NB AlterNAtives

2011 Strategy Outlook
Fund of Hedge Funds Team

Not for retAil clieNt use iN europe, AsiA ANd the middle eAst.

introduction
NB Alternatives continues to view the identification and bottom-up due diligence of individual managers as the key to successful hedge fund investing. Nevertheless, more thorough higher level analysis is helpful in identifying opportunities for specific strategies, as well as general trends that may affect funds across the industry. in this document, we discuss the opportunity set in the distressed and asset-backed securities markets, as well as the general opportunity for investing in emerging managers across strategies. in light of recent government policies, we also explore the impact of a rising interest rate regime on particular investment strategies. lastly, we provide thoughts regarding hedge fund performance during times of market illiquidity and identify positive illiquidity beta strategies that could meaningfully diversify a portfolio. our 2011 Strategy Outlook remains focused on empirically driven conclusions derived from the analysis of our detailed hedge fund database1 and an array of market and macro data provided by external sources. our market experience and commentary, coupled with these analyses, aim to provide constructive insights into the changing hedge fund landscape and the resulting opportunities for investing.
Chapter 1: Distressed Investing Update This section provides an update on the analysis conducted in our 2010 Strategy Outlook, along with a discussion regarding the current and future opportunity set, the liquidity of underlying investments and subsequent fund terms and considerations for non-U.S. distressed investing. We believe that the current and future opportunity set for distressed investing is robust. A large wall of forthcoming maturities in both the middle market and large cap space is likely to create opportunities for several years; we believe the middle markets present a particularly compelling area. A distinctive characteristic of distressed investing is that the liquidity is often longer term in duration, requiring longer lock-ups. Finally, as expressed in our 2010 Strategy Outlook, distressed investing outside the U.S. is often accompanied by additional process-related risks and requires specific expertise pertaining to the particular jurisdiction. Chapter 2: Rising Rates and Hedge Fund Performance If expansive monetary policy were to bring about inflation in developed world economies, how might concomitant rate rises impact hedge fund performance? We analyze performance across a variety of different hedge fund strategies in periods of rising rates, as compared to periods of static or falling rates. We then apply fundamental analysis to the findings to assess whether there is a sensible rationale to support the thesis that some strategies will benefit or suffer from a regime shift in rates. Finally, we consider the patterns of those returns and how a regime shift might impact the diversification properties of certain hedge fund strategies, such as Commodity Trading Advisors and Global Macro.

1

our team leverages proprietary peer groups that consist of over 3,500 hedge funds across 80 distinct sub-strategies and geographies. our own investment team members (not the fund manager or a third-party data provider) define the strategies of hedge funds to ensure that strategy descriptions accurately reflect each hedge fund’s activities and that each peer group consists of comparable data. returns for each fund in the peer groups are housed in pertrac. returns are updated both manually by the investment team and on an automated basis through data feeds from pertrac, eurekahedge and tAss.

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Chapter 3: Asset-Backed Securities and the Factors Influencing the Opportunity Set We have witnessed the launch of a number of hedge funds investing in the asset-backed space in 2010. These funds have benefited from the rally of asset-backed securities from near historic lows over the last 12 months. This section examines the residential mortgage-backed securities market in a post-2008 environment. We seek to define the universe and assess the supply and demand dynamics and liquidity of the underlying instruments. The analysis of current yields as well as the risks and limitations of the strategy in a hedge fund structure allow us to determine whether the market dislocations still provide significant opportunities for investors and the likely longevity of the opportunity. Chapter 4: Emerging Manager Outperformance: An Analysis of Renewed Importance The number of qualified managers seeking to launch new hedge funds has increased after the implementation of the Volcker Rule and the financial crisis of 2008. Within this context, we reexamine the concept of emerging manager outperformance in relation to their more established peers. What defines an “emerging” manager? Are some market environments better than others for emerging managers? Does the benefit of age influence some strategies more than others? These questions guide our evaluation of manager performance in various stages of the life cycle. Our analysis demonstrates compelling trends for investing in emerging managers for certain strategies, and highlights the potential alpha and diversification benefits of a thoughtful emerging manager allocation. Chapter 5: The Relationship between Various Hedge Fund Strategies and Market Illiquidity In this section, we revisit the notion of “illiquidity beta” and the implications for hedge fund investing in a post-2008 environment. We explore this illiquidity beta concept in an effort to assess the qualitative thesis that certain hedge fund strategies perform more poorly than simple equity or credit betas would suggest in times of decreasing capital markets liquidity. We observe the concept of an illiquidity factor in three different ways, measure the sensitivity of various hedge fund strategies to this factor, and discuss the portfolio construction implications of these results for well diversified fund of hedge fund portfolios.

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chapter 1: distressed investing update
In our 2010 Strategy Outlook, we considered the implications of various distressed trading styles on market exposures before and after a credit event. For this update, we included data through the end of 2009 and the first three quarters of 2010. We again focus on three sub-strategies: Long/Short and Capital Structure Arbitrage, Long-Biased Conservative Distressed and Long-Biased Aggressive Distressed and a subset of the NB Alternatives Peer Group. Data for the three sub-strategies are comprised of funds within our peer group where we have recent return data and where we are confident we can identify the underlying sub-strategy. As a brief review, Long/Short and Capital Structure Arbitrage includes managers who maintain lower levels of net exposure, with long and short positions used either as outright or as part of capital structure arbitrage trades. Long-Biased Conservative managers employ little or no leverage, invest a majority of their assets in the senior-most portion of a company’s capital structure (bank debt and senior secured bonds), and use less shorts. Long-Biased Aggressive managers are similarly long-biased and use less shorts, but differ from conservative managers in that they may use leverage, invest throughout a company’s capital structure (bank debt down to equity), and have a more concentrated portfolio with larger average position sizes. To understand if market exposure changes prior to and following major credit events, we observe the betas for two years prior to the credit spread widening and for two years following the event. The analysis looks at the multifactor two-year beta of each sub-strategy for both equity (S&P 500 Index) and credit (Barclays High Yield Index) markets. To understand if market exposure changes prior to and following major credit events (which often precede distressed cycles or distressed opportunities), we observe the betas for two years prior to the credit spread widening and for two years following the event (including the period of spread widening). In Figure 1.1, we consider betas for the following credit events: second half of 2000, Summer 2002, Spring 2005, Summer 2007 and the fourth quarter of 2008.
Figure 1.1: Multifactor Two-Year Beta for Each Sub-Strategy
S&P 500 Index Beta Long/Short and Cap Structure
Period second half 2000 summer 2002 spring 2005 summer 2007 Q4 2008 Average Pre-Event 0.07 -0.03 0.23 0.07 0.00 0.07 Post-Event -0.03 0.03 0.05 0.00 0.12 0.03

Distressed – Conservative
Pre-Event -0.08 -0.02 0.11 -0.01 0.05 0.01 Post-Event -0.02 -0.01 0.01 -0.01 0.03 0.00

Distressed – Aggressive
Pre-Event 0.11 -0.01 0.27 0.11 0.17 0.13 Post-Event -0.01 0.24 0.12 0.12 0.22 0.14

Barclays High Yield Index Beta (“HY Beta”) Long/Short and Cap Structure
Period second half 2000 summer 2002 spring 2005 summer 2007 Q4 2008 Average Pre-Event 0.18 0.05 0.10 0.52 0.23 0.22 Post-Event 0.05 0.18 0.38 0.17 0.12 0.18

Distressed – Conservative
Pre-Event 0.54 0.23 0.35 0.26 0.14 0.30 Post-Event 0.23 0.46 0.19 0.23 0.22 0.27

Distressed – Aggressive
Pre-Event 0.69 0.32 0.26 0.22 0.15 0.33 Post-Event 0.32 0.48 0.14 0.43 0.41 0.36

source: NB Alternatives peer Groups.

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Similar to our analysis last year, we continue to see that managers who run the most hedged portfolios, the Long/Short and Capital Structure Arbitrage managers, maintain the lowest level of beta to both credit and equity markets. The average S&P 500 beta of these managers across all events is 0.07 for the two years preceding the credit event and is 0.03 for the two years following the event. The average HY beta is 0.22 pre-event and 0.18 post-event. For long-biased managers, we observe that both the Conservative and the Aggressive managers have a higher level of market beta than that of more hedged managers, which in the case of the Conservative sub-strategy comes almost exclusively in exposure to credit markets, where the pre-event average is 0.30 and the post-event average is 0.27 for HY beta while the S&P 500 beta average is 0.01 pre-event and 0.00 post-event. For the Aggressive sub-strategy, the market sensitivity is driven again by the HY beta, with a pre-event average of 0.33, and 0.36 post-event, but also shows a positive value in the equity beta as well, with a 0.13 pre-event average, and 0.14 post-event average. The increased betas of the Aggressive sub-strategy are likely a result of their willingness to invest lower in the capital structure, to hold more market-sensitive securities for longer and to take on higher levels of leverage, which may result in magnifying market exposure. As we observed last year, and consistent with the typical tendencies of the sub-strategy, Aggressive managers have the highest absolute beta levels to both equity and credit markets. Feasible factors that could help explain both the direction and the magnitude of the change include 1) The exposure levels of managers, both gross and net, entering the spread widening period. 2) The magnitude of the spread widening. 3) The length of time over which the spread widening occurs. 4) The drivers of the spread widening. We also observe that the changes in pre-event and post-event betas are inconsistent. In some periods, we see betas fall in the wake of an event while betas in other periods rise from pre-event levels. Feasible factors that could help explain both the direction and the magnitude of the change include 1) the exposure levels of managers, both gross and net, entering the spread widening period, 2) the magnitude of the spread widening, 3) the length of time over which the spread widening occurs and 4) the drivers of the spread widening. If we look anecdotally at the most recent period, we can see that for Long/Short and Capital Structure Arbitrage, post-event credit beta has fallen, while for the Long-Biased sub-strategies, it has risen. While changes in other periods to manager exposure often explain changes in market betas, Figure 1.2 shows that this is not always the case. From November 2006 to September 2010, managers maintained relatively constant or reduced levels of pre-event and post-event net and gross exposure. As such, it is more likely that the changes in market betas can be explained by the strong performance of the asset class following the spread widening and the extent to which managers took advantage of the “beta” play over the past several quarters. Security selection has been less relevant to market performance while absolute exposure levels have more directly impacted performance.

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Figure 1.2: Exposures by Sub-Strategy (November 2006 – September 2010)
Figure 1.2a: Gross Exposure: Long/Short and Capital Structure Arbitrage
500% Fund 1 Fund 5 Fund 2 Fund 6 Fund 3 Fund 7 Fund 4 Average

Figure 1.2d: Net Exposure: Long/Short and Capital Structure Arbitrage
150% 100% 50% Fund 1 Fund 5 Fund 2 Fund 6 Fund 3 Fund 7 Fund 4 Average

400%

300%

0% -50% -100%

200%

100%

-150% -200% Nov-06

0% Nov-06

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

Figure 1.2b: Gross Exposure: Long-Biased Conservative
250%

Figure 1.2e: Net Exposure: Long-Biased Conservative
120%

200%

80%

150%

40%

100%

0%

50% Fund 1 0% Nov-06 May-07 Fund 2 Nov-07 May-08 Fund 3 Nov-08 Average May-09 Nov-09 May-10

-40% Fund 1 -80% Nov-06 May-07 Fund 2 Nov-07 May-08 Fund 3 Nov-08 Average May-09 Nov-09 May-10

Figure 1.2c: Gross Exposure: Long-Biased Aggressive
160% 140% 120% 100% Fund 1 Fund 2 Fund 3 Fund 4 Average

Figure 1.2f: Net Exposure: Long-Biased Aggressive
140% 120% 100% 80% Fund 1 Fund 2 Fund 3 Fund 4 Average

80% 60% 60% 40% 20% 0% Nov-06 40% 20% 0% Nov-06

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

sources: NB Alternatives analysis, NB Alternatives peer groups.

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Generally, the managers exhibiting the most market exposure performed the best in the period following the spread widening. The best performing sub-strategy in 2009 was Long-Biased Aggressive with an average return of 52.36%, followed by Long/ Short and Capital Structure Arbitrage with an average return of 23.72% and lastly, Long-Biased Conservative with an average return of 20.63%.2 The similar performance of Long-Biased Conservative and Long/Short and Capital Structure Arbitrage managers may be explained by similar levels of exposure, with Long-Biased Conservative managers maintaining relatively high short and cash exposures, making them appear more hedged and less market exposed. The broadly positive performance of all sub-strategies, the positive market betas and the positive performance of the broader credit markets suggest that beta has been a source of profits for managers since the fourth quarter of 2008. Year-to-date performance through September 2010 is again led by Long-Biased Aggressive with an average return of 9.79%, followed by Long-Biased Conservative with an average performance of 8.90% and Long/Short and Capital Structure Arbitrage with an average return of 4.14%.3 The relatively analogous performance of the two Long-Biased sub-strategies in 2010 may again be explained by similar levels of exposure. Given the “beta” nature of the rally which continued into 2010, the specific securities the two sub-strategies owned exerted less of an influence over performance. Further, as we are still relatively early in the cycle, both Aggressive and Conservative managers will tend to be invested in similar parts of the capital structure, causing their portfolios to display a greater level of overlap than at other points in the cycle. The broadly positive performance of all sub-strategies, the positive market betas and the positive performance of the broader credit markets (the Barclays High Yield Index was up 58.21% in 2009 and 11.52% YTD 2010 through the third quarter) suggest that beta has been a source of profits for managers since the fourth quarter of 2008. However, as spreads have returned to their pre-Q4 2008 levels4 and there are fewer “cheap” high beta names to own, dispersion of performance among managers and sub-strategies may rise going forward.

2 3

NB Alternatives analysis, pertrac, tAss, eurekahedge. NB Alternatives analysis, pertrac, tAss, eurekahedge. the Barclays high Yield index oAs was 708 as of June 26, 2008, and 621 as of september 30, 2010.

8

4

The Opportunity Set We believe a combination of decreased demand and ample supply is likely to create a compelling and sustained opportunity set for distressed investing. The decrease in demand stems from a number of sources, including 1) hedge funds operating at below average exposure levels, 2) investment banks’ diminished participation in direct investments due to the Volcker Rule,5 and 3) collateralized loan obligations (“CLOs”), the primary source of refinancing for loans, are running out of cash.
Figure 1.3: Primary Market for Institutional Loans
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 1H10 Banks, Finance and Insurance Co. source: J.p. morgan. Prime Rate Fund Hedge, Distressed and High Yield Funds CLOs

Figure 1.4: Maturity of CLOs
($bn) 300 250 200 150 100 50 0
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17 ’18 ’19 ’20 ’21 ’22

CLO Reinvestable Assets CLOs out of Reinvestment Window

sources: Wells fargo, intex, tpGc estimates.

While we have witnessed robust refinancing activity in 2009 and 2010 (approximately $152.6 billion of high yield issuance occurred in 2009 and $209.2 billion in 2010),6 we have also seen the maturity calendar pushed out by the “amend and extend” phenomenon, where covenants are breached, or companies get alarmingly close and terms are renegotiated. This typically extends the maturity, but also increases the cost to the companies. While the overhang may have been pushed out a few years and some of the volume has been reduced, the overhang remains considerable. We believe that the level of restructuring activity should remain above average for several years, even with more modest default expectations.
5

the Volcker rule prohibits a bank or a bank-holding company from engaging in proprietary trading and from owning or investing in a hedge fund or private equity fund. the rule also restricts the amount of liabilities the largest banks can carry. Barclays capital.

6

9

Figure 1.5: U.S. Refinancing Overhang
($bn) 450 400 350 300 250 200 150 100 50 0 2011 2012 2013 2014 2015 2016 2017 2018

Leveraged Loans High Yield

sources: J.p. morgan; credit suisse 2009 leveraged finance strategy update — may 31, 2010; and credit suisse 2008 leveraged finance outlook and 2007 Annual review.

Figure 1.6: European Refinancing Overhang
($bn) 140 120 100 80 60 40 20 0 2011
source: credit suisse.

Leveraged Loans High Yield

2012

2013

2014

2015

2016

2017

At a relatively reasonable projected default rate of 5% (around the historical average of Moody’s Speculative Grade Default Rate from 1990 to 2009),7 annual supply of defaulted paper in the U.S. will reach $81 billion between the end of 2010 and 2014. A higher projected default rate of 8% produces $131 billion of supply.8

7 8

moody’s investors service, “corporate default and recovery rates, 1920 – 2009.” J.p. morgan, s&p/lcd, tpG credit estimates.

