Preheat oven to 325 degrees F. In 3 quart saucepan, combine butter, salt, 1 1/2 cups milk and water and heat to boiling over a medium high heat. Gradually stir in grits, beating constantly with wire whisk to prevent lumps. Reduce heat; cover and cook, stirring occasionally, 5 minutes (grits will be very stiff). Remove saucepan from heat and blend in cheese.
In a large bowl, mix hot pepper sauce, pepper eggs, and remaining 2 cups milk until blended. Gradually stir grits mixture into the egg mixture.
Grease shallow 2 1/2 quart casserole. Pour grits mixture into casserole. Bake, uncovered, 45 minutes, or until knife inserted in the center comes out clean