Hedge Funds Overview

Hedge Fund Characteristics The Securities and Exchange Commission (SEC) has stated that

the term hedge funds “has no precise legal or universally accepted definition”, but most market participants agree that hedge funds have the following characteristics: almost complete flexibility in relation to investments, including both

long and short positions ability to borrow money (and further increase leverage through

derivatives) in an effort to enhance returns minimal regulation some illiquidity since an investor’s ability to get their money back is

restricted through lock-up agreements (first one to two years) and quarterly disbursement limitations thereafter (subject to “gates” which may further limit disbursements)

investors include only wealthy individuals and institutions such as university endowments, pension funds and other qualified institutional buyers (except through fund of fund investments, which are available to a broader array of investors)

fees that reward managers for performance

Comparing Hedge Funds and Mutual FundsHedge funds are pools of investment capital, as are

mutual funds, but the similarity stops thereMutual funds must price assets daily and offer daily

liquidity, compared to the typical quarterly disclosure of asset values to hedge fund investors and liquidity that is subject to certain limitations, as described in the previous section

In the U.S., hedge funds are limited to soliciting investments only from accredited investors, but mutual funds have no such limitation

Mutual funds are heavily regulated in the U.S. by the SEC, while hedge fund regulation is limited (although regulations are changing)

Comparing Hedge Funds and Mutual FundsThe hedge fund fee structure is also significantly different:

mutual funds usually receive management fees that are substantially lower than fees paid to hedge funds, and mutual funds generally do not receive the performance fees that hedge funds receive

While mutual funds typically to not use leverage to support their investments, leverage is a hallmark of hedge funds

Hedge funds engage in a much broader array of trading strategies, creating both long and short investment positions, utilizing derivatives and many other sophisticated financial products to create the exposures that they want

Mutual funds generally have less investment flexibility and, unlike hedge funds, are required to distribute a significant portion of their income

FeesA typical fee structure for hedge funds includes

both a management fee and a performance fee, whereas a typical mutual fund does not require a performance fee, and has a smaller management fee

Hedge fund management fees are usually around 2% of net asset value (NAV)

Performance fees are approximately 20% of the increase in the fund’s NAV

This “2 and 20” fee structure is significantly higher than for most other money managers, with the exception of private equity fund managers, who enjoy similarly high fees

Return ObjectivesHedge funds target “absolute returns”, which are investment

returns that are always positive (avoiding yearly losses) and don’t depend on the performance of broad markets and the economy, unlike the returns associated with mutual funds

However, the historical claim made by hedge funds that their returns are “uncorrelated” with market returns for traditional investments such as stocks and bonds is a subject of dispute following large losses by many hedge funds during 2008

A lack of correlation is an attractive characteristic for investors who are attempting to either lower risk in their investment portfolio while keeping returns unchanged or increase returns in their portfolio without increasing risk

Hedge funds attempt to achieve “double digit” returns in most years

Leverage Hedge funds frequently borrow (creating “leverage”) in order to

increase the size of their investment portfolio and increase returns (if asset values increase)

For example, if a hedge fund received $100 million from investors, the fund might by combining investor funds with $300 million from banks, using the $400 million of purchased securities as collateral against the $300 million loan: this is called a margin loan

Another form of leverage used by hedge funds is created through repurchase agreements, where a hedge fund agrees to sell a security to another party for a predetermined price and then buy the security back at a higher price on a specified date in the future

In addition, leverage is provided by selling securities short and using the proceeds to purchase other securities and through derivatives contracts that enable hedge funds to create exposure to an asset without using as much capital as would be required by buying the asset directly

Impact of LeverageWhen hedge funds borrow money, their losses, as well as

their gains, are magnifiedFor example, if a hedge fund receives $100 million from

investors it may then borrow $300 million to make investments totaling $400 million

A 25% fall in the value of its $400 million investment portfolio would result in a total loss of the investor’s capital if the hedge fund closed down

If, alternatively, the investment portfolio increased by 25%, investors would receive a 100% return on their investment, before subtracting management fees and operating costs

During the 2008 Financial Crisis, leverage made available to hedge funds dropped precipitously

Leverage Dropped During 2008

Hedge Funds’ Leveraged Assets Fell from $6.6 Trillion to $2.4 Trillion in Less Than a One-Year PeriodAssets under management and estimated total investable assets, $ in trillions

Note 1: Includes leverage from debt and off-balance sheet leverage through derivatives and other instrumentsNote 2: Leverage ratio = (total leverage + AUM) / AUMSource: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; International Financial Services, London; Financial Risk Management, Ltd.; Financial Services Authority

