1. 1 Hedge Funds The Indebted Society Economics 1813 Harvard University Michael Dubilier Dubilier & Company Ronald W. Sellers Atlantic Asset Management, LLC Stamford, Connecticut 203-351-2800 www.atlanticasset.com (research tab) November 22, 2004

2. 2 Order of Topics I. What Is A Hedge Fund? II. Industry Overview III. Investment Strategies IV. Case 1. Mortgage Derivative Hedge Fund V. Case 2. Macro Economics Hedge Fund VI. Appendix – Web Pages

3. 3 I. What is a Hedge Fund? Class questions: 1. How many have heard of hedge funds? 2. How many think they know what they are?

4. 4 What is a Hedge Fund? Formal definition – there is none Webster’s Dictionary has “hedge” between “hector” and “hedonism” with three definitions: 1. boundary 2. means of protection 3. a deliberately ambiguous statement Hedge funds have all these characteristics

5. 5 What is a Hedge Fund? Hedge funds in the U.S. investment industry–typical characteristics 1. L.P. or L.L.C., or other corporate structure 2. Formed onshore or offshore or both 3. Unregistered investment vehicle for “QPs” only 4. Both asset based and performance based 5. Managers are small special purpose firms 6. Operate a single investment strategy for absolute total return 7. Hedging is used to reduce certain investment risks 8. Leverage is used to enhance returns

6. 6 II.Industry Overview $875 billion assets in about 6,000 Hedge Funds

7. 7 Industry Overview Hedge Fund Asset Growth, $Billions

8. 8 Industry Overview Hedge Fund Net Performance January 1998 – June 2004 Net Compound Annual Return Standard Deviation CSFB/Tremont Hedge Fund Index 7.87.6 MSCI World 6.216.2 S&P 500 Index 12.315.3 Morningstar Average Equity Mutual Fund 9.815.8 LB Aggregate Bond Index 8.14.4

9. 9 Industry Overview Who invests in hedge funds? 19922002 Institutions % 19 52 Individuals % 81 48 Investors Include: High Net Worth IndividualsEndowments & Foundations Family OfficersPension Plan Sponsors (ERISA) Private BanksRetail Investors

10. 10 Industry Overview Hedge Fund Regulation Typically i. They are exempt from registration under the Investment Company act of 1940, and therefore not public mutual funds ii. They are exempt from registration under the Securities Act of 1933, and therefore cannot make public offerings iii. Their advisors are exempt from registration under the Investment Advisors Act of 1940

11. 11 Industry Overview Exemption from Registration Is achieved by: i. Have less than 100 investors or sell interests only to “qualified purchasers” (with $5 million of investments) ii. Do not offer securities publicly – no public solicitation iii. Have 14 clients or fewer – hedge fund is “one”

12. 12 Industry Overview Investment Advantages Removes restrictions and requirements with respect to: i. Use of leverage and short-selling ii. Computation of NAV, the basis for determining fees iii. Extensive reporting and disclaimer obligations, including printed prospectus approved by the SEC iv. SEC examiners and fiduciary duties to clients - disclosures, information requirements, fees and marketing restrictions

13. 13 III.Investment Strategies Convertible Bond Arbitrage  A typical arbitrage trade is holding a convertible security long and its underlying stock short. This is a relative value strategy in which returns should be made as the underlying stock and convertible bond move up or down in price. Dedicated Short Bias  Commonly referred to as “short sellers.” Often use intensive fundamental analysis to uncover accounting problems or frauds that could cause security price to fall. Distressed  Focuses upon the purchase of debt instruments that are mispriced on an absolute or relative basis. Distressed securities include the securities of companies “in trouble” involved in workouts, liquidations, reorganizations, bankruptcies and similar situations. Requires superior fundamental analysis and accurate evaluation of the value of the company. A relative value variant is capital structure arbitrage where a manager is long senior debt and short junior securities.

