Over the last decade or so, an increasing number of hedge and other investment funds have adopted shadow accounting — keeping a duplicate set of books — to enhance the accuracy and integrity of their data. There are several reasons for this adoption, including investor demand for transparency and accountability in the wake of high-profile financial scandals, and an increasingly rigorous regulatory environment.
If your fund is considering implementing shadow accounting or expanding or narrowing the scope of its current shadow accounting practices, it’s critical to evaluate the relative costs and benefits and to tailor your system to your fund’s risk profile. Recent surveys reveal that while the vast majority of investors want shadow accounting, a significantly smaller number are willing to pay for it.
As you evaluate the pros and cons of shadow accounting, ask these questions:
- What’s the scope? Shadow accounting generally refers to a system in which two separate sets of financial books and records are kept for the purpose of detecting mistakes and inconsistencies. In a fund context, the term can be used to describe a broad range of practices, from verifying a third-party administrator’s Net Asset Value (NAV) calculations to completely replicating all of the administrator’s accounting records.
- Full or partial? A recent trend is a move away from full shadowing to partial shadowing. Certain accounting operations, such as NAV computations, reconciliation, and fund statement administration, are becoming more standardized and automated. Additionally, most (if not all) administrators are obtaining SOC 1 reports from auditors, which is a report on the design and operating effectiveness of controls at a service organization. This can provide fund managers and investors with a greater level of comfort with third-party administrators’ results. Partial shadowing reduces a fund’s costs by focusing on higher-risk operations, such as valuation of illiquid assets or complex fee calculations. Keep in mind, however, that regardless of the level of shadowing, fund management ultimately is responsible to investors for a third-party administrator’s operations. Therefore, strong oversight is necessary.
- In-house or outsourced? Many funds perform shadow accounting functions in-house, but in recent years there’s been a trend towards outsourcing shadow accounting to a second administrator, accounting firm, or other service provider. The decision to outsource shadow accounting or keep it in-house depends on several factors, including investor demand (investors may be more comfortable with a third-party) and the relative costs and benefits.
Perhaps the most important advantage of outsourcing is that it allows fund managers to focus on core activities, such as portfolio management, fund raising, and strategic planning. Shadow accounting performed internally — particularly full shadowing — can place a significant strain on a fund’s financial, IT, and human resources.
Assessing Your Risk
As you consider the potential advantages and disadvantages of shadow accounting, it’s important to take a risk-based approach. For some funds, full shadowing may be desirable to mitigate risk and fulfill obligations to investors. For other funds, duplicating 100% of an administrator’s accounting operations — including functions that present little or no risk — may represent overkill. For these latter funds, the most cost-effective solution could be a partial shadowing system that focuses on an administrator’s higher-risk operations and outputs.
For more information on shadow accounting, contact your Untracht Early advisor.