- Data demands from fund managers and regulators are also expected to
swell exponentially, so administrators will need robust and flexible
technology platforms that are capable of high-volume transaction
processing and customized 'real-time' reporting.

-- Nearly three of four administrators are currently operating at between
71-100 percent of their technological capacity. If the alternative
investment industry grows as is forecast, administrators could face
serious infrastructural issues.