10

Figure 1.7: U.S. Projected Default Volume
($bn) 200 180 160
Default Volume

Historical Default Volumes 5% Projected Default Rate 8% Projected Default Rate

Annual Supply: @ 5%=$81 Billion @ 8%=$131 Billion

Projected Defaults

140 120 100 80 60 40 20 0 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14

sources: J.p. morgan, s&p/lcd, tpG credit estimates.

In Europe, at a projected default rate of 6%, the volume of defaulted paper will reach $20 billion. At 8%, this could rise to $27 billion between 2011 and 2014.9
Figure 1.8: European Projected Default Volume
($bn) 40 35 30
Default Volume

Annual Supply: @ 6%=$20 Billion @ 8%=$27 Billion Historical Default Volumes 6% Projected Default Rate 8% Projected Default Rate

Projected Defaults

25 20 15 10 5 0 ’00 ’01 ’02 ’03 ’04

’05

’06

’07

’08

’09

’10

’11

’12

’13

’14

sources: J.p. morgan, s&p/lcd, tpG credit estimates.

Higher interest rates could also lead to increased opportunities for hedge funds, particularly because of the number of corporates with floating rate debt. This, coupled with modest growth expectations, 10 could mean corporates find their interest burden increasingly problematic as rates rise and they are unable to “grow” their way out of bad balance sheets and nearing maturities.

9

J.p. morgan, s&p/lcd, tpG credit estimates. A group of 43 economists surveyed by the federal reserve Bank of philadelphia forecast Gdp growth of 2.5% in 2011 and 2.9% in 2012. http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professionalforecasters/2010/survq410.cfm

10

11

While we have seen a substantial pickup in refinancing activity in 2009 and 2010, much of the activity has been concentrated in larger companies as small and middle market companies continue to find it difficult to access the capital markets. As demonstrated in Figure 1.9 below, this is apparent in the diverging default rates for middle market versus large corporate issuers. While default rates for larger corporates have fallen in 2010, they have continued to rise for the middle market. As of June 2010, the 12-month default rate for middle market loans was 11.37%, compared to just 3.75% for large corporates.11 Until the capital markets reopen for smaller and middle market companies, these corporates may continue to have trouble repaying maturities and defaults may continue to remain high.
Figure 1.9: Default Rates
14% 12%
Default Rate

Middle Market Large Corporate

10% 8% 6% 4% 2% 0% Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

source: s&p leveraged commentary & data, as of June 30, 2010.

Further, the number of maturities coming due in the next several years is much greater for the middle market than for large capitalization companies. In 2011, middle market maturities total 39 while large cap maturities are only 2; these numbers increase as we near the looming maturity wall in 2014 – 2015 (see Figure 1.10). Additionally, middle market leveraged loan defaults have historically exceeded large cap defaults (see Figure 1.11).12 This, coupled with fewer players in this segment of the market and limited research analyst coverage, could lead to interesting opportunities.
Figure 1.10: Number of Maturities by Issue Size
400 350
Number of Maturities

Middle Market Large Cap 22

49

300 250 200 150 100 50 0 2 39 2011 2012 6 101

317 243 16 103 2013 2014 2015 7 105 2016

2 18 2017

sources: J.p. morgan, s&p/lcd, tpGc estimates.
11

s&p leveraged commentary & data, as of June 30, 2010. the default rate represents the percentage of defaulted loans by volume over the prior twelve-month period. J.p. morgan, s&p/lcd, tpGc estimates. middle market loans defined as pari passu loans less than $1 billion.

12

12

14

Figure 1.11: Leveraged Loan Defaults
100 90 80
Number of Defaults

Middle Market Large Cap

16

70 60 50 40 30 20 10 0 4 2 7 29 4

4

74 4 22 4 19 1 11 6 1 10 5 3 56 2 21

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

sources: J.p. morgan, s&p/lcd, tpGc estimates.

Managers also continue to find value in holding the post-reorganization equities of recently restructured companies.

Managers also continue to find value in holding the post-reorganization equities of recently restructured companies. A fairly common practice in the course of a restructuring is a debt-forequity swap, where creditors are given equity, either in combination with cash or new debt or on its own in exchange for forgiving their current debt. Given the taint often associated with recently restructured companies (even if the restructuring was due to a bad balance sheet rather than a bad business), these new equity securities often trade at a large discount to their peers, offering distressed investors who choose to hold the post-reorganization equity substantial upside. For example, Visteon, which emerged in early October 2010, is trading around 2.5x 2010E EBITDA and 2x 2011E EBITDA. Delphi, which emerged in October 2009, is trading around 3.25x 2010E EBITDA and 2.75x 2011E EBITDA. These compare favorably with average multiples for the automotive supplier universe of roughly 5.3x 2010E EBITDA and 4.7x 2011E EBITDA.13 The relatively attractive valuations of these companies may be further explained by the relatively concentrated shareholder base at the time of emergence, as well as the lack of research analyst coverage. Distressed investors will often hold these securities until they begin trading more in line with their peers and the value has been realized. Figures 1.12 through 1.15 show the performance of recently emerged companies versus a few related competitors. In many instances, the stock outperforms; in all instances, they are broadly in line with peers generating positive profits in the period after their emergence.
Figure 1.12: Spectrum Brands Holdings Inc.: Emerged 8/28/2009
$160 $140 $120
Share Price

Given the taint often associated with recently restructured companies, these new equity securities often trade at a large discount to their peers, offering distressed investors who choose to hold the post-reorganization equity substantial upside.

$100 $80 $60 $40 $20 $0 Sept-09 Proctor & Gamble Company (PG) Energizer Holdings Inc (ENR) Centaurus 2002 SICAV (CENTA) Spectrum Brands Holdings Inc (SPB) Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sept-10 Nov-10

sources: Bloomberg, imperial capital.
13

NB Alternatives analysis, Bloomberg, Visteon corporation, delphi. the multiples are approximate as of december 2010.

13

Figure 1.13: Lear Corporation: Emerged 11/9/2009
$250 $230 $210 $190
Share Price

Magna International Inc (MGA) Dana Holding Corporation (DAN) American Axle and Manufacturing (AXL) Lear Coporation (LEA)

$170 $150 $130 $110 $90 $70 $50 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sept-10 Nov-10

sources: Bloomberg, imperial capital.

Figure 1.14: CIT Group Inc.: Emerged 12/9/2009
$190 $170
Share Price

$150 $130 $110 $90 $70 $50 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10

United Bankshares Inc (UBI) Synovus Financial Corporation (SNV) BB&T Corporation (BBT)
sources: Bloomberg, imperial capital.

Bank of America Coporation (BAC) CIT Group Inc (CIT)

Figure 1.15: Smurf-It Stone Container Corporation: Emerged 6/30/2010
$120 $115 $110
Share Price

Weyerhaeuser Company (WY) International Paper Company (IP) Smurf-It Stone Container Corporation (SSCC)

$105 $100 $95 $90 $85 $80 $75 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10

sources: Bloomberg, imperial capital.

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Stricter liquidity terms are reasonable considering the underlying strategy of distressed managers and the situations in which they invest.

Liquidity In response to the challenges in 2008, many investors have demanded increased liquidity from their underlying managers. However, we believe it is more prudent to focus on whether hedge fund managers match their assets with their liabilities. When we consider the hedge fund universe, distressed managers tend to have less favorable liquidity terms when compared with other hedge fund strategies. Distressed managers may only offer liquidity on an annual, or less frequent basis, while macro and long/short equity managers are often able to offer monthly or quarterly liquidity. While these differences are material in terms of redemption frequency, we think the stricter liquidity terms are reasonable considering the underlying strategy of distressed managers and the situations in which they invest. Between 1980 and 2010, the average duration of the 907 Chapter 11 filings was 521 days, while the median duration was 401 days.14 In the more recent period of 2008 to 2010, the average and median durations of the 161 Chapter 11 filings have come down, with an average duration of 231 days and a median duration of 219.15 Figure 1.16 provides additional support for the significant number of opportunities in middle market companies versus large cap companies, given the larger number of filings of companies valued below $1 billion in assets in both periods.
Figure 1.16: U.S. Chapter 11 Filings
2008 – 2010
Number of Chapter 11 Filings Average Duration (in days) Median Duration (in days) Number of Chapter 11 Filings

1980 – 2010
Average Duration (in days) Median Duration (in days)

Asset Size

Greater than $10 Billion $1 – 10 Billion $500 million – $1 Billion less than $500 million Total

19 60 42 40 161

354 266 184 198 231

235 282 136 181 219

50 317 234 306 907

644 590 450 488 521

553 457 323 378 401

source: uclA school of law – lopucki Bankruptcy research database.

14

uclA school of law – lopucki Bankruptcy research database. the uclA school of law’s Bankruptcy research database contains data on all large, public company bankruptcy cases filed in the united states Bankruptcy courts from october 1, 1979, to the most recent update of the database. A case is “large” if the debtor reported assets of more than $100 million (measured in 1980 dollars) on the last form 10-K that the debtor filed with the securities and exchange commission before filing the bankruptcy case. A company is “public” if the company filed a form 10-K with the securities and exchange commission in the three years prior to bankruptcy. A “case” includes all cases filed by or against members of the 10-K-filing company’s corporate group provided that those cases are consolidated by the bankruptcy court for the purpose of administration. thus, a single “case” for the purpose of the WebBrd may be reported by the Administrative office of the u.s. courts as dozens or hundreds of cases. uclA school of law – lopucki Bankruptcy research database.

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15

To illustrate how a fund is involved in a more recent deal, we have provided a timeline and trading strategy for Delphi below. Restructurings are time consuming and more successful managers tend to match the duration of their underlying assets with the terms they offer their investors.
Figure 1.17: Delphi Bankruptcy Timeline

Delphi’s board approves an offer to split the company between GM and its lenders. Under the modified plan, GM will pay a little more than $3 billion totake back select U.S. plants and operations, including $1.75 billion to receive 35% of the new equity of the company. The DIP lenders will receive cash and 65% of the new equity of the company in exchange for forgiving their current debt.

July 2009:

Delphi files for Chapter 11 Bankruptcy Protection. At the time of filing, Delphi obtains a DIP loan to fund operations through the restructuring process.

October 2005:

Delphi obtains court approval to extend the maturity of the DIP loan to June 30, 2009.

December 2008:

November 2009:
Delphi stock trading in the OTC market at $8,350 per share.

2005

2006

2007

2008

2009 June 2009:

2010

Maturity date of the original DIP loan. Unable to pay, Delphi refinances with a new DIP loan scheduled to mature on December 31, 2008.

June 2008:

Plan of reorganization for Delphi is submitted. Under the plan the implied recovery to the DIP lenders is approximately 15 to 20 cents on the dollar. DIP lenders object to the plan and gain approval for a formal sale process of the company to obtain a higher bid.

Early October 2009:

The sale of Delphi is finalized and the company emerges from bankruptcy.

July 2009 – Early October 2009:

October 2005 – June 2008:

Delphi makes various unsuccessful attempts to exit bankruptcy prior to the maturity of the DIP loan.

June 2008 – October 2008:

Fund purchases DIP loan in the secondary market.

Certain DIP lenders, including the Fund, provide a backstop commitment for the new plan. Upon emergence, the Fund receives cash and new equity ($6,200/share at conversion) per the plan of reorganization. As a result of their participation in the backstop, the Fund is able to buy additional equity at a discount (approximately $1,000/share).

November 2009 – September 2010:

Fund scaling out of their position, trading selectively to realize profits.

sources: NB Alternatives analysis, delphi corporation, reuters, Bloomberg, forbes.

16

Unlike the U.S., where investors are accustomed to a “one-size-fitsall” Chapter 11 bankruptcy process, insolvency outside the U.S. is country-specific, with the rights of creditors dictated by individual jurisdictions.

Non-U.S. Distressed Investing In our 2010 Strategy Outlook, we briefly discussed some of the challenges associated with distressed investing outside of the U.S., primarily due to the lack of a standard insolvency regime. Unlike the U.S., where investors are accustomed to a “one-size-fits-all” Chapter 11 bankruptcy process, insolvency outside the U.S. is country-specific, with the rights of creditors dictated by individual jurisdictions. While there have been no material updates in the insolvency practices of individual countries, we have started to see some examples of workarounds for bankruptcies taking place outside of the U.S. The U.K. is probably closest to the U.S. when it comes to insolvency processes, with “administration” typically viewed as the most creditor-friendly process in Europe. Because of this, the management and creditors of European companies, notably cross-border companies with operations in multiple jurisdictions, have started to make strategic decisions about which jurisdiction will be responsible for the insolvency process. For example, in 2009, Wind Hellas, a Greek mobile phone operator, became the largest U.K. pre-pack administration16 after moving its Centre of Main Interests (“COMI”) from Luxembourg to the U.K. to take advantage of the U.K.’s insolvency laws. The COMI principle is important in the context of cross-border restructurings and insolvencies because it determines the appropriate jurisdiction for the insolvency proceedings. European Community (“EC”) Regulation requires that bankruptcy proceedings take place in the COMI, which is typically the location of the company’s registered office. However, it is worth noting that in the Wind Hellas case a judge ruled that the COMI had been changed due to the following actions on the part of Wind Hellas, 1) a new head office and principal operating address had been opened in London, where the company’s board meetings were held and from which correspondence was sent, 2) Wind Hellas had notified its creditors of the change of address, 3) a new bank account was opened in London, 4) Wind Hellas registered as a foreign company and as a U.K. establishment of an overseas company, and 5) all of the negotiations surrounding the pre-pack administration had taken place in London. The judge clarified that the purpose of the COMI was “to enable creditors in particular to know where the company is and where it may deal with the company.”17 As such, the judge deemed it appropriate to allow Wind Hellas to file in the U.K. This practice is growing as companies consider the laws of various jurisdictions, the implications for the efficiency of the administration process, the outcome of the administration and the viability of future operations. U.S. bankruptcies often have less process risk and higher potential preservation of value (particularly in Chapter 11 bankruptcies where reorganization is the explicit aim) when compared with European and Asian processes due to the following factors: 1) the automatic stay, 2) access to “debtor-in-possession” (“DIP”) financing,18 and 3) the retention of existing management. The automatic stay provides a period of time in which the creditors’ right to enforce their claims is suspended. The stay is implemented as soon as a company files for Chapter 11 protection and remains in effect until the termination of the bankruptcy proceedings.19 While European regulations provide limited coordination of European bankruptcy regimes, no single rule exists that provides a worldwide effect similar to Chapter 11’s automatic stay. As previously discussed, European regulations allow for cross-border companies to conduct bankruptcy proceedings within the COMI. However, the rule does not prevent secured creditors or lien holders from enforcing their rights wherever the secured asset may be located.20 Additionally, the rule does not appear to prevent creditors from enforcing claims against subsidiaries or assets located outside the E.U.
16

U.S. bankruptcies often have less process risk and higher potential preservation of value when compared with European and Asian processes.

pre-pack administration is the process of immediately selling a company once it has entered into administration. the specifics of the sale are prearranged before the company enters into administration. hellas telecommunications (luxembourg) ii scA [2009] eWhc 3199 (ch). New debt incurred by a firm during the chapter 11 bankruptcy process. this type of financing typically has priority over existing debt, equity and other claims. http://www.uscourts.gov/federalcourts/bankruptcy/bankruptcybasics/chapter11.aspx. http://www.insolvency.gov.uk/freedomofinformation/technical/technicalmanual/ch37-48/chapter41/part2/part_2. htm#$#41.14#$#41.14.

17 18

19 20

17

A further benefit of the U.S. process is the concept of DIP financing. As discussed in our 2010 Strategy Outlook, DIP financing may be required to preserve the value of the company during bankruptcy and provides fresh capital from new lenders to maintain the company as a going concern. The final advantage is the concept of management remaining in control. In the U.S., it is typical for the debtor to keep possession and control of its assets during reorganization. The appointment or election of a trustee occurs only in a small number of cases.21 Management is expected to act in accordance with their fiduciary duties and can be held personally liable for failing to do so. In most European countries, an external court-appointed administrator is given authority over the management of the business during insolvency. Distressed investing in Asia presents similar challenges with varying insolvency regimes and varying creditor protection, as well as other issues such as a landscape dominated by family-controlled companies and government intervention. Many investors avoid the region altogether and those participating tend to rely on deep relationships in the region to source and to understand opportunities. Each situation must be carefully assessed prior to involvement. Conclusion Given the large volume of debt maturing in the coming years and the relative lack of access to financing for middle market companies, we believe that the distressed opportunity set will continue for a number of years and will remain diverse, both geographically and by size. As distressed investing does not come without risks, particularly when investing abroad, manager selection is critical. Managers with expertise in valuation, risk management and the legal process will be better suited to make sound investment decisions.

We believe that the distressed opportunity set will continue for a number of years and will remain diverse, both geographically and by size.

