The Latest Trends in Shadow Accounting: What You Need to Know

As global financial regulations evolve, asset managers need to improve transparency, deploy advanced technology, and reshape the way financial data and recordkeeping are handled.

Together, these trends have given new life to shadow accounting, a parallel accounting system that gives fund managers much better visibility into their daily positions, cash balances, and P&L in order to improve the transparency and accuracy of reporting resulting in better investment related decision making.

Previously, funds either established their own internal shadow accounting team or procured additional services from their external fund administrator. However in an effort to validate the fund admin’s version of the truth more rapidly, funds are moving towards outsourcing services for shadow accounting. This approach allows funds to focus on core capabilities and generate alpha while getting all the benefits of shadow accounting from industry specialists. In addition, outsourcing gives funds access to detailed data that fund admins do not typically provide and in a much more timely manner.

With a better understanding of why demand for outsourced shadow accounting is growing, let’s take a closer look at six trends contributing to this situation.

1. Regulatory Scrutiny

Regulatory bodies are tightening oversight of fund managers and their accounting systems, a major change following a series of high-profile financial reporting scandals among very well-established organizations like Lehman Brothers. In fact, the company had hidden more than $50 billion in loans during the 2008 financial crisis. Using accounting loopholes, these loans were disguised as sales. An investigation by the SEC revealed that the company had sold toxic assets to Cayman Islands banks on a short-term basis. Another well-known example is Bernard L. Madoff Investment Securities, which swindled investors out of more than $64.8 billion.

These reporting failures negatively affect the entire financial market because they erode trust in the perceived quality of the systems virtually all asset managers use. This spurred regulators to enhance transparency and accountability by creating new regimes around data security and privacy as well as transparent, timely audits and reporting. Failing to comply with these regulations may lead to penalties. But compliance often depends on timely access to accurate financial data, which is often not possible with traditional fund admins. As a result, interest in shadow accounting is growing.

2. Technology Adoption

The fund management industry understands that adopting new technology is often the key to gaining a competitive edge. In many of these cases, an outsourced shadow accounting provider can shorten the learning curve. For example, when funds managers adopt a new accounting platform it typically requires a longer ramp-up before firms begin to see the benefits of efficiency, comprehensive coverage, and faster decision-making. Relying on the expertise of a shadow accounting firm that is familiar with these intricate accounting platforms across a broad range of strategies and asset classes can accelerate the process of adoption. Even in cases where a firm has well-established workflows, a shadow accounting firm can improve the speed and accuracy of accounting and reconciliation.

In many cases, outsourcing providers may use artificial intelligence (AI) and machine learning (ML) to a certain degree to streamline operations. Specifically, ML algorithms help automate reconciliations, data entry, and report generation while improving overall accuracy. This also enhances efficiency and allows real-time monitoring of final positions.

3. Outsourcing and Third-Party Providers

Facing increased competition, asset managers are reconsidering outsourcing as a way to manage operations more efficiently while achieving ambitious growth objectives. Fund managers and other asset managers also use outsourcing to differentiate from competitors and achieve better overall scalability. This is possible because outsourcing reduces the need to invest in infrastructure, headcount, ongoing integration, and other technology projects, which enables asset managers to add new funds and structures that generate alpha. Shadow accounting is a natural process to outsource because it is critical to operational efficiency but also resource-intensive to manage accurately. With outsourced shadow accounting, funds can take advantage of all the latest technology these third-party providers use to handle reconciliations, trade support, valuations, and daily internal reporting. Outsourced shadow accounting is not only more reliable but also time-tested and available at a reasonable cost.

4. Environmental, Social, and Governance (ESG) Reporting

ESG reporting discloses data about a company’s environmental impact, social responsibility, and corporate governance performances and initiatives. This reporting requires extensive data collection and verification that may also include non-financial matrices, which may be difficult to integrate within traditional financial accounting systems. Shadow accounting service providers that maintain parallel financial records can also be used to ensure the accuracy and reliability of ESG-related data, maintain the transparency of ESG reporting for investors and stakeholders, and ensure asset managers remain fully compliant.

5. Risk Management

As regulatory requirements tighten in an effort to reduce systemic risk in capital markets, asset managers must be increasingly focused on risk management. At the same time, investors are looking for fund managers that use reliable third-party valuations, manage operational and portfolio risk on a day-to-day basis, and adhere to investment guidelines for risk exposures. Likewise, investors want to ensure that fund managers are making informed decisions, so they request reports regarding exposures over specific periods to confirm managers have access to the data they need for prudent risk management. Shadow accounting helps track and manage risk more effectively. By maintaining two sets of books and records, asset managers can identify and mitigate potential risks earlier and more effectively. Overall, this can help protect the interests of investors and promote the long-term stability of the fund.

6. Evolving Asset Classes

As fund managers grow and diversify, they experience much greater complexity. This is especially true when moving into a new asset class, and this is one more area where outsourced shadow accounting can deliver an important advantage. For any new asset class, it is likely the outsourced shadow accounting team has hands-on experience in the asset and has already covered its related workflows for multiple funds. The outsourcing provider has already invested heavily in people, technology, and training to support a wide range of asset classes, so they have no learning curve to overcome and can start accounting for a new asset class immediately.

 Shadow Accounting is a valuable tool that helps fund managers improve efficiency, accuracy, transparency, flexibility, and risk management. What’s more, key industry trends are making it more main-stream than ever for funds to gain all of these benefits through expert outsourcing.

IVP Shadow Accounting Services is specifically designed to help fund managers better meet the needs of both investment teams and investors as well as promote the overall health and transparency of the fund. When it comes to improving operational efficiency and generating alpha while appealing to institutional investors and satisfying regulators, outsourced shadow accounting from IVP offers an ideal solution.