The Board of Audit and Inspection of Korea (BAI), a unit of the Blue House in Korea, is currently auditing the international asset exposures of the National Pension Service (NPS) and other institutional investors and financial groups.

The BAI is looking for different things in different places, and its actions have sparked a range of possible ramifications. In some cases the audits are resulting in some investors being strong-armed into agreeing to avoid future investments in hedge funds -- particularly if the institution had exposure to American fraudster Bernie Madoff.

The estimated size of exposure to Madoff's Ponzi scheme among Korean investors is slight, perhaps $250 million-300 million. Compared to losses from exposures to collateralised debt obligations and other structured products, it's a drop in the ocean.

What is striking, however, is that so many Korean institutions had exposures, albeit modest ones. Some in the domestic asset-management community say 50% of Korean institutional investors with international assets had Madoff exposure, mostly through funds of funds such as Greenwich Fairfield, but, at least in one case, also directly.

This has led the BAI to conduct a methodical and highly disruptive investigation of every institutional investor and the leading securities firms. "They were in here for weeks," says one person whose firm recently got the all-clear from the auditors. "It was highly disruptive."

The auditors are taking a hard line against pension funds or other institutions that had invested in Madoff funds. Industry sources say the auditors are extracting pledges from these investors to avoid hedge funds completely in future.

The spotlight is now on the $200 billion NPS, with a focus on its recent decisions to allocate funds to global private-equity and real-estate funds. (The NPS is prohibited by law from investing in hedge funds.)

All this comes at a time when institutional demand for alternative investments is starting to revive. Interest rates have ended a decade-long trend of decline, and domestic fixed income is about to become an unattractive asset class. There is a general sense that, with the turmoil of 2007-2008 over, Korean investors must increase risk appetite.

The hedge-fund industry has been given a morale boost by the declaration of the Korea Investment Corporation to allocate to the sector. So far the government investment arm has exposure to US-based hedge funds and this year is expected to make allocations to hedge funds in Europe.

Korea Post is also investing in hedge funds, and a few other institutions are expected to return to the arena. However, the latter group are smaller entities, as the big life insurers remain slow to move, and some of the bigger government pension funds are being forced by the government auditors to eschew hedge funds.

Views among investors regarding the audit range from "political theatre", designed to ensure the industry is squeaky-clean in the run-up to Korea's hosting of the G20 meetings in November, to "bullshit" motivated by politicians who think that any type of non-Korean exposure is inherently risky, to "routine".

AsianInvestor contacted one person who is linked to the BAI and who encouraged it to carry out the audits. He says Korean institutions have announced deals to allocate to overseas investments, both traditional and long-only, but there is a history of such deals never getting properly funded, because the announcements were about advancing careers.

"These guys can make it look like the money has been placed when it hasn't," says the source. "They say all kinds of things." It takes a deep, focused audit to ensure announced deals actually get carried out, he adds.

The good news for institutions is that the audit is unlikely to have any lasting impact, although it could cause disruptions this year. The NPS's investment process and staff are now highly regarded, and no-one in the industry believes there is any problem there.

Some of the smaller funds with Madoff exposure will need to improve their risk-management skills and systems, but are expected to resume activity by the end of the year, once the G20 meeting is over.

The April edition of AsianInvestor magazine will look in depth at hedge funds in Korea.