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Shadow Accounting - The Evolving Practice Of Exercising Due Diligence In Fund Reporting
Shadow Accounting - The Evolving Practice Of Exercising Due Diligence In Fund Reporting
Shadow Accounting - The Evolving Practice Of Exercising Due Diligence In Fund Reporting
Shadow Accounting - The Evolving Practice Of Exercising Due Diligence In Fund Reporting
Shadow Accounting - The Evolving Practice Of Exercising Due Diligence In Fund Reporting
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Shadow Accounting - The Evolving Practice Of Exercising Due Diligence In Fund Reporting


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  • 1. Risks Shadow accounting: The evolving practice of exercising due diligence in fund reporting Carol R. Kaufman President, InvesTier operating unit of SunGard Investment Management Systems, Inc. Abstract As alternative investment strategies gained increasing accept- ance, the past couple of years turned into boom years for hedge funds and funds-of-hedge-funds, bringing increased visibility to the entire industry. But under that spotlight, when mis-steps involving back office operational risk and the inde- pendence of net asset valuations drew the scrutiny of regula- tors and the media, a new trend emerged. In an effort to focus on core competencies, reduce liabilities in peripheral areas of their operations, and along the way achieve cost efficiencies, many in the industry turned to outsourcing. For CFOs, this new trend was anything but an excuse to wash their hands of some aspects of operations – it was a catalyst for a fast rise in com- plexity of a practice known as shadow accounting. This article explores the fiduciary responsibilities that compel funds to employ shadow accounting, the added layers of control over different facets of the organization that are gained from this practice, and the data and technology requirements that dif- ferent hedge funds or funds-of-hedge-funds may require as they strive toward due diligence through this method. 67
  • 2. Shadow accounting: The evolving practice of exercising due diligence in fund reporting Shadow accounting has become a frequent topic of conversa- ■ Ensuring that the trades it made or were made on its behalf tion among CFOs at many hedge funds and funds-of-funds. For were accurately executed and valued. CFOs this topic has progressed step-in-step with the rise of ■ Ensuring that the results calculated and reported by outsourcing, which was spurred by the desire for independent managers or administrators are accurate. valuations and cost efficiencies as well as the burdens of ■ Evaluating reported results of underlying managers in Sarbanes-Oxley certifications, investor demands for interim which a fund-of-hedge-funds firm is invested. reporting, and regulatory reporting pressures. Shadow accounting can be generally defined as the independent In years past, when traders and managers began to outsource crosschecking and confirmation of various aspects of account- various functions of their back offices to third-party adminis- ing functions being performed on a manager’s behalf. It can trators, especially offshore administrators, a number of man- encompass independent individual trade processing and valu- agers became concerned about the slowness of reporting and ation, fund NAV calculations and investor holdings, risk mana- even the accuracy of the numbers, due to the time lags gement reporting, and everything in between. between when the administrators received the data from the brokers and managers and when the numbers were finalized. Although the term is relatively new, shadow accounting has Investors would call frequently, soon after month-end, for been practiced for as long as traders have been trading. In the monthly performance information that some administrators 1960’s and 1970’s, traders frequently maintained their own generally provided many weeks or, unfortunately even personal blotter in elaborate manual spreadsheets used to months, after month-end. Consequently, managers would verify positions held at prime brokers and other places where reproduce the offshore work, both to provide timely fund esti- trading was being done, independent of their firm’s own mates to their investors and to confirm the accuracy of the accounting systems. numbers being reported by the administrators they hired. Later, in the early 1980’s, computerized spreadsheets and Most recently, shadow accounting has evolved to encompass portfolio accounting systems were created to process the every aspect of accounting, including monitoring investor trades and perform the independent crosschecks against the holdings as well as underlying outside investment holdings brokers with whom traders executed trades. Today, many and valuations. Much of this expanded review process is due to traders, hedge fund managers, fund-of-fund managers, pen- increased visibility, regulatory accountability, external investor sions and endowment funds, and corporations practice some pressures, and other industry requirements and responsibili- form of shadow accounting. ties placed upon firms, including: The case for shadow accounting ■ Aggregation of data - As it has become more common for a There are a variety of reasons firms perform shadow account- manager to allocate a fund’s business across multiple prime ing, but in many cases they stem from a firm’s recognition of brokers and to use different administrators across its funds, its fiduciary responsibility. Even though it may outsource a to obtain a true picture of one’s book of business, and risk portion or all of its back office or rely on reports from prime exposure, a firm has to aggregate the information brokers or administrators, inherently an investment manager generated from these multiple sources for risk analysis of or fund manager trading other people’s money retains the ulti- total holdings, performance consistency analysis, and mate responsibility to its investors for: reporting. If a firm is shadow accounting, regardless of the number of brokers or firms they use, their internal process provides the inherent aggregation they need. 68 - The Journal of financial transformation
