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41 Madison Ave, 31st FL New York, NY 10010 T: 646.202.2618 F: 646.349.3530 info@khromcapital.

com

October 14, 2012 Dear Partners: In the third quarter of 2012, our Partnership returned 8.9% net of fees and expenses. As of September 30th, our year to date net return is 27.8%. On average, we held 17% of our assets in cash throughout this year.

S&P 500 2008 2009 2010 2011 2012 YTD Annualized Return
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K.I.F., gross (32.6%) 91.9% 23.8% 22.8% 35.4% 23.8%

K.I.F., net (32.6%) 82.9% 18.6% 18.0% 27.8% 18.8%

(31.1%) 26.5% 15.1% 2.1% 16.4% 3.9%

Please refer to the disclosure at the end of this letter.

Theres No Such Thing As a FreeDrug Free options are one investment bucket to which we allocate capital. Derma Sciences (mentioned in our 2011 Q4 letter) owns a drug that accelerates the healing of diabetic foot ulcers. The drug should soon enter the final stages of the FDA approval process. Statistically, it has a 55% chance of making it to market. (Anecdotally, the odds are even higher.) Upon final FDA approval, the drug should be worth around $1 billion. We purchased Derma Sciences when it was valued at $80 million. Our attraction to the investment was that the market seemed to pay no attention to Derma Sciences two other business segments, one of which was growing rapidly. Those segments alone, plus the cash,

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were worth around $80 million. That effectively provided us the option on the potential blockbuster drug for free. We recently exited the investment, which generated a 64% IRR. Derma Sciences is still undervalued: the drug alone has an expected value in the hundreds of millions, yet the companys market capitalization today is only $140 million. However, we sold because at todays valuation, there is downside should the drug not be approved. Though Derma Sciences is clearly still a bet with a positive expected value, it no longer fits into our free options bucket. Getting Paid to Wait for the J-Curve Vistaprint is a new investment for our fund. Robert Keane, founder and current CEO, started with the idea to cheaply produce business cards for companies too small to order large quantities. Through the creation of printing technologies designed for low volume orders, Vistaprint significantly reduced the cost for a box of 250 business cards. The cheap prices they were able to offer small businesses enabled Vistaprint to rapidly grow from $0 to over $1 billion in annual revenues. Today, business cards account for only 30% of Vistaprints sales. The company has expanded its lowvolume concept to sell a wide range of customizable, printed marketing materials in small quantities and at cheap pricesfrom brochures and signage to customized apparel and stationary. In addition, the company now targets consumers as well as small businesses, with products such as wedding invitations and photo books. Vistaprint is a scale business. Every increment of growth increases their competitive advantage. Vistaprint has grown to currently process 76,000 orders per day. The more individual print jobs received in a time period, the more efficiently it can be aggregated and scaled over a fixed expense base. No competitor receives as many daily orders as Vistaprint, allowing the company to become the industrys lowest cost producer. It now only takes Vistaprint 13 secondsdown from 60 seconds a few years agoto produce a box of cards. That amounts to a fraction of the labor that traditional printers utilize. With every new customer, Vistaprint can scale its investments to further improve its products and manufacturing. For example, the $129 million that the company spent on technology and development last yeara sum greater than the revenues of most competitorscame out to only $5 per order for Vistaprint. The feedback loop this creates is obvious: more customers lead to greater scale, which allows better products and pricing, which leads to more customers. Vistaprint develops a similar edge with the cost of acquiring customers, i.e., their advertising. For example, no competitors have the size to justify the national TV ads that Vistaprint recently launched. The new TV commercials are part of Vistaprints efforts to target customers that still do their purchases offline. A large amount of small businesses still buy at the local print shopa source that is in terminal decline. Local print shops cannot effectively compete pricewise with their online counterparts.
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This causes the local shop to suffer from a negative feedback loop: as their sales shrink, there are less revenues to spread over their fixed expenses, which eventually leaves the shop with only red ink. Since 2004, over one-third of commercial printers have gone out of business. The printing world will continue to exist; it will just be a smaller market with probably fewer competitors. Robert Keane wants to accelerate Vistaprints acquisition of market share. Many companies will try to invest smoothly over time with no burden on currently reported income. Keanes priorities, himself being a substantial owner of Vistaprints stock, are long-term. Vistaprint has decided to trade-off nearterm earnings in favor of upfront investments that should increase customer retention, lower production costs, improve product quality, create new products, and expand the business beyond North America and Europe. Should improvement in these metrics lead to the growth that Keane expects, Vistaprint will be worth multiples of what we paid. In the interim, the currently depressed earnings have created uncertainty for many investors, which led to an attractive price for us to buy Vistaprint. We have no nave misconceptions about growth; it is highly challenging and hard to predict. It may not deliver in spades like Keane expects. But what we think the market fails to realize is that at Vistaprints current stock price, we are not paying for the growth. Vistaprint already has 14 million customers; it already is a profitable business with a competitive advantage. The recent contraction in earnings was not caused by a decline in customers, sales, or gross profit margins. It was derived from a substantial increase in employees.1 In the past year, Vistaprint hired almost 1,000 new employeesa 30% increase in just one year. We venture to assume this substantial increase in employees is not needed to service the revenues that Vistaprint already generates. Back out these incremental investments in headcount and adjust advertising to maintenance levels, and we purchased Vistaprint at a single-digit multiple of free cash flow. While the price we are paying does not give Vistaprint any credit for growth, we are taking on a risk related to the companys growth strategy. Vistaprints new investments could mask our ability to detect any deterioration in the economics of the core business. In the short-term, an unplanned decline in a companys competitive position produces the same effect on an income statement as a planned investment aimed at widening its moat. It requires careful forensic accounting and investigative scuttlebutt to distinguish between the two. Guiding the company through this landscape of risk and opportunity is a manager whose judgment we have found ample reason to trust. Robert Keane has an impressive track record, having built Vistaprint into a truly wonderful business, with a return on equity that has averaged over 21% for the past seven years. He is exceptional with collecting and interpreting data, a key skill given the centrality of datadriven marketing to Vistaprints business, and he personally owns a substantial amount of stock. Keane recently raised the hurdle at which he can exercise his stock options to $75 a share (more than double our purchase price), and the company has redesigned its executive compensation structure to ensure
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Excluding advertising, ~75% of Vistaprints expense increase was due to payroll.

