Shadow accounting: The evolving practice of exercising due diligence in fund reporting

As alternative investment strategies gained increasing acceptance, the past couple of years turned into boom years for hedge funds and funds-of-hedge-funds, bringing increased visibility to the entire industry. But under that spotlight, when mis-steps involving back office operational risk and the independence of net asset valuations drew the scrutiny of regulators and the media, a new trend emerged. In an effort to focus on core competencies, reduce liabilities in peripheral areas of their operations, and along the way achieve cost efficiencies, many in the industry turned to outsourcing. For CFOs, this new trend was anything but an excuse to wash their hands of some aspects of operations – it was a catalyst for a fast rise in complexity of a practice known as shadow accounting. This article explores the fiduciary responsibilities that compel funds to employ shadow accounting, the added layers of control over different facets of the organization that are gained from this practice, and the data and technology requirements that different hedge funds or funds-of-hedge-funds may require as they strive toward due diligence through this method.