21

http://www.uscourts.gov/federalcourts/Bankruptcy/BankruptcyBasics/chapter11.aspx.

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chapter 2: rising interest rates and hedge fund performance
Introduction There has recently been a growing interest regarding the potential impact of a period of rising interest rates on hedge fund performance. This interest has undoubtedly been fueled by the current low absolute level of interest rates, coupled with concerns over the potentially inflationary impact of a raft of expansive monetary policy measures. Investors are interested in the potential opportunities and challenges this type of environment creates for hedge funds and, more specifically, how different hedge fund strategies might perform in these conditions. In this section, we consider whether the path of interest rates might be a relevant factor in hedge fund performance and, if so, how interest rates may affect the level and distribution of returns amongst certain strategies. We assess both outperforming and underperforming strategies in periods of rising rates (compared with static or falling interest rate environments) in addition to assessing whether the diversification properties of certain strategies within a portfolio may change in a different rate regime. Empirical Analysis The issue of hedge fund performance in a period of rising rates is particularly intriguing as most measurable hedge fund data relates to a period of long-term declining rates. This fact, in itself, raises interesting questions about the industry’s experience in a different type of interest rate regime. As a result, when looking at the empirical data available to us, we have tried to balance observations with fundamental reasoning about whether the data make sense and whether the complete picture is actually being presented. We analyze data from January 2002 to October 2010 to capture a sufficiently large dataset of managers by strategy and to investigate the possibility of a meaningful relationship between the pattern of interest rates during the period and the performance of different hedge fund strategies. For individual strategy performance, we utilize data from our proprietary hedge fund peer groups, which collate performance data on a large number of different hedge fund strategies over time. Our own investment team (not the manager or a third-party data provider) defines the strategies of hedge funds to ensure that strategy descriptions accurately reflect each hedge fund’s activities and that each peer group consists of comparable data. We use the federal funds rate to look at interest rate patterns, given that the U.S. was the world’s largest economy over the period in question and, just as importantly, the preponderance of performance in mainstream strategies over the period related to activity in the U.S. market. As a first step to assessing rate impact, we split the period January 2002 to October 2010 into two types of “regime,” as can be seen in Figure 2.1. The first regime — representing by far the dominant share of the period in question — is characterized by static or falling federal funds rates (January 2002 to May 2004 and June 2006 to October 2010). The second regime is characterized by a rising federal funds rate, which we categorize as representative of a rising interest rate regime (June 2004 to June 2006).

The issue of hedge fund performance in a period of rising rates is particularly intriguing as most measurable hedge fund data relates to a period of long-term declining rates.

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Figure 2.1: Federal Funds Rate: January 2002 – October 2010
6% 5% Federal Funds Rate 4% 3% 2% 1% 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010

source: Bloomberg.

It should be noted that this type of empirical analysis on its own inevitably results in certain weaknesses. First, the dataset for performance in the rising rates period is relatively short (i.e., 24 data points). Second, the numbers on their own overlook the reason for rate regimes. Clearly, if rates were hiked aggressively as an emergency reaction to an inflationary shock, this would be a different environment than one characterized by relatively steady growth and a gradual increase of rates. Similarly, the rate cuts in 2008 differ extensively from the constant rate observed from June 2006 to June 2007 (discussed in more detail below). Finally, regimes defined using the federal funds rate mean that rate changes are captured as they happen rather than as expectations change (i.e., changes in market yields). We do, however, take a cursory look at 1-Year Treasury prices, which incorporate expectations. Nonetheless, the data is sufficient to warrant preliminary investigation. As always, the indicative data need to be accompanied by rational observations in order to establish whether any numerical patterns identified are supported by fundamental expectations. Level of Returns After splitting the time period by interest rate environment, we study the performance of a variety of hedge fund strategies in each period. The contrast in the two periods is evident in Figure 2.2, which illustrates the excess performance of each strategy in the rising rate regime over the static or falling rate regime. A positive number conveys excess performance in the period of rising rates relative to the static or falling, while a negative number reflects underperformance.
Figure 2.2: Strategy Outperformance/Underperformance During Periods of Rising Rates
12% 10% 8% 6% 4%
6

2% 0% -2%
Distressed Quant EMN Event-Driven Merger Arb Stat Arb Fundamental EMN Macro Credit Arb Fixed Income Arb Commodities LT CTA Convert Arb LS MC

5

-4%

4

3 source: NB Alternatives peer Groups.

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2

1

A multitude of factors other than just interest rates impact hedge fund performance.

Obviously, a multitude of factors other than just interest rates impact hedge fund performance through the period and we need to account for this in our analysis. As such, we can quickly eliminate some of the results from further discussion. For example, some strategies are significantly impacted by their market exposure in 2008. For example, Multi-Cap Equity Long/Short strategies in particular tend to exhibit a long equity bias and suffered significantly in the financial crisis of 2008. When we eliminate 2008 from the analysis, outperformance drops to less than 1%, so the “factor” driver here is primarily stock market beta (albeit recognizing that equities and rates are not entirely unrelated). Broad event-driven strategies also often exhibit strong market bias. When we eliminate 2008 from the analysis, relative outperformance in the rising rates period actually turns slightly negative. However, certain other strategies and characteristics are more persistent and are worth assessing in more detail.
Distressed

We found the data for distressed somewhat ambiguous. Although the data indicate a strong outperformance for the rising rate period, a portion of the 2004 – 2006 gains actually stems from the ongoing work-out of debt which had defaulted in 2002. Therefore, we cannot assume a straight causal relationship. From a distressed debt perspective, it should be noted that rising interest rates increase the burden of interest cost for companies and restrict the supply of credit. Importantly, bank loans are generally floating rate and adjust quickly to rate changes, which means that interest coverage ratios for companies with loans rapidly deteriorate when rates rise, increasing the likelihood for bankruptcy. Similarly, the cost of new issuance for both loans and bonds in the primary market increases with rising rates, as debt will be priced according to an interest rate spread, making refinancing more expensive for companies. These factors are likely to create an increased supply of distressed debt, should rates increase, offering greater opportunity for investors. We acknowledge the lag that typically exists between rising rates and a spike in defaults. For example, the 2-Year Treasury yield peaked at 14.7% in February 1980 during the last period of very significant rate rises (1976 – 1980). However, corporate defaults continued to escalate through the early-to mid-1980s as rates fell. While rising rates can contribute to a default cycle, monetary policy is likely to ease once the problems start; therefore, actual defaults may peak during a period of falling rates, until the effect of the monetary policy is achieved. Additionally, returns for distressed investors are often enhanced by rates falling as the increased liquidity can facilitate easier exits from bankruptcy. This poses a counterargument to outperformance. Concurrently, other aspects of rising rates support distressed credit performance. For example, if rising rates restrict credit, hedge funds face less competition as other lenders pull in their balance sheets, boosting returns for activities such as DIP financing or bridge lending. Meanwhile, if distressed funds make floating loans, the absolute return increases as they benefit from the rate rises (absent default). We believe there is some fundamental rationale to the assumption that rising rates may increase the opportunity set for distressed debt funds. We find this particularly relevant today, with $875 billion of U.S. leveraged loans and high yield debt scheduled to be refinanced between 2011 and 2014, over 50% of which is floating rate debt.
Commodities

As inflationary concerns creep into investor psychology, activity within commodities naturally tends to increase, creating opportunity for commodity hedge funds .

The Commodities strategy bucket consists of a mixture of relative value and more directional commodities traders (distinct from CTAs, which we discuss separately below). Again, we highlight that rates clearly are not the only factor that drive commodity strategy returns. We also note that the underlying data is skewed somewhat by the volatile nature of the directional commodity strategy returns, and likely overstates the case for outperformance, albeit it remains positive. Broad market interest in commodities is being driven, in part, by the following: concerns that monetary policy will drive inflation longer term, potential long-term weakening of the U.S. dollar and demand from China. As inflationary concerns creep into investor psychology, activity within commodities naturally tends to increase, creating opportunity for commodity hedge funds — particularly as the investor composition and diverse investor make-up creates inefficiencies and volatility. For example, passive index money, as well as speculative capital,

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from those trying to create “inflation-hedges” has created inefficiencies in supply and demand across commodity curves, generally distorting price action. The difficult question is how much of this happens while rates are already low versus once rates rise? If we enter into a period of rising rates, active investors in the space may initially be more concerned about inflation risk, which might exacerbate volatility and opportunities for commodity hedge funds. However, if rising rates effectively mitigate inflation and commodity prices fall, speculators on the long side could be caught out and dynamics could change for the worse — after all, it is always easier for traders to make money in any given asset class in a bull market, rather than in a bear market. Therefore, rate rises are potentially a double-edged sword. We also have to accept some “regime shift” in commodity strategy performance. Chinese demand has increasingly become the pull factor on commodity pricing. This is not independent of the U.S., as Chinese monetary policy is linked to that of the U.S. through currency management. It appears that the Chinese government’s reluctance to allow meaningful currency appreciation is a tacit acknowledgement that domestic demand is not yet strong enough to counterbalance a drop in export competitiveness. However, while China can use other forms of policy to manage the economy, such as lending quotas or property taxes, this can also be a major component on the demand side, which could act in a similar way to rate rises on the other side of the world.
Merger Arbitrage

Merger arbitrage strongly outperforms in the rising rate environment.

Merger arbitrage also strongly outperforms in the rising rate environment, regardless of activity in 2008. More than any other strategy, the relationship between interest rates and performance is traceable by studying the path of rates and strategy performance (see Figure 2.3 for 1-Year Treasuries versus our merger arbitrage peer group performance).
Figure 2.3: The Link between Merger Arbitrage Performance and Interest Rates
7% 6% 5% 4% 10% 3% 2% 1% 0% 5% 0% -5% -10% Merger Arb Rolling 12-Month Returns One-Year Rate 30% 25% 20% 15%

1999

2001

2003

2005

2007

2009

sources: Bloomberg, NB Alternatives peer Groups.

Plain vanilla merger arbitrage seeks to profit from monetizing the spread between target and acquirer. As with any relative value strategy, as rates increase, absolute returns and short rebates should also increase. This results in higher performance, albeit not necessarily on a risk-adjusted basis. The more recent divergence, where merger arbitrage returns have improved despite flat rates, may be attributable to a lower level of competition from hedge funds and proprietary trading desks following the financial crisis. However, over a longer period of time, interest rates and merger arbitrage returns do seem closely linked, so are there other factors linking the two?

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Intuitively, an increased cost of funding for debt-financed deals in a rising rate period might be thought to lead to a slowing in deal flow. However, the relationship between deal volumes and the federal funds rate between January 1998 and October 2010 actually demonstrates a modest positive relationship over time — higher rates have meant slightly higher deal flow. While this does not necessarily imply that rising rates will always result in higher deal flow, it suggests that higher rates do not automatically lead to a reduction in corporate mergers and acquisitions (“M&A”) and that volumes can still increase. Further, though greater volumes do not necessarily equate better spreads, a statistically significant relationship exists between merger arbitrage strategy performance and the levels of mergers over time, suggesting that higher volume does, in fact, create more profitable opportunities, or, at the very least, the ability to be more selective in terms of deal selection. If the ratio of hedge fund capital relative to deal volume declines (due to an increase in deals), there is proportionately less money to soak up spreads. Another factor at play relates to lower break rates. The thesis here is that corporate management is likely to exercise more discipline on M&A strategy in a rising rate environment when arranging financing and using valuable cash. As a result, management may be more committed to deals that they sign up to in a rising rate environment than in a period of “easier” money. Consistent with this, it is noteworthy that the break rate for deals in the rising rate period was 3.3%, compared with 4.2% in the static or falling period. Therefore, on balance, there is a case that healthy deal flow volumes and lower break rates could benefit merger arbitrage managers in a rising interest rate environment.
Quantitative Equity Market Neutral

Quantitative Equity Market Neutral manager outperformance remains high even when we exclude 2008 from our analysis. Our findings were mixed when we considered whether some basic factor models such as value, quality or earnings revision work better in a rising rate environment. In fact, a Fama-French analysis spanning over 40 years showed that high price-tobook stocks have actually outperformed low price-to-book stocks during periods of higher rates. This is contrary to what might be expected of outperforming quantitative managers, who often buy low price-to-book stocks and short their higher-priced peers. More intuitively, a “quality” factor analyzing balance sheet strength and, in particular, company debt levels might be expected to perform well during rising rate periods, as more indebted companies begin to run into problems. It could also be argued that increased rates may create higher levels of stock dispersion, which benefits the fundamental factors selected by quantitative investment programs. Consequently, while there may be a marginal case for quantitative equity market neutral outperformance during a period of rising rates, we do not see sufficient fundamental reasons to make the premise compelling.
Convertible Bond Arbitrage

Rising rates can create difficulties for any strategy entailing a long portfolio of assets that requires interest rate hedging because being under hedged becomes a cost rather than a benefit.

In contrast, Figure 2.2 suggests that convertible bond arbitrageurs struggle when rates rise. We agree with this for several reasons: 1) the cost of leverage may increase disproportionately, decreasing the profitability of arbitrage trades and increasing portfolio risk, 2) a crowded unwind is more likely — while periods of low rates may encourage investors to crowd into trades, these same investors risk being shaken out as rates increase and the cost of funding grows, causing exacerbated unwinds and related losses, and 3) increased interest rate risk (convertible bond managers may hedge their interest rate risk or swap it out, but if part of the portfolio is left unhedged, losses may result as rates rise and fixed coupon bonds lose value). In point of fact, the problem does not necessarily disappear even when interest rates are “fully” hedged because mark-to-market basis risk (between the interest rate hedge and the actual movement of the bond) may still exist in a theoretically hedged portfolio. In addition to convertible bond managers, credit arbitrage managers have also been impacted in the past — particularly at the investment grade level. Corporate bond prices do not always behave exactly as their modeled duration sensitivity would suggest during periods of interest rate volatility, creating mark-tomarket risk. Even if the manager asset swaps bonds, the availability and price of the asset swap market may become challenging as rates rise. Therefore, rising rates can create difficulties for any strategy entailing a long portfolio of assets that requires interest rate hedging because being under hedged becomes a cost rather than a benefit.
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Long-Term Commodity Trading Advisors (“Long-Term CTA”)

For these CTA strategies, the underperformance gives rise to some very relevant questions regarding the changing distribution of returns and the function of these strategies in a portfolio, discussed in more detail below.
Distribution of Returns

Do certain strategies become more or less diversifying in a period of rising rates than in a period of static or falling rates?

While the analysis so far provides insight into how various strategies have fared on an absolute basis in different interest rate regimes, hedge fund investors are also interested in the distribution of returns and, particularly, in the correlation and beta of performance to various market factors and to broad hedge fund performance. Clearly, many hedge fund strategies aim to diversify investors — beyond equity risk, interest rate risk or even hedge fund risk — in order to provide “uncorrelated returns.” As such, another way of analyzing the impact of interest rates on hedge fund performance is to consider potential changes in the distribution of returns in different regimes. Specifically, might certain strategies become more or less diversifying in a period of rising rates than in a period of static or falling rates? This is particularly relevant given that most hedge fund returns have largely been generated during a strong bull market for bonds, notwithstanding the period of rising rates identified in this section. If expectations of performance patterns are too backward-looking or entrenched in a regime not representative of the future, this could lead to surprises in the way that strategies and portfolios behave going forward. Figure 2.4 shows the betas of different hedge fund strategies of the S&P 500, the Barclays Global Aggregate and the HFRX Absolute Return Indices in the two different rate regimes.
Figure 2.4: Strategy Betas across Rising and Static/Falling Rate Regimes
Static or Falling
S&P 500 Barclays Agg HFRX Absolute Return S&P 500

Rising
Barclays Agg HFRX Absolute Return S&P 500

Difference
Barclays Agg HFRX Absolute Return

macro event-driven Quant emN lt ctA commodities stat Arb ls mc credit Arb distressed fixed income Arb merger Arb convert Arb fundamental emN

0.10 0.33 -0.02 -0.14 0.12 0.06 0.42 0.25 0.27 0.10 0.14 0.28 0.05

0.33 0.06 -0.02 0.37 0.86 0.21 0.00 0.01 0.03 0.22 0.13 0.55 0.03

0.63 1.26 0.37 0.06 1.18 0.13 1.34 1.25 1.42 0.50 0.47 1.44 0.38

0.52 0.53 0.06 0.59 0.32 0.00 0.70 0.13 0.27 0.07 0.29 0.14 0.17

-0.56 -0.43 -0.25 -0.50 -0.32 -0.11 -0.50 -0.20 -0.35 -0.33 -0.21 -0.42 -0.15

1.31 1.38 0.34 1.40 1.30 -0.01 1.28 0.54 0.85 0.25 0.75 0.88 0.44

0.42 0.20 0.08 0.73 0.20 -0.05 0.28 -0.12 0.00 -0.03 0.16 -0.14 0.11

-0.89 -0.49 -0.23 -0.87 -1.18 -0.32 -0.50 -0.21 -0.38 -0.55 -0.34 -0.97 -0.18

0.69 0.12 -0.03 1.34 0.12 -0.14 -0.06 -0.71 -0.58 -0.25 0.28 -0.56 0.06

source: NB Alternatives peer Groups.

