Overview of the business plan development process for hedge fund managers

1. DRAFT
Developing a Business Plan
for Hedge Fund Managers
W. Mechem
mechem@wjtcapital.com
4/11/10 Willard John Thomas Associates 1

2. Disclaimer
DRAFT
UNDER NO CIRCUMSTANCES SHOULD ANY MATERIAL IN THIS DOCUMENT BE
RELIED UPON FOR ANY PURPOSE OTHER THAN AS A CASUAL REFERENCE TO THE
BUSINESS PLANNING PROCESS WHICH SHOULD ONLY BE UNDERTAKEN WITH THE
GUIDANCE OF A QUALIFIED ADVISOR.
WILLARD JOHN THOMAS ASSOCIATES MAKE NO REPRESENTATION AS TO THE
SUITABILITY OF THE INFORMATION CONTAINED HEREIN FOR ANY PURPOSE
WHATSOEVER.
THIS DOCUMENT DOES NOT IN ANY WAY REPRESENT ADVICE WITH REGARDS TO
SECURITIES LAWS OR COMPLIANCE WITH THE SECURITIES ACT OF 1933, AS
AMENDED.
4/11/10 Willard John Thomas Associates 2

3. About WJT
DRAFT
Willard John Thomas Associates provides consul6ng services globally to
financial and technology clients, including investors and fund managers
in high frequency and quan6ta6ve hedge funds, and capital markets
technology providers.
Our focus is on creaYng opportuniYes in North America, LaYn America and
Asia. Offices in New York, SanYago, New Delhi and Shanghai give us global
reach and local insight.
Our services include:
– Uncovering investment opportuniYes with established and emerging fund
managers and trading teams
– Global mergers and acquisiYons research and introducYons
– CreaYng relaYonships among leaders in capital markets technology
– Building winning teams
For more informaYon on specific programs, please visit us at
h`p://wjtcapital.com
4/11/10 Willard John Thomas Associates 3

4. Business Plan
DRAFT
• Business Plan:
– a series of steps to be carried Must have a plan before we
out that should result in profits
being generated from business can dra6 a document, but
operaYons in a given context. dra6ing a document will help
• Business Plan Document: us fill in the gaps in our plan.
– Expresses in wri`en format, a
series of steps to be carried out
that should result in profits
being generated from business
operaYons in a given context.
• Document is generated for
one of two (someYmes both)
reasons:
– As an operaYonal plan
– To raise money
4/11/10 Willard John Thomas Associates 4

5. Major Components of the BP
DRAFT
• Vision • Clients
– What the business looks like or will look – Who will buy our vision?
like – Why?
• Management • CompeYYon
– Track Record – We are like…, We are different…
– Why we are likely to succeed? – Validates business model
• Vendor Partners • Edge
– Who’s on our team? – What is the company’s advantage in the
• Financial Statements market?
– Past performance / Future projecYons • Track Record
– Business Model – Back tesYng
• Market – Live trading
– Opportunity: Economy, geo‐poliYcal, • Risk Management
technology, regulatory – Risk versus loss aversion
– Size (potenYal) • Working Capital
– What we need to succeed
– What are we willing to exchange for
what we need
4/11/10 Willard John Thomas Associates 5

6. The document development process
DRAFT
Goals:
Most people dra6 a BP to
raise money.
To explain the business to
someone else (like the This is a usually a
requirement of insAtuAonal
bank or venture capital investors.
investor)
But the best reason to go
through the process is to
To make sure we make sure we understand
understand the context what we are ge/ng
ourselves in to!
under which we are
going to be operaYng.
4/11/10 Willard John Thomas Associates 6

7. Vision
DRAFT
• The Vision provides context “In 3 years (2014) we will be a
• Expresses quanAtaAve hedge fund managing
– self image $150M in AUM and trading in U.S.
– value proposiYon equiAes and FX.”
– public face
• What do we want to be when we “Our value is in providing medium to
grow up? high ROI with low volaAlity to our
• What this picture will look like in 3 investors.”
years / when we go to sell the
business / take it public / wind it “We will accomplish this through the
down use of quanAtaAve models (market,
– We make widgets in Bermuda. currency, and volaAlity neutral) that
– We will import“5‐sided” widgets to leverage our proprietary intellectual
AntarcYca and charge a premium. property and technology”.
– We will be a $50M widget company in 3
years
– We will be the number 3 widget “Our annual expected returns are 20
company globally as measured by – 40% and our expected average
market share. Sharpe raAo is around 4.0”
4/11/10 Willard John Thomas Associates 7

