Integrated Business

Almost all hedge funds can be thought of as an integrated business entity that combines, at a minimum, two entities: (1) a fund; and (2) the firm. Essentially, money that is used by a fund for investment activities – as well as the trading positions taken with invested capital – are legally identified to be part of a fund as opposed to the firm.

The firm generally houses the investment manager, or if delegating investment and trading decision, then the investment advisor. Additionally, if appropriate, there may also be investment sub-advisors as appropriate (if delegating to more than one investment advisor). An investment manager can manage more than one fund and is the administrative and management locus of a hedge fund.

Planning Drivers

A hedge fund has unique business requirements that drive the business planning around setting up a hedge fund. Though certainly not exhaustive, some of the key areas that drive business planning are as follows.

• People requirements. Although hedge funds can generally start with minimal overheads and a small headcount, the quality and skills of the headcount are absolutely critical since most early-stage hedge funds run very lean. Accordingly, first and foremost, a fund manager needs to ensure that the proper human resources are in place.
• Infrastructure requirements. A hedge fund manager must ensure their fund has robust infrastructure in place. This does not necessarily mean being in the nicest office or having the fastest execution speed in the world. What it does mean is ensuring you have access to any technology you need to be successful, which could range from specific software requirements, access to data providers, or any necessary systems to take and manage risk.
• Service provider requirements. Since hedge funds generally run lean, they rely on service providers such as accounting firms, administrators, law firms, and prime brokers to provide assistance. The price, quality, and use of service providers will differ according to the size of your fund, your fund's geography, and your fund's trading style. As such, it is worthwhile to think about service providers as early as possible.
• Financial resources of the founder(s). Much of a hedge fund's initial capital will likely come from the personal wealth of the fund founder(s). This will continue to be the case until investors have committed capital to the new fund. The fundraising process almost always takes longer than expected. As such, we recommend potential hedge fund managers to ensure they (and if applicable, their dependents) are financially secure enough that a prolonged delay in fundraising will not substantially affect them financially. Lack of sufficient personal financial preparation will take a psychological toll on the new manager and his or her family, leading to greater stress in an already stressful situation, which may ultimately affect investment performance.
• Market return potential and expectations. A new fund manager should think about opportunities to generate value and what their expectations are moving forward. Though no one is expecting a new fund manager to predict the future, a hedge fund manager's view of future opportunities and worldview are of great interest to potential investors. When starting a hedge fund, a new manager is implicitly expressing that there is opportunity to make money in the markets moving forward. Explicitly, a new manager should ask themselves: Do I feel I can make money on behalf of my investors? If yes, why do I feel that way? Thinking through these two questions and articulating the ‘why’ component of the query will be helpful when meeting with potential investors.
• Risk characteristics. It goes without saying that the financial industry has seen rough times lately. The experience of the last few years has reminded us of the importance of scenario planning and ensuring risk management practices are well developed. Related to the above, it is also important to craft policy regarding fund drawdowns and think about how to deal with redemptions from investors.
• Tax. Tax is a critical driver in the planning, starting, and managing of a hedge fund. A prospective fund manager ignores tax considerations at their peril. Lack of proper tax planning will likely be detrimental to a manager's personal wealth as well as providing an endless source of consternation if not thoroughly explored prior to launching the fund.

AUM Planning

As part of this process, a fund manager must determine the minimum AUM for their fund to launch and to remain active. Minimum AUM will vary depending on trading strategy and will largely be shaped by how much capital a fund manager can initially place into the fund. This is because, for many fund managers, the initial capital for a new hedge fund will almost entirely be coming from their own pocket. There are a few fund managers who are able to launch new funds with significant investment from institutional investors; however, the vast majority of fund managers rely on their own capital and perhaps a small group of friends and acquaintances to get their respective funds off the ground. Even with stellar performance, moving from this initial stage to receiving further injections of capital from larger investors will likely take longer than expected. This should be planned into the fund's business plan.

The process of growing AUM is a key component of any fund's continued success. Thought should be given to how assets will be increased. Additionally, the mindset of the more, the better is not always the case, so target AUM should be defined and a coherent rationale for how and why that target was decided on should be thought through.

