Hedge Funds Overview

Hedge Fund Characteristics

 The Securities and Exchange Commission (SEC) has stated that the term
hedge funds “has no precise legal or universally accepted definition”, but most
market participants agree that hedge funds have the following characteristics:
 almost complete flexibility in relation to investments, including both long and short
positions
 ability to borrow money (and further increase leverage through derivatives) in an
effort to enhance returns
 minimal regulation
 some illiquidity since an investor’s ability to get their money back is restricted
through lock-up agreements (first one to two years) and quarterly disbursement
limitations thereafter (subject to “gates” which may further limit disbursements)
 investors include only wealthy individuals and institutions such as university
endowments, pension funds and other qualified institutional buyers (except through
fund of fund investments, which are available to a broader array of investors)
 fees that reward managers for performance
Comparing Hedge Funds and Mutual Funds
 Hedge funds are pools of investment capital, as are mutual
funds, but the similarity stops there
 Mutual funds must price assets daily and offer daily liquidity,
compared to the typical quarterly disclosure of asset values to
hedge fund investors and liquidity that is subject to certain
limitations, as described in the previous section
 In the U.S., hedge funds are limited to soliciting investments
only from accredited investors, but mutual funds have no such
limitation
 Mutual funds are heavily regulated in the U.S. by the SEC,
while hedge fund regulation is limited (although regulations
are changing)
Comparing Hedge Funds and Mutual Funds
 The hedge fund fee structure is also significantly different: mutual
funds usually receive management fees that are substantially lower
than fees paid to hedge funds, and mutual funds generally do not
receive the performance fees that hedge funds receive
 While mutual funds typically to not use leverage to support their
investments, leverage is a hallmark of hedge funds
 Hedge funds engage in a much broader array of trading strategies,
creating both long and short investment positions, utilizing
derivatives and many other sophisticated financial products to
create the exposures that they want
 Mutual funds generally have less investment flexibility and, unlike
hedge funds, are required to distribute a significant portion of their
income
Fees
A typical fee structure for hedge funds includes both a
management fee and a performance fee, whereas a typical
mutual fund does not require a performance fee, and has a
smaller management fee
 Hedge fund management fees are usually around 2% of net
asset value (NAV)
Performance fees are approximately 20% of the increase in
the fund’s NAV
This “2 and 20” fee structure is significantly higher than for
most other money managers, with the exception of private
equity fund managers, who enjoy similarly high fees
Return Objectives
 Hedge funds target “absolute returns”, which are investment returns
that are always positive (avoiding yearly losses) and don’t depend
on the performance of broad markets and the economy, unlike the
returns associated with mutual funds
 However, the historical claim made by hedge funds that their
returns are “uncorrelated” with market returns for traditional
investments such as stocks and bonds is a subject of dispute
following large losses by many hedge funds during 2008
 A lack of correlation is an attractive characteristic for investors who
are attempting to either lower risk in their investment portfolio
while keeping returns unchanged or increase returns in their
portfolio without increasing risk
 Hedge funds attempt to achieve “double digit” returns in most years
Leverage
 Hedge funds frequently borrow (creating “leverage”) in order to increase the
size of their investment portfolio and increase returns (if asset values
increase)
 For example, if a hedge fund received $100 million from investors, the fund
might by combining investor funds with $300 million from banks, using the
$400 million of purchased securities as collateral against the $300 million
loan: this is called a margin loan
 Another form of leverage used by hedge funds is created through repurchase
agreements, where a hedge fund agrees to sell a security to another party for
a predetermined price and then buy the security back at a higher price on a
specified date in the future
 In addition, leverage is provided by selling securities short and using the
proceeds to purchase other securities and through derivatives contracts that
enable hedge funds to create exposure to an asset without using as much
capital as would be required by buying the asset directly
Impact of Leverage
 When hedge funds borrow money, their losses, as well as their
gains, are magnified
 For example, if a hedge fund receives $100 million from investors it
may then borrow $300 million to make investments totaling $400
million
 A 25% fall in the value of its $400 million investment portfolio
would result in a total loss of the investor’s capital if the hedge fund
closed down
 If, alternatively, the investment portfolio increased by 25%,
investors would receive a 100% return on their investment, before
subtracting management fees and operating costs
 During the 2008 Financial Crisis, leverage made available to hedge
funds dropped precipitously
Leverage Dropped During 2008
Hedge Funds’ Leveraged Assets Fell from $6.6 Trillion to $2.4 Trillion in Less Than a One-Year Period
Assets under management and estimated total investable assets, $ in trillions

