The Madoff scandal broke just over seven years ago but its impact lives on. Among the many branches of regulation changes came a behavioral shift in the emphasis of transparency and quality of fund operators. Institutional investors have used these changes as a means of differentiation, voluntary taking on costly operational quality reporting.
That trend has give new life to shadow-accounting, traditionally an accounting system in which an end user duplicates the book of records as a validation of the fund administrator's Net Asset Value (NAV). Completely voluntary, the shadow-accounting has evolved in institutions to encompass the post-trade lifecycle and provide data for frequent reporting.
An organized book of records also helps to enhance a fund's marketing capabilities because it provides the kind of transparency that satisfies regulators and attracts wary institutional investors.
Jonathan White, VP of business development at VITEOS, a global hedge fund and middle office services provider, believes in terms of fund managers above $1 billion AUM, 75% are running shadow books. In the range of $500 million- $1 billion AUM, about 40% are running shadow books, and for firms with less than $500 million, probably 30%. Mid-sized shops in the $1 billion to $10 billion range are embracing the benefits of outsourced shadow-platforms at an increasing rate powered by robust due diligence from institutional investors, White explains. "Those institutions want to know managers can understand and validate the data their fund administrators are providing."
Interestingly, running shadow-accounting is considered a very North America model, and trending more in Asia. Europeans continue to run on fund administrators.
But if you build the beast you must continue to feed it. That's a harsh reality for many companies who built internal shadow-systems that continue to function but struggle to keep up with industry improvement in data capture and reporting. In a white paper, White and David Ross, global head of marketing, write, "Even the very largest hedge funds struggle to justify the expense of the vast internal staff required to fill the gap between traditional fund administrators’ services and the operational quality needs of the modern complex hedge fund."
Simply put, owning a book of records in house consists of booking trades in the back office, handling security master setup, handling corporate action, and handle pricing and valuation. And once everything is booked, including complex cash reconciliation, the end-user wants access that information for reporting capabilities. The back office systems has a lot of tools but many tasks are still done manually ad hoc with excel spreadsheets.
From VITEOS' perspective there has been a substantial shift toward the adoption of “outsourced shadow-accounting” as a business solution over the past decade. Firms are looking to replace or build out their homegrown systems to enhance their functionality to address needs such reconciliation, trade support, valuations, and daily internal reporting requirements. Through outsourcing of shadow accounting, they can focus on their alpha centric operations.
"The concept of shadow-accounting is not going away," says Ross. "Particularly as it is redefined from the traditional meaning into a must-have business process that meets the customization demands for scalability, agility, and control in the modern hedge fund."