Balancing Risk and Efficiency: The Business Case for Shadowing in Private Credit

“Shadowing isn’t a one-size-fits-all solution. While smaller firms may mitigate the need with efficient cash reconciliations and robust teams, larger firms benefit from evaluating administrator quality and leveraging technology for enhanced operational oversight.”

This article includes highlights from a longer conversation that occurred between Piyush Singhi, Senior Managing Director of Credit and Private Funds at Indus Valley Partners, and Kevin Gee, Managing Director at Ares Management Corporation during “Shadow or Not to Shadow in Private Credit Space,” a webinar organized by LPGP Connect.

Singhi: What’s the business case for shadowing versus not shadowing?

Gee: In private credit, assets are not held in custody and operational risks have increased post-COVID due to a decline in service from both administrators and custodians. Shadowing mitigates these risks by ensuring data accuracy through reconciliation with administrators, which is crucial for meeting sophisticated LP demands.

How does your organization rationalize the costs of shadowing, and what challenges with fund administrators drive the need for internal shadowing?

Initially, relying on single systems exposed us to trade errors, which prompted a shift to a cost-effective internal shadow. Challenges with fund administrators, such as turnover and training gaps, necessitated active vendor management and monitoring through KPIs.

How do you get LPs comfortable with the costs associated with shadowing, particularly for separately managed accounts?

Onboarding separately managed accounts involves our primary administrator shadowing their records. This oversight ensures comprehensive exposure management and data integrity, backed by a cost-benefit analysis that emphasizes the benefits of risk mitigation and data quality.

Could you explain the concept of “shadow light” and how your organization manages loans versus non-loans across different asset classes?

For loans, we utilize WSO to compare records with our administrator’s data. For non-loans, like bonds, we leverage trading systems for daily positions. This is what we mean by a “shadow light” approach. It ensures accuracy without full NAV shadowing, allowing us to manage operational costs effectively.

How does your organization apply this approach to less liquid assets such as private equity?

With lower levels of activity in private equity, we minimize in-house shadowing. Instead, we focus our resources on more impactful areas like alternative credit and infrastructure funds. This strategy optimizes oversight while controlling operational expenses.

For asset classes where shadowing is less intensive, what systems or processes does your organization rely on to ensure administrators are performing adequately?

We conduct quarterly confirmations for private assets and leverage direct communications for share verifications. Real estate assets utilize service providers for rent rolls and property tracking, extending oversight beyond core credit operations.

Ensuring tailored controls by asset class and strategy is crucial. How does your organization approach this to ensure operational comfort?

By integrating trading systems for both liquid and private loans, we harness synergies across similar risks: trading, economic, and reputational. This approach underscores the necessity for robust shadowing solutions within our operational framework.

Transitioning from an in-house approach to the shadow light model must have had its challenges. Could you elaborate on that journey and any key lessons learned?

Initially, consolidating systems with administrators exposed critical pain points, prompting us to implement a shadow light model. Detailed mapping and contingency planning were essential, aligning with senior management’s risk mitigation objectives.

How did your organization approach testing the new systems, and what were the outcomes?

Testing focused on data accuracy and process efficiency. We hired and trained new staff, integrated data feeds, and automated processes, enhancing scalability and reducing manual errors across our extensive loan portfolios.

What ongoing checks and controls did your organization employ after the shadowing system was operational? How do you demonstrate value to senior management?

Key performance indicators include trade error rates and operational efficiency metrics, monitored rigorously to uphold performance standards. Regular updates and performance reviews with administrators ensure transparency and continuous improvement.

How did your organization approach the critical phase of historical data loading for shadowing?

Leveraging existing systems like WSO facilitated data integration and minimized complexity. Collaborations with vendors streamlined data loading processes, which is crucial for accurate shadowing of loan portfolios and operational efficiency.

How did your organization handle loading historical data into the shadow system, considering the complexities involved?

Timing played an important role in reducing effort and costs associated with data migration, given the availability of information in WSO for reporting needs.

Any final insights to share about deciding whether to implement a shadow system?

It is essential to recognize that shadowing isn’t a one-size-fits-all solution. While smaller firms may mitigate the need with efficient cash reconciliations and robust teams, larger firms benefit from evaluating administrator quality and leveraging technology for enhanced operational oversight.

How does your organization monitor primary administrators and spot data errors to maintain operational integrity?

We conduct daily P&L checks and implement more than 30 controls, ensuring proactive management of primary administrators and swift identification of data discrepancies.

What role do solutions like the IVP Security and Reference Master and IVP Pricing and Valuation Automation Solution play in enhancing operational controls and efficiency?

These solutions are pivotal in building robust controls and checkpoints, as well as facilitating exception reporting to promptly identify and resolve discrepancies. All of this helps us optimize scalability and operational efficiency.

As private credit evolves, in other words, firms must adapt technology and processes accordingly. This includes considering the unique demands of the asset class and ensuring systems can support these complexities effectively. Firms should instead prioritize dedicated technology specifically designed for private credit and investing in systems capable of supporting diverse debt structures and evolving alternative asset investment strategies. Embracing dedicated technology and processes helps firms position themselves for success.

Download Factsheet: Maximize Private Debt Efficiency and Transparency

Overall, focusing on value-added services and creative deal structuring will allow firms to justify interest rates while remaining competitive. Additionally, leveraging data insights from past deals can inform strategic decisions and enable firms to negotiate from a stronger position and drive value for both borrowers and lenders.

Learn more about the IVP for Credit platform or contact us to set up a live or online demo.