6.5 6.6
Leverage through derivative positions
Leverage through debt
Assets under management
4.8
3.3 -64%
3.9
3.6
3.4
2.9 2.6
1.5 2.4
1.7 1.3
1.5 0.8
0.8 0.9
0.7
0.6 0.3
0.4
1.9 1.9
1.1 1.4 1.4 1.2
1.0

2004 2005 2006 2007 H1-08 H2-08 Q1-09

Implied
Leverage 2.9 3.1 3.4 3.4 3.5 2.6 2.0
Ratio2 (total)

Note 1: Includes leverage from debt and off -balance sheet leverage through derivatives and other instruments
Note 2: Leverage ratio = (total leverage + AUM) / AUM
Source: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; International Financial
Services, London; Financial Risk Management, Ltd.; Financial Services Authority
Fund of Funds
 A “fund of funds” is an investment fund that invests in a portfolio
of other investment funds, rather than investing directly
 A fund of hedge funds attempts to provide a broad exposure to the
hedge fund industry and risk diversification
 They typically charge a management fee of 1% to 1.5% of AUM
and also receive performance fees that range from 10% to 20%
 As a result, if a fund of funds invests in a dozen hedge funds that
charge “2 and 20” fees on average, total management and
performance fees paid by fund of fund investors could be about
3.25% and 35%, respectively
 For some investors, these fees outweigh the benefits of investing
in hedge funds
Fund of Funds
 However, many investors who may not qualify to invest in hedge funds
because they have insufficient capital to invest, or are not recognized as
qualified investors in the U.S. by the SEC, will invest in a fund of funds as
the only vehicle through which they can invest in hedge funds
 In addition, since many fund of funds have investments in 10 or more
different hedge funds, they provide more diversification than some
investors might achieve directly due to limited amounts of investible capital
 Some high net worth and institutional investors will channel money through
a fund of funds because they value the “due diligence” process by which
fund of funds weed out poor hedge fund managers
 However, there are many recent examples of inadequate due diligence,
where fund of funds have performed at or worse than hedge fund indexes,
based on poor investment decisions that reflect inadequate investigation of
hedge fund practices and investment strategies
Growth
 Hedge funds grew at a remarkable rate since 1990, from 530 funds with under $39
billion in assets to more than 7,600 funds at the end of 2007, with assets of almost
$1.9 trillion, based on the following developments:
 Diversification: Investors were looking for portfolio diversification beyond “long-only”
investment funds
 Absolute returns: Most traditional investment funds try to beat market averages such as
the S&P 500 Index, claiming excellent management skills if their fund outperforms the
relevant index, but if the index return is negative, the outcome would be inferior to a
hedge fund that that tries to achieve an absolute return (meaning a return greater than
0%)
 Increased institutional investing: Because university endowments such as
Yale’s endowment achieved spectacular returns from investing up to 50% of
their entire portfolio in alternative assets such as hedge funds, private equity,
real estate and commodities (achieving an average annual return of over 23%
between 2001 and 2007), many large institutional investors such as pension
funds and other university endowment funds substantially increased their
exposure to hedge funds
Growth
 Favorable market environment: This period was characterized by a
benign credit environment, strong equity market and accommodating tax
and regulatory conditions, enabling hedge funds to take advantage of low
interest rates and flexible credit leverage to augment returns
 Human capital growth: Hedge funds were able to draw talent from
investment banks and asset managers because of very high compensation
and the opportunity to be more independent
 Financial innovation: Hedge funds’ ability to execute increasingly complex
and high-volume trading strategies was made possible by product and
technology innovations in the financial market and by reductions in
transaction costs.
 Electronic trading platforms: Direct market access tools for futures and
swaps allowed hedge funds to profitably trade a broad range of financial
assets, while at the same time, more effectively manage their risks
Growth
Estimated Total Number of Hedge Funds and Fund of Funds
1990 – 2008
12,000

