No matter who serves as the official fund administrator, back-up verification or “shadow accounting” has already become the modus operandi for the largest funds and is quickly taking hold among smaller ones. Over 75 percent of hedge fund managers do it.
What is new is that they are apparently opting to outsource the work and can select from a lot more flavors. As a result, making the right decision can be very difficult. Regardless, making the wrong one can be even more costly in reputational damage and financial loss.
Outsourcing middle and back-office operations to fund administrators is the norm for hedge funds. The funds are typically run by expert traders, who don’t have the interest or resources to handle the middle and back-office tasks on their own. Using third-party providers also makes them look good to regulators and investors who like the idea of independent oversight of their operations. Such administrators reconcile positions, market values and cash payments in and out of the fund. They also verify the existence of assets and value the portfolio.
But surprisingly, outsourcing doesn’t relieve hedge fund managers of all their worries, because they are ultimately responsible for any errors. It is those concerns which are prompting them to take a hard look at just how rigorous they want the oversight of their service providers to be.
“What was once simply a high-level matter of validating net asset values has turned into a full monte of mirroring all of the operational tasks of the official fund administrator, including investor reporting, cash flows and everything in between,” explains David Ross, director of marketing for Viteos Fund Services, a Somerset, New Jersey-based hedge fund administrator. Specializing in shadow accounting services, the firm has just issued a white paper touting the merits of outsourced shadow accounting.
As a rule of thumb, say shadow accounting experts, full accounting calls for replicating the all of the books and records of the hedge fund manager, including allocating the net asset value to individual investor levels and calculating management and incentive fees. By contrast, partial accounting may consist only of ensuring cash and P&L are in sync on a daily basis.
No one will say just how much all of the extra work will cost, because it depends on the size of the fund manager’s book of business, the number of funds involved and their investment strategies. The shadow services might end up being paid for only by the hedge fund manager, or by a combination of the fund manager and investors.
The benefits of any shadow accounting are obvious: hedge funds can ensure that operational tasks performed by the official fund administrator are accurate. It is also another way that funds can prove to regulators and investors alike that they aren’t cooking their books — an important comfort after Madoff and other well-publicized scandals. The investment scam run by the imprisoned Bernard Madoff handled all of its operations in-house so there was no third party to check on whether reported trades were actually made; they weren’t. The result: over $100 billion in losses to investors who are still working their way through the courts and trustee to collect cents on the dollar.
Criminal intentions aren’t necessary to make a mistake. For all their deep pockets and alleged expertise, even the largest fund administrators aren’t perfect, and errors could end up damaging the hedge fund manager or its investors. It could also cost the official fund administrator plenty as evidenced by the US$43.5 million that hedge fund administrator GlobeOp Financial Services paid up to UK hedge fund Regent Park Capital Management in 2009 for miscalculating net asset value. GlobeOp was acquired by SS&C Technologies in 2012.
Far From Perfect
Shadow accounting providers are hesitant to specify just what percentage of reports and calculations from official fund administrators go astray, but there are plenty of red flags. “The most common errors occur when position and market values are mismatched, corporate actions are incorrectly processed, trade accrual differences are overlooked, or the computation of performance and management fees fall short of the offering documents,” says Ross.
The reasons: the largest fund administrators are relying on legacy and bolt-on technology which might be just fine for hedge fund managers using the traditional long-short investing strategies. That technology may not do, however, when it comes to more complicated asset-classes and multi-legged transactions. While well-established hedge fund administrators — typically the largest custodians — might easily dispute such claims of their shortcomings, the thriving business of shadow accounting firms who are paid to find errors indicates that the performance of official administrators must bear watching.
At the core of any third-party shadow accounting service is reconciliation. That’s the plain-vanilla foundation of any flavor offered. But shadow accounting specialists claim to be a lot more thorough than traditional reconciliation software providers when it comes to handling over-the-counter derivatives, bank loans, and so-called Level 3 assets — the most exotic financial instruments which require fancy math to value.
Shadow accounting service providers take the exact same data that the hedge fund manager provides to its “official” hedge fund administrator and ensures that it matches up and is accurate. The data includes prices of specific securities, valuations of non-exchange traded securities, allocations of profit and losses to each investor, cash flows and margin calls. Any discrepancies are immediately flagged as potential breaks to be investigated by either the hedge fund manager or the shadow accounting firm.
