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Institutional investors continue to demand more from their hedge fund managers in every facet of their business, whether that be a better understanding of their investment strategy, a more robust cybersecurity infrastructure or a more comprehensive disaster recovery plan. Fund administration is no different, and shadow administration services continue to grow in importance for investors looking to verify data coming from their hedge fund managers. AlphaWeek’s Greg Winterton caught up with Anthony Mascia, Managing Member of New York-based admin firm EFSI to learn more about the importance of the space.
GREG WINTERTON: Anthony, most start-up hedge fund managers need significant capital to sustain their businesses for a few years as they build a track record. Adding shadow administration services adds yet another layer of cost. Why is it important to do this from the get-go?
ANTHONY MASCIA: Hi Greg. It is important for any individual starting any type of business that they make sure to put their best foot forward. As a fund manager, it is extremely important that they understand the costs involved in owning, managing, and operating a fund. You need to make sure that what you represent is true and transparent; allocators’ reporting expectations are evolving – they want more information, and they want it delivered faster.
Over the last decade, an increasing number of funds have adopted “shadow accounting” — keeping a complete separate set of fund records for the sole purpose of finding and correcting mistakes — in order to enhance the accuracy and integrity of their data. Some fund managers perform shadow accounting in-house which can overload the fund’s financial, IT, and HR departments. As a result of that and because of increasing regulations and investor demand for transparency, hiring a third-party administrator has become industry standard. By outsourcing the shadow accounting responsibility, a fund manager can focus on managing the portfolio and raising assets.
An Ernst & Young 2012 Global Hedge Fund and Investor survey stated that nine in 10 investors believe that shadow accounting is “highly beneficial to accurate valuation and reporting.” As competition has increased for institutional assets, outsourced shadow-accounting capability is becoming a “must have” especially for the start-up/emerging space. The ability to shadow is in fact a necessary capability for firms to attract certain types of capital, manage ongoing operations, and secure growth over time.
GREG WINTERTON: Hedge fund managers looking to add a shadow administration function have the option of full or partial shadow administration. Tell us which option is most applicable to which managers, and why.
ANTHONY MASCIA: I think this really comes down to budget – as I mentioned in the previous question, you are starting a business and need to prioritize your spend. As a start-up manager, your focus should be, first and foremost, your trading strategy and how to prove the returns, but a close second is focusing on how to keep the lights on. Funny enough, in this post-COVID world, working remotely has changed our views on office space and needing the expensive city office. This actually is beneficial to the manager and their investors. The less the manager needs to spend on “keeping the lights on”, the more the manager can focus on building the fund’s track record.
I would suggest that on day one, a fund should always have a full services administrator in place to be the official books and records of the fund, but if they cannot and need to self-administer, then shadow administration is the next best option.
When you say full or partial, then in my opinion, there is not really a big difference in the fact that shadow administration is exactly what it means – it is shadowing the books of another group or individual. Most fund managers nowadays typically hire an administrator to perform a full service, which will include full fund accounting and investor services/treasury functions. Having an administrator on the hedge fund side has been best practice for a long time.
Most hedge fund managers don’t even consider administering inhouse and outsourcing shadow – they just start with a full-service admin shop out of the gate. Sometimes they will have an administrator in place and then pay for shadow services from another provider. This keeps the administrator on their toes because if the shadow admin keeps finding mistakes, guess what happens?
GREG WINTERTON: OK. What are some of the most common mistakes that an outsourced shadow administration function would catch?
ANTHONY MASCIA: I would say the most common mistakes are as follows:
• Incorrect or inconsistent security pricing
• Breaks in cash or securities reporting
• Differences in the accrual accounting for income and expenses (i.e. – dividend and interest accruals and fund expenses)
• Management and performance fees calculated incorrectly
• Profits and losses not allocated correctly
• Capital activity not processed correctly or processed in an incorrect period
• Entries posted to incorrect general ledger accounts
This isn’t an exhaustive list, but it is the main ones.
GREG WINTERTON: Back to costs. What’s the impact of shadow accounting from a cost perspective?
ANTHONY MASCIA: As I mentioned in my first two answers, cost is always a factor, but to have an investor’s peace of mind, what is that worth to you? Typically, shadow admin is a fraction of what full-service administration costs. If you start a fund and fear the costs associated with it, then you probably shouldn’t be starting one in the first place.
GREG WINTERTON: To those managers who are still unconvinced about adding a shadow accounting function, what’s your message?
ANTHONY MASCIA: Having a shadow accounting function is best for the fund manager who has a few years under his/her belt. By that, I mean the fund has a somewhat established track record and is ready for ‘prime time’. They are making some traction with investors and have service providers in place and have established a working relationship with them.
That’s the time, in my opinion, to test the work of those service providers. Are you receiving the right service and are they providing you with correct information/reporting? The worst thing is having an established relationship with a service provider and come to find out that they’ve been messing up because it could negatively reflect on you and your fund.
Anthony D. Mascia is Managing Partner at EFSI. Connect with him on LinkedIn here.
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EFSI is an independently owned, SOC-1 compliant, full-service fund administration firm. We provide accounting, reporting, administrative, and capital introduction services to a wide range of alternative investment funds including hedge funds, funds of funds, private equity funds, real estate funds, venture capital funds, and family offices. The center of EFSI’s service incorporates resilient technology and accomplished staff, providing clients a tailor-made service with exhaustive transparency. Give us a call today or reach out to our support team online. We look forward to hearing from you soon.