10,096
10,000 9,462
9,176
8,661

8,000 7,436

6,297
6,000 5,379
4,454
4,000 3,617 3,873
3,325
2,781 2,990
2,383
1,945
2,000 1,514
1,105
610 821

0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Estimated Total Number of Hedge Funds -versus- Fund of Funds

1990 – 2008
9,000
Fund of Funds 7,634
8,000
7,241
Hedge Funds 6,808
7,000 6,665

5,782
6,000
5,065
5,000 4,598
3,904
4,000
3,335
3,102
2,848
3,000 2,392 2,564 2,462 2,368
2,221
2,006 1,996
2,000 1,654 1,654
1,277 1,232
937 781
1,000 530 694 515 538 550
291 377 389 426 477
80 127 168 237
0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Hedge Fund Research, Inc.

Growth
Estimated Growth of Assets
Hedge Fund Industry 1990 – 2008, $ in billions
2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

200

0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Estimated Growth of Assets

Fund of Fund Industry 1990 – 2008, $ in billions
800

700

600

500

400

300

200

100

0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Hedge Fund Research, Inc.

 Investors
Share of High Net Worth Individuals Has Fallen

31% 30%
42% 44% 44% 44% 40%
48%
54% 53% 54%
61%
High net-worth individuals
31% 32% Fund of hedge funds
23%
27% 24% 24% Endowments and foundations
20% 30%
18% 20% 17%
14% 12% 12% Corporations and institutions
9% 9% 9% 9% 18%
10% 8% 8% Pension funds
7%
11% 7% 8% 7% 8% 8% 12% 11%
8% 7% 7% 8%
9% 15% 15% 15% 15% 12% 11% 14% 15%
5% 10% 12% 14%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: McKinsey Global Institute.; Hennessee Group LLC; International Financial Services, London estimates
 Largest Hedge Funds
Top 10 Hedge Funds by Assets Under Management at the End of 2008

Firm Region AUM ($bln)

Bridgewater Associates U.S. 38.6
J.P. Morgan U.S. 32.9
Paulson & Co. U.S. 29.0
D.E. Shaw Group U.S. 28.6
Brevan Howard1 Europe 26.8
Och-Ziff Capital Management U.S. 22.1
Man AHL1 Europe 22.0
Soros Fund Management U.S. 21.0
Goldman Sachs Asset Management 1 U.S. 20.6
Farallon Capital Management2 U.S. 20.0
Renaissance Technologies2 U.S. 20.0

Note 1: As of December 31, 2008. All other figures as of January 1, 2009.

Note 2: Tied for 10th place.
Source: Absolute Return Billion Dollar Club, March 2009 rankings
 Revenue Concentration
Hedge Fund Revenues are Highly Concentrated in the Top 205 Funds
Hedge Fund Revenue Pool for 2006
Assets Under Management
>$5bn (64 funds)
$3-5 bn (64 funds) 205 funds
$2-3 bn (77 funds)
26%
<$2 bn (5,000+ funds)
43%