  • 3. Shadow accounting: The evolving practice of exercising due diligence in fund reporting ■ Due diligence and contingency planning - With certain these sometimes complex calculations, or if a firm uses SEC and CFTC regulatory mandates incorporated into the multiple outsourcers and selling agent carve-outs are based 2003 Federal Register relating to the continuity of a firm’s on aggregated assets raised. business in the event of a future significant business disruption and with the NASD proposing more changes, At its most basic level, a firm’s adoption of shadow accounting pursuant to Section 19(b)(1) of the Securities Exchange Act consists of reasonability and spot checking, possibly incorpo- of 1934, firms have found that, as part of their operations rating spreadsheet calculations that reproduce certain NAV or plan, they should have certain contingency plans in place, fee calculations. At the other end of the spectrum, shadow such as the ability to switch providers at a moment’s notice, accounting includes the actual reprocessing of certain por- having pertinent information at hand without having to ask tions of the firm’s or fund’s book of business, such as daily val- an outside provider to prepare an ad hoc special report, and uations, fee calculations, even performance table results. The even self-sufficient backup if one or more of the providers shadow accounting may be performed internally; there are fail to deliver. An additional strategy is, of course, to also vendors – that to date have marketed their services to maintain a competitive environment to ensure the best private wealth family offices – that offer some level of shadow execution, commissions, services, and cost structure for the accounting to confirm the results provided by other outside firm and its funds. providers. ■ Availability of detailed data for interim reporting and The frequency of these operations varies, based on the firm, additional, critical internal research - With heightened the function, and even the level of risk associated with the awareness and focus on operational risk of market function. NAV recalculation might be monthly, bi-monthly, or movements, there is an increasing need or desire for even daily. Independent price checking against managers can information to perform interim valuations or performance be as frequent as weekly. calculations more frequently (e.g., ad hoc, weekly, or daily) than the contracted periodic reporting of such information Although the initial reaction to these processes is that it is a from one’s administrator or outsourcer. This might include duplication of effort, shadow accounting can actually head off holdings, trades or pricing/valuations with which to evaluate potential back office operational risk. Divergent results can price and strategy drift, comparative performance, and flag misinterpretations and reduce the time in identifying dis- proactive analytics. By having the data internally, firms can crepancies early on, before they impact performance, NAV, perform those additional valuations, what-if scenarios and and reporting. Offering memorandums that set forth the rules analytics to help them monitor their market exposure and of a fund can be vague and open to interpretation. The imple- properly react in a timely manner to market changes. mentation of those rules can impact performance calcula- tions, fee calculations, and allocation methodologies, resulting ■ Ability to process and provide adjunct information - in accounting and legal implications. Some firms utilize third parties, such as selling agents, to bring in investors. The selling agents can be incentivized a Focus: funds-of-hedge-funds (FOFs) number of ways - by carve-outs, or sharing, of fees or by Notably, the practice of shadow accounting has taken hold receiving a trail based on the percentage of assets brought among FOF managers, who inherently create an additional in. These calculations may be outside of the scope of the layer between the hedge funds in which they invest and the services that outsourcers may be providing to the firm, for outsourcer upon whom they rely to provide results. Since FOF a variety of reasons, including lack of tools that can do managers are generally disconnected from the underlying 69
  • 4. Shadow accounting: The evolving practice of exercising due diligence in fund reporting trading, additional information can become necessary for Coordination of efforts with the firms a hedge fund or FOF them to make informed decisions. Transparency debates are uses is key. It is one thing for prime brokers, third party admin- increasing in intensity, from both the perspectives of FOFs istrators, and hedge funds to allow their processed data, such managers seeking to ensure that their underlying funds follow as investor capital transactions and investments, to be down- their stated investment strategies and hedge fund managers loaded into external hedge funds, pricing data, and even protecting their proprietary trading models. The gamut runs underlying open trade positions; it is another to be certain from hedge fund managers refusing to provide detailed trade that data can be synchronized and reconciled, and that there information, to some allowing only risk parameters and peri- is an agreed upon plan when discrepancies occur. odic ‘snapshots’ to others embracing the concept, at least for select investors. On the other side, some FOF managers will If a hedge fund or FOF works with two or more firms from not invest with managers that refuse to offer transparency, which it wants to obtain data, it is important to consider while others feel that volumes of trade information are not import and export approaches that ensure the consistency necessary to their due diligence. Some FOF managers feel that and segregation of data, but still allow a firm to internally the key to proper investment due diligence for their clients is aggregate data. through review and evaluation at a higher level of aggregation of the underlying managers’ data. In this light, it is critical to understand the difference between interface and integration. An interface is a one-directional The complexities of both strategies and structures dynamically data flow. Integration describes a bi-directional data flow, with change the process that the FOF’s manager can use to be able built-in synchronization and automated reconciliation. An inte- to evaluate and monitor operational risk of both underlying grated solution is strongly preferable, to avoid synchroniza- managers and external administrators. From small, growing tion and reconciliation issues with the other parties with which FOF firms to international, well established ones, shadow the firm will send and receive data. accounting is setting a standard: Mark Graham, Managing Partner of Blue Advisers, a new, U.S.