8. Management
DRAFT
• Investors bet on the jockeys / not the horse
– Best plan / business will fail without ability to execute
Is this a career change for me?
• Management “Bios” establish groundwork for credibility How much money have I
– Done this before?
– Done something else important before? managed before?
– Relevant experience and educaYon? Was I trading the same types of
• Smart enough to know their shortcomings?
– Does the plan cover all the bases? assets in the past?
– MarkeYng, technology, operaYons, compliance, legal,
microstructure, financial domain, asset specific knowledge Who have I worked for?
• Plan for gaps? Was it a small shop or a large
– Hiring, outsourcing?
• Management experience? shop?
– Financial Am I used to lots of resources
– People
• Have their past ventures been similar in scale? or doing it myself?
– $1M vs $100M = different set of problems What roles have I held in the
• Commitment and ability to see plan through to compleYon?
– Financial past that enable me to
–
–
EmoYonal
Family support?
understand the BUSINESS as a
• How long has the team been together? whole?
– Past conflicts? How resolved?
• How are decisions made?
– Do team members have clearly defined roles?
4/11/10 Willard John Thomas Associates 8

9. Vendor Partners
DRAFT
• Aser core team, arguably most important Do they understand our
part of your strategy.
business?
• Vendor selecYon process can be lengthy and
confusing, but having the right vendor
partners is criYcal. Are their costs compe<<ve?
– Assures investors they are dealing with
professionals
– Reassures investors their money is safe Do they have the resources
– Provides you with peace of mind to provide us with the
– Offloads administraYve overhead needed level of support?
• Does not off load responsibility
• Types of Vendors How many clients do they
– Prime Brokers
– Custodians
support?
– Fund Administrators
– Accountants Will we be working with a
– A`orneys firm Partner or an associate?
– Compliance Advisors
– ExecuYng Brokers
– Technology Providers Can we integrate with /
leverage their technology?
4/11/10 Willard John Thomas Associates 9

10. Financial Statements
DRAFT
• Pro Forma Financial statements express the business • Budget is expressed via P&L (income and expenses)
plan in mathemaYcal terms, similarly to the way a – Where you intend to spend money reflects how
quanYtaYve model expresses a trading strategy you expect to make money
– P&L – Money spent on X produces income (loss) • R&D, Personnel, Technology, MarkeYng
of Y Budget “Story” must be raAonal
– Balance Sheet – At a point in Yme we (will) have – If we are going to beat Citadel…
these assets and these liabiliYes (this is what our
• Then we be`er have a boat load of money
business will look like)
allocated to R&D and technology
– Statement of cash flows (uses of cash) – Money
– AUM “story” must be raYonal
will come from here and go there
• We will raise $500M AUM @ 2% and 20%
• Money is neither created nor destroyed, it
simply moves around • We will take X% of FoF money in the Dubai
• Pro forma Income Statement (P&L) market
– Recipe
– How money will be spent is “secret sauce”
– Input: Cash (Expenses) + Revenues (Sales)
– Output: Profit (loss)
• Return on Investment (ROI), return on
assets, (ROA)
• Budget allocaYons express the investment strategy
4/11/10 Willard John Thomas Associates 10

11. Market
DRAFT
• This secYon validates
business model
– Provides context
– Establishes realism of
plan expectaYons
• Explains scale of
opportunity
– US$ trillion market or How many FoF invest in my type of strategies?
US$ 50M?
4/11/10 Willard John Thomas Associates 11

12. Clients
DRAFT
• Who will buy our “Vision”? “Our value is in providing medium to
• How will we recognize clients?
– What do they look like? high ROI with low volaAlity to our
– Where do they shop? investors.”
• On what do they base their buying decisions?
• What are they sensiYve to?
– VolaYlity
– Sharpe
– Asset class
– Porzolio correlaYon
– Overnight risk
– Fees
– Taxes
• How will we reach them?
– Third party marketers?
– Referrals?
– Prime Broker Capital Intro?
• Are we OK with regards to securiYes laws?
How well do we know our prospec<ve clients?
4/11/10 Willard John Thomas Associates 12

