Hedge Fund Issues and Performance

1. Hedge Fund Issues and Performance L6: Hedge Fund Issues and Performance

2. Hedge Fund Performance • 2008 was a watershed year in the hedge fund industry • Assets under management (AUM) by hedge funds dropped by unprecedented levels and the concept of managing for absolute returns (positive returns) was, in part, invalidated by significant losses • As a result of these losses, investor withdrawals increased substantially • This withdrawal activity, combined with reductions in asset values, resulted in a drop in AUM by approximately 25%, from almost $1.9 trillion at the end of 2007 to just over $1.4 trillion by the end of 2008 • Part of the problem during 2008 was that too many funds bought the same assets and as markets fell, many hedge funds sold these assets to gain liquidity, pushing prices even lower • Compounding this problem was the need for some institutions to raise cash when the equity market decline caused minimum equity allocation benchmarks to be breached, triggering a need to take money out of hedge funds and reinvest directly in equity instruments. L6: Hedge Fund Issues and Performance

3. Hedge Fund Performance • The Fund Weighted Composite Index tracked by Hedge Fund Research (HFR) fell by 19.0% during the year compared to the drop in Standard & Poor’s 500 stock index of 38.5%, including dividends • Therefore, even though hedge fund losses were significant, they were substantially less than the broader equity market • 2008 marked only the second calendar year of negative returns for hedge funds since 1990 • Approximately two thirds of the decline in assets during 2008 was a result of poor hedge fund performance and the remaining one-third came from clients withdrawing their assets • Fund of hedge funds underperformed hedge funds, losing 21.3% for the year. • Despite the overall poor performance, however, it is important to reemphasize that hedge funds (both in aggregate and across the major investment strategies) still outperformed the broader market L6: Hedge Fund Issues and Performance

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7. Searching For Returns • Hedge funds have traditionally been associated with “alpha based” returns which are independent of market conditions, but, increasingly, hedge funds participate in the same investment activity as traditional fund managers • To differentiate themselves, hedge fund managers have had to search for new sources of returns in new markets, but this search has pushed them into less liquid investments, including private equity investments and other private transactions • This activity extends their investment horizon, requires longer lock-ups and results in the need to hire new managers who have long-term investment expertise • Hedge funds have become active participants in leveraged bank loans, mezzanine financings, insurance-linked securities and in LBO transactions • In other words, hedge funds have moved a significant amount of their investment base from public transactions to private transactions in their search for alpha-based returns L6: Hedge Fund Issues and Performance

8. Fund of Funds • 2008 ended on a bad note with the disclosure of over $20 billion in losses experienced by those who invested in Bernard Madoff’s investment funds • While Madoff wasn’t a hedge fund manager, a number of fund of funds that allocate investor money to hedge funds also allocated money to Madoff through feeder funds • This created concern about the quality of fund of funds due diligence processes and the ensuing crisis of confidence in fund of funds resulted in many investors withdrawing money from these funds, which in turn, caused money to be taken out of hedge funds • Fund of funds have sold themselves to investors on the basis that they offer three key benefits: diversification, access to sought-after managers and due diligence • The financial crisis weakened the first two benefits from the perspective of many investors • The Madoff scandal significantly undermined the third benefit L6: Hedge Fund Issues and Performance

9. Fund of Funds • Compounding the difficulties of fund of funds was the leverage employed by these funds. • Many fund of funds borrowed money to supplement investor money when they made investments in various hedge funds • Since most of the hedge funds they invested in were already leveraged, this doubling up of leverage created enhanced losses beyond the losses of the underlying funds • In part, because of this leverage, average losses from fund of hedge funds during 2008 were 21%, compared to average losses for hedge funds of 19% • With lenders retracting credit, fund of funds were forced to dump assets, putting further pressure on hedge funds and the markets in general • As a result, a number of high profile hedge funds liquidated or froze redemptions during 2008, traumatizing the investor base and triggering additional requests for redemption by some investors who sought liquidity wherever they could find it (even from hedge funds that were generating positive returns) L6: Hedge Fund Issues and Performance

10. Benefits Revisited • Historically, hedge fund managers have articulated the following benefits for investors who place money in their funds • Attractive risk-adjusted returns, focusing on positive returns, low volatility and capital preservation • Low correlation with major equity and bond markets • Investment flexibility to invest long or short, using a variety of instruments, investing in segments of the market that suffer from structural inefficiencies and in smaller asset pools • Focus on marketable securities • Structural advantages including performance-based compensation, managers’ personal investment (which aligned interests) and the ability to attract the “best and brightest” L6: Hedge Fund Issues and Performance

11. Benefits Revisited • An analysis of these benefits in light of the major dislocations of the market during 2007 and 2008 suggests the following about hedge funds • Achievement of positive (absolute) returns has become a problematic objective during periods of major market dislocation • Achievement of low correlation with major equity and bond markets is difficult to obtain during periods of major market dislocation • Investment flexibility continues to be a major benefit of hedge funds • Some hedge funds have invested a portion of their assets in nonmarketable securities, creating a mismatch between asset maturities and investor withdrawal requirements • Structural advantages, including performance-based compensation and aligned interests L6: Hedge Fund Issues and Performance

12. Transparency • Hedge fund investors historically have not required a significant amount of investment transparency from hedge fund managers • Many investors are now pushing for greater position-level transparency, but some managers resist this based on their concern that disclosure of strategies will benefit competitors and cause arbitrage opportunities to disappear • Managers are generally willing to provide organizational and process transparency regarding assets under management, profit and loss attribution, key investment themes, new product initiatives, and personnel • In addition, risk transparency is usually provided through disclosure of credit exposure, volatility exposure, long verses short positions, leverage, geographic focus, portfolio concentration, industry focus and market capitalization focus • However, hedge fund managers will attempt to keep specific investment strategies, ideas, and short positions confidential, so investors must decide whether the level of overall transparency provided is adequate in the context of the risks and benefits associated with investing in hedge funds L6: Hedge Fund Issues and Performance

