Bus Planning Process

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Developing a Business Plan for Hedge Fund Managers

W. Mechem [email protected]

4/11/10 1 Willard John Thomas Associates

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Disclaimer

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

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About WJT 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


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Business Plan •  Business Plan:

–  a series of steps to be carried out that should result in profits being generated from business operaYons in a given context.

•  Business Plan Document: –  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


Must have a plan before we can dra6 a document, but dra6ing a document will help us fill in the gaps in our plan.

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Major Components of the BP •  Vision

–  What the business looks like or will look like

•  Management –  Track Record –  Why we are likely to succeed?

•  Vendor Partners –  Who’s on our team?

•  Financial Statements –  Past performance / Future projecYons –  Business Model

•  Market –  Opportunity: Economy, geo‐poliYcal,

technology, regulatory –  Size (potenYal)

•  Clients –  Who will buy our vision? –  Why?

•  CompeYYon –  We are like…, We are different… –  Validates business model

•  Edge –  What is the company’s advantage in the

market?

•  Track Record –  Back tesYng –  Live trading

•  Risk Management –  Risk versus loss aversion

•  Working Capital –  What we need to succeed –  What are we willing to exchange for

what we need


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The document development process

Goals:

To explain the business to someone else (like the bank or venture capital investor)

To make sure we understand the context under which we are going to be operaYng.


Most people dra6 a BP to raise money.

This is a usually a requirement of insAtuAonal investors.

But the best reason to go through the process is to make sure we understand what we are ge/ng ourselves in to!

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Vision •  The Vision provides context •  Expresses

–  self image –  value proposiYon –  public face

•  What do we want to be when we grow up?

•  What this picture will look like in 3 years / when we go to sell the business / take it public / wind it down –  We make widgets in Bermuda. –  We will import“5‐sided” widgets to

AntarcYca and charge a premium. –  We will be a $50M widget company in 3

years –  We will be the number 3 widget

company globally as measured by market share.

“In 3 years (2014) we will be a quanAtaAve hedge fund managing $150M in AUM and trading in U.S. equiAes and FX.”

“Our value is in providing medium to high ROI with low volaAlity to our investors.”

“We will accomplish this through the use of quanAtaAve models (market, currency, and volaAlity neutral) that leverage our proprietary intellectual property and technology”.

“Our annual expected returns are 20 – 40% and our expected average Sharpe raAo is around 4.0”


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Management •  Investors bet on the jockeys / not the horse

–  Best plan / business will fail without ability to execute •  Management “Bios” establish groundwork for credibility

–  Done this before? –  Done something else important before? –  Relevant experience and educaYon?

•  Smart enough to know their shortcomings? –  Does the plan cover all the bases? –  MarkeYng, technology, operaYons, compliance, legal,

microstructure, financial domain, asset specific knowledge •  Plan for gaps?

–  Hiring, outsourcing? •  Management experience?

–  Financial –  People

•  Have their past ventures been similar in scale? –  $1M vs $100M = different set of problems

•  Commitment and ability to see plan through to compleYon? –  Financial –  EmoYonal –  Family support?

•  How long has the team been together? –  Past conflicts? How resolved?

•  How are decisions made? –  Do team members have clearly defined roles?


Is this a career change for me? How much money have I managed before? Was I trading the same types of assets in the past? Who have I worked for? Was it a small shop or a large shop? Am I used to lots of resources or doing it myself? What roles have I held in the past that enable me to understand the BUSINESS as a whole?

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Vendor Partners •  Aser core team, arguably most important

part of your strategy. •  Vendor selecYon process can be lengthy and

confusing, but having the right vendor partners is criYcal. –  Assures investors they are dealing with

professionals –  Reassures investors their money is safe –  Provides you with peace of mind –  Offloads administraYve overhead

•  Does not off load responsibility •  Types of Vendors

–  Prime Brokers –  Custodians –  Fund Administrators –  Accountants –  A`orneys –  Compliance Advisors –  ExecuYng Brokers –  Technology Providers


Do they understand our business?

Are their costs compe<<ve?

Do they have the resources to provide us with the needed level of support?

How many clients do they support?

Will we be working with a firm Partner or an associate?

Can we integrate with / leverage their technology?

