Fund Derivatives

1. 5 September 2008 Fund Derivatives David Wakeling Allen & Overy LLP

2. What I will be talking about today • Two presentations for the price of one • Hedge Funds (& Mutual Funds) Vs Exchange Traded Funds

3. Conceptual differences • Mutual Funds • Hedge Funds • ETFs • Liquid • Price transparency • Equity-like characteristics • Secondary market • Uniformity of product (although differences emerging?) • Illiquid • Pricing issues (delays) • Fund Manager NAV • Transferability? • Highly bespoke (reliance key person/ manager etc)

4. Different documentation • Hedge Funds (and Mutual Funds): 2006 ISDA Fund Derivatives Definitions • Exchange Traded Funds: The ETF Supplement?

5. Hedge funds

6. Characteristics of Hedge Funds • Key characteristics of hedge funds (and mutual funds) • Pricing & Liquidity • Transparency • Fund risk profile & structure • A derivative on a hedge fund reflects these characteristics

7. Pricing & Liquidity • When Hedge Funds Bar the Door – “If you thought getting into a hedge fund was tough, try getting out of one”

8. Transparency • Never have so many short sellers made so much money – Harbinger Capital; Paulson & Co. • Bear Sterns; HBOS; Fannie Mae and Freddie Mac • SEC moves to curb short selling • FSA ruling lifts lid on hedge funds’ positions • Australia takes aim at short selling • Bets on HBOS rise in spite of short-sell rule

9. Fund Structure and Risk Profile • Lahde Capital flew high and called it a day • GLG and Greg Coffey • Peloton flew high, fell fast • As the markets throw knuckle balls, hedge-fund stars still hit home runs • Paulson & Co. made money betting on the collapse of subprime mortgages in 2007 • Harbinger Capital reaps subprime profits

10. Characteristics of Hedge Funds • Key characteristics of hedge funds (and mutual funds) • Pricing & Liquidity • Transparency • Fund risk profile & structure

11. Characteristics of Hedge Funds • Key characteristics of hedge funds (and mutual funds) • “KYF” (“know your fund”) and the building block approach • Fund derivative reflects these difference- Equity Derivatives Definitions not up to the job… • 2006 ISDA Fund Derivatives Definitions

12. 2006 Fund Derivatives Definitions • Structural similarities between the Fund Definitions and the Equity Definitions • Key differences between the Fund Definitions and the Equity Definitions • Reflect key characteristics of hedge funds

13. 2006 Fund Defs- Structural similarities to the Equity Definitions • Modelled on the 2002 ISDA Equity Derivatives Definitions • Stand-alone booklet of definitions to be incorporated into short-form Confirmations for individual trades • Options, forwards and swaps covered • Single “Fund Interest” (analogous to Share) and basket trades contemplated • Knock-in and Knock-out trades contemplated • Mechanics of exercise for option transactions • Mechanics of prepayment for forward transactions

14. 2006 Fund Defs- Structural similarities to the Equity Definitions • Fund swap mechanics • Valuation provisions • Cash and physical settlement provisions • Dividends • Adjustments and modifications • Extraordinary Events • Miscellaneous representations, agreements and acknowledgement

15. Key differences between the Fund Definitions and the Equity Definitions • Key characteristics of hedge funds (and mutual funds) • Pricing & Liquidity • Transparency • Fund risk profile & structure • A derivative on a hedge fund reflects these characteristics

16. 1/ PRICING & LIQUIDITY

17. 1/ Differences- pricing & liquidity • KYF- how do you value an interest in the fund? • Many funds, especially hedge funds, set up, administered and valued in “off-shore” jurisdictions • Primarily concerned with funds not traded on a public exchange. No liquid secondary market • Less transparency in terms of regulatory disclosure requirements • Meaning of NAV • Fees, incentive fees, trail fees • Hold back/ claw back

18. 1/ Differences- pricing & liquidity • KYF- how do you buy and sell interests in the fund? • Primarily concerned with funds not traded on a public exchange. No liquid secondary market • Transfer restrictions • Timing of subscription and redemption • Gating • Use of side letters

19. 1/ Differences- pricing & liquidity • Valuation methodologies based on subscriptions and redemptions (not secondary market) • Reported Value Method and Deemed Payout Method

20. 1/ Differences- pricing & liquidity: Deemed Payout Method of Valuation • Deemed Payout Method, Observation Dates & subscription/ redemption cycles • measures redemption payments • Redemption Proceeds per Fund Interest Unit “that would be received by the Hypothetical Investor … in connection with a redemption of all Fund Interest Units that are subject to valuation during the period from, and including, the Initial Observation Date to, and including, the Final Observation Date” (Section 1.18 Relevant Price, Section 5.9 Final Price, Section 7.3 Settlement Price) • Redemption Proceeds (Section 1.43) - the redemption proceeds “that would be paid by the related Reference Fund to a Hypothetical Investor who, as of the relevant Redemption Valuation Date, redeems such amount of such Fund Interest” • Provided that proceeds that would or could be paid in property other than cash shall be valued or treated as payable in cash

21. 1/ Differences- pricing & liquidity: Deemed Payout Method of Valuation • “Final Observation Date” (Section 1.50) – with respect to a Valuation Date, specified date, failing which the Valuation Date itself, subject to Sections 6.6 and 6.7 (Disruption), 11.1 (Adjustments) and 11.2 (Correction) • Section 11.2(ii) - where Redemption Proceeds that would have been paid to Hypothetical Investor adjusted to reflect additional payment or claim for repayment (clawback), and adjustment made by end of Cut-off Period starting on Final Observation Date, Calculation Agent to adjust to account for correction • “Cut-off Period” (Section 1.51) - unless specified, one year (or up to earlier specified Final Cut-off Date)