Investor Planning and Targeting

With trading strategy in place and an AUM target in mind, a fund manager can then focus on investors. Reaching out to investors, marketing the fund, and maintaining relationships with investors and potential investors requires a dedicated plan by itself. Initially, the fund manager will do much of the planning with inputs from experts – such as prime broker capital introduction teams, consultants, and other service providers. For many funds, as they grow, it may make sense to bring some of this expertise in-house. This will depend on the fund and the types of investor.

As the hedge fund universe is heterogeneous, the investor universe is equally, if not more, heterogeneous. Investors will have different investment timelines, liquidity requirements, desired returns, and other constraints depending on the governance structure by which they operate. For example, a pension fund will be subject to different investment guidelines from a family office. These differences among potential investors must be considered throughout the relationship between a fund and its investors. These differences will manifest themselves in terms of liquidity requirements, length of capital lock-ups, and the process by which capital can be redeemed. Additionally, a fund may negotiate bespoke management and performance fee arrangements with investors on a case-by-case basis.

Feasibility Testing

Though perhaps not a common practice among hedge fund managers, in our experience we find that fund managers who perform feasibility testing can identify areas of strength as well as areas of focus that may require further attention.

Feasibility analysis, a practice frequently used as part of strategic planning, is a systematic analysis of the opportunity, threat, participants, resources, and other variables that go into a significant business decision. A start-up hedge fund, like any new business venture, should assess the feasibility of its business to determine its viability and potential challenges.

This is important for two reasons. First, as a business tool, feasibility testing will highlight areas of concern for a fund manager. Second, investors, service providers, and other parties who will be evaluating the fund will raise many of the issues considered during feasibility testing. As such, we suggest using feasibility testing to get ahead of the curve.

Although there is no patented formula for conducting a feasibility test, successful tests will consider factors such as the market, the risk-taking and risk-management strategy, the firm's intellectual and financial capital, investors, tax considerations, technology, and relationships with service providers.

Beyond the Start

Undoubtedly, a business plan is useful in providing a road map in the early stages of launching a fund. Its usefulness, however, does not end there. We echo the late management guru, Stephen Covey, when he counselled in his best-selling book 7 Habits of Highly Effective People to ‘begin with the end in mind’. This principle applies equally to hedge funds and their business plans. A business plan should think beyond a fund's launch to its continued successful management. Some key factors worth considering include the following.

1. Business optimization. As the fund evolves, much of a manager's time will be spent on what we refer to as ‘optimizing the business’. On the risk-taking side, a fund manager will want to identify and maintain an optimal exposure to the market and disciplined guidelines regarding risk and cash management.

   There may also be an ideal AUM due to scaling limitations found in energy and commodities markets. For example, in some markets there may be a maximum AUM that can reasonably be deployed without significant impairment to the risk/reward ratio. A fund which exceeds that optimal AUM may find it difficult to efficiently deploy its remaining capital. After spending so much time trying to raise money, wondering what to do with extra money may seem like a nice dilemma but can quickly turn into a nightmare if a fund manager cannot effectively deploy that capital. Thinking through that dilemma at the beginning of the fund will help keep a fund manager disciplined and focused. Part of that process will require evaluating the trade-offs that may exist between deploying more capital in existing markets or extending to new markets. Although final decisions do not have to be made when crafting the business plan, various scenarios should be considered.

   Beyond absolute AUM, a manager will want to ensure a proper mix of investors. Not all investor money is good money. If an investor does not understand a fund's investment strategy, this will require a manager to spend additional time and energy educating the investor; time and energy that could have been better used to generate returns. Additionally, investors who do not fully understand a fund's investment strategy or are not fully comfortable with the strategy will frequently be the first to ask for their money back at the slightest hiccup.

2. Cash management. It is absolutely critical to have disciplined cash management. Good investors usually do a good job of this when it comes to investing, but managing cash as it relates to dealing with operational expenses is often a different matter. A fund manager can be the best investor in the world, but a hedge fund can still lose money through poor cash management. Avoiding unnecessary waste does not require extraordinary intelligence, just attention to detail.

   Cash management begins with understanding cash flow, which will be dictated by fee revenue, divided between management fees and performance fees. It is important to understand what fee structure makes sense for a particular fund and its strategy. Additionally, early investors may insist on some sort of fee discount or other economic incentive. It is important to think through such negotiations carefully as these issues will directly impact cash management. Though 2 and 20 is perceived as some sort of market norm, we have found that this is more perceived convention than actual reality. It is wise to think about what fee structure makes sense in both the short and long run and with which types of investors (e.g., early investors or institutional investors).