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Financial Statements

•  Pro Forma Financial statements express the business plan in mathemaYcal terms, similarly to the way a quanYtaYve model expresses a trading strategy –  P&L – Money spent on X produces income (loss)

of Y –  Balance Sheet – At a point in Yme we (will) have

these assets and these liabiliYes (this is what our business will look like)

–  Statement of cash flows (uses of cash) – Money will come from here and go there •  Money is neither created nor destroyed, it

simply moves around

•  Pro forma Income Statement (P&L) –  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

•  Budget is expressed via P&L (income and expenses)

–  Where you intend to spend money reflects how you expect to make money •  R&D, Personnel, Technology, MarkeYng

Budget “Story” must be raAonal –  If we are going to beat Citadel…

•  Then we be`er have a boat load of money allocated to R&D and technology

–  AUM “story” must be raYonal •  We will raise $500M AUM @ 2% and 20% •  We will take X% of FoF money in the Dubai

market


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Market

•  This secYon validates business model –  Provides context –  Establishes realism of plan expectaYons

•  Explains scale of opportunity –  US$ trillion market or US$ 50M?


How many FoF invest in my type of strategies?

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Clients •  Who will buy our “Vision”? •  How will we recognize clients?

–  What do they look like? –  Where do they shop?

•  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?

“Our value is in providing medium to high ROI with low volaAlity to our investors.”

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How well do we know our prospecYve clients?

•  Fund of Hedge Fund DistribuYon by Fund Domicile •  Fund of Hedge Fund Asset DistribuYon by Fund Domicile •  Fund of Hedge Fund DistribuYon by Manager Domicile •  Fund of Hedge Fund Asset DistribuYon by Manager Domicile •  Fund of Hedge Fund Domicile against Manager Domicile •  Fund of Hedge Fund DistribuYon by US Fund Domicile •  Fund of Hedge Fund Asset DistribuYon by US Fund Domicile •  Fund of Hedge Fund DistribuYon by US Manager Domicile •  Fund of Hedge Fund Asset DistribuYon by US Manager

Domicile •  US Fund of Hedge Fund Domicile against US Manager

Domicile •  Fund of Hedge Fund DistribuYon by Fund Currency •  Fund of Hedge Fund Asset DistribuYon by Fund Currency •  Fund of Hedge Fund DistribuYon by Minimum Investment •  Fund of Hedge Fund Asset DistribuYon by Minimum

Investment •  Fund of Hedge Fund DistribuYon by SubscripYon Frequency •  Fund of Hedge Fund Asset DistribuYon by SubscripYon

Frequency •  Fund of Hedge Fund DistribuYon by RedempYon Frequency •  Fund of Hedge Fund Asset DistribuYon by RedempYon

Frequency •  Fund of Hedge Fund DistribuYon by Fund Size Bands

•  Fund of Hedge Fund Asset DistribuYon by Fund Size Bands •  Fund of Hedge Fund DistribuYon by Fund Age Bands •  Fund of Hedge Fund Asset DistribuYon by Fund Age Bands •  Fund of Hedge Fund DistribuYon by Management Fee Bands •  Fund of Hedge Fund Asset DistribuYon by Management Fee

Bands •  Fund of Hedge Fund DistribuYon by Performance Fee Bands •  Fund of Hedge Fund Asset DistribuYon by Performance Fee

Bands •  12‐Month and 3‐Year Returns against Fund Domicile •  12‐Month and 3‐Year Returns against Manager Domicile •  12‐Month and 3‐Year Returns against Fund Currency •  12‐Month and 3‐Year Returns against Minimum Investment •  12‐Month and 3‐Year Returns against SubscripYon Frequency •  12‐Month and 3‐Year Returns against RedempYon Frequency •  12‐Month and 3‐Year Returns against Fund Size Bands •  12‐Month and 3‐Year Returns against Fund Age Bands •  12‐Month and 3‐Year Returns against Management Fee Bands •  12‐Month and 3‐Year Returns against Performance Fee Bands •  Fund Domicile Category against Fund Manager Domicile

Category •  Fund Currency against Minimum Investment •  SubscripYon Frequency against RedempYon Frequency •  Fund Size Bands against Fund Age Bands •  Largest Featured Fund of Hedge Funds by Assets •  Management Fee against Performance Fee


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“We are not like Citadel…

“We are like Getco…

“We are kind of like Jump…

“They are market makers…

“We are market takers…

“We are somewhat like 2Sigma…

“We are ultra high frequency traders…

“We’ want to be like Ren Tech…Fortress…Millenium

CompeYYon •  Why are they compeYtors?

–  How alike? –  How different?

