Hedge Funds During the Credit Crisis: The Good, The Bad and The Ugly

1. Hedge Funds During the Credit Crisis: The Good, The Bad and The Ugly Moderator: Robert Phay, Associate General Counsel, Commonfund Panelists: Jennifer Thomson, Partner, Walkers - Cayman Islands Joel Wattenbarger, Partner, Ropes & Gray Friday, November 20, 2009 3:30 p.m. - 4:30 p.m. EDT The Ritz-Carlton, Washington, D.C.

2. Credit Contagion TimelineJuly 2007 – January 2008 August 9: The European Central Bank injects €94.8B into the money markets to shore up confidence in the financial system. This unprecedented level of intervention follows a statement from BNP Paribas, the French bank, that it has decided to suspend redemptions on three investment funds. August 17: The Fed cuts the Discount Rate, the rate banks can borrow from the Fed, by one-half percent just 10 days after the FOMC meeting. January 18: MBIA, the largest bond insurer, raised $1B in capital to maintain its Fitch triple-A rating. Fitch strips AMBAC, the second largest bond insurer, of its triple-A rating and suggests further downgrades are possible. Four days later AMBAC reported a $3.26B loss. Jul-07 Aug-07 Dec-07 Jan-08 July 25: Bankers raising $20B for the private equity buyout of Chrysler Group are forced to postpone the sale of $12B in loans for the car group. August 16: The Chicago Mercantile Exchange, the world’s largest derivatives exchange, raises margin requirements for 24 of 400+ contracts, including those based on currencies, interest rates and stock indices. January 22: FOMC cuts the Federal Funds rate by 75bps in an emergency action between scheduled meetings. This was the largest rate cut since 1982. January 30: FOMC cuts rates another 50 bps, for an unprecedented total of 125 basis points in a nine day span. July 7: Bear Stearns closes two hedge funds after total losses on subprime bets worth more than $20B. Source: Financial Times, Bloomberg 2

3. Credit Contagion TimelineFebruary – September 2008 Feb 7: The Bank of England cuts interest rates by a quarter of one percent to 5.25% April 8: IMF warns the potential losses from the credit crunch could reach $1 trillion and may even be higher. Sept 29: TARP readjusted. Citigroup makes an offer for Wachovia July 13: IndyMac fails. March 7: Federal Reserve makes a $200 billion of funds available to banks and other institutions to try and improve liquidity in the markets. May 22: UBS launches a $15.5bn rights issue to cover some of the $37bn of losses linked to U.S. mortgage debt. Sept 5: U.S. unemployment rises to 6.1%. Feb-08 Mar-08 Apr-08 May-08 June-08 Jul-08 Aug-08 Sept-08 Feb 17: British government announces that struggling Northern Rock is to be nationalized for a temporary period April 10: The Bank of England cuts interest rate by a quarter of one percent to 5.0% June 25: Barclays announces plans to raise £4.5bn in a share issue to bolster its balance sheet. Sept 10: Lehman Brothers posts a loss of $3.9bn Sept 15: Lehman files for Chapter 11 March 17: Bear Stearns is acquired by rival JPMorgan Chase for $240m in deal backed by $30b of central bank loans. July 14: Financial authorities step in to assist Fannie Mae and Freddie Mac, owners and guarantors of $5 trillion worth of home loans. Source: Commonfund, BBC Special Report – Global Credit Crunch 3

4. Credit Contagion TimelineOctober – December 2008 October 3: President Bush signs TARP into law. Wells Fargo makes a higher offer for Wachovia, taking it from Citigroup October 21: The US Federal Reserve announces it will spend $540 billion to purchase short-term debt from money market mutual funds. December 29: The Treasury provides $6 billion rescue to GMAC December 5: Oil falls below $40 per barrel November 25: The US Federal Reserve pledges $800 billion more to help revive the financial system. $600 billion will be used to buy mortgage bonds issued or guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, and the Federal Home Loan Banks. December 16: The Federal Open Market Committee decided to establish a target range for the federal funds rate of 0 to 1/4 percent October 11: The Dow caps its worst week ever with its highest volatility day ever recorded in its 112 year history. Over the last eight trading days, the DJIA has dropped 22% Nov-08 Oct-08 Dec-08 October 8: Central banks in US England, China, Canada, Sweden, Switzerland and the European Central Bank cut rates in a coordinated effort to aid world economy. December 1: the National Bureau of Economic Research officially declared that the U.S. economy had entered recession in December, 2007 November 12: Treasury Secretary Paulson abandons plan to buy toxic assets under the $700 billion TARP. Paulson said the remaining $410 billion in the fund would be better spent on recapitalizing financial companies December 19: US announces $17.4 billion rescue package for US auto makers October 14: The US taps into the $700 billion available from the Emergency Economic Stabilization Act and announces the injection of $250 billion of public money into the US banking system. December 12: Bernard Madoff arrested in $50 billion Ponzi scheme Source: Commonfund, BBC Special Report – Global Credit Crunch 4

