Many investment funds outsource their back office and fund administration services to third-party administrators. Fund administration services typically include calculation of net asset value (NAV), daily, weekly or monthly P&L reporting, fee calculations and other activities that constitute being the official books and records. The reasons for using third-party administrators are well documented and typically include investors’ preference for an independent firm to oversee a fund’s financials. In addition, third-party administrators provide the ability to scale and often provide a sliding pricing model that goes up when a firm does well and down when a firm does not. Lastly, firms can take advantage of admin technology without the need for supporting this infrastructure in-house.
Shadow accounting is the process of maintaining an additional set of financial books for the purposes of comparison with the third-party administrator.
Reasons for shadowing your administrator
|Speed of reporting||Maintaining their own set of books affords funds the flexibility to determine their own schedule. While third-party administrators are held to service level agreements, they often do not cover ad-hoc reporting requirements and if they do, the agreements usually do not offer turn around times that are typically expected by senior management. Having your own systems and ability to report allows funds the opportunity for off-cycle reporting and if applicable, real-time analytics.|
|Reconciliation with the Fund Administrator||As mentioned previously, the responsibilities of an outsourced administrator can be broad. They’re often responsible for producing the NAV which has a direct correlation to the calculation of fees. Since there are many factors that go into these calculations, funds often like to have a separate process for producing these calculations to compare with their admin. When the numbers match, all is well. When the numbers are different, an investigative process will be conducted to determine the correct values.|
|Aggregation of multiple administrators||When funds have a multi-fund administrator model, it is sometimes difficult to get a complete picture across the fund family. Maintaining a shadow set of books allows funds to report across individual strategies and produce a holistic view of their performance.|
|Connection to risk and reporting systems||As part of the overall fund technology infrastructure, financial data is often sent downstream to allow for risk reporting, budgeting and forecasting, P&L data and other analytics. While this may not be the primary reason for shadow accounting, funds can become dependent on this data and having this data in-house may provide better data and allow for better reporting.|
|Lack of comfort/trust||Certain funds feel like they must outsource their back office and middle office operations since investors require it. When going through this process, if the admin fails to garner the trust of the in-house fund accountants, the fund may feel uneasy about eliminating their internal calculations and controls. In this era of increased regulatory scrutiny, it is more important than ever to have accurate information as incorrect filings can lead to fines and penalties.|
|Valuation accuracy||Producing a second set of books gives the fund an opportunity to apply their valuation and pricing strategy to their portfolio. In theory, this should match the admin’s valuation policy, but many times differences surface due to alternative market data sources. In the end, shadowing the portfolio leads to informed decisions when valuing investments.|
|Investors and allocators want it||There are investors or allocators that strongly prefer when a fund shadows their admin. It provides another level of control and has a positive impact on the due diligence reports conducted by potential investors. With the number of firms competing for investors, providing evidence of increased controls through shadow accounting has become a requirement.|
Full Shadow Accounting vs. ‘NAV lite’
NAV lite (or NAV light) is the process of taking in key inputs from the admin or other external sources and performing a check on the NAV calculation. In addition, it is common for the internal fund team to perform fee calculations as both an input and output to the NAV. Funds choose to do this to gain a level of comfort and provide senior management with confidence that the calculations are correct. The advantages of this approach are staffing requirements are reduced, and a full-service fund accounting system is not needed. Having confidence in the calculations is often enough to ensure the accuracy of the administrators. Some would argue however, there is no substitute for starting from the trade and entering all the debits and credits needed to calculate a NAV and a full set of financials in order to ensure accuracy. Shadowing only the NAV involves dependencies from the data being supplied by the admin and therefore comes with risks that mistakes could be made and the NAV can still be incorrect.
A recent survey indicated that over 80% of all investment managers perform some level of shadow accounting. It is rare for an investment firm to have the ability to raise capital without additional scrutiny that has become the norm in the industry. Investors and allocators have a large population of investment managers to choose from and have applied increased scrutiny as part of their due diligence. Most allocators have made it clear that shadow accounting is a requirement or at least desired. In addition, the data investors, auditors, and regulators are asking for is easier and quicker to produce when internal systems can be used. Therefore, funds have overwhelmingly made the choice to fully shadow or partially shadow their admins.
The Realities of Shadow Accounting
The realities of this decision are the increased investment from a cost and resource perspective, in a fund’s infrastructure. Funds are increasingly choosing order management systems and performance management applications that either has an accounting engine or can produce reports that can be used to produce a NAV. Choosing a system or systems to perform this function can be difficult and proper resources should be dedicated towards the selection and implementation. Similarly, choosing an outsourced shadow accounting provider is a critical decision that should be made after proper vetting. All funds are unique and therefore making decisions based on what worked for other funds typically leads to failed implementations. Choosing a system or vendor is a long term decision that is difficult to undo and requires attention to detail and diligence to get it done properly.
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FinServ Consulting is an independent experienced provider of business consulting, systems development, and integration services to alternative asset managers, global banks and their service providers. Founded in 2005, FinServ delivers customized world-class business and IT consulting services for the front, middle and back office, providing managers with optimal and first-class operating environments to support all investment styles and future asset growth. The FinServ team brings a wealth of experience from working with the largest and most complex asset management firms and global banks in the world.