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that bonuses are not paid until the growth strategy is reflected in the stock price. Furthermore, the company continues to aggressively repurchase its own shares. There is an added kicker to our investment: we are being paid double-digit rates to lend our stock to short sellers who have taken the other side of our bet. Essentially, we are being paid to wait and see if Vistaprint can accomplish a J-curve effect in earnings. Whether or not Vistaprints growth strategy works, the odds are we should earn a high double-digit IRR. Can Someone Please Close That Discount? Another investment bucket to which we allocate capital are stocks that trade at substantial discounts to their net asset values where management is committed to closing the gap. We invested in two internationally listed companies with such dynamics. For one of them, management mentioned stock buybacks twenty-four times on their latest conference call. The other one was taken control of by an aggressive businessman who built his net worth into the hundreds of millions by not sitting around. *** As always, virtually my entire net worth is invested in the Partnership as I aim to compound my wealth alongside yours. I look forward to writing to you again in the New Year.

Sincerely, Eric E. Khrom Managing Partner Khrom Capital Management, LLC

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DISCLOSURE:
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2008 performance only includes March 1st, 2008 to December 31st, 2008, due to fund inception date of March 1, 2008.

Performance data of the S&P 500 Index is included to facilitate comparisons between the Partnerships returns and overall market performance. Due to the differences among the Partnerships investment strategies and the securities that compose the S&P 500 Index, the General Partner cautions potential investors that no such index is directly comparable to the Partnerships investment strategy. S&P 500 index performance results include the reinvestment of dividends. The results portrayed above are intended to show the investment performance that would have been experienced by a single limited partner of the Partnership who remained invested throughout each annual or partial year period shown, after the reinvestment of interest, dividends, and other earnings, and the deduction of costs and the profit allocation that the General Partner would have accrued as of the end of each year. Results are based on the Partnerships internal books and are subject to adjustment following the audit of its financial statements. Future investments may be made under different economic conditions and in different securities and using different investment strategies than were used during the time discussed herein. It should not be assumed that future investors will experience returns, if any, comparable to those of the Partnership discussed herein. The information given above is historic and should not be taken as any indication of future performance.
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This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation to invest in Khrom Investments Fund LP (the Fund) may only be made by means of delivery of an approved confidential offering memorandum. Past results are no guarantee of future results and no representation is made that an investor will or is likely to achieve results similar to those shown. All investments involve risk including the loss of principal. Performance results in separately managed accounts will be different from the performance results of Khrom Investments Fund LP. Khrom Capital Management, LLC or affiliated entities (Khrom Capital) is not responsible for any liabilities resulting from errors contained in this communication. Khrom will not notify you of any errors that it identifies at a later date. An investment in any product managed or offered by Khrom Capital may be deemed speculative and is not intended as a complete investment program. It is designed only for sophisticated persons who are able to bear the risk of the substantial impairment or loss of their investment in the Fund. Products managed or offered by Khrom Capital are designed for investors who do not require regular current income and who can accept a certain degree of risk in their investments.

Khrom Capital Management LLC www.khromcapital.com