The statistics for the Long-Term CTA strategies are noticeable. In the period where rates were flat or falling, beta to equities was -0.14; this jumps to +0.59 in the rising rate period. Beta to bonds (Barclays Aggregate) drops sharply from slightly positive to -0.5. Here, a strong rationale supports the outcome — CTAs aim to catch trends. Therefore, if rates trend lower, CTAs are likely buyers of bonds (they also may often be sellers of equities if bond buying comes at the expense of equity investments). If rates trend higher, they are more likely to be short bonds. Given that we have been in a long-term bull market for bonds, with rates essentially trending lower over 20 years, CTAs have tended to be long bonds (and often short equities) much more than the reverse. As a result, over the years, CTA strategies have gained a reputation as being

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effective “portfolio diversifiers” because, in contrast to risky assets such as equities, credit, real estate or many other hedge fund strategies, they have been profitable when bonds have rallied and equities have fallen. Although these funds may trade numerous asset classes and so have diversified portfolios, this does raise a potential issue. Rates are currently very low, with little room in most major economies for further decreases; thus the profitability for a long bond trade may be capped. However, if rates rise, Long-Term CTAs will likely try to capture the trend by positioning short bonds. A portfolio with a short bond bias clearly does not offer the same diversification against risky assets as a portfolio that is long bonds. Therefore, if Long-Term CTAs can no longer leverage a long-term bull market for bonds, the distribution of their returns relative to other asset classes is likely to change. In fact, if rates are rising and they short bonds, they are more likely to be correlated to risky assets. Additionally, as the data suggests, the correlation to other hedge fund strategies could increase substantially in a period of rising rates (Figure 2.4 shows a beta of 1.4 to HFRX Absolute Return Index in a rising rate regime compared with near zero in a flat or falling rate regime). This does not mean that Long-Term CTAs cannot be profitable in a rising rate environment (although they exhibit some underperformance in Figure 2.2), rather that investors who have invested in Long-Term CTA strategies with the expectation of being “long volatility” and diversifying away from risky assets could be surprised by the way their portfolio behaves if rates start to rise. We would note, however, that shorter-term CTA managers may be better positioned to continue to diversify returns, as a result of the significantly higher turnover of their portfolios and their ability to catch much more momentary or shorter-term price trends in the market. Global Macro Global Macro strategies are very diverse and difficult to categorize with a single comment. However, certain Global Macro managers could be seen to possess similar attributes to the Long-Term CTA Peer Group discussed above. Figure 2.4 supports this, showing a much more positive relationship to equities and a negative relationship to bonds in a rising rate environment. We note that many successful macro players have also benefited from a long bond trade over time and seek to capture asset class trends, albeit in a more discretionary rather than model-driven manner. These strategies have also seen positive flows post-crisis, as many investors have taken the view that Global Macro allocations will consistently offer diversification in challenging market environments. However, the variable nature of Global Macro exposures means that they will not necessarily diversify investors away from risky assets on a consistent basis and, in particular, it may be much harder for them to do so in a period of rising rates. Conclusion Most hedge fund strategies have little measurable trading data during prolonged periods of interest rate rises. The available evidence, combined with fundamental reasoning, suggests that the opportunity set for distressed debt, merger arbitrage and commodity relative value/ directional trading could benefit from rising rates. In such cases, the opportunity is somewhat dependent on the path and the efficacy of rate rises. In the case of commodities especially, this could be hand-in-hand with an increase in risk profile. Leveraged strategies may struggle; and investors should be more cognizant of unwind risk and also of how interest rate risk is being hedged in the convertible bond arbitrage and credit trading strategy areas. However, one of the more interesting effects of rising interest rates might be a change in the distribution profile of Long-Term CTA strategy returns. The same could be said of Global Macro strategies, although the dispersion of this universe is very wide and more difficult to generalize. If rates were to trend upwards for a period of time, it is plausible that Long-Term CTAs in particular might cease to exhibit the “long volatility” profile that has made the strategy popular with investors and thus may become increasingly correlated to a broader universe of risky assets. This could affect how a Long-Term CTA allocation might fit within a broader portfolio of hedge fund strategies. It should be noted that this analysis refers to broad strategy groups and clearly the distinct positioning of individual managers for differing environments will be a key determinant in their success or failure.
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The available evidence, combined with fundamental reasoning, suggests that the opportunity set for distressed debt, merger arbitrage and commodity relative value/directional trading could benefit from rising rates.

chapter 3: Asset-Backed securities and the factors influencing the opportunity set
Introduction Mortgage-backed securities are bonds whose cash flows are secured by a collection of underlying mortgage loans. The underlying mortgage payments are then used to pay both interest and principal on the bonds. Other asset-backed securities (“ABS”) may be collateralized by pools of other asset types, including commercial real estate, credit card receivables and student or auto loans through a process known as securitization. Typically, structured asset-backed securities are split into different tranches, with each containing its own cash flow and risk characteristics. Both principal and interest repayments as well as losses are allocated amongst these tranches based on seniority. Most asset-backed issues assume a three-tiered approach of junior, mezzanine and senior tranches. This process aims to bring liquidity to the otherwise illiquid assets. Pooling individual mortgages or assets together into structural securities turns them into a tradable security available to a wider range of investors. An increasing number of hedge funds started to invest in the mortgageand asset-backed space beginning in 2002. Several high profile hedge fund blow-ups propelled the asset class into the headlines in 2008. That same year, 36 hedge funds with portfolios of residential mortgages and other asset-backed securities went out of business, primarily due to the magnifying effects of leverage.22 In addition, many funds realized large losses as a result of significant redemptions in a period of increased illiquidity in the markets. Simultaneously, the U.S. housing market suffered a severe downturn, the origins of which may be traced back to the low interest rate environment between 2002 and 2006. During that time period, financial institutions made loans to increasingly risky subprime and Alt-A borrowers. Starting in mid-2007, U.S. real estate prices fell, resulting in an increase in delinquencies. By December 2009, over 50% of all subprime mortgages issued between 2005 and 2007 were 60+ days delinquent.23 The deterioration of mortgage fundamentals resulted in massive spread widening across all sectors in the asset-backed universe, and the substantial unwinding of leverage added to these pressures. By late 2008, many types of residential mortgage-backed securities (“RMBS”), previously regarded as relatively risk-free, were trading at distressed prices in an environment with minimal liquidity. Uncertainty surrounding future government policy and intervention in the housing market is likely to create additional volatility in the mortgage-backed market. The housing market stabilized in 2009 and 2010, partially assisted by U.S. government intervention. A broad rally in asset-backed securities followed; however, $3.1 trillion of outstanding mortgage balances are still delinquent or underwater,24 meaning that defaults may continue to occur while real estate prices continue to fall. Uncertainty surrounding future government policy and intervention in the housing market is likely to create additional volatility in the mortgage-backed market. The landscape of both the mortgage-backed securities market and the broader asset-backed market has changed significantly in recent years. We will examine whether these dislocations can be successfully exploited by hedge funds in the pursuit of attractive risk-adjusted returns. Mortgage-Backed Market Structure As previously stated, residential mortgage-backed securities are debt obligations that represent claims to the cash flows from pools of residential mortgage loans. They are purchased from mortgage companies and banks and then grouped together. Buyers have a claim to the principal and interest payments made by the underlying borrowers of the loans in the pool. The U.S. residential mortgage market currently stands at $11 trillion and is the second largest investable asset class (see Figure 3.1).25
22 23 24 25

hedgefund.net. Bank of America merrill lynch structured products research department. Amherst securities. http://www.federalreserve.gov/.

26

Figure 3.1: U.S. Market Value by Asset Class
($ Trillion) 18 16 14 12 10 8 6 4 2 0 U.S. Equities Residential Mortgages Treasury Securities Corporate Debt

Market source: http://www.federalreserve.gov/.

Broadly speaking, the universe can be split into agency and non-agency. Governmentsponsored enterprises (“GSEs”) Ginnie Mae (“GNMA”), Fannie Mae (“FNMA”) and Freddie Mac (“FHLMC”) issue agency mortgage-backed securities. GNMA is fully backed by the federal government while the others have only implicit backing. Until 2005, these entities were responsible for the majority of new issues. Private institutions such as brokerage firms, home builders and banks are also able to securitize mortgages, or private-label mortgage securities and, by 2006, these accounted for over half of the total primary market at over $1.1 trillion of new issuance. Without government guarantees, investors of these securities rely on credit rating agencies to assign a level of risk to their investment. The role of the ratings agencies during the financial crisis of 2008 was controversial; many AAA-rated mortgages were downgraded. Standard and Poor’s downgraded the credit ratings on $1.9 trillion of mortgagebacked securities between Q3 2007 and Q2 2008, many as a result of a potentially questionable initial rating. The non-agency market is broken down in Figure 3.2.

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Figure 3.2: Factors Influencing the Non-Agency Market
Less Risky Cash Flows

Jumbo Prime

Perceived Risk

Alt-A

Pay Option ARM Front pay Subprime Second pay Last cash flow

More Risky source: NB Alternatives analysis.

Losses

These mortgages may be fixed rate, floating rate or adjustable rate, based on a set of predetermined triggers or variables. Mortgage-backed securities can also exist as principalonly strips, which are issued at a considerable discount to par. The cash flows increase as the principal component of the mortgage payments grow. Conversely, cash flows for interest-only strips start high and decline over time. The complex nature of the mortgage market means that the different underlying securities are impacted by different external factors, which we consider later in this analysis. The cash flows for these pass-through pools of securities depend on their position in the capital structure and the security type (i.e., interest-only or principal-only). Interest and principal payments are allocated on a top-down basis while losses are allocated starting from the bottom of the capital structure. The largest risk associated with monthly cash flows is prepayment risk. The right to prepay before final maturity is embedded in mortgages. When payments are made early, interest payments cease on that portion of the principal, reducing the cash flow of the bond. Prepayments can be affected by interest rates; when rates are low, prepayments increase as borrowers are more likely to refinance. Defaults of the underlying loans also influence the cash flows and weighted average life of the paper. Mortgage-backed securities can trade at levels where they are attractive based on yield alone, on price upside or some combination of the two. Mortgage-backed securities can trade at levels where they are attractive based on yield alone, on price upside or some combination of the two. In addition to owning a security on an outright long basis, funds often pursue other trades which are more relative value in nature, including 1) spread and duration plays where investors believe they will ultimately receive principal or interest back over a time period that is shorter or longer than currently priced in, 2) capital structure trades which look to benefit from structural differences between the different tranches and their related cash flows and, 3) whole loan strategies, which involve the purchase of individual mortgages rather than the bonds (i.e., the buyer acts as both the mortgage lender and servicer). Loan servicing, or collecting payments and managing foreclosures, is operationally intensive and costly and, therefore, experience in servicing can be considered a competitive advantage.

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The purchase of whole loans allows for more control and an informational edge; however, the resource intensive nature, reduced liquidity, and added expense of loan servicing can be a drawback. The majority of hedge funds focus either exclusively or primarily on the RMBS space. We focus our analysis in this area, and further narrow it by focusing on the U.S. market (the largest for RMBS), although we believe that opportunities also exist in Europe and to a lesser extent in Asia. Supply and Demand We examine the supply and demand imbalances in order to gauge the RMBS opportunity set. In terms of supply, 2008 – 2010 has been a period of reduced new issuance, particularly in the non-agency space.
Figure 3.3: The Pattern of New Issuance
($bn) 1,200 1,000 800 600 400 200 0 2004 2005 2006 2007 2008 2009 2010 Agency Mortgage-Backed Securities

($bn) 1,200 1,000 800 600 400 200 0 2004 source: Barclays capital.

Non-Agency Mortgage-Backed Securities

2005

2006

2007

2008

2009

2010

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Once origination returns to the non-agency space, underwriting quality should be stronger than pre-2008, providing a stable backdrop for future growth of the asset class.

According to LoanPerformance, so far in 2010, $157 billion of non-agency residential mortgage backed securities have been paid off either through default or prepayment. Coupled with the lack of new issuance this means the asset class is contracting. Further, the supply outstanding has declined from $2 trillion to $1.5 trillion in the last two years.26 Through October 2010, only one non-agency deal of any material size has been issued. In April, Redwood Trust issued $237 million of bonds backed by home mortgage loans through Citigroup. Although this indicates a recovery in the new issue market, tougher mortgage origination standards, conservative rating agencies, muted home sales and refinancing means that new issuance is likely to remain subdued in the near term. On the positive side, once origination returns to the non-agency space, underwriting quality should be stronger than pre-2008, providing a stable backdrop for future growth of the asset class. On the demand side, agencies such as FNMA and FHLMC, as well as collateralized debt obligations (“CDOs”) and structured investment vehicles (“SIVs”), comprised a significant percentage of the buyers market prior to 2008. FNMA and FHLMC are no longer alpha seekers while CDOs are net sellers of mortgage securities. This phenomenon, coupled with the exit of proprietary desks and many hedge funds, leaves long-only funds and select hedge funds, banks and insurance companies as the remaining players. This has created opportunities for the sophisticated and experienced investor to seek value. However, the U.S. Treasury’s Public Private Investment Program (“PPIP”) has recently increased demand by bringing nearly $16 billion of purchasing power to the market as well as $14 billion of dry powder to inject into the markets. Many participants have recently returned to the space as the housing market appeared to stabilize. This has helped create positive supply and demand dynamics, which appear to be driving up prices of mortgage-backed securities. Should forced selling reoccur, this balance could be upset, though many believe the government would intervene to ensure a measured supply of distressed inventory. Thus, we believe that the market is currently in a state where sufficient demand exists to drive asset-backed prices higher, yet remains sufficiently uncrowded for skilled investors to exploit mispricings that have resulted from market dislocations. Liquidity within the Mortgage-Backed Securities Market In addition to supply and demand dynamics, liquidity is also an important consideration, given that illiquidity was a major contributor to the universe’s difficulties in 2008. Managers have been quick to highlight the improved liquidity of the underlying asset-backed markets, particularly in the residential space. In March 2009, we witnessed no bids for RMBS whereas we are now seeing 10 – 20 bids per issue. However, inadequate transparency with respect to pricing allows investors to exploit the wide divergence in bid/offers on the same security. One manager estimates that the weekly trading volume of the total residential market currently is approximately $5 – 10 billion. As previously discussed, banks, regional dealers, hedge funds and large CDO liquidations are suppliers. In the non-agency market, weekly volumes have remained fairly consistent throughout 2010, averaging $1.5 billion and peaking at $3 billion.27 We believe that the forced unloading of the asset-backed securities remaining on the balance sheets of financial institutions or other significant news events pose a risk to the market and could potentially cause volumes to spike. High volumes are synonymous with price weakness in the market. One manager we spoke with highlighted that in the last 15 months, prices have fallen sharply on the four occasions when the non-agency market traded in excess of $3 billion per week. An example of this scenario was news of loan repurchases and foreclosures in October. Although market liquidity has improved, RMBS remains a comparatively illiquid asset class. We believe that matching assets and liabilities is crucial for hedge funds. We tend to favor funds with an initial lock-up period to create a stable capital base and to reduce the pressures of potential forced selling.

We believe that the market is currently in a state where sufficient demand exists to drive asset-backed prices higher, yet remains sufficiently uncrowded for skilled investors to exploit mispricings that have resulted from market dislocations.

26 27

http://www.loanperformance.com. NB Alternatives manager meetings with managers who invest in ABs space.

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Sources of Opportunity The collapse of the U.S. housing market was partially responsible for the mortgage-backed securities sell-off in 2008. As Figure 3.4 illustrates, the S&P Case-Shiller home price index peaked in mid-2006 before falling 30% in mid-2008. During this period, quarterly foreclosures rose from 300,000 in 2006 to over 900,000 in 2010. It is estimated that 31% of mortgages are currently underwater compared with 5% in 2006; this negative equity has exerted knock-on effects on home sales and refinancing activity.28
Figure 3.4: Case-Shiller Composite 20 Index
250

200

150

100

50

0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

source: standard & poor’s.

In most instances, managers have built up conservative assumptions into their scenario analyses, so only an outsized decline in house prices would materially impact returns.