5. Financial Conditions IndexJanuary 1992 – September 2009 Source: The Bloomberg Financial Conditions Index. The index combines yield spreads and indices from the money markets, equity markets, and bond markets into a normalized index. The values of this index are z-scores, which represent the # of standard deviations that current financial conditions lie above/below the average from 1992 – Sept 30, 2009 5

6. Hedge Funds During the Credit Crisis: The Good, The Bad and The Ugly Joel Wattenbarger, Partner, Ropes & Gray LLP 4021523.1

7. The Credit Crunch Hedge funds faced: • Global credit crunch • Unanticipated illiquidity of portfolio securities • Special events (Lehman bankruptcy) • Significant demand for withdrawals / redemptions

8. The Credit Crunch Investors faced: • Global credit crunch • Need for liquidity to satisfy operational needs, redemption requests (funds of funds), capital calls • Uncertain liquidity of portfolio funds • Restrictions on redemptions

9. Historic Tools for Managing Redemptions • Gates • Side pockets • Right to satisfy redemptions in-kind • Right to suspend redemptions

10. Historic Assumptions • Imposing gate or suspending redemptions = commencing wind-down of fund • Satisfying redemptions in-kind =unacceptable from a client relations standpoint • Side pockets = tool to enable p.e.-style investments within hedge fund structure

11. What Have We Experienced? • Unprecedented wave of redemption requests • No fund was safe • Widespread “contingent” redemptions • Substantial use of gates and suspensions • Erosion of historic stigma • Use of side pockets as a means of managing unexpected illiquidity • "Synthetic side pockets" • Relying on right to establish SPVs, make in-kind redemptions

12. What Have We Experienced? (Cont.) • Seeking investor consent to restructurings / changes in fund terms • Substantial differences in investor interests / perspectives • Partial suspensions • Secondary sales of fund interests • Tender offers • Principal transactions • Liquidations

13. HEDGE FUNDS DURING THE CREDIT CRISIS: THE GOOD, THE BAD AND THE UGLY Jennifer Thomson, Partner November 2009

14. SUSPENSION • Suspension perceived as an action of last resort and relatively minimal focus on drafting… • Grounds for suspension – Articles v PPM • Suspension – all or nothing? • Grounds must not conflict • Suspension in breach of Articles – ultra vires/personal liability • Amend the Articles? • Timing of declaration – redemptions/redemption payments NAV (Strategic Turnaround/Matador)

15. RETURNING CAPITAL TO SHAREHOLDERS DURING SUSPENSION – DIVIDEND/COMPULSORY REDEMPTION • Dividend • restrictions in Articles/PPM • any adverse/unexpected tax consequences for investors • drop in NAV per share • Compulsory redemption • any restrictions in Articles/PPM • ability to effect compulsory redemption during suspension • directors’ duties in lifting and re-imposing

16. REDEMPTIONS IN KIND – CURRENT ISSUES Authorisation in fund documents Must redeem in kind with an asset of the fund (Gottex) Consider fund’s ability / desire to transfer asset directly to redeeming investor Consider nature of assets and equitable division among redeeming investors Assets transferred should, on date of transfer, have a value equal to the redemption price on the redemption day Is it defensible to distribute a percentage of assets representing a redeeming investor’s proportional share of the fund on the redemption day? 16

17. REDEMPTIONS IN KIND – INTERESTS IN SPV Redemptions in kind with shares of an SPV Assets must be valued at “fair value” adjusted for risk SPV shares may be subject to a discount for counterparty risk, redemption and transfer restrictions Auditors to consider valuation issues – audit difficulties? 17

18. ROLE OF INDEPENDENT DIRECTORS • Historic perception of independent directors • Role of independent directors during the financial crisis • Benefits for managers • Benefits for investors

19. Walker House 87 Mary Street George Town Grand Cayman KY1-9001 Cayman Islands +1 345 949 0100 Jennifer Thomson +1 345 914 4280 Jennifer.thomson@ walkersglobal.com

20. Lessons Learned • Understanding liquidity terms • Do terms match investment strategy? • Who are your fellow investors? • Monitoring fund liquidity / redemptions • Monitoring investments • Monitoring managers

21. Lessons Learned (Cont.) • Investment restrictions • Role of independent directors • Increasing interest in separate accounts / single-investor funds