Hedge Fund Preparation

These pages are dedicated towards modeling / case study prep. I want to limit repetitive information you can find elsewhere online. For detail about what is HF, different types of HF strategies, and what the associate role looks like ---scroll to the bottom.

We are working hard to release our HF models / case studies. Will be available by August.

Modeling / Case Studies:

I'm not talking quant here. If that's what you're looking for, my services won't help you. Here, I cater towards those gunning for L/S HF seats. 

Compared to PE, HF cases are much more geared towards your understanding of a business and the organic drivers for value creation vs. financial engineering. HF cases typically involve the construction of a 3-statement model and a DCF. Some multi-day cases will include the build out of tabs for LBO, M&A, and SOTP scenarios. 

The best part about HF prep is that you can practice all you want with the thousands of available public companies and sense check your output with valuations estimates provided by research analysts and gurus.

Building a 3-Statement Model:

  1. Bust open 10-Ks, 10-Qs, and earnings presentations to input ~3 years of historical information 
  2. Assess historical performance and current events to drive some assumptions for your model (revenue growth, EBITDA margin, NWC changes, Capex, debt issuance, etc). For the most part, all income statement assumptions are a % of sales
  3. Use your assumptions to forecast the income statement over 5-10 years
  4. Forecast core balance sheet items such as working capital line items (AR, AP, Inventory), PP&E, and the debt balance
  5. Tie back items such as D&A and interest expense into the income statement. Add net income to shareholders' equity and complete the balance sheet projection. Cash should be the last item to plug
  6. Use the income statement and balance sheet to drive the cash flow statement
  7. Tie your ending cash balance back to the balance sheet. At this point, your balance sheet should balance and you'll complete your 3-statement model 

Building a DCF: 

  1. Spread revenue, EBITDA, and unlevered free cash flow over 5-10 years (you can leverage your 3-statement model here)
  2. Calculate your WACC. You should know how to do this by now. If not, check the 'Learning Point' here: "The Pulse" --#77 / U.S. & Mexico ❤️
  3. Calculate your terminal value using the Gordon Growth Method and Multiples Method
  4. Discount back your unlevered free cash flow and terminal value using the WACC to arrive at your enterprise value
  5. Deduct debt and add back cash to arrive at your equity value
  6. Divide equity value by the fully diluted shares outstanding to arrive at your share price

Core Components of a Good Investment: 

  1. Can you buy it for the right price? Or below intrinsic value? 
  2. Is the business aptly profitable and/or does it have great growth potential?
  3. What is the business model? Do you understand it? 
  4. What does the competitive landscape look like? 
  5. Is the management team strong and well-incentivized? 
  6. Other considerations including: stock issuance vs. repurchasing plans as a means of assessing the accretive / dilutive nature of my position in the business

Much more detail on the components of a good investment can be found in our market update here: "The Pulse"--#56 / Components of a Good Investment

A Little Bit About HF:

This is going to be brief, I do not want to waste time on areas you can just Google. 

As previously mentioned, I will only be speaking in the context of Long-Only and Long / Short hedge fund strategies. I will not be covering anything quantitative or even macro since those are largely out of the scope for the target audience. 

A long-only strategy involves a fund taking long positions across a concentrated portfolio of 'good companies.' These are typically 'compounders.' Compounders are companies with incredible ROIC, semi-monopolistic business models, and deep motes. A long-short strategy involves a fund taking long and short positions across a mostly concentrated portfolio of good and bad companies. Most hedge funds do not take large enough positions to dictate the operations of any given company. 

A traditional hedge fund is designed to be a capital-preservation vehicle so that you can always achieve X% regardless of the economic environment. This can be accomplished by taking longs and hedging some risk with shorts. 

Hedge funds have largely evolved from capital-preservation vehicles into outperformance vehicles. Many hedge funds now have a goal to beat a certain index such as the S&P 500. The idea is that a group of professionals meticulously combing through investment material can create a portfolio that beats the market (rarely happens after fees). Just like private equity and private credit, hedge funds are designed with a lucrative business model. Fees vary widely across funds, but it is usually in the ballpark of a 2/20 model (2% of AUM, 20% of outperformance). 

It is important to note that a large differentiator between hedge funds and private equity funds is the underlying fund design. Hedge funds invest capital from a similar pool of LPs found in a PE fund such as endowments, pension funds, and insurance companies. However, they call all capital upfront in exchange for looser redemption provisions to allow investors to pull their money upon their discretion. After all, hedge funds are largely investing in liquid, public equities.  

Different Types of HF:

Also, will not spend a ton of time here because you can find this detail on Google.

Hedge funds in the L/S and Long-Only world are largely split across multi-manager and single-manager strategies. The large funds like Millenium, Citadel, DE Shaw, etc are multi-manager funds. You have many managers running pods that roll up under a single name. Single-manager strategies encapsulate all of the smaller shops that usually only have one manager calling the shots. 

Different Strategies:

  1. Traditional L/S (taking longs and shorts; most HF roles are L/S)
  2. Long-Only (taking only longs)
  3. Event-Driven (investing only during large corporate events such as M&A)
  4. Macro (only investing in the macroeconomic story)
  5. Emerging Market (investing in emerging market economies)
  6. Distressed (only investing in underperforming businesses)
  7. Short-Only (only taking shorts)
  8. Activist (taking large positions to exhibit control on a company)

The Associate Role:

This is a very different job from banking. In fact, it is much more similar to equity research than anything else. As an associate, you'll cover a small group of companies and learn to 'own the names' by becoming an expert on everything related to those businesses. 

Your core responsibilities include:

The detail required can be excruciating. Some models are 5,000+ lines deep with endless scenario analysis. The idea is that you should digest every single piece of available information to arrive at the best possible conclusion of the viability of an investment.

Overall, this is true investing. You're not calling the shots by any means, but you're seriously analyzing different companies to determine where there could be a good place to deploy capital. There is much less politicking and negotiation within the HF realm and you rarely 'set it and forget it' as you would in a transaction-oriented role such as PE, VC, or PC. 

Your principal and managers will actually be the ones deciding where to invest capital. You'll be conducting the analysis needed to help shape a view to decide one way or another.