The continuing institutionalisation of the hedge fund industry can be illustrated by a growing demand among managers – and indeed their investors – for shadow administration. Market regulation is pushing firms to stay operationally compliant. As a result, hedge funds need to be comfortable, and confident, that the investment books and records are accurate.
To do this requires an additional set of eyes; someone who is watching the watchers.
“Do you build an operations team that fully shadows the books and records? Do you put in review controls to get comfortable with the administrator? Or do you appoint a third party to shadow your administrator? This last solution, which brings an unbiased objective viewpoint, is probably the best of the three in terms of giving investors the most confidence,” comments Brian Bekiers, Senior Managing Director in the Alternative Investment Solutions team at U.S. Bancorp Fund Services.
The shadow accounting solution offered by U.S. Bancorp Fund Services not only provides additional control to the manager, acting as a safety net to identify any errors the appointed administrator may have made, it takes a lot of the pressure off their back office, many of which rely on Excel-based workbooks and tools to monitor and report key figures. That is not ideal when your typical manager today might be reporting under Form-PF, CPO-PQR, FATCA, even AIFMD in Europe.
“Shadow accounting is a great fit as we can aggregate the data for all the different reports to investors and regulators, thus taking the strain off the manager,” says Steven Gargano, Senior Managing Director, confirming that U.S. Bancorp Fund Service’s shadowing solution can deliver daily P&L, exposure reports, attribution reports as well as NAV reconcilement.
“We perform the full set of books and records, just as a manager’s current administrator does, but in addition we then reconcile the administrator’s books and records against our shadow books and records. This produces two sets of books and records from two disparate systems, ensuring that all of the portfolio details are in line,” adds Bekiers.
When discussing why managers might turn to an extra set of eyes, Gargano points out that whilst the appointed administrator might be good at doing all the month-end reconciliation work, etcetera, they may lack the expertise in regulatory reporting.
“Are you going to pull the plug altogether on your administrator just because you need additional information? Of course not. When it comes to using shadow accounting solutions, it’s not necessarily that investors are demanding it, it’s that managers are thinking forward; maybe they see their assets rising and they are thinking two steps ahead about how to better run their business.
“A shadow solution can, in effect, help managers to hedge themselves against future market changes, especially regulations; they know that they can rely on a team of people to answer these questions and demands. In addition, it helps remove key man risk. What are you going to do if your CFO walks out?” explains Gargano.
Key to having a successful shadow accounting solution is coming up with a workflow that works for all parties concerned: the manager, the administrator and the prime broker.
If a red flag pops up, U.S. Bancorp Fund Services lets all three key parties know. By doing it on a daily basis, errors can be nipped in the bud. Once everyone is more aware of these issues, the proper controls can be put in place to try and prevent it happening again in future.
“We have to make sure we can cater to the different ways that managers and administrators are geared up to work, the way information flow is reviewed within that process; it’s something that one has to develop on a case-by-case basis.
“We’re taking the stance that shadow accounting is something that is going to be beneficial for the industry. But it requires education, and that’s what we’re doing a lot of right now,” says Gargano.
Ultimately, managers can’t afford to get things wrong. But the obvious question that arises when talking about shadow administration is, “What about the other administrator? Don’t they see it as an affront to their reputation?”
Gargano is happy to respond: “One talks about reputation risk in the context of managers, but for the appointed administrator it is actually somewhat of a relief that everything is being double-checked. In this day and age, word spreads fast if an administrator makes a mistake. It’s a relief to have that peer-to-peer review.
“It happens in the accounting industry with respect to audits and there’s no issue, rather it’s about instilling good practices and learning from each other. The idea that shadow accounting is a competitive threat does not hold. Once people start viewing shadow accounting through this lens, it’ll hopefully start to make sense,” concludes Gargano.
About U.S. Bancorp Fund Services
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