Hedge funds are increasingly accompanying private transactions of private equity and real estate in the next chapter of the alternative institutional relationship.

Funded ratios for U.S. pensions have slightly increased due to a recent equity markets rally in February. Plans sponsored by S&P 1500 companies reached an aggregate funded ratio of 79% as of February, compared with 75% in December 2011, according to Mercer.

Public plans experienced a $20 billion improvement in funding due to a $24 billion improvement in asset value that offset a $4 billion increase in the pension benefit obligation, according to the Milliman Pension Funding Index.

While the general rise in equity markets have contributed to keeping pensions afloat, alternatives continue to be a saving grace.

“We’re never going to make the 8% yield if we don’t go to alternatives,” said Steven LeBlanc, senior managing director of the Teachers Retirement System of Texas, a $110 billion pension that invests on behalf of 1.3 billion Texas public school employees. LeBlanc runs the fund’s private equity and real estate portfolio, which comprises approximately 15% of the investment portfolio.

With a shaky economy crushing faith in the standalone equity and debt markets, and as beneficiaries increase in numbers, it’s not surprising that pensions have continued pursuing alternative investment opportunities.

Many of the largest plans are eyeing name-brand hedge funds. Texas Teachers recently bought a $250 million non-voting stake in Bridgewater Associates, the $122 billion hedge fund headed by Ray Dalio. And three public plans from New York City have opted for alternative expertise from D.E. Shaw and Brevan Howard, which is reportedly the largest hedge fund in the U.K.
The name-brand allure is mainly derived from a post-Madoff world where allocators are most concerned in the market for partners that can properly perform due diligence before deals are made.

Start-up hedge funds, especially, have grown since regulation, such as the Volcker Rule, as this has pushed sell-side proprietary traders to implement bold investment techniques away from banks into hedge funds. Such a move could potentially make hedge funds a more dangerous trade, as they are collectively a much “less regulated environment”, according to Richard Johnson, head of quantitative electronic services for the Americas at Societe Generale.

LeBlanc of Texas Teachers added that confidence plays a key role in any relationship.

“Trust between GPs (general partners of a private firm), and LPs (limited partners of an institution) is a two-way street,” LeBlanc said an at industry conference. “We need transparency in today’s markets because we know what it means to be a fiduciary, but the LP also needs to know we’re going to keep certain information proprietary.”

For LeBlanc, a strong sense of trust and solid performance in some cases trumps fee structure when it comes to alternative ventures.

LeBlanc said: “Institutional money is sticky, so, for sophisticated investors, it’s less about fees—those are more important when you’re a high net worth investor,” citing the mantra “you get what you pay for”.

“We want to keep fees low but we’re not going to buy the crappiest product out there,” he added. “We don’t care if we need to give you five and 50 as long as we’re both making money.”

While thoughts on fees vary across the investor spectrum, risk management does not. Pensions, especially, are de-risking their portfolios through various strategies, and service providers are ensuring both institutions and their managers are getting the analytical tools they use to analyze their investment risks.

“Our risk solutions are primarily targeted toward investors that are looking to manage risk in their portfolio when full transparency on holdings is not always possible, timely or cost effective,” said Brendan Dolan, president of analytics provider PerTrac. “We give investors the analytical tools they need to understand how investments in a particular fund affect the overall risk in their portfolio.”

Another way to monitor risk is to approach alternative investing with a multi-manager approach. While many of the largest institutions have long-favored the largest players in the hedge fund space, LeBlanc finds value in diversifying investments to emerging managers across the alternative spectrum.

Texas Teachers currently has a $2 billion program just for emerging managers, and it is primarily because of such programs that smaller private equity firms can take a shot at investing for institutions.

“It’s nearly impossible to go from individual investors to investing for institutions,” said Shahab Moreh, a partner at accounting-consulting firm WeiserMazars. “But you can get there with baby steps.”

For small private equity shops, hope lies within deal funding coming from non-institutional sources such as retail and high net-worth investors. Small firms, such as Onyx Equities, primarily find their backing from high net-worth sources, and know they can’t rely on fees to solicit capital.

“As a smaller fund, we don’t make money on fees; our model is to show investors on success and execution,” said Jonathan Schultz, managing principal of Onyx.

However, pensions are not standalone investors in the alternative space; LeBlanc noted that sovereign wealth funds, endowments, and foundations are showing increased interest in beefing up their alternative portfolios. And institutions are not the only ones interested in getting in—high net-worth has long-accounted for the growth of hedge funds. Hedge funds trail only equities as the asset class most weighted in a high net-worth portfolio.

“If you’re a private equity firm, or hedge fund that already has a network of relationships on the high net-worth side, there’s no reason you should change your business model to go after just institutional sources,” said Seth Weintrob, managing director at Morgan Stanley. “There’s an intermingling of the two. Capital is flowing from across the globe, especially from the U.S. and across Asia.”