Scenario Planning & Using What-if Forecasting Models

Transcription

1 Scenario Planning & Using What-if Forecasting Models Mark A. Regier, CFA Vice President of Finance / Planning & Analysis Manager Dimensional Fund Advisors

2 Annual budget targets become obsolete..rather quickly!! 80% 70% 60% 50% Budget Target Life Span 64% 71% 74% 40% 30% 32% Typical Year 20% 10% 8% 0% Before the year begins/ already have 1-3 months into the fiscal year 4-6 months into the fiscal year 7-9 months into the fiscal year month into the fiscal year

3 Seven Key Problems with Traditional Budgeting 1. Budgets take too long to prepare (often making them out-of-date once published) 2. Budgets cost too much (resources and $) 3. Budgeting is based on assumptions that are nearly always wrong 4. Budgeting causes gaming (sand bagging) 5. Budgeting triggers unnecessary spending (spend it or lose it) 6. Budgeting gives the illusion of control by robbing potential 7. Budgets don t really tell the story

4 Why do we have so much confidence in our ability to predict the future? We have a detailed plan (maybe a budget) We have management buy-in (accountability) We have a predictive model Historical data Probabilities and distributions Monte Carlo or other simulations But these have shortcomings: internal events only ability to control input variables not all outcomes are in the model and it s still a range not a point estimate

5 Why engage in Scenario Planning & What-If Analysis? Frequent scenario planning allows finance to forecast the potential impact of a range of uncontrollable events to the annual plan Flips the planning function from reactionary to proactive Gives the firm options Provides management with floors and ceilings in which to take action Creates management playbooks to mitigate risks and take advantage of emerging opportunities

6 How you engage in Scenario Planning & What-if Analysis? 1. Identify several key input variables What are the main drivers of my business? Which variables are the most volatile? Which variables are out of my control? Which variables have the largest effect on my outcomes (net income, cash flow)? 2. Focus on threats and opportunities by asking three questions What could go wrong? How will I know about it? Leading indicators? What will I do if it happens? 3. Determine your scenarios, outputs, and timelines How many scenarios should I run? Generally 4-7 How might I best present these results? Floors/Ceilings Best case/worst case What timeline do I care about (short-term, long-term?)

7 What are you going to do when you re wrong? Temporary disruptions or cyclical events Competitor responses Market factors Macro events with global market impact (including the Black Swans ) Conclusion: You WILL be wrong nearly 100% of the time

8 It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change. -Charles Darwin

9 Case Study: Dimensional Fund Advisors Asset manager based in Austin, Texas ~$540 Billion in assets under management Offices in London, Sydney, Charlotte, Santa Monica, Vancouver, Berlin, Toronto, Amsterdam Revenue directly driven by asset levels (fees exclusively based upon assets)

10 Input Variable: Revenue Volatility Problem: Even if we can predict the numbers of new clients added and/or retained (imperfect but somewhat controllable), we know we cannot predict markets (and revenue) Several macro factors affect market returns (asset levels): exchange rates, interest rates, and fiscal, monetary, and foreign policies Market goes down 40%, assets under management goes down 40% no matter what we do (cannot change prices even if market would allow due to contracts, fund boards, etc.) Revenue declines as assets under management decline

11 Base Scenario is our Plan Base Plan could be a zero percent market return in a given time period Alternative Scenarios: Negative #1 What is breakeven level of assets (causing zero cash flow)? #2 What level of assets required to comply with bank covenants (such as interest coverage ratio)? #3 What level of assets required to notify a regulatory agency / contractual agreements? Alternative Scenarios : Positive What level would assets need to grow in which we may need additional staffing? Additional cash management alternatives? What level of new inflows may affect our ability to onboard clients? Service clients?

12 Alternate Scenarios Understanding the drivers of expenses (and, therefore, income/cash flow) in your rolling forecast model Start: How much flexibility occurs naturally in our business model? Expenses tied to asset levels Bonuses tied to profits Expenses tied to different types of revenue True discretionary spending

13 Spending time on the negative what-if scenarios Can boost morale during tough times Identifies processes and procedures that are not up-to-par Identifies opportunities for improvement (trim the fat) Develops a set of plans (the Playbook) Creates Less speculation (and politics) Assists in a more methodological approach to cost cutting (Less kneejerk reaction and across the board cuts)

14 What is the other benefit of developing a playbook when it s not needed? You are forced to look at your expense structure; identify critical versus noncritical expenses; identify projects, functions or divisions that can be reduced you evaluate risks you may be prepared to take (cost/benefit of additional compliance resources, et al.) Might be easier to have the conversation when times are good and less emotional

15 The Playbook What actions can we take in addition to the natural volatility? Action Steps Implemented Revenue Decline and Duration > More Than but < Less Than Longer Than Plan A A% B% X Months Plan B B% C% Y Months Plan C C% ---- Z Months

16 General Application of Playbook Principles Using your business drivers, look at scenarios: breakeven; loan covenant requirements; natural expense flexibility Activity One: How can you increase expense flexibility (without harming business)? Activity Two: How much decline (and for how long) before we would take any actions? Activity Three: How much decline/duration would cause me to take actions and what would they be? develop a Playbook

17 Process Steps Department Managers: what would you do if you were forced to reduce expenses by 10% - 20% beyond the areas of natural flexibility? Avoid the across the board, everybody feels pain mentality The confidential playbook can be rolled out quickly if a threshold is crossed Additional steps depending upon the industry: Business continuity planning Supply chain disruptions Localized (geography, segment, product) Competitor actions Challenge is to produce a helpful, representative set of responses without going through every scenario

18 Spend less time in planning for a single outcome and more time on what you will do when the range of outcomes unfolds

19 The more you sweat in peace, the less you bleed in war. -George S. Patton