In Figure 3.4, we see the stabilization of home prices coincided with a decline in 30-day delinquencies. That said, the overhang of unsold homes makes it difficult to envision any near-term house appreciation, particularly given higher down payment, FICO score requirements and generally stricter underwriting practices. Therefore, we believe that managers need to structure RMBS deals to withstand declines in home prices and additional mortgage foreclosures. In most instances, managers have built up conservative assumptions (i.e., fairly large declines) into their scenario analyses, so only an outsized decline in house prices would materially impact returns. Forced selling and weak fundamentals in 2008 led to new lows in asset-backed securities prices, as shown by the 07-02 and 06-01 ABX indexes29 in Figures 3.5 and 3.6. The forced selling has, for the most part, passed as banks continue to stabilize. This improvement, along with increased liquidity, improved supply and demand dynamics, and a more positive macroeconomic outlook resulted in a strong rally in the asset-backed space through 2009 and 2010.

28 29

realtytrac. the ABX.he is a subprime mortgage-backed credit derivatives index. four series were issued at six monthly intervals from the beginning of 2006 and each comprises of 20 subprime underlying transactions issued during these periods. 250

31
200

Figure 3.5: ABX.HE.07-02
105 95 85 75 65
Price

BBBB A AA AAA

55 45 35 25 15 5 -5 Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

source: Barclays capital.

Figure 3.6: ABX.HE.06-01
105 95 85 75 65
Price

55 45 35 25 15 BBBBB A AA AAA Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

5 -5 Jan-06

source: Barclays capital.

Despite the strong recovery, particularly in the AAA tranches, prices remain far from historical highs. In addition, uncertainties surrounding government policies and changing supply and demand dynamics will likely result in volatility and price instability in this market. In early 2009, it was possible to purchase senior prime and Alt-A securities with a 15 – 20% yield. Following the rally in 2009 and, to date in 2010, yields have tightened to 5 –10% (see Figure 3.7). An indiscriminate buy-and-hold strategy is no longer sufficient as the beta rally has subsided. Investors can look to lower credit-quality securities where yields remain higher, purchase seasoned securities still trading at distressed levels (and where fundamental analysis reveals that they are undervalued), or employ financial leverage. We believe that attractive returns may still be available in some select securities such as subprime AAA Mezzanine, Alt-A and Option adjustable-rate mortgage and the riskier interestonly strips (see Figure 3.7). Non-agency yields are higher than their corporate equivalents

105 95 85 75 65 55 45

32

35 25 15

despite the strong rebound in prices. Generally, the complexity and dislocation of the market means that managers may still be able to isolate pools of collateral that remain undervalued by the market and that trade at discounts, thereby allowing returns to be generated from both cash flows and potential realized price appreciation.
Figure 3.7: Unlevered Yields in Residential Mortgage-Backed Securities
Agency
Jumbo ssNrs Alt-A ssNrs re-remic ssNrs 7 – 8% 10% 5 – 6%

Non-Agency
Jumbo fixed rate Jumbo Adjustable rate Alt-A fixed rate Alt-A Adjustable rate AAA mezzanine second pay subprime seasoned subordinate Bonds super senior pay option Arm option Arm interest-only principal-only inverse interest-only 6 – 7% 5 – 6% 8 – 9% 9 – 10% 20 – 25% 9 – 15% 12 – 15% 12 – 13% 20% 20% 15 – 25%

Successful Loan Put-Back CMBS SD AAA sources: Barclays, NB Alternatives research.

40 – 50% 4 – 7%

Individual Trades Below, we highlight various trade ideas that take advantage of the most significant market dislocations within the mortgage-backed space and, consequently, where we believe the best risk/reward exists. We broadly divide these ideas into two groups: 1) where the fund believes it will ultimately receive principal, but timing is uncertain due to potential volatility of the cash flow, and 2) where the fund anticipates receiving cash flows only before liquidation or loan payment. Prepayments, liquidation timelines and loan modifications will affect duration. Duration contractions and a decrease in defaults and severities are favorable for some instruments and detrimental to others. Figure 3.8 contains a detailed analysis of how various instruments react differently to a medley of market variables. Detailed analysis of the cash flows and their characteristics is crucial. Some funds are structured to distribute pro rata while others are structured to distribute sequentially down the capital structure. The underlying bonds have significantly different dollar prices and durations, enhancing a manager’s ability to build a highly diversified portfolio. • Senior Alt-A Pass-Through: Value is driven by the ultimate recovery of principal. A trade benefits from duration contraction because principal will be recovered earlier. In other words, this trade is essentially a bet that principal will be recovered faster than is priced into the bond. A second built-in assumption is that defaults and loss severities will be lower than anticipated. • AAA Mezzanine: AAA Mezzanine sits lower in the capital structure and is therefore earlier in line to take losses resulting from defaults. The bonds benefit from duration extension as they continue to receive cash flows even as they are unlikely to receive principal. Typically, the mezzanine tranche can tolerate a greater level of government intervention programs and may even perform better with an increase in modifications because, by not seeking to receive principal, they are unaffected if modifications reduce defaults (treated as prepayments in cash flow models).
33

• Super Senior Pay Option Adjustable Rate Mortgages (“ARMs”): These mortgage loans are adjusted periodically based on a fixed set of indices, making ARMs particularly sensitive to interest rate fluctuations. Similar to other mortgages, ARMs have an embedded prepay right; however, prepayments of principal do not shorten the total duration due to the embedded structure. • Interest-Only: These AAA-rated interest-only strips can be either agency or non-agencybacked. They have a short-term life of 2 – 3 years and mirror the AAA tranche. Prepayment risk stems from home sales or refinancing because cash flows cease once the mortgage is paid. These instruments sit at the top of the capital structure and are largely unaffected by defaults. They never look to receive principal, but benefit from delayed foreclosures as servicers continue to advance payments until the liquidation is complete. These strips benefit from slower prepayments due to declining home prices, the continued challenges involved in securing refinancing and stricter mortgage underwriting standards. • Inverse Interest-Only: These instruments pay a fixed rate minus LIBOR on a declining notional principal balance whose rate is determined by the speed of refinancing the loan pool backing the bond. These securities benefit from slower refinancing and prepayment rates. If refinancing remains low (e.g., during a low-interest rate environment) or U.S. home prices decline, these securities could potentially possess higher yields because of their sensitivity to interest rate fluctuations and prepayments. • Principal-Only: These strips are sold at a considerable discount to par. Cash flows start out small and increase over time as the principal component of the mortgage increases. They benefit from higher prepayments such that in a falling rate environment, price appreciation occurs. • Monoline: Monoline-backed securities are a subset of RMBS where the paper has been trading at significant distressed prices since 2008. Examples include wrapped deals issued by Ambac, FGIC, MBIA and XLCA that guaranteed the payment of cash flows and principal. These trades are usually hedged through equity or credit short positions for the monoline insurers with perceived balance sheet weaknesses. Consequently, such strategies require detailed fundamental analysis of the insurers.
Figure 3.8: Sensitivity of Various Tranches to Variables Allow for Diversified Portfolio Construction
Prepayment Rise Interest Rates Rise Weighted Avg Life Rise Loss Severities Rise Defaults Increase Liquidation Speed Increases House Prices Decline

Jumbo fixed rate super senior option Arm senior Alt-A subprime senior mezzanine interest-only inverse interest-only principal-only

Negative Neutral positive positive Negative Negative positive

Neutral Negative positive positive Negative Negative Negative

positive N/A Negative positive positive positive Negative

Neutral Neutral Neutral Negative Neutral Neutral Neutral

Negative Negative Negative Negative Negative Negative Neutral

Negative Neutral positive Negative Negative Negative Neutral

Negative Negative Negative Negative Neutral positive Negative

source: NB Alternatives analysis.

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Nontraditional Strategies “Loan put-backs,” a strategy that has recently gained momentum, involves putting loans back to the mortgage originator at par when representations and/or warranties have been violated. In late October 2010, a consortium of bondholders including Pimco, BlackRock and the New York Federal Reserve, asked Bank of America for a put-back of 115 underlying RMBS worth $47 billion. At that time, Bank of America had repurchased nearly $5 billion of loans as a result of put-back requests. If bondholders can demonstrate that the bond underwriter breached fixed underwriting guidelines, banks and other mortgage originators are required to buy back the nonperforming mortgages at par. These breaches can include factual misrepresentations, such as opening and closing discrepancies in loan-to-values, faulty debt-to-income ratios, and drifting FICO scores. These breaches are particularly prevalent in loans originated between 2005 and 2007, when underwriting standards slipped in the rapidly expanding mortgage market. The ability of the bondholder to source the loan files is a key factor in the success of a loan put-back request. This is notoriously difficult because in order to make a formal request of the trustee, a stated minimum percentage of bondholders must be in agreement. For private labels, this is typically 25 – 50% of the voting rights, necessitating either large ticket sizes by an individual manager or successful collaboration with other investors. More recently, the GSEs have begun to pursue repurchases in the private label space. They often represent up to 75% of the total bonds issued. J.P. Morgan estimates total put-backs will be in the range of $55 – 120 billion, with losses realized over a period of approximately five years. J.P. Morgan estimates total put-backs will be in the range of $55 – 120 billion,30 with losses realized over a period of approximately five years. They assume that agencies and non-agencies will attempt to put back 25% and 40% of loans, respectively, with a success rate of approximately 40% and 20%, respectively. The private market has a wider set of underwriting standards where it is more difficult to prove a breach of terms. Supporting documentation also states that breaches must be settled in a timely manner, which means that currently delinquent mortgages have a greater likelihood of being put-back than foreclosures, although a small number of hedge funds so far have anecdotally had success with both. Access to loan files is the key challenge to put-backs. Even when requests are successfully met, response times can be long and litigation may be required to gain access to the files or to appeal the eventual put-back decision. Consequently, the estimated timeline for these trades is 18 months to three years. As shown in Figure 3.7, the projected yield on successful put-back trades is 50% (based on discussions with hedge funds pursuing this strategy) while unsuccessful trades will be in line with the underlying instruments. The long duration and resource-intensive nature (e.g., legal fees) of the put-back strategy make it difficult for traditional RMBS managers to pursue the opportunity set. The process echoes the restructuring trades that traditional distressed hedge funds implement. The best-suited funds for this type of opportunity are those with sufficient resources to conduct underlying analysis on the securities should the put-back requests fail. The Importance of Collateral and Fundamental Analyses Loan level analysis is the common denominator tying the above trades together. The characteristics of the underlying mortgages and the different vintages of origination can vary dramatically. Detailed collateral analysis can help determine the quality of the mortgage pool, including loan quality (indicated by the loan-to-value ratio), borrower profile (indicated by the FICO score), vintage, geography, loan documentation, debt-to-income ratio and the layered risk of the borrower. Within these factors, assumptions are made about prepayments, modifications, foreclosure rates and loss severities. The manager typically sources this information from LoanPerformance, which collects and collates data on all underlying pools.31 Other fundamentals that may potentially influence cash flows include interest rates,
30

they break this down into $23-$35 billion in agency-wrapped loans, $40-$80 billion in non-agency and $20-$30 billion in second liens. loanperformance is the leader in mortgage finance, servicing, and securitization information and analytics. they created and maintain the industry’s largest and most robust mortgage securities and servicing databases and provide analytical tools that their banking, trading, and securities customers use to understand and manage their loan portfolios.

31

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government programs and foreclosure timelines. Servicer behavior and the wide variance in their efficiency can also influence returns. In a sequential pay structure, securities at the top of the capital structure benefit from faster foreclosure rates, while securities at the bottom of the capital structure benefit from duration extension. Government programs can potentially cause atypical behavior in prepayments and defaults, and their impact must be monitored. Recent reports of ‘robo-signing’32 on foreclosures have frozen foreclosures in several states, resulting in longer timelines and extended foreclosure procedures even when the documentation is correct. Barclays estimates that the delays will be in the range of 3 – 6 months, affecting option ARMs and subprime yields where liquidations comprise 25 – 50% of cash flows. On the other hand, interest-only paper should benefit from this extended timeline by extending the cash flows. Improper documentation and ensuing legal claims would be a larger issue. On the other side of the equation, faster loss cram-downs33 and short sales can decrease the duration of a bond. Government programs can potentially cause atypical behavior in prepayments and defaults, and their impact must be monitored. Finally, we may see an increase in delinquencies due to the imminent wave of resets for ARMs due in late 2010 and into 2011. Limitations and Risks While meaningful opportunities appear to exist in the space, managers have anecdotally referenced the increased difficulty in sourcing some types of paper with the same return characteristics experienced in early 2009. We believe that this is a function of the price rally and the increase in market participants. While this does not decrease the potential for attractive returns in the mortgage-backed securities space, it suggests that the returns in 2009 and 2010 to date are not sustainable in the long run. We believe that the key risk factors threatening the recovery of mortgage-backed securities as a broad asset class include larger-than-anticipated home price declines (managers typically model a 15 – 20% decline assumption), significantly higher than projected defaults and high levels of forced selling by banks. Additionally, increased government intervention in the form of loan modifications and debt forgiveness can pose a risk, as the impact and timing are hard to predict and will affect each tranche differently. The Use of Leverage In hindsight, overreliance on leverage hurt many asset-backed hedge funds in 2008 (e.g., Peloton was utilizing leverage of 4 – 5x).34 Since then, we have seen a significant shift in the use of leverage. Although some strategies have resumed utilizing leverage, they are very much in the minority. The vast majority of asset-backed funds either do not employ leverage or cap it at 1.5 – 2x. Those that do employ leverage tend to be pursuing relative value and basis opportunities, including relative value trading of different maturities between mortgage-backed securities, relative value trades versus the treasury market and opportunistic issuer swaps. These types of returns tend to be only a few basis points, so leverage is required to make the strategy worthwhile from a return standpoint. In January 2010, Reuters reported that Wall Street firms were offering 10-to-1 leverage on certain securities; we have seen funds pursuing these strategies using up to 16x on a notional basis. Although these trades are less risky, they may still be subject to systematic risk and liquidity shocks that would be magnified with leverage. Yields in the last 18 months have generated strong IRRs without the use of leverage. However, if yields continue to fall as the market recovers, an increasing number of managers may resort to employing leverage. We also note that in addition to the use of explicit financial leverage (i.e., borrowed money), some mortgage-backed instruments have implicit leverage. Inverse interest-only strips are particularly sensitive to changes in short-term rates and prepayment. Given that prepayments fall when short-term rates rise, this makes inverse interest-only notes leveraged, even to small

We believe that the key risk factors threatening the recovery of mortgage-backed securities as a broad asset class include larger-than-anticipated home price declines significantly higher than projected defaults and high levels of forced selling by banks.

32 33

robo-signing refers to the practice of automatic document generation. A cram-down refers to the involuntary imposition by a court of a reorganization plan over the objection of one or more creditors. reuters, http://uk.reuters.com/article/iduKNiduKN2859650120080228.

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price movements. A report by Fidelity suggests that interest-only paper may be more than 10x riskier than buying any other mortgage-backed security. For this reason, more conservative managers tend to avoid these instruments. We advise that caution should be exercised when evaluating a manager that has significant exposure to such instruments. Hedging a Portfolio of Residential Mortgage-Backed Securities Managers have cited the challenges involved in constructing a short book in 2009 and 2010, when the rally extended across asset classes regardless of fundamental differentials. Short trades in a portfolio can be separated by alpha generative short positions and portfolio hedges. The latter can be further dissected to include both credit risk (idiosyncratic borrower-dependent) and more general systematic risk. Non-agency RMBS are exposed to a range of external factors, including correlation to broader credit and equity markets, interest rate risk and its impact on prepayment rates, and the risk of loan modifications and government intervention. In order to hedge against the first two risks, managers may use a combination of broad market indices such as the Markit CDX and SPX indices. The risks associated with interest rates and prepayments may be hedged using interest rate swaps or other interest rate derivatives. The impact of government modifications is harder to mitigate, largely due to the idiosyncratic nature of programs such as the Home Affordable Modification Program (“HAMP”) announced in early 2009. Such interventions are difficult to hedge against and can create counterintuitive behavior in the market. Arguably, this is a source of concern in the agency space where government intervention is more likely. With regard to the capital structure, the impact tends to be nonlinear because duration extensions and contractions and changes to the principal balance do not impact all tranches equally. Buying other bonds in the capital structure or exposure to bonds that act differently to changes in variables such as prepayments may partially offset the risks. Being different from other RMBS, interest-only and inverse interest-only paper is most commonly used for this purpose. The ABX is the most common index utilized to hedge in the RMBS space. The ABX was launched in January 2006 and is a subprime mortgage-backed credit derivative index. The index was launched with four different series, each comprising 30 underlying subprime transactions. A subset of the ABX, the TABX, is composed solely of BBB and BBB-tranches and allows investors to hedge exposure to this specific tranche. The CMBX is an index comprising 25 different commercial mortgage-backed security tranches. The index is rolled over on a biannual basis to bring in new securities and is consequently a relatively sound proxy for the health of the underlying market. Markit MBX and ComboS are total return swaps on for-interest-only and principal-only securities. The introduction of the Markit PrimeX Index in April 2010 represents the first prime mortgage credit default swap index, comprising of four baskets of synthetic credit default swap on tranches of AAA-rated securities. The four subindices comprise 20 underlying deals each across both fixed rate and hybrid adjustable rate mortgages. The index also increases transparency within the market sector as participating dealers are required to provide daily pricings. The most sophisticated managers can run different scenarios for their long portfolio in terms of severities, defaults, modifications and house prices at the individual loan level in order to customize a direct hedge, although this can be expensive with the ABX spread ranging from 0.25 to 0.5 basis points.35

Non-agency RMBS are exposed to a range of external factors, including correlation to broader credit and equity markets, interest rate risk and its impact on prepayment rates, and the risk of loan modifications and government intervention.