•  How does their business model compare to ours? –  How do their results compare to

ours? •  “Halo effect”

–  We are just like … –  See what these guys have done?

We are just like them… •  “Double edged sword”

–  If these guys can’t do it what makes you think you can?

–  The market is owned by XYZ, you will get crushed!


Why will we be successful compe<ng in this market versus these guys?

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Edge •  Why are we be`er / different / faster /

smarter? •  If “as good as” them…

–  Then money goes to the guys with the experience and track record.

•  Beware of “Motherhood and Apple Pie” –  Great people, great idea, …not a differenYator –  Lots and LOTS of great people in the world –

many of whom have already proven they can succeed.

–  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”? –  I.P. / un‐explored market dynamics,

inefficiencies in the market / different approach to making money / feed off the scraps, neural network, geneYc de‐composiYon…?

Are we: Faster? Smarter? More Agile? Richer? Do we know something they don’t?


…un‐explored market dynamics, inefficiencies in the market / different approach to making money , neural network, gene<c de‐composi<on…?

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Risk Management •  Market Risk

–  Are strategy specific risk controls in place (draw down, stop loss, calendars, etc.)

•  Counter‐party Risk –  Are clearing & se`lement policies known,

understood, and documented? •  OperaYonal Risk

–  Who is in charge? –  What processes and checks and balances in

place? –  Do we have sufficient back office staff to

handle volume? •  Economic Risk

–  Can the fund afford the risk models they are trading with?

–  Will we survive draw downs, etc or go out of business if there are no fees coming in?

Is my broker self clearing? Am I dealing with the Prime or Mini‐prime? Who holds the accounts? What happens if the broker’s server goes down? Are there emergency measures and “shut off” valves in place? If there is a fire in the office, what happens tomorrow? Is there a plan? How do I close out my posiYons?


Risk is a component of any strategy Understanding exposure to risk is the highest priority the fund manager has.

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Track Record •  Establishes context for investors

–  Type of strategy –  Amount of risk –  systemaYc versus discreYonary –  QuanYtaYve versus fundamental –  Intra‐day versus overnight –  Trading versus investment

•  Enables comparison shopping –  Is this a fit with the client’s goals? –  Is it highly correlated with their other

investments? –  Will this have un‐intended / undesirable tax

consequences? •  Establishes experience

–  Have we done this in real life or it an idea? •  Demonstrates execuYon viability

–  Will the orders get filled? –  Will commissions eat up spreads?

•  Shows scale –  What is the capacity of our models? –  How much money have we managed in the

past?

•  Back tesYng –  How much tesYng have we done? –  What assumpYons have we made? –  Have we been guilty of curve fi}ng? –  Have we used out of sample data? –  What Yme interval is the data? –  How do we account for slippage? –  What transacYon costs are we considering? –  How much leverage have we employed? –  Walk forward? –  Paper trading?

•  Live trading –  No subsYtute –  Rarely resembles back test results


If we cannot provide actual live trading track record due to confiden<ality / ownership issues etc., then we must have a SOLID reference handy that can vouch for our role and performance and numbers.

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Working Capital •  Working capital is

–  Different kind of risk than AUM –  Not valued same way as AUM otherwise

investors would invest in AUM or FoF

•  What is needed for us to succeed? –  Keep the lights on during AUM ramp up –  ENOUGH money to get to profitability

stage (self sustaining) –  “Half a bridge is no bridge”

•  Investor value might include –  Working capital –  Access to vendor partners –  Access to Clients (addiYonal AUM) –  Access to experience and advice –  Market exposure and credibility –  Access to expensive technology –  Access to research


What’s in it for the investor?

AUM (Investment Capital) Investors seeking ‐ > Return over Assets under Management with given volaYlity (Sharpe)

versus

OperaAng Capital Investors seeking ‐ > Return Over Investment with pre‐calculated risk (NPV or discounted cash flow versus risk free rate)

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Is what is expected in exchange for working capital raYonal?

•  Time invested demonstrates your commitment

•  Investors cash = real risk –  Equity as risk premium

•  How much of your Equity vs. Investor’s Risk?

•  Equity share and P&L payout must be raYonal in the context of expected earnings over Yme.

A VC osen hopes to sell its equity (stock, warrants, opYons, converYbles, etc.) in a porzolio company in three to seven years…

VCs look for a return on investment of at least 25 percent, and in many situaYons they expect to see as high as 50–100 percent return on investment per year.


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References

•  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


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