74% of revenues are

13% concentrated in the
205 largest funds
18%
based on AUM

Source: McKinsey Global Institute; Lipper Hedge World; Merrill Lynch; McKinsey Global Institute hedge fund interviews
 Hedge Fund Strategies
 Global Macro strategy bases its holdings - such as long and short positions in
various equity, fixed income, currency, and futures markets - primarily on
overall economic and political views of various countries (macroeconomic
principles).
 Equity hedge (long/short equity) strategy involves purchase of stocks that are
undervalued or short sale of stocks that are overvalued. In most cases, the fund
will have positive exposure to the equity markets –having 70% invested long in
stocks and 30% invested in shorting stocks and the net exposure to the equity
markets is 40% (70%-30%) and the fund would not be using any leverage (Their
gross exposure would be 100%). If the manager increases long positions to 80%
maintaining 30% short position, the gross exposure of 110% (80%+30% =
110%) will have leverage of 10%.
Drivers of Alpha & Beta
Absolute return strategies: where the
hedge fund manager is unchained from a
stock-and-bond index.
Market segmentation: allows fund
managers to identify sweet spots within a
broad asset class like collateralized debt
market. Concentrated portfolios: offers
greater opportunity for excess return. Eg:
CGF & PEF have only a few very
concentrated positions in their portfolio.
Nonlinear return distributions: exhibit
option-like payoffs with a “kinked”
distribution or may replicate an option
payoff structure by virtue of their trading
strategy. Eg: merger arbitrage, event-
driven, fixed income arbitrage, and
managed futures.
 Rethinking Asset Allocation
Strategic Asset Allocation Equity Beta & Alpha Drivers
 Returns
Since 1990, Hedge Fund Strategies Have Outperformed Both Bonds and Equities (Even Accounting for Risk)
Risk vs. return for hedge fund strategies compared to blended portfolios of bonds and equities, 1990 - 2008
15
Macro
14
Equity Hedge
13
Event-Driven
Average Return %

12

11
Relative Value
10

9 Portfolio composition:
100% equities, 0% bonds
8
Additional 5% bonds, moving to the left
7 0% equities, 100% bonds

3 4 5 6 7 8 9 10 11 12 13
Standard Deviation %
Source: McKinsey Global Institute; Hedge Fund Research, Inc.; Datastream
 Returns
Top Quartile Hedge Funds Outperformed U.S. Equities and Bonds1
Average annual returns (net of fees) by strategy for risk-adjusted quartiles, 2001 – 2007, %
Equity Hedge Macro Event-Driven Relative Value

1st
19.4 31.3 19.0 13.6
Quartile

2nd
11.2 15.4 13.9 9.9
Quartile

3rd
0.4 12.7 4.0 7.5
Quartile

4th
0.2 4.1 -2.6 2.2 S&P 500
Quartile
Lehman US
Aggregate
2.4 6.1 2.4 6.1 2.4 6.1 2.4 6.1 Bond Index

Note 1: Quartiles are defined based on risk-adjusted performance, defined using fund Sharpe ratio between 2001 and 2007. The
Sharpe ratio is given by Average (R – Rf) / Standard Deviation (R), where R is the return and the benchmark rate Rf is the S&P 500
average between 2001 and 2007 (2.43%).
Source: McKinsey Global Institute; Hedge Fund Research, Inc.
 Returns
Comparison of Hedge Fund Returns to the S&P 500 Index’s Returns, 2000 – 2008
Annualized Total Return, %
26.4%

15.4% 13.9% 13.6% 12.6%

9.6% 9.0%
7.6%
4.9% 4.4% 3.0% 3.0% 3.5%

-10.1%
-13.0% Hedge funds
S&P 500 -19.1%
-23.4%

-38.5%

2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Credit Suisse/Tremont; S&P 500 data provided by Commodity Systems Inc.
 Trading Volume
Hedge Funds Account for a Significant Share of Trading Volume
Hedge Fund’s Estimated Share of Trading, %

Cash Equity on NYSE and LSE 50

U.S. Government Bonds 30
High-Yield Bonds 25
Credit Derivatives - Plain Vanilla 60
Credit Derivatives - Structured 30
Emerging Market Bonds 45
Distressed Debt 47
Leveraged Loans 32