35

NB Alternatives manager meetings with managers who invest in ABs space.

37

While there are a number of ways to potentially hedge a portfolio of mortgage-backed securities, most hedge funds appear to be operating with a significant net long bias or what is essentially a long-only strategy. Hedging this strategy can actually materially increase the risk profile of a fund due to the inherent basis risk between the longs and the shorts, but the portfolios can be structured or hedged to exhibit less sensitivity to interest rates and other variables. Detail of Asset-Backed Universe It is worth noting that due to a number of hedge funds being forced out of the space in 2008, the asset-backed peer group is likely to contain above average levels of survivorship bias. That said, despite the considerable disparity in returns between funds and the high profile blow-ups in 2008, the HFRI Asset-Backed Index finished the year up 0.05%, presumably bolstered by the funds that gained from being short subprime. As Figure 3.9 indicates, the peer group has performed well and in line with the wider beta rally for the rest of the class.
Figure 3.9: Asset-Backed Index Performance
55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Barclays Mortgage-Backed Securities Index HFRI Fixed Income Asset-Backed Index

source: Barclays capital.

Total assets in the space peaked in Q2 2007, at an estimated $69.6 billion before falling below $20 billion by late 2008 and then stabilizing in 2009.36 Currently, the HedgeFund.Net database contains over 75 hedge funds that primarily invest in asset-backed securities. We have observed a number of new launches, particularly for RMBS-focused hedge funds through 2009 and 2010. With respect to the broader peer group, we track a more focused collection of 15 – 20 funds in addition to exposure gained from within the distressed peer group. Many of these funds invest primarily in residential and, to a lesser extent, commercial-based mortgage strategies. Assets under management range from $15 million to $2.4 billion with an average size of $560 million. Four funds predate 2007, while the remainder have since launched to take advantage of the market dislocations.

36

hedgefund.Net: mBs, ABs and securitized credit funds strategy focus report 2009.

38

These 15 to 20 funds performed well in 2009, posting an average annualized return of 23.37% net of fees (up 14.39% year-to-date through October). The returns also show low correlation and beta to the equity markets as shown in the table below, suggesting that the asset class could act as a potential portfolio diversifier.
Figure 3.10: Average Correlation and Beta of Mortgage-Backed Peer Group to S&P 500 Since inception of the underlying funds
correlation Beta 0.16 0.04

sources: NB Alternatives analysis, pertrac.

Figure 3.11: Average Correlation and Beta of Mortgage-Backed Peer Group to S&P 500 Since January 2009 (or Fund inception, if after January 2009)
correlation Beta 0.08 0.02

sources: NB Alternatives analysis, pertrac.

A hedge fund focusing on asset-backed securities can essentially make money in three ways: 1) interest income, 2) realized gains from principal pay downs and 3) mark-to-market price appreciation of the bond. While securities have rallied from their lows, we still believe a robust opportunity set exists. Yields remain attractive on a relative value basis (compared with other fixed income securities) despite their coming down in the last 18 months and often on an absolute basis (helped by favorable supply and demand dynamics). Although bond prices have rallied, they are still below historic highs. We believe that in certain instances, this is justified and, thus, underscores the importance of fundamental analysis. Conclusion With little sign of improvement in the housing market, these dislocations will likely remain for the foreseeable future. Going forward, managers will need to focus on conducting detailed fundamental analysis of the underlying collateral, both to reduce risk and to identify the securities that remain the most mispriced. Further along this point, it is important to note that individual funds can take unique idiosyncratic bets that have low levels of the systematic risks associated with the broader strategy, thus making bottom-up selection of managers increasingly significant. In general, despite a broadly positive outlook, the difficulty of hedging a mortgage-backed portfolio coupled with potential illiquidity of the underlying instruments reminds investors that prudent manager selection is crucial within a fund of funds portfolio.

Managers will need to focus on conducting detailed fundamental analysis of the underlying collateral, both to reduce risk and to identify the securities that remain the most mispriced.

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chapter 4: emerging manager outperformance: An Analysis of renewed importance
Introduction Do emerging hedge fund managers tend to outperform their more established peers? This question has long been the subject of debate within both the financial industry and academia. Generally, the consensus is that emerging managers do tend to outperform for the following intuitive reasons: 1) greater nimbleness to uncover off-the-run opportunities, 2) better flexibility to redeploy capital, and 3) increased manager motivation (i.e., greater reliance on performance fees as opposed to management fees, and the general psychological need to “make it”). To be fair, potential downfalls of emerging manager investing exist, including the relative lack of capital stability and deep infrastructure as well as the potential lack of meaningful portfolio management experience. However, investors who possess the skill and resources to assess both the manager’s investment acumen and the future potential for success may not only benefit from the early stage outperformance frequently displayed by emerging managers, but may also gain early access to some future marquee managers. A multitude of recent industry shifts have shed new light on the positive effect a thoughtfully constructed emerging manager allocation can wield in a portfolio: • Robust supply of talented, newly launched managers in need of funding. Due to the Volcker Rule, headcount was significantly reduced for many proprietary trading desks. Additionally, a number of existing hedge funds remain below their high water marks and/or have diminished asset bases since 2008. These changes have resulted in a growing pool of talented, experienced money managers looking to relaunch or create new hedge fund businesses. • Underperformance of a few, high profile hedge funds have demonstrated that sizeable assets under management (“AUM”) is not necessarily better or safer. Generally, as AUM grows, a fund’s investable universe decreases, and style drift and performance erosion can occur. Large firms may devote more time to cultivating investor relationships (and management fees), leaving less time to focus on return generation. Providing capital to quality emerging managers could result in more favorable liquidity terms, transparency and fee arrangements, short-run alpha generation, and a unique source of diversification to more commonly held hedge funds, of which the industry is increasingly over-concentrated. • Hedge fund inflows overlook emerging managers. Asset flows in 2010 indicate renewed interest in hedge funds; $42.3 billion was allocated to hedge funds over the first three quarters of the year (the first year of net subscriptions since 2007). However, allocations were biased towards the most established managers: 90% of Q3 inflows went to managers with $500 million or more, with 75% concentrated in those managers with over $5 billion (representing less than 5% of the overall hedge fund universe).37 This implies that, all else equal, established managers are disproportionately favored over emerging managers. As such, providing capital to quality emerging managers could result in more favorable liquidity terms, transparency and fee arrangements, short-run alpha generation, and a unique source of diversification to more commonly held hedge funds, of which the industry is increasingly over-concentrated. Interestingly, industry flows continue to flock to the largest funds despite the negative publicity about industry overcrowding. The trend of asset flows to more established funds coupled with the glut of experienced money managers seeking capital provides a unique opportunity for those investors emphasizing prudent manager selection over the perceived safety of a brand name fund.

37

hfr Global hedge fund industry report – 3Q 2010.

40

The fact that these managers are frequently overlooked is precisely what makes them potentially appealing to those investors who possess the infrastructure and process to allocate capital at the early stage of a fund’s lifecycle.

Defining an Emerging Manager In this chapter, we seek to use empirical data to evaluate the notion that emerging managers tend to outperform their more established peers. We begin our analysis by defining “emerging manager.” Despite the amount of industry research devoted to the topic, no universal definition of the term “emerging manager” exists. Many define emerging managers purely along the metric of longevity: those funds possessing track records of less than two to four years. Yet the small group of high profile hedge fund launches — those launching with a critical mass in assets such as Eton Park, TPG Axon, and Centerbridge — quickly attract institutional assets in their incipient years and are seldom considered “emerging” by the investment community. For this reason, we believe it is more useful to consider a manager as “emerging” when the manager is both relatively new to the market and has yet to gain traction in terms of fundraising. Such funds can frequently be overlooked or under-researched, as some investors face restrictions regarding the length of a track record or face concentration limits, where their assets cannot exceed a certain percentage of total fund assets. The fact that these managers are frequently overlooked is precisely what makes them potentially appealing to those investors who possess the infrastructure and process to allocate capital at the early stage of a fund’s lifecycle. For the purpose of this study, we will define an emerging manager as a fund within its first 36 months of operation and that manages less than $500 million. Overall Analysis To measure and compare the performance of emerging and emerged managers, we have constructed two indexes from our universe of hedge fund investments since January 2002. Survivorship and backfill biases have always complicated the emerging manager analysis, as many funds only report to databases once they have generated positive returns, thereby excluding those that have failed or performed poorly. We seek to mute these biases by using our proprietary database which includes track records of several early-stage funds that subsequently folded and failed to report to public data providers, a total universe of 288 hedge funds across various strategies and geographies. Based on our emerging manager definition, we created an equally-weighted track record for both emerging and emerged managers; as a fund reached its 37th month of performance or exceeded the $500 million AUM threshold, it moved out of the emerging manager track record and became a part of the emerged manager composite (see Figure 4.1).
Figure 4.1: Summary Statistics Comparing Emerging Managers with Emerged Managers and with the Overall Hedge Fund Universe
Emerging
Annualized Return Annualized Volatility Information Ratio 9.49% 5.88% 1.6

Emerged
7.61% 5.70% 1.3

HFRX Global
2.73% 6.11% 0.4

Correlation
s&p index msci World index russell 2000 index Barclays hY index hfrX Global hf index 0.53 0.60 0.51 0.50 0.78 0.69 0.74 0.67 0.71 0.95 0.65 0.70 0.64 0.70 –

Beta
s&p index msci World index russell 2000 index Barclays hY index hfrX Global hf index 0.19 0.23 0.14 0.26 0.75 0.24 0.27 0.18 0.35 0.89 0.25 0.27 0.18 0.37 –

Alpha
s&p index msci World index russell 2000 index Barclays hY index hfrX Global hf index 0.72% 0.71% 0.69% 0.57% 0.59% 0.56% 0.55% 0.52% 0.35% 0.41% 0.17% 0.16% 0.13% -0.05% –

source: NB Alternatives peer Groups.

41

The near-1 correlation and beta of emerged managers to the HFRX Global Hedge Fund Index indicate that the performance of larger hedge funds tends to track the overall hedge fund industry.

Based on this analysis, the emerging manager’s trend of outperformance seems clear. On both an absolute and risk-adjusted basis, emerging managers perform better than their emerged counterparts, notably with less correlation, less beta and more alpha to all major market indices. The performance statistics to the HFRX Global Hedge Fund Index, an index designed to represent the overall hedge fund universe, are revealing: while correlation and beta metrics to this index are admittedly high across both emerging and emerged classes, the near-1 correlation and beta of emerged managers indicate that the performance of larger hedge funds tends to track the overall hedge fund industry. However, both the emerging and emerged managers in our database perform considerably better than the industry benchmark. It is notable that the index is asset-weighted, with the performance of the largest funds having the most influence on its performance statistics. Clearly, prudent manager selection can lead to emerged managers that outperform the industry, but a thoughtfully constructed emerging manager allocation can provide even stronger performance statistics. In order to better evaluate the trend between longevity and performance, we performed an analysis defining emerging managers along the same AUM guidelines, but on different time horizons: less than 24 months, 36 months, and 48 months of track record (see Figure 4.2). The side-by-side comparison of these performance streams brings to light the magnitude of outperformance even earlier in the life cycle, as most of the performance statistics (e.g., returns, volatility, correlation, beta and alpha) are better for the youngest class, and deteriorates marginally as the emerging manager definition embraces funds a year older.
Figure 4.2: Summary Statistics Comparing Emerging Managers at Different Stages in their Life with Each Other
Equal to or less than 24 Months
Annualized Return Annualized Volatility Information Ratio 10.46% 4.81% 2.2

Equal to or less than 36 Months
9.49% 5.88% 1.6

Equal to or less than 48 Months
7.13% 6.51% 1.1

Correlation
s&p index msci World index russell 2000 index Barclays hY index hfrX Global hf index 0.45 0.54 0.43 0.45 0.78 0.53 0.60 0.51 0.50 0.78 0.57 0.63 0.55 0.59 0.84

Beta
s&p index msci World index russell 2000 index Barclays hY index hfrX Global hf index 0.14 0.17 0.10 0.19 0.62 0.19 0.23 0.14 0.26 0.75 0.23 0.26 0.17 0.34 0.90

Alpha
s&p index msci World index russell 2000 index Barclays hY index hfrX Global hf index 0.81% 0.80% 0.78% 0.69% 0.69% 0.72% 0.71% 0.69% 0.57% 0.59% 0.53% 0.52% 0.49% 0.33% 0.38%

sources: NB Alternatives peer Groups.

This broad analysis seems to demonstrate that emerging managers could contribute meaningfully to portfolio diversification, given their relatively lower correlation and beta.

42

Acknowledging that some periods of time are more favorable to some strategies than others, one hypothesis for emerging manager outperformance is that a manager could benefit from a strategy tailwind if the manager strategically chose to launch at the “right time.”

Strategy-Specific Analysis Understanding that the prior analysis did not control for different strategies or geographies, we decide to narrow our analysis within more specific peer groups to further test the thesis and more reliably assess performance characteristics. We utilized our proprietary U.S. Long/ Short Peer Group of 182 funds and Distressed Peer Group of 64 funds to evaluate manager performance against their respective benchmarks. Acknowledging that some periods of time are more favorable to some strategies than others, one hypothesis for emerging manager outperformance is that a manager could benefit from a strategy tailwind if the manager strategically chose to launch at the “right time.” For this analysis, we disregarded AUM in defining an emerging manager, as 1) AUM information for non-investments is harder to rely upon, and 2) we were exploring the specific idea of “market-timing” a fund launch. For instance, if we consider those funds with at least six years of track record and calculate a broad average of the first three years of life compared with the average of its following three years, the fund in its emerging state tends to generate more attractive returns than during the following three year period. Evaluated alone, these results could support either the emerging manager argument or could be interpreted as a sign that funds tend to launch at attractive times for their strategy.
Figure 4.3: Returns Change Over Time
NB Alternatives U.S. Long/Short Peer Group1
Annualized Return Annualized Volatility Information Ratio

first three years second three years

20.94% 11.64%

12.96% 11.99%

1.6 1.0

NB Alternatives Distressed Peer Group2
first three years second three years 19.30% 14.56% 6.93% 8.61% 2.8 1.7

sources: NB Alternatives analysis, pertrac. 1 Analysis conducted from Jan. 1995 to sept. 2010. 2 Analysis conducted from Jan. 2002 to sept. 2010.

To investigate the market-timing issue, we attempted to strip out the impact of specific market environments by analyzing how emerging and emerged managers performed in the same exact market environment. To do this, we split markets into three-year blocks, during which managers were both emerging and already emerged. Interestingly, the class of emerging long/ short funds outperformed their emerged equivalents on an absolute and risk-adjusted basis across every three-year market environment since 1998 (see Figure 4.4). Furthermore, the emerging managers were generally less reliant on beta and generated considerably more alpha across all of these market environments as well.

43

Figure 4.4: Annualized Return and Alpha Comparison across Emerging and Emerged U.S. Long/Short Managers
40% 35% 30% 25% Returns 20% 15% 10% 5% 0% -5%
Jan 1998 – Jan 1999 – Jan 2000 – Jan 2001 – Jan 2002 – Jan 2003 – Jan 2004 – Jan 2005 – Jan 2006 – Jan 2007 – Dec 2000 Dec 2001 Dec 2002 Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009

Emerging Manager Returns Emerged Manager Returns Emerging Manager Alpha Emerged Manager Alpha

9% 8% 7% 6% Alpha 5% 4% 3% 2% 1% 0%

source: NB Alternatives peer Groups.