1.0 1.1 1.41.9 1.9

1.4 1.2

0.4 0.60.8

1.30.8

0.70.3

1.51.7

2.6

3.3 3.9

1.5

0.9

2004 2005 2006 2007 H1-08 H2-08 Q1-09

Leverage through derivative positions

Leverage through debt

Assets under management

Implied Leverage Ratio2 (total)

2.93.4

4.8

6.5 6.6

3.6

2.4

2.9 3.1 3.4 3.4 3.5 2.6 2.0

-64%

Fund of FundsA “fund of funds” is an investment fund that invests in a

portfolio of other investment funds, rather than investing directly

A fund of hedge funds attempts to provide a broad exposure to the hedge fund industry and risk diversification

They typically charge a management fee of 1% to 1.5% of AUM and also receive performance fees that range from 10% to 20%

As a result, if a fund of funds invests in a dozen hedge funds that charge “2 and 20” fees on average, total management and performance fees paid by fund of fund investors could be about 3.25% and 35%, respectively

For some investors, these fees outweigh the benefits of investing in hedge funds

Fund of Funds However, many investors who may not qualify to invest in hedge

funds because they have insufficient capital to invest, or are not recognized as qualified investors in the U.S. by the SEC, will invest in a fund of funds as the only vehicle through which they can invest in hedge funds

In addition, since many fund of funds have investments in 10 or more different hedge funds, they provide more diversification than some investors might achieve directly due to limited amounts of investible capital

Some high net worth and institutional investors will channel money through a fund of funds because they value the “due diligence” process by which fund of funds weed out poor hedge fund managers

However, there are many recent examples of inadequate due diligence, where fund of funds have performed at or worse than hedge fund indexes, based on poor investment decisions that reflect inadequate investigation of hedge fund practices and investment strategies

Growth Hedge funds grew at a remarkable rate since 1990, from 530 funds

with under $39 billion in assets to more than 7,600 funds at the end of 2007, with assets of almost $1.9 trillion, based on the following developments:Diversification: Investors were looking for portfolio diversification beyond

“long-only” investment fundsAbsolute returns: Most traditional investment funds try to beat market

averages such as the S&P 500 Index, claiming excellent management skills if their fund outperforms the relevant index, but if the index return is negative, the outcome would be inferior to a hedge fund that that tries to achieve an absolute return (meaning a return greater than 0%)

Increased institutional investing: Because university endowments such as Yale’s endowment achieved spectacular returns from investing up to 50% of their entire portfolio in alternative assets such as hedge funds, private equity, real estate and commodities (achieving an average annual return of over 23% between 2001 and 2007), many large institutional investors such as pension funds and other university endowment funds substantially increased their exposure to hedge funds

GrowthFavorable market environment: This period was

characterized by a benign credit environment, strong equity market and accommodating tax and regulatory conditions, enabling hedge funds to take advantage of low interest rates and flexible credit leverage to augment returns

Human capital growth: Hedge funds were able to draw talent from investment banks and asset managers because of very high compensation and the opportunity to be more independent

Financial innovation: Hedge funds’ ability to execute increasingly complex and high-volume trading strategies was made possible by product and technology innovations in the financial market and by reductions in transaction costs.

Electronic trading platforms: Direct market access tools for futures and swaps allowed hedge funds to profitably trade a broad range of financial assets, while at the same time, more effectively manage their risks

GrowthEstimated Total Number of Hedge Funds and Fund of Funds1990 – 2008

Estimated Total Number of Hedge Funds -versus- Fund of Funds1990 – 2008

Source: Hedge Fund Research, Inc.

610 821 1,1051,514

1,9452,383

2,781 2,9903,325 3,617 3,873

4,454

5,379

6,297

7,436

8,6619,462

10,096

9,176

0

2,000

4,000

6,000

8,000

10,000

12,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

80 127 168 237 291 377 389 426 477 515 538 550 7811,232

1,6541,996 2,221 2,462 2,368

530 694 9371,277

1,6542,006

2,392 2,5642,848

3,102 3,3353,904

4,5985,065

5,782

6,6657,241

7,634

6,808

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Fund of Funds

Hedge Funds

GrowthEstimated Growth of AssetsHedge Fund Industry 1990 – 2008, $ in billions

Estimated Growth of AssetsFund of Fund Industry 1990 – 2008, $ in billions

Source: Hedge Fund Research, Inc.