22. 1/ Differences- pricing & liquidity: Deemed Payout Method of Valuation • “Fund Disruption Event” where “Fund Settlement Disruption” on the relevant Valuation Date (Section 6.3) • “Fund Settlement Disruption” where failure by the Reference Fund to pay the full amount of the Redemption Proceeds by the scheduled payment date • Consequence is to postpone the relevant Valuation Date (and therefore the Final Observation Date) to next undisrupted day or last day of Cut-off Period (Section 6.6)

23. 1/ Differences- pricing & liquidity: Reported Value Method of Valuation • Reported Value Method • Reported Fund Interest Value … as of the Valuation Date … subject to the applicable Reported Value Convention” (Section 1.18 Relevant Price, Section 5.9 Final Price, Section 7.3 Settlement Price) • If Confirmation specifies Calculation Agent Adjustment, Calculation Agent to adjust to reflect: • fees that would be charged • Redemption Proceeds that would have been received by the Hypothetical Investor • If Calculation Agent determines no adjustment will produce a commercially reasonable result, Deemed Payout Method shall apply • Calculation Agent Adjustment makes outcome similar to Deemed Payout Method, but involves more discretion

24. 1/ Differences- pricing & liquidity: Reported Value Method of Valuation • “Reported Value Convention (Section1.42) – the method to be used for determining Reported Fund Interest Value where Valuation Date is not a Scheduled Fund Valuation Date: • “Prior Redemption Valuation Date” – immediately preceding Scheduled Redemption Valuation Date value (this is the fallback if no Convention is specified) • “Following Redemption Valuation Date” – next following Scheduled Redemption Valuation Date value • “Prior Fund Valuation Date” – immediately preceding Scheduled Fund Valuation Date value • “Last Reported Value Date” – most recently available Reported Fund Interest Value • “Following Fund Valuation Date” – next following Scheduled Fund Valuation Date value

25. 1/ Differences- pricing & liquidity: Reported Value Method of Valuation • “Fund Disruption Event” where “Fund Valuation Disruption” on the relevant Valuation Date (Section 6.3) • “Fund Valuation Disruption” occurs • where Reported Value Convention is Prior Redemption Valuation Date or Following Redemption Valuation Date, if Reference Fund fails to determine redemption value on scheduled redemption valuation date • where any other Reported Value Convention applies, if Reference Fund fails to determine the fund value on scheduled fund valuation date • Consequence is to postpone the relevant Valuation Date to next undisrupted day or last day of Cut-off Period (Section 6.6)

26. 2/ TRANSPARENCY

27. 2/ Differences- Transparency • KYF- how do you know what is going on with the fund? • Many funds, especially hedge funds, set up have less transparency in terms of regulatory disclosure requirements • Personalised investment (fees, subscription and redemption date etc)

28. 2/ Differences- Transparency • Hypothetical Investor” (Section 1.33) • Introduces a measure of objectivity and separation between reference investor and the actual hedging investor that may be important for some analysis, but also introduces a potential basis risk • Related Definition: “Hypothetical Investor Jurisdiction” (Section 1.34) - as specified or if not specified, the jurisdiction of the Equity Amount Payer or Seller • For subscription, deemed to have submitted a duly completed notice requesting subscription on the relevant Subscription Notice Date • For redemption, deemed to have submitted a duly completed notice of redemption on the relevant Redemption Notice Date • Role of Calculation Agent

29. 3/ RISK PROFILE & Structure

30. 3/ Differences- Risk profile & Structure • KYF- What is the fund about? • Fund focuses on particular investment strategy or strategies in contrast to general business of the issuer of an equity share • Investment restrictions • Service providers • Legal nature and status of fund (often not in corporate form - for example trust, partnership), domicile

31. 3/ Differences- Risk profile & Structure • Extraordinary Fund Events: Fund Modification & Strategy Breach • Extraordinary Fund Events: Adviser Resignation Event • Fund Service Provider concept

32. 3/ Differences- Risk profile & Structure • “Fund Interest” (Section 1.8) and “Fund Interest Unit” (Section 1.9) – “interest issued to or held by an investor in a fund, pooled investment vehicle or any other interest identified as such …” • “Reference Fund” (Section 1.11) – “the issuer of, or other legal arrangement giving rise to, the relevant Fund Interests” • “Fund Documents” (Section 1.29) – “the constitutive and governing documents, subscription agreements and other agreements of the related Reference Fund specifying the terms and conditions relating to such Fund Interest and any Additional Fund Documents, in each case, as amended from time to time”

33. Exchange traded funds

34. Exchange traded funds • Two presentations for the price of one • Hedge Funds (& Mutual Funds) Vs Exchange Traded Funds

35. Exchange Traded Funds- key characteristics • What is an ETF? • Strategy • Exchange traded • Creation Units • Pricing & liquidity, transparency and risk profile • Key players • Developments in the market

36. ETF Supplement • Ignores Creation Units (probably) • Index equity ETFs only • Share trade • Share and index trade • Valuation disruption (level of index) • Index Disruption Events • Underlying exchanges • Share and index and fund trade • Extraordinary Fund Events

37. 5th September, 2008 Fund Derivatives David Wakeling