While the long/short analysis refutes the idea of strategy lift and supports the general trend that emerging managers outperform, the same analysis proved less conclusive for our Distressed Peer Group. While emerged distressed managers outperform their emerging counterparts earlier in the decade, emerging managers begin to outperform, albeit with higher volatility, in more recent years.
Figure 4.5: Annualized Return and Alpha Comparison across Emerging and Emerged Distressed Managers
35% 30% 25% 20% Returns 15% 10% 5% 0% -5% -10%
Jan 2002 – Dec 2004 Jan 2003 – Dec 2005 Jan 2004 – Dec 2006 Jan 2005 – Dec 2007 Jan 2006 – Dec 2008 Jan 2007 – Dec 2009

Emerging Manager Returns Emerged Manager Returns Emerging Manager Alpha Emerged Manager Alpha

6% 5% 4% 3% 2% 1% 0% -1% Alpha

source: NB Alternatives peer Groups.

The results for these two strategies highlight some of their fundamental differentiating characteristics. Regardless of market environment, long/short emerging managers seem to generate alpha-driven returns which highlight the relatively low barrier to entry in long/ short investing. While resources are of course necessary, the proverbial “manager and a Bloomberg” could effectively identify “good” stocks and “bad” stocks with great success. Distressed investing, on the other hand, tends to favor those institutions with the necessary corporate, legal and technical infrastructure to better navigate situations with typically poor information dissemination, and as such, emerged managers register some periods of outperformance. However, the commonality between the two analyses is that the emerged
44

The fact that emerging managers were actually better-equipped to weather the storm points to the benefits of the early years and presumably smaller size during periods of illiquidity and volatility.

managers in both strategies fared far worse in the recent crisis and have actually generated negative returns and low or negative alpha on average. The fact that emerging managers were actually better-equipped to weather the storm — a dramatic change in the trend for distressed managers — points to the benefits of the early years (i.e., a clean investment slate devoid of troubled legacy positions) and presumably smaller size (i.e., having the nimbleness to get out of crowded trades and only invest in one’s highest conviction ideas) during periods of illiquidity and volatility. It would seem that market environments influence distressed managers more than they affect long/short managers, perhaps because of illiquidity differences and the inherent cyclicality of default rates. The fact, though, that more established distressed funds better trade a more normalized market environment tempers the emerging manager argument; as mentioned in our earlier section on distressed investing, the strategy requires robust intellectual capital resources — funded by the AUM that typically comes with age — to manage the complicated nature of distressed deals efficiently. Of course, one cannot blindly invest in newly launched funds without the appropriately tailored due diligence, particularly as there seems to be different factors motivating strategy performance. Finally, we compared the upside/downside captures of emerging and emerged managers over each three-year period by using the Long/Short Peer Group, in which emerging managers consistently outperform. As demonstrated in Figure 4.6, the relatively dispersed nature of emerging managers in relation to the clustering of emerged managers underscores the variety within emerging managers. This range highlights the importance of manager selection, particularly in the evaluation of emerging managers. Most of the emerged managers are clustered around the solid line which represents the point at which upside capture equals downside capture. This reveals a tendency and an ability to “play it safe.” The scatterplot for emerging managers reveals a focus on alpha generation: the relative higher upside capture, and even a few periods of time with negative downside capture, point to the emerging managers’ need to establish a noteworthy track record.
Figure 4.6: Upside/Downside Capture of Emerging and Emerged Long/Short Managers versus the S&P 500 Index Over Time
100% 90% 80% Upside Capture 70% 60% 50% 40% 30% 20% 10% 0% -60% -40% -20% 0% 20% 40% Emerged – Long/Short Emerging – Long/Short

60%

80%

100%

Downside Capture
Emerging Managers Emerged Managers

Average upside capture Average downside capture

66.86% 8.58%

35.59% 15.51%

sources: NB Alternatives analysis, pertrac.

While it seems that well-selected emerging managers are a strong generator of alpha in spite of market environments, and a potential source of diversification when markets are irregular, their relative lack of predictability makes manager due diligence integral.

45

Emerging manager performance appears to be more dependent on manager-specific skills rather than broad exposure to a particular market environment.

Conclusion We believe that despite some of the qualifying points, there are clear benefits to investing in emerging managers. Emerging manager performance appears to be more dependent on manager-specific skills (leading to alpha) rather than broad exposure to a particular market environment (market or strategy beta). This highlights why emerging managers are attractive investments and why bottom-up due diligence and the ability to evaluate each emerging manager on a case-by-case basis is so important. In doing so, we focus on the skill of the manager and the manager’s background with a live portfolio across different historic market environments, with a particular emphasis on risk management process. Operational due diligence is also key to ensure the presence of a working infrastructure and a realistic business plan to grow. It is notable that the supply of emerging managers is persistent: even over the past three turbulent years, managers within their first three years of life have comprised an average of 29% of the overall industry and managers with less than $500 million in assets make up 17% of the universe.38 These industry statistics highlight the desirability of actively monitoring emerging managers on a continuous basis: on the one hand, the universe is robust enough to conduct ample due diligence on a fund’s peer group and invest in the most desirable; on the other hand, these managers represent a diversification of ideas away from the remaining 71% and 83% of industry assets that are relatively concentrated in a smaller number of large managers. Within the broader context of emerging managers’ alpha-generation and diversification capabilities, the increased supply of talented, experienced managers looking to launch funds makes the emerging manager opportunity particularly compelling for 2011. Today’s best-of-breed emerging managers could become the more established, tenured managers of tomorrow; research and anecdotal evidence suggests that investors could be rewarded for performing the deep due diligence necessary to invest in these funds early in their development cycles.

38

hfr Global hedge fund industry report – Q3 2010, Q3 2009, Q3 2008.

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chapter 5: the relationship between various hedge fund strategies and market illiquidity
Introduction Following the market events of 2008, we decided to revisit the concept of “illiquidity beta” and its implications for portfolios of hedge funds due to the numerous monthly observations that a considerable number of event-driven and relative value hedge funds lost money between Q3 2007 and Q1 2009, despite the fact that the historical track records of these hedge funds exhibited no measurable equity and/or credit beta, and the funds maintained net exposures to the markets at the time of near zero. Whether it was quantitative equity market neutral strategies in August 2007 or capital structure arbitrage funds in Q4 2008, a large number of structurally factor neutral funds suffered large losses. Similar observations can be made throughout the recent history of hedge funds (e.g., Fall 1998, Summer 2002, Spring 2005). Our previous hypothesis was that an illiquidity factor, distinct from direct exposure to common market factors such as equity or credit, was responsible for the consistent negative performance of these hedge funds during periods of sharply rising volatility and falling equity/ credit markets. The qualitative reasoning behind this thesis was that periods of forced selling often result in widening bid/offer spreads, particularly when the positions being sold are widely held in hedge fund portfolios. In these stressed periods, hedge funds typically suffer losses on their long positions as bid prices decline on thin demand and large supply, while short positions, which are marked to the offer price, are often the victims of covering-induced price rallies and fail to provide the relied upon market “hedge.” Further, we can draw a connection between the types of assets generally held by funds employing a given strategy and those funds’ sensitivity to illiquidity shocks. For example, we can break down the broader strategy of Fixed Income Arbitrage so that we have subgroups focused on global relative value, mortgage-backed securities and asset-backed securities. Intuitively, some asset-based sub-strategies, such as direct lending, will have greater illiquidity sensitivities than fixed income relative value because a direct loan is less liquid than sovereign debt. In the analysis that follows, we explore this illiquidity beta concept in greater detail in an effort to test the qualitative thesis that certain hedge fund strategies, during times of decreasing capital markets liquidity, perform worse than simple equity or credit betas would suggest. We explore the concept of an illiquidity factor, measure the sensitivity of various hedge fund strategies to this factor, and discuss the implications of these results for well-diversified, market neutral fund of hedge fund portfolios. Methodology and Analysis39 In order to assess various strategies’ sensitivities to market illiquidity (equity or credit-related), we can utilize a number of different approaches. For the analysis that follows, we focus on three different ways to measure a strategy’s sensitivity to illiquidity. First, we address equity illiquidity by utilizing the average daily ratio of absolute stock return to dollar volume.40 Here, we assume that in illiquid markets, small trading volumes can produce large absolute price

39

We constructed strategy return series by utilizing our proprietary peer group database, where we group funds by granular strategy level. for the period January 2000 through september 2010, we take the monthly average of all funds with available return data within a given month, which comprises the returns of funds that are no longer in existence, as well as funds that are active and still reporting earnings. We believe this provides a more realistic picture of the return characteristics of a given peer group for each month. We will examine two levels of aggregated peer group return data: a broad strategy return and more granular sub-strategy returns where appropriate. for example, we consider a combined ctA return series that encompasses short-term ctAs, long-term trend-following ctAs, and diversified, or multi-term ctAs. using the average daily ratio of absolute stock return to dollar volume is a concept researched and introduced in Amihud, Y., “illiquidity and stock returns cross-section and time-series effects,” Journal of financial markets 5,2002:31–56.

40

47

movements. Second, we examine the utility of the TED spread41 as a proxy for credit-related illiquidity. Again, the concept is that during periods of widening credit spreads (which can be the result of illiquidity), we can generally expect negative performance from certain strategies. The traditional approach used to assess sensitivity to a given factor is a linear regression model with the factor as the independent variable and the asset (in this case the strategy-level returns) as the dependent variable. However, upon closer examination of the data, this type of approach does not appear to be appropriate for this analysis. Specifically, the relationship is generally flat when there is little or no illiquidity. When there is moderate to severe illiquidity, the relationship is positive, flat, or negative, depending on the given strategy’s sensitivity to illiquidity. Therefore, we employ a quadratic model to allow for the relationship, if it is present. The model used is as follows:

return

illiq +

(illiq)ˆ2

where illiq is the equity illiquidity factor noted above. Figure 5.1 shows some examples of the quadratic model fitting the equity illiquidity factor to each set of strategy returns. In the various figures, the x-axis is the illiquidity factor value and the y-axis is the return for the given month. It is notable that for the more illiquidity-sensitive strategies, extremely high values of the illiquidity factor correspond to extreme negative performance. This model appears to be more intuitive than the typical linear model. For example, we would expect some relationship between returns and illiquidity when illiquidity is present, but we would not necessarily expect a relationship to be present when illiquidity is absent (i.e., we would not expect symmetrically high returns when markets are extremely liquid). Similar patterns form when we charted the relationship between strategy returns and the TED spread.42 As one can deduce from reviewing the trend lines, both factors for assessing illiquidity generally provide similar conclusions across all strategies.

41

the ted spread is defined as the difference between the rates on u.s. three-month t-bills and the three-month london interbank offered rate (liBor). please refer to the appendix for the ted spread graphs.

42

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Figure 5.1: Strategy Returns versus Equity Illiquidity Factor

Event-Driven — Distressed
10 10

Event-Driven — Multi Global
10

CTA — Diversified

Return (%)

Return (%)

Return (%)
0.02 0.03 0.04 0.05

5

5

5

0

0

0

-5

-5

-5

0.01

0.02

0.03

0.04 0.05

0.01

0.01

0.02

0.03

0.04 0.05

Illiquidity factor

Illiquidity factor

Illiquidity factor

CTA — Trend-Following
10 10

CTA — Short-Term
10

Equity Market Neutral

Return (%)

Return (%)

Return (%)
0.02 0.03 0.04 0.05

5

5

5

0

0

0

-5

-5

-5

0.01

0.02

0.03

0.04 0.05

0.01

0.01

0.02

0.03

0.04 0.05

Illiquidity factor

Illiquidity factor

Illiquidity factor

Long/Short Global
10 10

Fixed Income Arb —MBS
10

Credit Arb

Return (%)

Return (%)

Return (%)
0.02 0.03 0.04 0.05

5

5

5

0

0

0

-5

-5

-5

0.01

0.02

0.03

0.04 0.05

0.01

0.01

0.02

0.03

0.04 0.05

Illiquidity factor

Illiquidity factor

Illiquidity factor

source: NB Alternative peer Groups.

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The final manner in which we chose to quantify illiquidity sensitivity was to observe the relationship between illiquidity and positive autocorrelation through our own peer group data.43 We examine both the long-run relationship of these factors with various hedge fund strategy returns, as well as the time-varying relationship using rolling 36-month windows. We use the average strategy return series for each strategy over the period from January 2000 through September 2010 (i.e., 129 months). Figure 5.2 provides the long-run basic summary statistics for the different strategies under consideration.
Figure 5.2: Summary Statistics by Hedge Fund Strategy
Peer Group Autocorrelation Beta to Equity Illiquidity Factor T-Stat Beta to TED Spread T-Stat

distressed credit Arb event-driven long/short equity fixed income Arb — mBs equity market Neutral macro — discretionary macro — model-driven ctA — trend-following ctA — diversified ctA — short-term

58.20% 61.90% 48.20% 29.80% 55.20% 16.40% -4.90% 3.70% 6.80% 11.50% -7.40%

-1.80 -1.64 -1.48 -1.29 -0.51 -0.39 -0.61 -0.45 0.23 0.51 0.58

-5.73 -5.69 -4.62 -3.40 -2.45 -2.15
-1.97 -1.42 0.38 0.90 1.48

-0.0082 -0.0066 -0.0106 -0.0139 -0.0057 -0.0035 -0.0033 -0.0022 0.0043 0.0061 -0.0002

-2.75 -2.60 -3.41 -3.58 -2.71
-1.80 -0.95 -0.66 0.66 1.04 -0.04

sources: factset, Bloomberg, NB Alternatives analysis. Note: t-statistics in italics are statistically significant at the 0.05 level of significance.

As expected, autocorrelation is highest for the known less-liquid strategies such as Event-Driven, Credit Arbitrage, Distressed and the MBS sub-strategy within Fixed Income Arbitrage; autocorrelation was lowest for the recognized more liquid strategies: Equity Market Neutral (“EMN”), CTA and Macro. The results of this autocorrelation analysis seem to confirm our intuition that the more liquid the assets traded by a given strategy, the less sensitive it will be to illiquidity shocks. Similarly, we find that the strategies with the largest negative sensitivities to the equity market illiquidity factor are Event-Driven, Long/Short Equity, and Fixed Income Arbitrage, while the strategies employing more liquid assets, CTA and Macro, exhibit closer to flat exposure to this factor. Equity Market Neutral, by design, has close to flat exposure to the equity market illiquidity factor, but does have greater liquidity sensitivity than CTAs. The results of this autocorrelation analysis seem to confirm our intuition that the more liquid the assets traded by a given strategy, the less sensitive it will be to illiquidity shocks.

43

lo, A., “risk management for hedge funds: introduction and overview”, financial Analysts Journal 57,2001:16 – 33. Getmansky, m., A. lo, and i. makarov, “An econometric model of serial correlation and illiquidity in hedge fund returns,” Journal of financial economics 74,2004:529 – 609. Khandani, A and A. lo, “illiquidity premia in Asset returns: An empirical Analysis of hedge funds, mutual funds, And u.s. equity portfolios,” Working paper, 2009.

50

Over most of the 36-month windows, most strategies have negative sensitivity to equity market illiquidity.

We now consider the time-varying versions of these same illiquidity measures by calculating 36-month rolling versions of the same measures used above. In Figure 5.3, we show the rolling 36-month sensitivities to the equity illiquidity factor. We note that over most of the 36-month windows, most strategies have negative sensitivity to equity market illiquidity.
Figure 5.3: Rolling 36-Month Sensitivities of Various Hedge Fund Strategies to the Equity Illiquidity Factor
0.1 -0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6
p slo ard pw iod u er ve ha his p ds t fun ring CTA d du n tre ing
Credit crisis — CTA funds react with positive returns Quant meltdown — EMN funds most affected

Beta to Equity Illiquidity Factor

CTA Long/Short Equity Market Neutral Jan-08 May-08

Fixed Income Arb Event-Driven Macro Sept-08 Jan-09

Jan-07

May-07

Sept-07

sources: factset, NB Alternatives analysis.

We find several noteworthy characteristics in Figure 5.3. First, the combined CTA Peer Group shows a general increasing trend during the period from mid-2007 through early 2009, a period of general market stress. Second, during the massive quant fund sell-off in August 2007, the Equity Market Neutral Peer Group shows a sharp increasingly negative sensitivity to equity market illiquidity beta. Third, during the credit crisis in Fall 2008, Long/Short Equity, Event-Driven, and Fixed Income Arbitrage funds all show sharp negative sensitivities to equity market illiquidity, while CTA, EMN, and Macro funds show positive sensitivities.

51

The strategy level trend is clear and can be informative from a portfolio construction perspective.

