757 Third Avenue, 20th FL New York, NY 10017 T: 212.376.5337 info@khromcapital.

com

February 6, 2013 Dear Limited Partners: In the fourth quarter of 2012, our Partnership returned 6.8% net of fees and expenses. Our total net return in 2012 was 36.4%. On average, we held 23% of our assets in cash throughout that year.

S&P 500 2008 2009 2010 2011 2012 Annualized Return Since Inception
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K.I.F., gross (32.6%) 91.9% 23.8% 22.8% 46.8% 24.5%

K.I.F., net (32.6%) 82.9% 18.6% 18.0% 36.4% 19.4%

(31.1%) 26.5% 15.1% 2.1% 16.0% 3.6%

Please refer to the disclosure at the end of this letter.

Pocket Aces? Several months ago, Sears Holdings (SHLD) conducted a rights offering to spin-out its subsidiary Sears Hometown and Outlet Stores (SHOS). We purchased the rightswhich allowed us to eventually buy shares of this subsidiaryon the first day it traded. After all the conversions, we wound up with an average cost basis of $25/share in SHOS. SHLD continues to be the operator of the well-recognized, giant mall-based Sears stores. The spinoff SHOS, however, will own the Sears franchise network. Most people are surprised it is possible to franchise a Sears. The franchised1 stores are less than one-fifth the size of a conventional Sears and effectively sell only appliances, tools, hardware and garden items. Not only is this concept unfamiliar to
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SHOS employs both a franchise and dealer model. For our purposes, the two concepts are essentially the same so we use the term franchise throughout.

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the general public, it is misunderstood by investors. Though SHOS seemed like an established business with ~1,200 stores upon its spinout, the evolution of this former subsidiary has just begun. As the Sears franchise concept gains popularity and investors continue to awaken to the potential of SHOS, we will continue to witness a repricing of its stock. The business model that SHOS resembles is Ace Hardware (privately owned). Ace was launched in 1924 by a group of retailers that transitioned into a dealer-owned cooperative for hardware stores. The cooperative structure allows individual stores to purchase merchandise in bulk at the lowest possible price. This partnership enables even the smaller Ace stores to compete effectively with the larger stores in their market. As Aces retailer base has grown, so has its buying power. Ace now has over 4,000 U.S. stores and generates nearly $4 billion per year in revenues. Ace Hardware is now the sixth largest franchise operation in the world, ranked only behind McDonalds, 7-Eleven, KFC, Subway and Burger King. 2 Over the past couple of decades, Ace has never had an unprofitable year. A franchisor3 has a powerful business model because of its inherent cost structure. The franchisors expenses are primarily variable, consisting of advertising, distribution, and commissions to the franchisees. The franchisees expenses are mainly fixed, consisting of rent, payroll and utilities. Essentially, the franchisees absorb the economic volatility of the franchisors business. This creates relative earnings stability for the franchisoran increased ability to remain profitable throughout business cycles. Stability allows a business to safely employ borrowing leverage (think real estate). This advantageous capital structurecoupled with a capital light business that has barriers to entrymakes it possible to earn high returns on equity. Since 1991, Ace has averaged a 32% ROE.4 SHOS is currently earning just a ~10% return on its equity, but it has the ability to replicate Aces capital structure and dramatically improve its ROE. Even though both companies earn close to the same amount5, SHOS is almost debt free while Ace carries around $250 million of net debt. It is no coincidence that post-spinout, SHOS entered into a credit facility that allows for up to $250 million in borrowing. With Edward Lampert at the helm of SHOS, this is a valuable lever the company has at its disposal. (See Lamperts previous involvement in Autozone for a glimpse of what is possible). There is also a switch that SHOS can flip to bring its $2.4 billion in annual revenues closer to Aces $4.0 billion. Note that SHLD continues to close its unprofitable mall-based stores. They are too large and sell items in which Sears has no competitive advantage, such as clothing. SHLDs core competency where it dominates the market and produces a profitare appliance sales. So what can SHLD do to

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According to the 2011 Franchise Times Top 200TM Franchise Systems list based on retailers annual worldwide retail sales in 2010. Aces franchise opportunity is structured slightly different than the typical franchise model. It is a retailer-owned cooperative where Ace retailers are the owners of the corporation. However, it functions effectively as a franchise. 4 As an aside, there is a difference between Aces and SHOS balance sheets. Aces payable terms are more favorable than SHOS because Aces vendors largely finance its inventory. However, Ace passes on this benefit to its franchisees, which results in Ace having to carry a large accounts receivable balance. SHOS virtually has no receivables balance, so net/net there is no major difference in the working capital structure of both companies. In fact, SHOS earns a higher return on assets than Ace. 5 In the last twelve months ending September/October 2012, Ace earned $120 million in earnings before interest and taxes versus $107 million for SHOS.

