5 Key Considerations in Developing Your Hedge Fund Business Plan

If you want life to be organized and run as smooth as possible, it is a known fact that planning is essential. Any type of structure requires a solid plan and an end goal. The same applies to your fund. Although you may not see it this way, your fund is your business. Having a solid hedge fund business plan helps to better decide short and long term goals.

When you’re starting a financial services firm, as with any other type of business, it’s necessary to develop a business plan before you go headlong into a venture. Update your plan on a regular basis as your business develops. It’s vital to sit down and put pencil to paper to document your goals and how you plan to get there. All the related corporate documents, including the mission statement as well as your motto, brand, and company culture, need to stand as representations of who you are and what you stand for as an individual and a firm.

Even if you are starting out on your own and have no one else involved as partners, set the roadmap and tone for yourself and for those who will join you in the future.

All professional service companies, including investment firms, list in their mission statement the goals of (client) service, (financial) success, and (professional) satisfaction in one manner or the other. The relevant differentiator among the companies is in which order these three things rank in importance. I rank professional satisfaction at the top, with the view that a professionally satisfied staff provides excellent service, which drives financial success. Without happy, quality staff there is no way a financial services company can deliver to their clients.

When I hire, I look for “SWANs”: people who are Smart, Work hard, are Ambitious, and Nice. I believe that the characteristics of energy, drive, enthusiasm, motivation, morale, determination, dedication and commitment provide for the perfect employee.  Their commitment to your company is returned with your commitment to them, as demonstrated by providing an environment that balances their lives with rewarding work and a flexibility of workload that provides for quality family life. We work to live, we do not live to work.

Throughout your company policies and procedures, I recommend you convey the importance of your core principles.

Sample Core Principles: Tower’s Core Principles

Accountability – the assumption of responsibility for actions and decisions while encompassing the obligation to report and be answerable for resulting actions. There is as much emphasis on being accountable for and taking ownership of positive outcomes as of shortfalls.

Humility – the quality of being modest and respectful. This includes interactions with clients and fellow team members.

Integrity – consistency of actions, values, principles, expectations, and outcomes. Ethics stands above all, for both the individual and the company as a whole. The perception of integrity is insufficient without demonstrating it in all your actions.

Perseverance – continued effort to do or achieve something despite difficulties or opposition. Continually challenge yourself as an individual and a company to grow in knowledge and ability. Studies have shown that for the collective judgment, knowledge, experience, and ability of a company’s members to grow, there must be ongoing, continual effort at all levels.

To teach and be taught – By developing the skills of its members, the company adds to the only resource it has to sell: professional judgment and talent.

I have seen incredibly happy and productive people living by these standards continuously succeed at companies, which has contributed tremendously to the company’s growth and success.

Budgeting for your Fund Management Company – Not For the Faint of Heart

It’s time to take a hard look at your living expenses and see what you will need for the next two to three years to live on. Let’s be honest, the management fee you collect from the fund is supposed to be all you need to keep the lights on and run your business.  This is what you should expect to draw from to take care of yourself on your own home front. Do not bank on making a performance fee that’s sufficient to cover those things.

When considering your budget, there are of course two sides of the equation, revenues and expenses. Expenses can be quite manageable and you can work on a bare-bones office setup. The revenue side of the equation will be a fight right from the get-go.  Everyone will be trying to push to reduce fees and we all know that most of us start with the “Friends and Family Plan” members as your first investors. We also know that Uncle Bob and good old Dad-in-Law are expecting a good cut in fees. The management fee is set, while the performance fee is a little more negotiable, since investors are more than happy to share in the profits and you get to eat what you kill on that fee.

The DDQ and YOU

A good guide for what you will need to have a well-supported investment management firm is the Alternative Investment Management Association’s (AIMA) due diligence questionnaire (DDQ). Besides covering all operational and infrastructure aspects of what investors are concerned about, it gives you an insight into concerns that firms like yours should be thinking about as you grow. Obviously, a new fund manager with limited capital and human resources cannot address all the questions in the DDQ, which is quite all right, but you can use the DDQ as a road map to see what you should be implementing over time.

I have always recommended to the managers I work with that they should start with the DDQ and keep updating it as they grow. It should be a living document that also shows potential investors you have given thought to establishing yourself as an institutional-minded firm and has acknowledged the areas they would (or should) have concerns about and how you will address them. It can also save you valuable time when meeting prospective investors. When they receive this before your meeting and can go through the operational aspects addressed in the DDQ, this frees up meeting time that can now be dedicated to discussing your strategy and allowing them get to know you personally.

The DDQ is meant to cover key points about the investment manager and the details of all the funds you have under management. In addition to the fund’s performance details, the DDQ delves into very specific qualitative aspects of the fund such as portfolio construction methodology, specific investment types, cash deployment, leverage, and risk management.