Conclusion We have demonstrated the difference in sensitivity to various proxies of market illiquidity for a number of different hedge fund strategies. Strategies such as Equity Market Neutral and Macro demonstrate little or no negative sensitivity to market illiquidity; while CTA strategies — particularly those with shorter holding periods and where mean reversion models are a higher proportion of a fund’s exposure — actually exhibit positive sensitivity to periods of market illiquidity (i.e., positive performance during illiquidity events). Conversely, strategies such as Distressed, Event-Driven, Long/Short Equity, MBS Fixed Income Arbitrage, and Credit Arbitrage are shown to have varying degrees of negative sensitivity to market illiquidity (i.e., negative performance during illiquidity events), with Distressed, Event Driven, and Credit Arbitrage having the worst performance during illiquidity events. It is worth noting that individual funds within these negative illiquidity beta strategies could potentially generate a positive illiquidity beta and attractive returns due to their idiosyncratic positioning; that being said, though, the strategy level trend is clear and can be informative from a portfolio construction perspective. Inclusion of some of the more illiquidity-defensive strategies is important in trying to minimize the negative effects of illiquidity shocks. The benefit of diversification is well illustrated if we compare the performance of our Credit Arbitrage Peer Group (which had the highest autocorrelation) and the Short-Term CTA Peer Group (which had the lowest autocorrelation) across periods of market stress. The 2007 Quant crisis, the Lehman Brothers bankruptcy and the resultant credit crisis, and the “flash crash” of May 2010 are all events that provide recent, memorable case studies of illiquid markets.
Figure 5.4: Peer Group Monthly Performance during Recent Periods of Market Stress
6% 4% 2% 0% Return -2% -4% -6% -8% -10% Short-Term CTA Peer Group Credit Arbitrage Peer Group Jun-07 Jul-07 Aug-07 Aug-08 Sep-08 Oct-08 Nov-08 May-10 Average

Inclusion of some of the more illiquidity-defensive strategies is important in trying to minimize the negative effects of illiquidity shocks.

source: NB Alternatives peer Groups.

The trend that Short-Term CTAs are either flat or positive during months of high illiquidity and volatility is clear. On the whole, some of the worst months for the credit arbitrage strategy correspond to strong monthly returns from Short-Term CTAs. The average return differential over these eight months is a material 5.89%. Of course, every portfolio has a different risk/ return objective but, where appropriate, a considerable allocation to funds and strategies that perform well (positive sensitivities) during periods of market illiquidity (e.g., futures trading strategies, particularly short-term trading funds), can contribute meaningful returns when they are needed most.

52

Appendix: strategy returns versus ted spread
Event-Driven — Distressed
10 10

Event-Driven — Multi Global
10

CTA — Diversified

Return (%)

Return (%)

Return (%)
0.1 0.2 0.5 1.0 2.0

5

5

5

0

0

0

-5

-5

-5

0.1

0.2

0.5

1.0

2.0

0.1

0.2

0.5

1.0

2.0

TED spread

TED spread

TED spread

CTA — Trend-Following
10 10

CTA —Short-Term
10

Equity Market Neutral

Return (%)

Return (%)

Return (%)
0.1 0.2 0.5 1.0 2.0

5

5

5

0

0

0

-5

-5

-5

0.1

0.2

0.5

1.0

2.0

0.1

0.2

0.5

1.0

2.0

TED spread

TED spread

TED spread

Long/Short Global
10 10

Fixed Income Arb — MBS
10

Credit Arb

Return (%)

Return (%)

Return (%)
0.1 0.2 0.5 1.0 2.0

5

5

5

0

0

0

-5

-5

-5

0.1

0.2

0.5

1.0

2.0

0.1

0.2

0.5

1.0

2.0

TED spread

TED spread

TED spread

source: NB Alternatives peer Groups.

53

definitions
Alpha (Jensen’s Alpha): A risk-adjusted performance measure that is the excess return of a portfolio over and above that predicted by the capital Asset pricing model (cApm), given the portfolio’s beta and the average market return. Jensen Alpha’s measures the value added of an active strategy. Barclays Capital U.S. MBS Index: measures the performance of investment grade fixed-rate mortgage-backed passthrough securities of Government National mortgage Association (“GNmA”), federal National mortgage Association (“fNmA”) and freddie mac (“fhlmc”) that have 30-, 20-, 15-year and balloon securities that have a remaining maturity of at least one year, are investment grade, and have more than $250 million or more of outstanding face value. in addition, the securities must be denominated in u.s. dollars and must be fixed-rate and non-convertible. the index is a market capitalization weighted, and the securities in the index are updated on the last calendar day of each month. Beta: A measure of the systematic risk of a portfolio. it is the covariance of the portfolio and the benchmark divided by the variance of the benchmark. Beta measures the historical sensitivity of a portfolio’s returns to movements in the benchmark. the beta of the benchmark will always be one. A portfolio with a beta above the benchmark (i.e. >1) means that the portfolio has greater volatility than the benchmark. if the beta of the portfolio is 1.2, a market increase in return of 1% implies a 1.2% increase in the portfolio’s return. if the beta of the portfolio is 0.8, a market decrease in return of 1% implies a 0.8% decrease in the portfolio’s return. Correlation: A statistical measure of how a portfolio moves in relation to its benchmark. correlation values range from +1.0 to -1.0. A positive correlation implies that they move in the same direction. Negative correlation means they move in opposite paths. A correlation of +1.0 means that the portfolio and benchmark move in exactly the same direction; 1.0 means they move in exactly the opposite direction; 0.0 means they do not correlate at all with each other. Downside capture ratio: A measure of the manager’s performance in down markets relative to the market itself. A value of 90 suggests the manager’s loss is only nine tenths of the market’s loss. during the selected time period the return for the market for each period is considered a down market period if it is less than zero. the returns for the manager and the market for all down periods are calculated. the downside capture ratio is calculated by dividing the return of the manager during the down periods by the return of the market during the same periods. Federal Funds Rate: the interest rate at which private depository institutions lend balances at the federal reserve to other depository institutions, usually overnight. HFRI Fixed Income – Asset Backed Index: includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a fixed income instrument backed physical collateral or other financial obligations (loans, credit cards) other than those of a specific corporation. strategies employ an investment process designed to isolate attractive opportunities between a variety of fixed income instruments specifically securitized by collateral commitments which frequently include loans, pools and portfolios of loans, receivables, real estate, machinery or other tangible financial commitments. investment thesis may be predicated on an attractive spread given the nature and quality of the collateral, the liquidity characteristics of the underlying instruments and on issuance and trends in collateralized fixed income instruments, broadly speaking. in many cases, investment managers hedge, limit or offset interest rate exposure in the interest of isolating the risk of the position to strictly the yield disparity of the instrument relative to the lower risk instruments. HFRX Global Hedge Fund Index: the Global index is designed to be representative of the overall composition of the hedge fund universe and is built on a “strategy-up” basis from the 8 single strategy indices representing the main hedge fund strategies. the equally Weighted index is equally weighted among the 8 single strategy indices. All indices are comprised of hedge funds that are open for investment. the Global index follows an asset weighted approach to accurately reflect the changing opportunities in the hedge fund. currently represented strategies are convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage and relative value arbitrage. Information ratio: A measure of risk adjusted return. the average excess return (over an appropriate benchmark or risk free rate) is divided by the standard deviation of these excess returns. the higher the measure, the higher the risk adjusted return. the information ratio of the benchmark will equal zero. London Interbank Offered Rate (“LIBOR”): A daily reference rate based on the interest rates at which banks borrow unsecured funds, in marketable size, from other banks in the london wholesale money market or interbank market. the liBor is fixed on a daily basis and is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year. Market capitalization: the total market value of all of a company’s outstanding shares. market capitalization of a company is the product of the total number of shares outstanding and the current market price per share. the investment community uses this figure to determine a company’s size, as opposed to sales or total asset figures. Markit ABX.HE Index: composed of the 20 most liquid cds on u.s. home equity ABs. the ABX.he index is the key trading tool for banks and asset managers that want to hedge asset-backed exposure or take a position in this asset class. Markit CMBX Index: A synthetic index referencing 25 commercial mortgage-backed securities. the markit cmBX indices were created in response to the rapid pace of growth in the cds of cmBs market, providing investors with an efficient, standardized tool to quickly gain exposure to this asset class. Markit PrimeX Index: A synthetic cds index referencing non-Agency prime rmBs. each subindex references 20 prime rmBs deals from 2005, 2006, and 2007. the index launched on April 28th, 2010. Markit TABX.HE Index: constructed using the underlying names of the BBB and BBB- markit ABX.he indices. the goal of markit tABX.he is to provide investors with the ability to gain/hedge their exposure on the underlying names to specific tranches of varying levels of risk within the portfolio structures.

54

MSCI World Index: A free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. As of may 27, 2010 the msci World index consisted of the following 24 developed market country indices: Australia, Austria, Belgium, canada, denmark, finland, france, Germany, Greece, hong Kong, ireland, israel, italy, Japan, Netherlands, New Zealand, Norway, portugal, singapore, spain, sweden, switzerland, the united Kingdom, and the united states. Price-to-book ratio: the ratio is used to compare a stock’s market value to its book value, assessing total firm value. the ratio is calculated by taking the market value of all shares of common stock divided by the book value of the company. (Book value is the company’s total assets, less intangible assets and liabilities.) A lower price to book ratio could mean that the respective stock is undervalued. Russell 2000® Index: measures the performance of the 2,000 smallest companies in the russell 3000® index, which represents approximately 8% of the total market capitalization of the russell 3000® index. the index is market cap-weighted and includes only common stocks incorporated in the united states and its territories. S&P 500 Index: consists of 500 stocks chosen for market size, liquidity, and industry group representation. it is a market value weighted index (stock price times number of shares outstanding), with each stock’s weight in the index proportionate to its market value. the “500” is one of the most widely used benchmarks of u.s. equity performance. As of september 16, 2005, s&p switched to a float-adjusted format, which weights only those shares that are available to investors, not all of a company’s outstanding shares. the value of the index now reflects the value available in the public markets. Upside capture ratio: A measure of the manager’s performance in up markets relative to the market itself. A value of 110 suggests the manager performs ten percent better than the market when the market is up. during the selected time period, the return for the market for each period is considered an up market period if it is greater than zero. the returns for the manager and the market for all up periods are calculated. the upside capture ratio is calculated by dividing the return of the manager during the up market periods by the return of the market during the same periods. S&P/Case-Shiller® Home Price Index: designed to be a reliable and consistent benchmark of housing prices in the united states. their purpose is to measure the average change in home prices in a particular geographic market. they cover ten major metropolitan areas (metropolitan statistical Areas or msAs), which are also aggregated to form a national composite. the indices measure changes in housing market prices given a constant level of quality. changes in the types and sizes of houses or changes in the physical characteristics of houses are specifically excluded from the calculations to avoid incorrectly affecting the index value.

risk considerations
While hedge funds offer you the potential for attractive returns and diversification for your portfolio, they also pose greater risks than more traditional investments. there is no guarantee that any fund will meet its investment objective. An investment in hedge funds is only intended for sophisticated investors. investors may lose all or a substantial portion of their investment. You should consider the risks inherent with investing in hedge funds: Leveraged and Speculative Investments: An investment in hedge funds is speculative and involves a high degree of risk. hedge funds commonly engage in swaps, futures, forwards, options and other derivative transactions that can result in volatile fund performance. leveraging may increase risk in hedge funds. Limited Liquidity: there are limited channels in the secondary market through which investors can attempt to sell and/or purchase interests in hedge funds; and an investor’s ability to transact business in the secondary market is subject to restrictions on transferring interest in hedge funds. hedge funds may suspend or limit the right of redemption under certain circumstances. thus, an investment in hedge funds should be regarded as illiquid. Absence of Regulatory Oversight: hedge funds are not required to be registered under the u.s. investment company Act of 1940; therefore hedge funds are not subject to the same regulatory requirements as mutual funds. Dependence upon Investment Manager: the General partner or manager of a hedge fund normally has total trading authority over its respective fund. the use of a single advisor applying generally similar trading programs could mean the lack of diversification and, consequently, higher risk. Foreign Exchanges: selective hedge funds may execute a portion of their trades on foreign exchanges. material economic conditions and/or events involving those exchanges may affect future results. Fees and Expenses: hedge funds often charge high fees; such fees and expenses may offset trading profits. fees on funds of funds are in addition to the fees of underlying funds, resulting in two layers of fees. performance or incentive fees may incentivize the manager of those funds to make riskier investments. Complex Tax Structures: hedge funds may involve complex tax structures and delays in distributing important tax information. Limited Reporting: While hedge funds generally may provide periodic performance reports and annual audited financial statements, they are not otherwise required to provide periodic pricing or valuation information to investors. Business and Regulatory Risks of Hedge Funds: legal, tax and regulatory changes could occur during the term of a hedge fund that may adversely affect the fund or its managers. in addition to these risk considerations, specific risks will apply to each hedge fund based on its particular investment strategy. Any investment decision with respect to an investment in a hedge fund or a private equity fund of funds should be made based upon the information contained in the confidential private placement memorandum of that fund. Hedge Fund Data and Analyses: the hedge fund data contained in this material is based upon internal analyses of information obtained from public and third-party sources. Any returns shown were constructed for illustrative purposes only. there are numerous limitations inherent in the data presented, including incompleteness and unavailability of hedge fund holdings, activity and performance data (i.e., unavailability of short activity and intra-quarter activity), and the reliance upon assumptions. No representation or warranty is made as to the accuracy of the information shown, the reasonableness of

55

the assumptions used, or that all assumptions and limitations inherent in such analysis have been fully stated or considered. changes in assumptions may have a material impact on the data and the results presented. the simulated, estimated and expected returns and characteristics constructed for any hedge fund strategies are shown for illustrative purposes only, and actual returns and characteristics of any fund or group of funds may differ significantly from any simulated, estimated and expected returns shown. All return data is shown net of fees and other expenses and reflect reinvestment of any dividend and distributions. Any investment decision with respect to an investment in a hedge fund should be made based upon the information contained in the confidential private placement memorandum of that fund. the information contained herein is not intended to be complete or final and is qualified in its entirety by the offering memorandum and governing document for each fund. the Neuberger Berman Group is comprised of various wholly owned subsidiaries, including, but not limited to, Neuberger Berman llc, Neuberger Berman management llc, Neuberger Berman fixed income llc, NB Alternative fund management llc, NB Alternative investment management llc, NB Alternatives Gp holdings llc and NB Alternatives Advisers llc. “Neuberger Berman” and “NB Alternatives” are marketing names used by Neuberger Berman Group and its subsidiaries. the specific investment adviser for a particular product or service is identified in the product offering materials and/or applicable investment advisory agreement. This document is for informational purposes only and is not an offer or solicitation with respect to the purchase or sale of any security. This summary is intended only for the person to whom it has been distributed, is strictly confidential and may not be reproduced or redistributed in whole or in part, nor may its contents be disclosed to any other person under any circumstances. This summary is not intended to constitute legal, tax, or accounting advice or investment recommendations. Prospective investors should consult their own advisors about such matters. We do not represent that this information is accurate or complete and it should not be relied upon as such. opinions expressed herein are subject to change without notice. the products mentioned in this document may not be eligible for sale in some states or countries, nor are they suitable for all types of investors. this material has been prepared by NB Alternative investment management llc and issued by Neuberger Berman europe limited, which is authorized and regulated by the uK financial services Authority (“fsA”) and is registered in england and Wales, lansdowne house, 57 Berkeley square, london, W1J 6er. No part of this document may be reproduced in any manner without the written permission of NB Alternative investment management llc. Not for use with retail clients in europe, Asia and the middle east. this document is being made available in Asia by Neuberger Berman Asia limited, 紐伯格伯曼亞洲有限公司 (“NBAL”), a hong Kong incorporated investment firm licensed and regulated by the hong Kong securities and futures commission (“SFC”) to carry on types 1, 4 and 9 regulated activities, as defined under the securities and futures ordinance of hong Kong (cap.571) (the “SFO”).

56

Partnering With Clients For Over 70 Years

Neuberger Berman LLC 605 Third Avenue New York, NY 10158 www.nb.com

This report was prepared by the NB Alternatives Fund of Hedge Funds global investment and operational due diligence teams.

NB AlterNAtives fuNd of hedge fuNds iNvestmeNt teAm ANd operAtioNAl due diligeNce memBers
eric Weinstein, patrick deaton, cAiA, ian haas, cfA, fred ingham, AcA, cfA, Jeff majit, cfA, matthew rees, Jim mcdermott, ph.d., paresh shah, laura hawkins, Avery Kiser, sophie steele, Junjie Watkins, cfA, vishal Bhalla, Josh myers, declan redfern, Justin scott Please contact your Neuberger Berman representative or hedgefundclientservice@nb.com for additional information.

J0058 01/11 ©2011 Neuberger Berman. All rights reserved.

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