13. How well do we know our prospecYve clients?
DRAFT
• Fund of Hedge Fund DistribuYon by Fund Domicile • Fund of Hedge Fund Asset DistribuYon by Fund Size Bands
• Fund of Hedge Fund Asset DistribuYon by Fund Domicile • Fund of Hedge Fund DistribuYon by Fund Age Bands
• Fund of Hedge Fund DistribuYon by Manager Domicile • Fund of Hedge Fund Asset DistribuYon by Fund Age Bands
• Fund of Hedge Fund Asset DistribuYon by Manager Domicile • Fund of Hedge Fund DistribuYon by Management Fee Bands
• Fund of Hedge Fund Domicile against Manager Domicile • Fund of Hedge Fund Asset DistribuYon by Management Fee
• Fund of Hedge Fund DistribuYon by US Fund Domicile Bands
• Fund of Hedge Fund Asset DistribuYon by US Fund Domicile • Fund of Hedge Fund DistribuYon by Performance Fee Bands
• Fund of Hedge Fund DistribuYon by US Manager Domicile • Fund of Hedge Fund Asset DistribuYon by Performance Fee
Bands
• Fund of Hedge Fund Asset DistribuYon by US Manager
Domicile • 12‐Month and 3‐Year Returns against Fund Domicile
• US Fund of Hedge Fund Domicile against US Manager • 12‐Month and 3‐Year Returns against Manager Domicile
Domicile • 12‐Month and 3‐Year Returns against Fund Currency
• Fund of Hedge Fund DistribuYon by Fund Currency • 12‐Month and 3‐Year Returns against Minimum Investment
• Fund of Hedge Fund Asset DistribuYon by Fund Currency • 12‐Month and 3‐Year Returns against SubscripYon Frequency
• Fund of Hedge Fund DistribuYon by Minimum Investment • 12‐Month and 3‐Year Returns against RedempYon Frequency
• Fund of Hedge Fund Asset DistribuYon by Minimum • 12‐Month and 3‐Year Returns against Fund Size Bands
Investment • 12‐Month and 3‐Year Returns against Fund Age Bands
• Fund of Hedge Fund DistribuYon by SubscripYon Frequency • 12‐Month and 3‐Year Returns against Management Fee Bands
• Fund of Hedge Fund Asset DistribuYon by SubscripYon • 12‐Month and 3‐Year Returns against Performance Fee Bands
Frequency
• Fund Domicile Category against Fund Manager Domicile
• Fund of Hedge Fund DistribuYon by RedempYon Frequency Category
• Fund of Hedge Fund Asset DistribuYon by RedempYon • Fund Currency against Minimum Investment
Frequency
• SubscripYon Frequency against RedempYon Frequency
• Fund of Hedge Fund DistribuYon by Fund Size Bands • Fund Size Bands against Fund Age Bands
• Largest Featured Fund of Hedge Funds by Assets
• Management Fee against Performance Fee
4/11/10 Willard John Thomas Associates 13

14. CompeYYon
DRAFT
• Why are they compeYtors? Why will “We are not like Citadel…
– How alike? we be
– How different? successful “We are like Getco…
• How does their business model compe<ng
compare to ours? in this “We are kind of like Jump…
– How do their results compare to market
ours? “They are market makers…
versus
• “Halo effect” these guys? “We are market takers…
– We are just like …
– See what these guys have done?
We are just like them… “We are somewhat like 2Sigma…
• “Double edged sword” “We are ultra high frequency
– If these guys can’t do it what traders…
makes you think you can?
– The market is owned by XYZ, you “We’ want to be like Ren Tech…
will get crushed!
Fortress…Millenium
4/11/10 Willard John Thomas Associates 14

15. Edge
DRAFT
• Why are we be`er / different / faster / Are we:
smarter?
• If “as good as” them… Faster?
– Then money goes to the guys with the Smarter?
experience and track record.
• Beware of “Motherhood and Apple Pie”
More Agile?
– Great people, great idea, …not a differenYator Richer?
– Lots and LOTS of great people in the world –
many of whom have already proven they can
Do we know something they
succeed. don’t?
– Why should an investor give their money to
someone who is a riskier bet when others “as
good as” are already proven?
• What’s our “Edge”? …un‐explored market dynamics,
– I.P. / un‐explored market dynamics, inefficiencies in the market / different
inefficiencies in the market / different
approach to making money / feed off the approach to making money , neural
scraps, neural network, geneYc de‐ network, gene<c de‐composi<on…?
composiYon…?
4/11/10 Willard John Thomas Associates 15