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

0

100

200

300

400

500

600

700

800

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

InvestorsShare of High Net Worth Individuals Has Fallen

Source: McKinsey Global Institute.; Hennessee Group LLC; International Financial Services, London estimates

5% 10% 12% 14% 15% 15% 15% 15% 12% 11% 14% 15%9%8% 7% 7% 8% 7% 8% 8%

7% 8%12% 11%11%

10% 8% 8% 9% 9% 9% 9%7%

18%12% 12%14%

18% 20% 17%20% 27% 24% 24% 30%

23%31% 32%

61%54% 53% 54% 48% 42% 44% 44% 44% 40%

31% 30%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

High net-worth individuals

Fund of hedge funds

Endowments and foundations

Corporations and institutions

Pension funds

Largest Hedge FundsTop 10 Hedge Funds by Assets Under Management at the End of 2008

Note 1: As of December 31, 2008. All other figures as of January 1, 2009.Note 2: Tied for 10th place.Source: Absolute Return Billion Dollar Club, March 2009 rankings

Firm Region AUM ($bln)

Bridgewater Associates U.S. 38.6

J.P. Morgan U.S. 32.9

Paulson & Co. U.S. 29.0

D.E. Shaw Group U.S. 28.6

Brevan Howard1 Europe 26.8

Och-Ziff Capital Management U.S. 22.1

Man AHL1 Europe 22.0

Soros Fund Management U.S. 21.0

Goldman Sachs Asset Management1 U.S. 20.6

Farallon Capital Management2 U.S. 20.0

Renaissance Technologies2 U.S. 20.0

Revenue Concentration

Hedge Fund Revenues are Highly Concentrated in the Top 205 Funds

Source: McKinsey Global Institute; Lipper Hedge World; Merrill Lynch; McKinsey Global Institute hedge fund interviews

43%

18%

13%

26%

Hedge Fund Revenue Pool for 2006

>$5bn (64 funds)

$3-5 bn (64 funds)

$2-3 bn (77 funds)

<$2 bn (5,000+ funds)

74% of revenues are concentrated in the 205 largest funds based on AUM

Assets Under Management

205 funds

ReturnsSince 1990, Hedge Fund Strategies Have Outperformed Both Bonds and Equities (Even Accounting for Risk)Risk vs. return for hedge fund strategies compared to blended portfolios of bonds and equities, 1990 - 2008

Source: McKinsey Global Institute; Hedge Fund Research, Inc.; Datastream

Relative Value

Event-Driven

Equity Hedge

Macro

3 4 5 6 7 8 9 10 11 12 13

7

8

9

10

11

12

13

14

15

Standard Deviation %

Aver

age

Retu

rn %

Portfolio composition:

100% equities, 0% bonds

Additional 5% bonds, moving to the left

0% equities, 100% bonds

ReturnsTop Quartile Hedge Funds Outperformed U.S. Equities and Bonds1

Average annual returns (net of fees) by strategy for risk-adjusted quartiles, 2001 – 2007, %

Note 1: Quartiles are defined based on risk-adjusted performance, defined using fund Sharpe ratio between 2001 and 2007. The Sharpe ratio is given by Average (R – Rf) / Standard Deviation (R), where R is the return and the benchmark rate Rf is the S&P 500 average between 2001 and 2007 (2.43%).Source: McKinsey Global Institute; Hedge Fund Research, Inc.

0.2

0.4

11.2

19.4

4th Quartile

3rd Quartile

2nd Quartile

1st Quartile

Equity Hedge

4.1

12.7

15.4

31.3

Macro

-2.6

4.0

13.9

19.0

Event-Driven

2.2

7.5

9.9

13.6

Relative Value

6.12.4 6.12.4 6.12.4 6.12.4

S&P 500Lehman US Aggregate Bond Index

ReturnsComparison of Hedge Fund Returns to the S&P 500 Index’s Returns, 2000 – 2008 Annualized Total Return, %

Source: Credit Suisse/Tremont; S&P 500 data provided by Commodity Systems Inc.