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keep only its profitable store square footage and get rid of the rest? It can close the big-box stores and transfer all the hardline sales (appliances, tools, lawn & garden items) to the small-box SHOS stores. For months, we have kept track of dozens of instances where Sears closed a big-box store coupled with a SHOS franchise opening within a ~30 minute driving radius. (There has even been a big-box mall store that was subdivided. A SHOS franchise is taking over that locations hardline sales and the remaining square footage is being leased out to other companies.6) SHLD does approximately $10 billion in U.S. hardline sales. Should even a small portion of that transfer, it will result in a substantial revenue increase for SHOS. Ace survived the onslaught of competition from Home Depot and Lowes super-sized stores, with comparable same store sales that continue to outperform them. Home Depot attempted to enter the small-format store model in 2005 with its purchase of Yardbirds Home Center. That experiment quickly failed and Home Depot closed those stores in 2009. Both Ace and SHOS have the advantage of locations that are more convenient for customers and located in urban areas where the big chains have found it difficult to establish large stores. Their advantage also stems from the franchise model: local storeowners are more incentivized to sell and provide better customer service than a salaried employee within a massive organization. And SHOS has further advantages over Ace. Ace spends $100 million on advertising annually versus Sears $2 billion. Ace sells no appliances. For SHOS, that is their main focusa segment that Sears dominates with a market share 50% greater than the 2nd largest competitor. Sears also owns the largest appliance repair network and its delivery distribution is evolving to use SHOS stores as its hub-andspoke for online sales. It is also important to note that Ace has ~600 international stores while SHOS has none outside North America. In a fortunate stroke of serendipity, SHOS has begun taking applications for international franchised stores. Anytime there is a new store opening, SHOS only provides the store with inventory that it can take back if the location does not work and needs to be closed. This allows SHOS to profit from constantly opening stores in certain pockets of market opportunitydomestically and internationallywhile the franchisee takes on the bulk of the risk. We purchased SHOS at a cheap price because its business model was misunderstood and none of the additional upsidewhether from the above-referenced developments or the fact that appliance sales are currently at cyclical lowswas factored in. We were dealt aces; then we sat and let them play out. The Land of Inefficiency Lender A (LEA) is our new investment in a micro lender outside the U.S. We purchased this company which just received a license to operate as a mutual bankat around book value. LEA now sits at the start of a very impressive growth runway.
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The Leigh Mall space previously occupied by Sears has been subdivided to accommodate a Sears Hometown Store, Ross Dress for Less and another unnamed business. At least 8,024 square feet are being renovated for a Sears franchise.

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The founder and CEO owns ~45% of the stock, i.e., 45 cents of each equity dollar that LEA lends out is the CEOs money. Our meeting and discussions with management led us to conclude that this is an experienced and conservative group. They have prudently kept the length of their loans at a maximum of 6 months (their average loan duration is 2 months). The short cash cycle allows for tight risk management. Theoretically, LEA could convert the majority of its loan book to cash in 60 days. The risk is further kept to a minimum by the fact that 80% of the loans are made to repeat customers. The risk of such a loan book is incommensurately low relative to the high returns it generates. A few months ago, LEA was the first domestic bank to be granted a banking license in thirteen years. The more stable and low cost deposit base will allow LEA to penetrate a market in which it currently has less than 1% market share. Management was given a license to compound. Walt Disney once remarked, I do not like to repeat successes, I like to go on to other things. We, however, are more enamored with repetitive successes and stay away from magic. A competitor of LEAs has compounded its book value per share at 24% per annum, resulting in its stock returning over 100x within just 10 years. With its new license in hand, LEA just has to follow the already made blueprint. From Straw, To Sticks, To Brick Speaking of blueprints, Khrom Capital is heading into its sixth year of successful operations. Over this time, we have earned a greater degree of trust from our current and prospective investors. We are happy to announce that this has allowed us to implement a much more long-term commitment structure for the Partnerships capital. Our new lock-up will give us a substantial advantage over other funds that are at the mercy of short-duration capital. This will increase our ability to a) better deploy capital during market panics, when we can step in as buyers while others are forced sellers; and b) continue our concentration on profiting from time arbitrage, where we make money by investing in a company whose investment thesis may take three yearsrather than three monthsto play out. *** Our fund is currently open to new contributions. Should you wish to add or make a new investment, please contact us at (212) 376-5337 or info@khromcapital.com. As always, virtually 100% of my net worth is invested in the Partnership as I aim to compound my wealth alongside yours. I look forward to writing to you again after the first quarter.

Sincerely, Eric E. Khrom Managing Partner Khrom Capital Management, LLC

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Khrom Capital Management LLC www.khromcapital.com

DISCLOSURE:
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2008 performance only includes March 1st, 2008 to December 31st, 2008, due to fund inception date of March 1st, 2008.

Performance data of the S&P 500 Index is included to facilitate comparisons between the Partnerships returns and overall market performance. Due to the differences among the Partnerships investment strategies and the securities that compose the S&P 500 Index, the General Partner cautions potential investors that no such index is directly comparable to the Partnerships investment strategy. S&P 500 index performance results include the reinvestment of dividends. The results portrayed above are intended to show the investment performance that would have been experienced by a single limited partner of the Partnership who remained invested throughout each annual or partial year period shown, after the reinvestment of interest, dividends, and other earnings, and the deduction of costs and the profit allocation that the General Partner would have accrued as of the end of each year. Results are based on the Partnerships internal books and are subject to adjustment following the audit of its financial statements. Future investments may be made under different economic conditions and in different securities and using different investment strategies than were used during the time discussed herein. It should not be assumed that future investors will experience returns, if any, comparable to those of the Partnership discussed herein. The information given above is historic and should not be taken as any indication of future performance.
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This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation to invest in Khrom Investments Fund LP (the Fund) may only be made by means of delivery of an approved confidential offering memorandum. Past results are no guarantee of future results and no representation is made that an investor will or is likely to achieve results similar to those shown. All investments involve risk including the loss of principal. Performance results in separately managed accounts will be different from the performance results of Khrom Investments Fund LP. Khrom Capital Management, LLC or affiliated entities (Khrom Capital) is not responsible for any liabilities resulting from errors contained in this communication. Khrom will not notify you of any errors that it identifies at a later date. An investment in any product managed or offered by Khrom Capital may be deemed speculative and is not intended as a complete investment program. It is designed only for sophisticated persons who are able to bear the risk of the substantial impairment or loss of their investment in the Fund. Products managed or offered by Khrom Capital are designed for investors who do not require regular current income and who can accept a certain degree of risk in their investments.

Khrom Capital Management LLC www.khromcapital.com