16. Risk Management
DRAFT
• Market Risk
– Are strategy specific risk controls in place Is my broker self clearing?
(draw down, stop loss, calendars, etc.) Am I dealing with the Prime or
• Counter‐party Risk Mini‐prime?
– Are clearing & se`lement policies known, Who holds the accounts?
understood, and documented? What happens if the broker’s
• OperaYonal Risk server goes down?
– Who is in charge? Are there emergency
– What processes and checks and balances in measures and “shut off”
place? valves in place?
– Do we have sufficient back office staff to If there is a fire in the office,
handle volume?
what happens tomorrow?
• Economic Risk
Is there a plan?
– Can the fund afford the risk models they are
trading with? How do I close out my
– Will we survive draw downs, etc or go out of posiYons?
business if there are no fees coming in?
Risk is a component of any strategy
Understanding exposure to risk is the highest
priority the fund manager has.
4/11/10 Willard John Thomas Associates 16

17. Track Record
DRAFT
• Establishes context for investors • Back tesYng
– Type of strategy – How much tesYng have we done?
– Amount of risk – What assumpYons have we made?
– systemaYc versus discreYonary – Have we been guilty of curve fi}ng?
– QuanYtaYve versus fundamental – Have we used out of sample data?
– Intra‐day versus overnight – What Yme interval is the data?
– Trading versus investment – How do we account for slippage?
• Enables comparison shopping – What transacYon costs are we considering?
– Is this a fit with the client’s goals? – How much leverage have we employed?
– Is it highly correlated with their other – Walk forward?
investments? – Paper trading?
– Will this have un‐intended / undesirable tax • Live trading
consequences? – No subsYtute
• Establishes experience – Rarely resembles back test results
– Have we done this in real life or it an idea?
• Demonstrates execuYon viability
– Will the orders get filled? If we cannot provide actual live trading
– Will commissions eat up spreads? track record due to confiden<ality /
• Shows scale ownership issues etc., then we must
– What is the capacity of our models? have a SOLID reference handy that can
– How much money have we managed in the
past? vouch for our role and performance and
numbers.
4/11/10 Willard John Thomas Associates 17

18. Working Capital
DRAFT
• Working capital is What’s in it for the investor?
– Different kind of risk than AUM
– Not valued same way as AUM otherwise AUM (Investment Capital)
investors would invest in AUM or FoF Investors seeking ‐ > Return
• What is needed for us to succeed? over Assets under
– Keep the lights on during AUM ramp up
– ENOUGH money to get to profitability Management with given
stage (self sustaining) volaYlity (Sharpe)
– “Half a bridge is no bridge”
• Investor value might include versus
– Working capital
– Access to vendor partners
– Access to Clients (addiYonal AUM) OperaAng Capital
– Access to experience and advice Investors seeking ‐ > Return
– Market exposure and credibility Over Investment with pre‐
– Access to expensive technology calculated risk (NPV or
– Access to research
discounted cash flow versus
risk free rate)
4/11/10 Willard John Thomas Associates 18

19. Is what is expected in exchange for
working capital raYonal?
DRAFT
• Time invested
demonstrates your
commitment
• Investors cash = real risk
– Equity as risk premium
• How much of your
Equity vs. Investor’s
Risk? A VC osen hopes to sell its equity (stock,
warrants, opYons, converYbles, etc.) in a
• Equity share and P&L porzolio company in three to seven years…
payout must be raYonal
in the context of VCs look for a return on investment of at least 25
expected earnings over percent, and in many situaYons they expect to
Yme. see as high as 50–100 percent return on
investment per year.
4/11/10 Willard John Thomas Associates 19

20. References
DRAFT
• h`p://www.mycapital.com/companies/
venturecapital101.php
• h`p://www.spress.com/arYcles/arYcle.aspx?
p=102237
• h`p://www.barclayhedge.com/products/
fund‐of‐fund‐directory.html
4/11/10 Willard John Thomas Associates 20