From my discussions with various investors, the DDQ offers the background information they use to determine where pitfalls may lurk for them. More importantly, it helps them determine from the very start the most important facet of the manager; namely, does the manager’s product (the fund) have a differentiating edge that is repeatable and manageable? And, does that product fit into the investors’ portfolio?

Professional Liability Insurance – E&O and D&O

  • Errors and Omissions (“E&O”) policies cover the fund manager against claims alleging a wrongful act, error, omission, misstatement, misleading statement, or breach of duty in providing or failing to provide professional services as an adviser to the fund.
  • Directors and Officers (“D&O”) policies cover the directors and officers of the fund and the adviser entity (including general partners and members) against claims alleging a wrongful act, error, omission, or breach of fiduciary duty.

Common claims include allegations by investors of fraud or misrepresentations contained in the fund’s offering documents, and claims from investors who have had difficulty getting money out of the fund.

The SEC and individual state securities commissions have increased personnel and stepped up examinations, investigations and enforcement actions against all alternative investment managers.

Even during a routine examination by one or more of the commissions, your legal costs can skyrocket as your attorneys’ work with you to gather information and respond to routine requests and questions. In most cases, once you have covered the insurance policy deductible, the insurer will advance attorney costs.

Hedge funds have been evolving and venturing into areas that they never delved into before, specifically, investing in hard-to value investments. Holding many illiquid or hard-to-price securities may cause funds to modify or halt redemptions, or more commonly, cause some funds to misstate and market incorrect performance numbers. These are the areas that E&O insurance policies will most likely be used for.

For activist investors, venture capital and private equity funds, it is expected that your management team with take board of directors seats on companies, which could lead to exposure from the underlying company investors. Make sure you and your portfolio companies have D&O policies in place to cover you from both ends.

Succession Plan or “Hit By the Bus”

Considerations: “Key Man Insurance”

The new or emerging fund manager wears many, if not all of, the hats needed to run the firm and the fund. On a personal level, no one really likes to think about questions like “Will my family be taken care of if something happens to me?” Taking it one step beyond those you care most about, how many of us ask the question “Will my investors be taken care of if something happens to me?” Probably not. On the rare occasion that fund managers have talked about this with me, the conversation is triggered by a meeting they’ve had with a prospective investor who raises the question. Because most investors in new managers are friends, family and other individuals, many don’t raise this question, since none of them are using a due diligence questionnaire with this question in it. It is something you need to think about.

At a minimum, a one-person operation needs a backup plan for the proverbial “hit by the bus” situation. Have someone who can step in and unwind your portfolio in an orderly manner so investors can get their capital returned to them. The prime broker you work with can make arrangements with their outsourced trading desks to execute a liquidation plan once they’ve been contacted by your attorney or fund administrator.

If your firm has more than just you in it, does someone in your group have the knowledge and ability to wind up the fund if that is what is needed? Is there depth to the group that will keep the firm going? How would the change in management be communicated to your investors? What is the plan for trying to minimize the impact of possible large redemption requests? Address all these questions related to worst-case scenarios, but also consider them as part of your overall hedge fund business plan and a key part of how you select and grow people in your firm. Are there other people in your organization now, or do you have a skill set in mind for future hires who would be able to step into your shoes some day?

Don’t stop at thinking about yourself and your role in the firm. As you grow and create key positions, make this thought process part of your regular hedge fund business planning meetings. Not that you should be thinking constantly about who might die, but it’s important to face the reality that many people in key positions who are not equity stakeholders leave for other jobs. Are you prepared for that?

Another consideration for both you and those integral partners or employees is key man insurance, or more inclusively, key person insurance. There is no legal definition for the term. It is a simple life insurance policy taken out by a business to compensate for financial losses that would arise from the death or extended incapacity of a person important to that business. The policy does not protect you from lawsuits or specific losses that might arise, but is meant to compensate the company for expected costs involved with replacing that key person or maintaining the company during the tough times that could follow such a loss.  These policies pay a set amount upon the death of the key person.

Benjamin Franklin once stated, “By failing to prepare, you are preparing to fail.” The future of your fund depends on the effort you put into your preparation and planning. There must be an understanding that all factors associated with your firm, from employees to family, require an objective that will eventually lead to a common goal – success!

On October 13, 2016, I, Vincent Sarullo (co-founder of Tower Fund Services), spoke at the Emerging Manager Forum hosted by the New York Society of Security Analysts (NYSSA) in regards to common managers’ mistakes and the importance of planning!  Check out the video:

Starting a hedge fund and need guidance on choosing hedge fund service providers? Contact us today at 732-704-7297.



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