13. Fees • Following the poor industry performance during 2008, some hedge funds decided to reduce fees from 2% to 1% • Renaissance Technologies, one of the largest and most successful hedge funds, waived all management fees for 2009 for its Renaissance Institutional Futures fund and the fund agreed to not receive any performance fees until 2008 losses of 12% were recovered • Other funds, including Highbridge Capital Management, launched new share classes with lower fees in exchange for longer lock-up periods • At the end of 2008, Citadel Investment Group gave back about $300 million in fees it had previously collected, after completing a money-losing year and other firms also gave back fees and remained committed to not receiving performance fees until they reached their high water marks • At some funds, fee cuts came principally from performance fees, rather than management fees, based on the view that management fees are essential to keeping the funds operational L6: Hedge Fund Issues and Performance

14. High Water Mark • A hedge fund high water mark is a mechanism that is implemented to make sure that managers do not take a performance fee in the current period when the fund has had negative performance over previous performance fee periods • The high water mark is the colloquial term for a “cumulative loss account” • A cumulative loss account starts with a zero balance at the beginning of any performance period (monthly, quarterly, or yearly, as determined by the firm) and it records net losses during that period • It was estimated that only one in 10 hedge funds received performance fees during 2008 because of losses and application of high water marks • This created significant compensation pressures for many funds since their management fees were insufficient to keep the business going, which resulted in significant downsizing of headcount and office space L6: Hedge Fund Issues and Performance

15. High Water Mark • The high water mark may create a perverse incentive for the hedge fund manager to either take extra risk to generate returns high enough to deplete the cumulative loss account so that a performance fee will be paid, or to close down the fund and start again • Both of these actions could be damaging to investors, forcing them to either make a redemption at an inopportune time, or continue with their investment with a potentially higher risk profile • If a hedge fund manager shuts down a fund, the investor might suffer disproportionate losses as assets are sold in a fire sale environment • However, to keep money invested in the fund under a higher risk profile may also not be in the investor’s best interest and taking money out to invest with another manager might subject the investor to the same high water mark issue L6: Hedge Fund Issues and Performance

16. High Water Mark • As a result of this conundrum, in some cases, it might make sense for investors to consider modification of the high water mark • An alternative to the standard hedge fund high water mark is a modified high water mark: resetting the high water mark to the current fund level under circumstances where to do so better aligns everyone’s interest, amortizing losses over a several year period to enable some modest level of performance fees during this period, or rolling the high water mark over a more extended period • A modified high water mark may create value for investors by keeping a manager in the game and reducing the incentive of the manager to take excessive risk • As a quid pro quo, some hedge fund managers may be willing to accept lower performance fees L6: Hedge Fund Issues and Performance

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18. Merging of Functions • Hedge funds, private equity funds and investment banks compete against each other and are, at the same time, major sources of revenue for each other • Each of the largest participants in these three industries conducts business activities in all three areas • Goldman Sachs has an industry leading sales and trading business, providing trading and lending services to hedge funds and a large investment banking business that provides services to private equity funds • In fact, private equity funds and hedge funds are the two most important clients of Goldman Sachs’ investment banking division and trading division, respectively • In addition, Goldman Sachs historically conducted one of the world’s largest hedge fund businesses between their proprietary trading desk and their Asset Management Division and one of the world’s largest private equity businesses between their principal investment area and their Asset Management Division • As a result, Goldman Sachs is both an important provider of services to hedge funds and private equity funds, as well as one of their principal competitors L6: Hedge Fund Issues and Performance

19. Merging of Functions L6: Hedge Fund Issues and Performance

20. Merging of Functions L6: Hedge Fund Issues and Performance

21. Merging of Functions L6: Hedge Fund Issues and Performance

22. Future Developments • Hedge funds suffered significant pain during 2007-2009: redemptions created loss of income and forced sales of assets that compounded losses, fees were reduced as performance waned, regulators reached toward greater regulation and more taxes, and many investors became concerned with the hedge fund model. As a result, a number of significant, lasting developments have occurred: • Hedge funds have more limited access to leveraged financing, which, in particular, impacts convertible arbitrage, fixed income arbitrage and statistical arbitrage investment strategies • The ability to maintain confidentiality over investment strategies has been reduced as investors demand more transparency and liquidity • Losses, gates and fraud have forced hedge funds to become more open in their activities and more willing to share details of their business and associated risks with investors • Fees have been reduced from the typical 2/20 schedule to a lesser fee system that allows greater returns to investors and acknowledges the lower return environment L6: Hedge Fund Issues and Performance

23. Future Developments (continued) • The decline in alpha is well documented and many hedge funds are now viewed as creating diversified beta instead of finding significant returns from market inefficiencies • This still represents value added, but differentiation from many well-managed traditional investment funds is more difficult • Hedge funds are subject to additional regulatory constraints, which limit somewhat their flexibility, especially in long/short equity, event driven and other equity based strategies • A less favorable tax environment will result in reduction in after-tax compensation received by hedge fund managers • As hedge funds adjust to the new realities of the market they are developing longer lock-up arrangements that better match the lengthening maturity profile of their investments, enabling them, in turn, to expand long-term investment activity to take advantage of higher yields available for patient capital • The balance of power has shifted from general partners to limited partners • The result is that limited partners have been successful in obtaining better transparency, improved liquidity and the other benefits described above L6: Hedge Fund Issues and Performance