   Along with rent, the largest regular expense most funds will have is compensation. We assume that fund managers reading this are committed to fair compensation for all their employees. It may be tempting to marginalize junior employees or support staff, but this type of behaviour is often short-sighted since it contributes to low employee morale and high employee turnover. We are not advocating that low performers be rewarded equally well as high performers or everyone from the founder to the secretary be paid equally. What we do advocate is being fair and as transparent as possible.

   Beyond fair compensation, compensation scheduling is important as well to manage cash outflows. How frequently will salaries be paid? When will bonuses be paid? What are the implications of those payment schedules in terms of tax planning and the firm's budget?

   Part of cash management is also dealing with sustained drawdowns and redemptions. Various drawdown and redemption scenarios should be tested to ensure that the business is sustainable through a drawdown period or in the face of wide-scale redemptions. A fund manager will want to ensure they understand and are comfortable with their drawdown policy.

   Early on, a fund manager will need to create discipline around expenses paid to service providers. The expenses for accountants, lawyers, fund administrators, investor relations, new technology, filings, side-letters, etc. have a way of creeping upwards. Yes, it is important to engage quality service providers but it does not require paying top dollar for everything. Clear policies will also need to be established about which entity will pay particular costs. For instance, certain expenses will be covered by the fund with other expenses paid for by the investment manager (or investment advisor as the case may be).

   We suggest meeting with various service providers and finding the right balance between cost and service that best fits the needs of your fund and its budget. Additionally, at some juncture there may be a tipping point where it becomes cheaper to bring people in-house instead of outsourcing. A fund manager will not know when that point is unless expenses are actively managed. A fund manager who does not do a good job of managing these expenses early on risks jeopardizing the viability of the firm.

   Though potentially tedious initially, making an upfront commitment to planning around these types of expense will make a fund manager's life much easier. Unexpected cash-flow challenges distract fund managers from their primary role as investors. Early discipline and effort will pay long-run dividends by preventing issues from arising down the road.

3. Evolution. If a hedge fund launches and becomes a successful ongoing concern, it will undoubtedly face strategic inflection points that should also be considered as part of constructing the fund. These points may not show up in the final business plan but they nonetheless need to be addressed since they will likely appear in various legal documents governing the formation and management of the firm and fund(s).

   During the life of the firm, there may be times when it is crucial to value the business. Some examples can include the exit of a founding partner, merger with another fund management company, or the sale of all or part of a fund manager's equity to another fund management company. These are sensitive, critical transition points for the life of any fund and should be given thorough thought before the actual situations arise.

Additionally, as a fund grows it may be necessary to add new advisors or sub-advisors to help invest the fund's capital. If those advisors are a good fit but located in a different geographical area, there will be additional costs related to communication, travel, and infrastructure. Even if not a new geography, success may require expansion in terms of office or staff. Although nothing need be written in stone, these are prospective situations that should also be given some thought.

Reviewing the Plan

It is always a bit embarrassing to reveal one's own work; a little bit of embarrassment now, however, will prevent a lot of misery down the road. Time and again, we have seen very successful traders who have left the convenience of an established institution such as an investment bank and come to the stark realization that they have only minimal understanding of the infrastructure that made their lives so easy. Superior skills as an investor do not automatically equal superior business management acumen, which is why the upfront effort in a good business plan is especially critical for prospective hedge fund managers.

Constructing a business plan will quickly reveal how much a hedge fund manager does not know about starting and running a business. This is okay and expected. A new hedge fund manager should rely on auditors, tax advisors, legal counsel, and other sources of knowledge throughout the life of a fund.

What better time to strengthen those relationships than when the business plan is complete. Although a business plan will likely be crafted with some input from these advisors, a hedge fund manager should absolutely review the business plan with their fund's auditors, accountants, prime broker(s) (e.g., business consulting team or equivalent if available) and lawyers once the plan is finished. The right service providers have likely advised multiple funds and will be able to help you detect omissions, adjust expectations, and further educate you regarding details germane to successfully launching and maintaining a new fund.