Ingenious Initiatives, a Mt. Kisco, New York-headquartered investor accounting software firm, also offers a shadow accounting service, but on a more limited basis. The fund manager must license its software which specializes in catching discrepancies between the management and performance fees calculated by the fund manager and those calculated by the hedge fund administrator. Currently, the platform coined Penny, requires the fund manager to manually look for the differences on its own through the report issued by Penny, but the firm is adapting the system to automatically flag the differences.
“Investors need to ensure that the fees they are paying are accurate, because errors can occur, particularly for funds with complicated tiered structures, ” says Ron Kashden, founder of Ingenious Initiatives. “Fund administrators trying to standardize processes may miss the nuances of the manager’s offering documents and fee arrangements. Complications such as clawbacks and liquidity gates are particularly vexing due to their wide variations across the industry.” Investors can claw back or reclaim previous performance fees if the hedge fund manager’s performance subsequently tanks, while managers can also set some strict policies on just how often and when liquidity gates open — aka when investors can redeem assets out of the fund.
Shadow-accounting can also involve more than just checking the operational work of the official fund administrator. It has taken on additional facets of transparency, frequency and customization. Investors want to see — and quickly — whether the administrator can do the job it was paid for or whether the fund manager is holding its hand behind the scenes because it is unable to process certain asset classes, needs to cobble calculations offline in spreadsheets, or cannot generate risk metrics.
Viteos says it can speed up the frequency — to trade data or next-day basis — reporting that is typically provided on a monthly basis by the official fund administration. Other custom reporting may include analysis of the methodology used by the administrator to strike the net asset value as well as gross or estimated NAVs each day. Also on the menu: position appraisal, profit and loss, corporate actions and a host of reconciliation and collateral management information, as well as regulatory reporting.
The Dublin-headquartered Custom House Global Fund Services — which offers shadow accounting as well as traditional fund accounting — says it too provides customized sophisticated reports to fund managers and investors on an array of nitty-gritty details: transactions, commissions, mark-to-market P&L, purchase and sale P&L, realized and unrealized P&L, value-at-risk, stress tests and flash exposure, are just a few.
Whether or not a fund manager relies on basic or full-blown outsourced shadow accounting — and any additional custom reporting — depends on several factors: its size, pocketbook, and even more importantly institutional investor demand. “It’s not necessarily about the value of assets under management, but what institutional investors want,” says Scott Price, US regional director for Custom House.”Should they want the full shadow-accounting of all the functions of a fund manager, then that’s what the fund manager needs to do.”
However, size does count when it comes to either doing the work in-house or relying on a third-party provider. Viteos’ Ross says his firm targets hedge fund managers with US$1 billion to US$10 billion in assets. Firms with less than US$1 billion will likely want to do the shadow accounting work in-house. Firms with over US$10 billion in assets will likely have enough resources — technology and staff — to take on the task entirely on their own. These large hedge fund managers must rely on a team of back-office professionals who often do nothing else than shadow accounting.
Two secondary benefits come from outsourcing shadow accounting: hedge fund managers don’t have to worry that overworked back-office staff will simply check off on the calculations of administrators in a pinch. Hedge fund managers can also rest assured they can trade any asset class they want to, when they want to, regardless of whether or not their own operations or those of their official fund administrator are up to snuff. The shadow accounting firms can far more easily incorporate the asset into their technology. Or so they claim.
One approach to outsourced shadow accounting that won’t catch on is having two official administrators, shadow accounting experts tell FinOps Report. The widely-publicized 2013 decision of hedge fund manager Bridgewater Associates to tap Chicago’s Northern Trust to shadow the work of BNY Mellon, the first official administrator hired in 2011, and serve in the role of second official administrator is an anomaly. Northern Trust officials were unavailable for comment at press time.
“Such a scenario presumes that a fund manager, and two official fund administrators can seamlessly share and process portfolio and accounting data on an apples-to-apples basis,” says one executive at a hedge fund administration firm who declines to be identified. “With fund administrators often doing reconciliation on a batch process across multiple teams and systems it won’t be easy to coordinate their activities and tie them back to the fund manager.”
Regardless of the extent of shadow accounting, and whoever accomplishes the task, it appears that the search for errors and the need to fix them fast — even at the cost of doing the work twice — is a given. While that might be a comforting thought for institutional investors and regulators, it is understandably a headache for hedge fund managers. “We understand it’s the cost of doing business, but it comes down to a lot of extra relationship and workflow management,” says one operations executive at a US hedge fund management shop. “The payoff is there, but not always immediate.”