Source: McKinsey Global Institute; NYSE; LSE; U.S. Bond Market Association; IMF; Greenwich Associates; Financial News; Gartmore;
Stern School of Business; British Bankers’ Association; ISDA; McKinsey CIB practice
Lock-ups and Gates
 Hedge funds generally focus their investment strategies on financial
assets that are liquid and able to be readily priced based on reported
prices in the market for those assets or by reference to comparable
assets that have a discernable price
 Since most of these assets can be valued and sold over a short period of
time to generate cash, hedge funds permit investors to invest in or
withdraw money from the fund at regular intervals and managers
receive performance fees based on quarterly mark-to-market valuations
 However, in order to match up maturities of assets and liabilities for
each investment strategy, most hedge funds have the ability to prevent
invested capital from being withdrawn during certain periods of time
 They achieve this though “lock-up” and “gate” provisions that are
included in investment agreements with their investors
Lock-ups
 A lock-up provision provides that during an initial investment
period of, typically, one to two years, an investor is not allowed
to withdraw any money from the fund
 Generally, the lock-up period is a function of the investment
strategy that is being pursued
 Sometimes, lock-up periods are modified for specific investors
through a side letter agreement
 However, this can become problematic because of the resulting
different effective lock-up periods that apply to different
investors who invest at the same time in the same fund
 Also, this can trigger “most favored nations” provisions in
other investor agreements
Gates
 A gate is a restriction that limits the amount of withdrawals during a
quarterly or semiannual redemption period after the lock-up period expires
 Typically gates are percentages (usually 10% to 20%) of a fund’s capital
that can be withdrawn on a scheduled redemption date
 A gate provision allows the hedge fund to increase exposure to illiquid
assets without facing a liquidity crisis
 Gates also offer some protection to investors that do not attempt to
withdraw funds because if withdrawals are too high, assets might have to
be sold by the hedge fund at disadvantageous prices, causing a potential
reduction in investment returns for remaining investors
 During 2008 and 2009, as many hedge fund investors attempted to
withdraw money based on poor returns and concerns about the financial
crisis, there was considerable frustration and some litigation directed at
hedge fund gate provisions
Side Pockets
 Hedge funds sometimes use a “side pocket” account to house comparatively
illiquid or hard-to-value assets
 Once an asset is designated for inclusion in a side pocket, new investors don’t
participate in the returns from this asset
 When existing investors withdraw money from the hedge fund, they remain as
investors in the side pocket asset until it either is sold or becomes liquid
through a monetization event such as an IPO
 Management fees are typically charged on side pocket assets based on their
cost, rather than a mark-to-market value of the asset and incentive fees are
charged based on realized proceeds when the asset is sold
 Usually, there is no requirement to force the sale of side pocket investments by
a specific date
 Investors are concerned about unexpected illiquidity arising from a side pocket
and the potential for even greater losses if a distressed asset that has been
placed there continues to decline in value
High Water Mark and Hurdle Rate
 A high water mark relates to payment of performance fees
 Hedge fund managers typically receive performance fees only when the value of the
fund exceeds the highest net asset value it has previously achieved
 For example, if a fund is launched with a net asset value (NAV) of $100 per share and
NAV was $120 at the end of the first year, assuming a 20% performance fee, the
hedge fund manager would receive a performance fee of $4 per share
 If, however, at the end of the second year, NAV dropped to $115, no performance fee
would be payable
 If, at the end of the third year, NAV was $130, the performance fee would be $2,
instead of $3, because of the high water mark (($130-$120) x 0.2)
 Sometimes, if a high water mark is perceived to be unattainable, a hedge fund may be
incented to close down
 In addition, some hedge funds agree to a hurdle rate whereby the fund receives a
performance fee only if the fund’s annual return exceeds a benchmark rate, such as a
predetermined fixed percentage, or a rate determined by the market such as LIBOR or
a T-bill yield
Comparing Hedge Funds and Private Equity Funds
 Hedge funds are similar to private equity funds in a number of ways
 They are both private pools of capital that pay high management fees and
high performance fees based on the fund’s profits (2 and 20) and both are
lightly regulated
 However, hedge funds generally invest in relatively liquid assets,
purchase minority positions in company stocks and bonds and in many
other assets (taking both long and short positions for many investments)
 Private equity funds, by contrast, typically purchase entire companies,
creating a less liquid investment that is often held for three to seven years
 Although there is an intention to create liquidity after this period, since
exit events often include an IPO, where only a portion of the investment is
sold, or an M&A sale, where the consideration could be in shares of
another company, rather than cash, liquidity is not assured even then