4.9% 4.4% 3.0%

15.4%

9.6% 7.6%

13.9% 12.6%

-19.1%

-10.1%-13.0%

-23.4%

26.4%

9.0%

3.0%

13.6%

3.5%

-38.5%

2000 2001 2002 2003 2004 2005 2006 2007 2008

Hedge funds

S&P 500

Trading Volume

Hedge Funds Account for a Significant Share of Trading VolumeHedge Fund’s Estimated Share of Trading, %

Source: McKinsey Global Institute; NYSE; LSE; U.S. Bond Market Association; IMF; Greenwich Associates; Financial News; Gartmore; Stern School of Business; British Bankers’ Association; ISDA; McKinsey CIB practice

32

47

45

30

60

25

30

50

Leveraged Loans

Distressed Debt

Emerging Market Bonds

Credit Derivatives - Structured

Credit Derivatives - Plain Vanilla

High-Yield Bonds

U.S. Government Bonds

Cash Equity on NYSE and LSE

Lock-ups and Gates Hedge funds generally focus their investment strategies on

financial assets that are liquid and able to be readily priced based on reported prices in the market for those assets or by reference to comparable assets that have a discernable price

Since most of these assets can be valued and sold over a short period of time to generate cash, hedge funds permit investors to invest in or withdraw money from the fund at regular intervals and managers receive performance fees based on quarterly mark-to-market valuations

However, in order to match up maturities of assets and liabilities for each investment strategy, most hedge funds have the ability to prevent invested capital from being withdrawn during certain periods of time

They achieve this though “lock-up” and “gate” provisions that are included in investment agreements with their investors

Lock-upsA lock-up provision provides that during an initial

investment period of, typically, one to two years, an investor is not allowed to withdraw any money from the fund

Generally, the lock-up period is a function of the investment strategy that is being pursued

Sometimes, lock-up periods are modified for specific investors through a side letter agreement

However, this can become problematic because of the resulting different effective lock-up periods that apply to different investors who invest at the same time in the same fund

Also, this can trigger “most favored nations” provisions in other investor agreements

Gates A gate is a restriction that limits the amount of withdrawals

during a quarterly or semiannual redemption period after the lock-up period expires

Typically gates are percentages (usually 10% to 20%) of a fund’s capital that can be withdrawn on a scheduled redemption date

A gate provision allows the hedge fund to increase exposure to illiquid assets without facing a liquidity crisis

Gates also offer some protection to investors that do not attempt to withdraw funds because if withdrawals are too high, assets might have to be sold by the hedge fund at disadvantageous prices, causing a potential reduction in investment returns for remaining investors

During 2008 and 2009, as many hedge fund investors attempted to withdraw money based on poor returns and concerns about the financial crisis, there was considerable frustration and some litigation directed at hedge fund gate provisions

Side Pockets Hedge funds sometimes use a “side pocket” account to house

comparatively illiquid or hard-to-value assets Once an asset is designated for inclusion in a side pocket, new

investors don’t participate in the returns from this asset When existing investors withdraw money from the hedge fund, they

remain as investors in the side pocket asset until it either is sold or becomes liquid through a monetization event such as an IPO

Management fees are typically charged on side pocket assets based on their cost, rather than a mark-to-market value of the asset and incentive fees are charged based on realized proceeds when the asset is sold

Usually, there is no requirement to force the sale of side pocket investments by a specific date

Investors are concerned about unexpected illiquidity arising from a side pocket and the potential for even greater losses if a distressed asset that has been placed there continues to decline in value

High Water Mark and Hurdle Rate A high water mark relates to payment of performance fees Hedge fund managers typically receive performance fees only when the

value of the fund exceeds the highest net asset value it has previously achieved

For example, if a fund is launched with a net asset value (NAV) of $100 per share and NAV was $120 at the end of the first year, assuming a 20% performance fee, the hedge fund manager would receive a performance fee of $4 per share

If, however, at the end of the second year, NAV dropped to $115, no performance fee would be payable

If, at the end of the third year, NAV was $130, the performance fee would be $2, instead of $3, because of the high water mark (($130-$120) x 0.2)

Sometimes, if a high water mark is perceived to be unattainable, a hedge fund may be incented to close down

In addition, some hedge funds agree to a hurdle rate whereby the fund receives a performance fee only if the fund’s annual return exceeds a benchmark rate, such as a predetermined fixed percentage, or a rate determined by the market such as LIBOR or a T-bill yield

Comparing Hedge Funds and Private Equity Funds Hedge funds are similar to private equity funds in a number of

waysThey are both private pools of capital that pay high

management fees and high performance fees based on the fund’s profits (2 and 20) and both are lightly regulated

However, hedge funds generally invest in relatively liquid assets, purchase minority positions in company stocks and bonds and in many other assets (taking both long and short positions for many investments)

Private equity funds, by contrast, typically purchase entire companies, creating a less liquid investment that is often held for three to seven years

Although there is an intention to create liquidity after this period, since exit events often include an IPO, where only a portion of the investment is sold, or an M&A sale, where the consideration could be in shares of another company, rather than cash, liquidity is not assured even then