Understanding Fund Terms: Shadow Equity
Operational due diligence is a multidisciplinary subject. An investor beginning the operational due
diligence process for the first time may encounter subjects with which they have little to no
familiarity. As the scope of operational due diligence has become broadened in recent years, even
seasoned operational due diligence professionals may encounter terms which
they may be unfamiliar. The purpose of this section of Operational Due Diligence
Insights is to cast a spotlight on some of the words and terms which investors
may have not previously encountered, or which tend to get overlooked in
operational due diligence reviews.
This issue's word:
Shadow Equity (also known as Phantom Equity)
Shadow equity refers to a type of compensation scheme for hedge fund
investment professionals. Employees compensated via a shadow equity scheme
are not compensated as if they were direct owners of the hedge fund (i.e. -
General Partner), but are effectively treated as investors of the fund.
What investors should know:
The way in which a fund manager compensates its employees can provide useful insights into how it
values and retains its professionals. Shadow equity schemes are compensation schemes that seek
to align the interest of personnel with those of investors. The theory is that this so-called skin in the
game helps to generate harder working investment professionals who will act in the best interest of
investors. Employee compensation schemes can also contain vesting components which facilitate
the retention of employees through financial incentives for remaining at a firm.
During the operational due diligence process investors should analyze not only the management and
performance fees generated by a fund manager, but also the ways in which these fees are
distributed to employees via internal compensation structures, such as shadow equity. Funds that
have carefully structured employee compensation to incentivize employees and retain talent often
have lower turnover.
Originally posted in the August 2012 edition of Corgentum Consulting's Operational Due Diligence
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About Corgentum Consulting:
Corgentum Consulting is a specialist consulting firm which performs operational due diligence
reviews of fund managers.
The firm works with investors including fund of funds, pensions, endowments, banks ultra-high net-
worth individuals, and family offices to conduct the industry's most comprehensive operational due
diligence reviews. Corgentum's work covers all fund strategies globally including hedge funds, private
equity, real estate funds, and traditional funds. The firm's sole focus on operational due diligence,
veteran experience, innovative original research and fundamental bottom up approach to due
diligence allows Corgentum to ensure that the firm's clients avoid unnecessary operational risks.
©2012 Corgentum Consulting, LLC