Authored by: David Proskin, Managing Director, Integrated Solutions
Contributions by: Rafael Beck, Senior Managing Director, Integrated Solutions
In the world of asset management, particularly within hedge funds and private equity—shadow accounting has evolved from a discretionary practice to a critical control mechanism. This article defines what shadow accounting is, why it matters, and who relies on it most.
To understand its growing importance, we must look at the evolution of fund structures, investor expectations, and regulatory scrutiny. As institutional investors demand greater transparency and operational due diligence becomes more rigorous, maintaining internal books and records alongside those of third-party administrators is no longer optional. For fund managers, shadow accounting is now a core component of a robust operational infrastructure, ensuring accuracy, mitigating risk, and reinforcing investor confidence.
Historical Context
Alternative Investments as an asset class have now existed for well over a half century. How and why the asset class has evolved over time and why is beyond the scope of this article. It is important to understand that Alternative Investments which generally have come to include Hedge, Private Equity, Private Credit, Real Estate among other fund strategies. Common factors will include centralized portfolio management, typically provided by a founding sponsor of the entity who will earn fees for their efforts. Fees typically fall into two categories:
- Management Fees- asset-based fees which will be earned regardless of whether the entity makes or loses money and are designed to cover operating costs of the venture.
- Performance Fees- arguably the more lucrative component, will be a fee (or allocation) based on the performance of the Fund. The computational aspect of the performance fee is limited only to the imagination of the Fund Manager and the objectives and requirements of its investors.
Fund strategies employed by Fund Managers are limited only by the Fund Manager’s imagination, their professional background and skill set and what they understand their “edge” to be. At the heart of the Alternative Investment model is the Fund Manager, typically a General Partner (GP), in a traditional limited partnership structure, responsible for managing a portfolio of assets on behalf of their investors (Limited Partners or LPs). Fundamentally, it is the obligation of the GP to maintain accounting records that support performance which is typically expressed as the Net Asset Value (“NAV”) of the Fund. NAV is reported periodically to the Limited Partners to understand how effectively the Fund Manager is fulfilling its fiduciary duty.
Before the 2008 financial crisis, Fund Accounting was generally considered to be a routine back-office function. However, the Madoff Scandal was a pivotal event and a wake-up call for Limited Partners. In a nutshell, Limited Partners had placed too much reliance on the reputation and marketing efforts of the General Partner. The concept of “trust but verify” now became the operating model. Whereas prior to 2008, accounting and preparation of the NAV was all over the map including internally, for the smallest and resource constrained Funds to the use of Third-Party Administrators to provide some level of verification and to maintain the books and records on behalf of the Fund Manager, today independent NAV verification became a non-negotiable control. Investors now expect third-party administrators to maintain books and records, ensuring transparency and safeguarding capital.
It is important to note that the mere existence of an Independent Fund Administrator in no way relieves the Fund Manager of its obligation to its investors in terms of the performance of, and reporting by, the Fund. This point is critical to understanding how Shadow Accounting came to be a thing.
Shadow Accounting: A Critical Control in Alternative Investments
Building on the historical context, the definition of shadow accounting in the asset management space becomes clear: it refers to the internal controls put in place by the Fund Manager to ensure that information and fee calculations being reported and charged to its Limited Partners are accurate. In today’s environment, this is no longer a luxury, it’s a necessity.
Given the diversity of strategies and structures in alternative investments, shadow accounting is not a one-size-fits-all solution. From the simplest investment strategies at the most rudimentary levels of implementation and given the amount of limited resources available to the Fund Manager, the level of shadow accounting can be limited to some level of detailed review of the period end NAV package generated by the Fund Administrator which would at a minimum include:
- Reviews of the reconciliations of cash balances and holdings versus prime broker records
- Verification valuation methodologies in line with offering documents
- Independent recalculation of management and performance fees
- Review of investor statements for accuracy and consistency
It is worth noting that particular attention should be paid to transaction boundaries, particularly those involving cash movements. Prior to launch, it is imperative that cash controls between the Fund and the Third-Party administrator be discussed, risks identified, and controls implemented to ensure that all cash movements are valid, understood and documented. This would include processes for receipt and payment of investor subscriptions and redemptions, payment of Fund expenses and collateral movements.
These controls must be well-documented, understood by all parties, and tested regularly to mitigate operational risk.
As a Fund Manager moves across the spectrum of growth and complexity of their operation, it will need to be mindful of the need to be flexible and scalable in terms of how the Shadow Accounting will be accomplished.
It goes without saying that for an emerging manager, resources are scarce and prospective investors, initially at least, have an expectation that those resources are best allocated to portfolio construction, research and risk management. Today, with the availability of technology, service provider solutions and an increasingly higher level of investor expectations, a robust control environment with a best in class, well-articulated, shadow accounting process has become a requirement rather than an option.
Summary: Shadow Accounting as a Strategic Imperative
Based on the current environment, it is safe to say that some level of Shadow Accounting is required to attract capital of any sort and the higher the level of sophistication of the targeted investor base is, the more comprehensive the Shadow Accounting framework will need to be.
At Integrated Solutions, we bring a unique perspective in the ecosystem because of our role as both a Fund Administrator and a provider of Outsourced C-Suite services, we understand the operational, fiduciary, and governance challenges fund managers face. Importantly, we recognize the potential for conflicts of interest and maintain strict boundaries—we do not serve as Fund Administrator for any fund where we also provide C-Suite services.
Our dual perspective allows us to offer tailored guidance to fund managers, helping them determine the appropriate level of shadow accounting based on their strategy, investor profile, and growth trajectory. Whether you're an emerging manager or an established firm scaling operations, we can help design a scalable, intelligent shadow accounting framework that supports your long-term objectives and meets the expectations of today’s investors.