14. 14 Investment Strategies Emerging Markets  A specialty area where there can be more inefficiencies found in the valuation of securities. Typically can invest in both equities and debt. Sovereign risks and liquidity are the key concerns in these markets. Equity Market Neutral  Trade generation is typically quantitative and model-driven. An example is statistical arbitrage where managers take advantage of small equity pricing anomalies through the rapid turnover of large portfolios. Another strategy is pairs trading which employs the matching purchase and sale of similar securities. Fixed Income Arbitrage  Can be divided into mortgage and fixed income relative value sub-strategies. Mortgage strategies involve the purchase of mortgage back securities and hedging of risks including interest rate risk or duration. Relative value strategies involve the sale and purchase of fixed income instruments where carry is an important source of profits. Fixed income strategies in general employ higher levels of leverage.

15. 15 Investment Strategies Global Macro  Mangers seek opportunities in markets around the world. The strategy is not typically restricted to a given asset class and is therefore highly opportunistic in nature. Global Macro managers examine macroeconomic data in order to develop a fundamental economic outlook or to identify a developing trend. Positions are taken in interest rate, credit, foreign exchange, or index derivatives. Long/Short Equity  Equity alternative where managers invest long and short in stocks. As with traditional equities, managers often specialize by geography, industry, style and capitalization. Managed Futures  A systematic strategy separated into trend-following and mean-reverting models. Trend-following systems model financial time series over short, medium and long term looking for price trends that can be exploited. Mean-reverting strategies expect dislocations from the mean to revert.

16. 16 Investment Strategies Risk Arbitrage  Involves the purchase and sale of securities of two companies involved in a merger with the intent of going long or short the closure of the transaction. May also invest in reorganizations and spin-offs. Note: Descriptions were generally taken from CSFB materials.

17. 17 IV.Case 1. Mortgage Derivative Hedge Fund Business History 1999 $4 million managed, 1 investor, 5 employees, 3-year return 35% per year net of fees, for regulatory purposes losing financial backer 2004 $1 billion managed, over 100 investors, 15 employees, 7 year return 30% +/year net of fees, owned by employees, Atlantic and the first large investor 2004 Projected to have $20-30 million profit

18. 18 Mortgage Derivative Hedge Fund Investment Strategy Core I/O’s (interest only mortgage strips) assets High yield, but very large negative duration 500% exposed to prepayment risk Securities evaluated on a loan by loan basis Leveraged up to 2 to 1 Hedge Interest rate exposure hedged to ‘0’ duration with Treasuries and MPT purchased forward Prepayment risk hedged with P/O’s and other, all risk factors hedged dynamically

19. 19 Mortgage Derivative Hedge Fund Management Issues Liquidity15% cash, 12 repo lines – double dealer haircut PricingMark to market always vs. mark to model, complete transparency of process ProfessionalsAvg. 15 year experience from proprietary head trader positions, one-third Phd’s SuccessStorybook success so far

20. 20 V. Case 2. Macro Economics Hedge Fund Business History 1993 - 1999Initial development of LAB Model at Harvard 1999 - 2003 LAB Account $1-2 million invested, with average return near 40% annually 2003Started Atlantic Macro Economics Fund, $1.5 million invested 2004Returned 26% last 13 months, annual expenses about $700,000

21. 21 Macro Economics Hedge Fund LAB Model

22. 22 Macro Economics Hedge Fund Investment Strategy Equilibrium level for interest rates is correlated historically with actual rates Forecast is yield one month out for 10-yr. spot and the yield difference between the 10-yr. and 1-yr. Based on the forecast, cash portfolio duration is increased or decreased each month If correct, short-term gains accumulate

23. 23 Macro Economics Hedge Fund Management Issues Forecast AccuracyStatistically correct 65% of the time Volatility of ReturnsTake only measured bets, use stop-loss trading Start-up MarketingSeeking anchor investor, prospective investors will watch and wait CommitmentMust have multi-year commitment to have possibility of success

24. 24 Summary Hedge Fund Industry Start-ups1,000 annually est. Terminations10-25% annually est. Reasons50% caused by business operational failures est. WinnersA $1 billion fund earning 20% in one year has a performance fee of $40 million FailuresLong Term Capital lost $.5 billion in one day with a $3.6 billion bailout at the end (1998)

25. 25 Summary Hedge funds are now a booming business Attracting the most talented managers Alternative for sophisticated investors seeking better returns Words of Wisdom: Investing for consistently good returns is very difficult. Hedge fund business success is very very difficult.

26. 26 Appendix Web pages to follow………………………….

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