$ 100 million FOF firm, With this in mind, when setting up a shadow accounting envi- feels that ‘shadow accounting is part of the service we provide ronment, the firm should strive to find a product or suite of to our investors. It operates as a crosscheck. We are running a products that allow for an open database environment. Open business and need the right financial controls in place for our technology for easy importing and exporting should be a key investors.’ Glenn P. Cummins, Managing Director and Chief component when discussing shadow accounting. How much of Financial Officer of Ivy Asset Management, reports that ‘Ivy the process would a firm want to perform independently? It Asset Management Corp. performs shadow accounting on its would have to ensure that it and its partners don’t overwrite funds as an additional internal control on the quality of the each other’s data. The best architecture incorporates a cen- data being reported to our investors. We view timely and accu- tralized data warehouse where many departments could tap rate performance reporting as a key component of our client into the same set of data. This allows the client services group, services model.’ the research group, the investment managers, and the execu- tives all to be looking at the same consistent set of data Implementing shadow accounting results. There are a number of key factors hedge funds or FOFs must consider when implementing shadow accounting, factoring in Functionality is also key. CFOs should consider what they want their specific situation (one or multiple outsourcers or prime to do now, but also consider possibilities down the road. Is the brokers), their budget, their staffing, and their ability to imple- system solution under consideration a scalable one? Does it ment and maintain their stated plan. provide for adjusting the level of shadow accounting being 70 - The Journal of financial transformation
  • 5. Shadow accounting: The evolving practice of exercising due diligence in fund reporting performed (the fund may want to take on more – or less – of need or desire for information to perform valuations more fre- the responsibility in the future, without requiring a major con- quently than the contracted periodic reporting with adminis- version of data). The questions below are useful in evaluating trators or outsourcers. To implement shadow accounting, a proposed software solution: firms must coordinate efforts with the prime brokers and other partners they work with and ensure a plan is in place for ■ What functionality does the fund need now and what might when discrepancies occur. For a shadow accounting imple- it want in the future? (e.g., tax, accounting, portfolio mentation to be successful, firms should employ a bi-direc- management, risk management, investor accounting, tional import and export approach for exchanging data and salesman tiebacks) carefully evaluate the functionality, scalability, and flexibility ■ How comprehensive is the proposed solution? Does it of the shadow accounting system they employ. support all investment products? ■ Is it scalable? Can a hedge fund start out with reduced To assess whether shadow accounting is really necessary, functionality and increase it as it finds you need more? firms must carefully consider their situations and philoso- ■ How quickly does it adapt when new products or tax phies: Are confirmations of certain accounting functions per- consequences are introduced that need to be incorporated? formed on the firm’s behalf viewed as important elements in ■ How flexible is it? Can it handle complex calculations and complying with the firm’s fiduciary responsibility? Does the structures? Can it be customized? firm face situations where information – whether for decision ■ Is it fully integrated? Is it necessary to input data more support, due diligence, or responding to investors or regula- than once? tors – is maintained outside the firm and is not immediately ■ How accessible is it? Can you get to your data 24 hours/day, available? Does the use of multiple outside providers (e.g., 7 days/week? prime brokers, administrators, etc.) require the firm to manu- ■ How user-friendly is it? Is there a support hotline? ally aggregate data into useful information? Firms answering ■ How reliable is it? How long has it been on the market? yes to any of these questions have rightfully confirmed the ■ How secure is it? Are there backup procedures? heightened interest surrounding shadow accounting and make User security levels? this practice worthy of consideration. ■ What is the delivery mechanism? In-house? ASP model? Outsourced? Can the client try it first? Switch from one service level or another? Lease it? All of the above? References • NASD Rulemaking: Release No. 48503; File No. SR-NASD-2002-108 (Notice of Filing of Amendment Nos. 4 and 5 to a Proposed Rule Change by the National Association Conclusion of Securities Dealers, Inc. Relating to Business Continuity Plans and Emergency Contact Information) September 17, 2003 Pursuant to Section 19(b)(1) of the At its most basic level, shadow accounting allows firms to Securities Exchange Act of 1934 (‘Act’)1 and Rule 19b-4 thereunder. ensure that the trades they made or were made on their behalf were accurately executed and valued. For managers who use different administrators and allocate a fund’s busi- ness across multiple prime brokers, shadow accounting can aggregate data from these multiple partners. Consequently, fund-of -funds managers, who by definition have an addition- al layer between the funds in which they invest and the out- sourcer who provides them with results have taken particular interest in shadow accounting. As awareness of the opera- tional risk of market movements grows, there is an increasing 71