New Developments in Hedge Fund Land: Leverage, Governance and Strategy Jane Buchan Chief Executive Officer Pacific Alternative Asset Management Company

Contents Section I – A New Measure: Limited Liability Leverage (L3) Section II – Governance: Does Good Governance Cost? Section III – New Trends in Investment Strategy

A portfolio of hedge funds has a different risk profile than that of a hedge fund with a portfolio of investment strategies (a multi-strat fund.) Q: You are an investor and you want to know what the “average” leverage is in your hedge fund portfolio. PAAMCO Limited Liability Leverage (L3) The difference is the limited liability Section I

Traditional Leverage with Multiple Funds Consider two decentralized structures: (A) 100 investments in funds each with leverage of 2 (B) 99 investments with l=1, one in l=100 Traditional leverage is l p =2 for both structures  For (A):  For (B): Which one has the lowest risk? Risk with Multiple Funds  For fund (A): If the risk factor drops by 50%, all 100 funds lose all of their value: the total loss is 100%  For fund (B): If the risk factor drops by 50%, the total portfolio loses 50.5% only PAAMCO Limited Liability Leverage (L3) Reference: Jorion and Cherem (2010) “Limited Liability Leverage (L^3): A New Measure of Leverage,” Journal of Alternative Investments

What is the Harmonic Mean? (Level 1 CFA) Dollar Cost Averaging, P/E Ratios Physics – Car travels sequential same distances at different speeds. What Is the average speed for the car? PAAMCO Limited Liability Leverage (L3) N i i w L    x l lili Define now Limited Liability Leverage (L 3 ) as the harmonic mean  For (A):  For (B): L 3 correctly indicates that B has lower risk /[ i L3L3   =  (1/100)  x  1 + (1/100) x 0.01]  = 1/[ ]=1.01  /[ (1/100) x (1/2)] = 1/(1/2) = 2 i L3L3  == 

Bottom Line: When computing portfolio statistics we understand that not all measures are simple linear averages (for example, the standard deviation of a portfolio.) However, the same care that is used on computing equity portfolio statistics (remember, stocks have limited liability) needs to be transferred to computing portfolio of hedge fund statistics. PAAMCO Limited Liability Leverage (L3)

Section II Governance: Does Good Governance Cost? In particular, given the events of 2008, people started focusing on principal/agent issues with respect to hedge fund investments. Some issues we discussed – Representations regarding quality, pricing, liquidity of securities – Asymmetry in fees – heads they win; tails we lose – General fee levels (Q: What is really needed to extract the economic rents) PAAMCO Governance

Summary results from different governance characteristics and returns were examined using the TASS Database Percent of TASS database with the following characteristic Entire DatabaseTop Quartile Funds (based on Performance) Accepts Managed Accts29%31% Lock up38%40% No High Water Mark29% High Fees (at 10% return earn at least 3.5%) 56%62% PAAMCO There appears to be little difference between the characteristics of top quartile performance funds and the entire database. Governance

Performance QuestionYesNoDifferenceT-Stat Accepts Managed Accounts? 7.61%6.74%87 bps0.38 Has No Lock up?7.19%7.09%10 bps0.31 Has a High Water Mark? 7.28%7.00%28 bps1.58 Charges Lower Fees For Same Dollar Amount? 6.90%7.29%-39 bps0.96 PAAMCO Better performance is found with managers who accept managed accounts, have no lock-up, have a high water mark, and charge higher fees. Governance

Large Institutional Investors Utah Retirement Systems Tiered Fee Structure Rescindment of Redemption Penalty Performance Fee Hold Back Hurdle Rate CalPERS Crystallization of Performance Fees Adequately Financed Business Operations Separate Accounts Risk Information Transparency PAAMCO Governance

Section III: New Trends in Investment Strategy Approaches and Perspectives Investment Themes Unusual Ideas PAAMCO Strategy Trends

Approaches and Perspectives Leverage has returned Trying to lower the risk of the portfolio by lowering the correlation amongst positions  “event driven” trades Capital structure agnostic PAAMCO Strategy Trends

Investment Themes US Distressed Wave is Over – But, Basel III, European banks with stressed loans to middle market companies Post re-organization equities Playing the government fiscal situation  short defense stocks Potential mergers in both finance and technology sectors PAAMCO Strategy Trends

Unusual Ideas UCITs Credit funds CLOs – they are coming back Proprietary desks shutting down, but where will the liquidity be? PAAMCO Strategy Trends Final Thought: Most common campus recruiting response “Really, my private equity background is very applicable to hedge funds.”