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N b a l t e r na t i v e s

2011 Strategy Outlook


Fund of Hedge Funds Team

Not for retail client use in Europe, Asia and the middle east.
Introduction
NB Alternatives continues to view the identification and bottom-up due
diligence of individual managers as the key to successful hedge fund investing.
Nevertheless, more thorough higher level analysis is helpful in identifying
opportunities for specific strategies, as well as general trends that may affect
funds across the industry. In this document, we discuss the opportunity set
in the distressed and asset-backed securities markets, as well as the general
opportunity for investing in emerging managers across strategies. In light
of recent government policies, we also explore the impact of a rising interest
rate regime on particular investment strategies. Lastly, we provide thoughts
regarding hedge fund performance during times of market illiquidity and
identify positive illiquidity beta strategies that could meaningfully diversify
a portfolio.

Our 2011 Strategy Outlook remains focused on empirically driven conclusions


derived from the analysis of our detailed hedge fund database1 and an array of
market and macro data provided by external sources. Our market experience
and commentary, coupled with these analyses, aim to provide constructive
insights into the changing hedge fund landscape and the resulting opportunities
for investing.

Chapter 1: Distressed Investing Update


This section provides an update on the analysis conducted in our 2010 Strategy Outlook, along
with a discussion regarding the current and future opportunity set, the liquidity of underlying
investments and subsequent fund terms and considerations for non-U.S. distressed investing.
We believe that the current and future opportunity set for distressed investing is robust.
A large wall of forthcoming maturities in both the middle market and large cap space is likely
to create opportunities for several years; we believe the middle markets present a particularly
compelling area. A distinctive characteristic of distressed investing is that the liquidity
is often longer term in duration, requiring longer lock-ups. Finally, as expressed in our
2010 Strategy Outlook, distressed investing outside the U.S. is often accompanied by additional
process-related risks and requires specific expertise pertaining to the particular jurisdiction.

Chapter 2: Rising Rates and Hedge Fund Performance


If expansive monetary policy were to bring about inflation in developed world economies,
how might concomitant rate rises impact hedge fund performance? We analyze performance
across a variety of different hedge fund strategies in periods of rising rates, as compared to
periods of static or falling rates. We then apply fundamental analysis to the findings to assess
whether there is a sensible rationale to support the thesis that some strategies will benefit or
suffer from a regime shift in rates. Finally, we consider the patterns of those returns and how a
regime shift might impact the diversification properties of certain hedge fund strategies, such
as Commodity Trading Advisors and Global Macro.

1
Our team leverages proprietary peer groups that consist of over 3,500 hedge funds across 80 distinct sub-strategies
and geographies. Our own investment team members (not the fund manager or a third-party data provider) define the
strategies of hedge funds to ensure that strategy descriptions accurately reflect each hedge fund’s activities and that
each peer group consists of comparable data. Returns for each fund in the peer groups are housed in Pertrac. Returns are
updated both manually by the investment team and on an automated basis through data feeds from Pertrac, Eurekahedge
and TASS.

3
Chapter 3: Asset-Backed Securities and the Factors Influencing the Opportunity Set
We have witnessed the launch of a number of hedge funds investing in the asset-backed space
in 2010. These funds have benefited from the rally of asset-backed securities from near historic
lows over the last 12 months. This section examines the residential mortgage-backed securities
market in a post-2008 environment. We seek to define the universe and assess the supply
and demand dynamics and liquidity of the underlying instruments. The analysis of current
yields as well as the risks and limitations of the strategy in a hedge fund structure allow us to
determine whether the market dislocations still provide significant opportunities for investors
and the likely longevity of the opportunity.

Chapter 4: Emerging Manager Outperformance: An Analysis of Renewed Importance


The number of qualified managers seeking to launch new hedge funds has increased after
the implementation of the Volcker Rule and the financial crisis of 2008. Within this context,
we reexamine the concept of emerging manager outperformance in relation to their more
established peers. What defines an “emerging” manager? Are some market environments
better than others for emerging managers? Does the benefit of age influence some strategies
more than others? These questions guide our evaluation of manager performance in various
stages of the life cycle. Our analysis demonstrates compelling trends for investing in emerging
managers for certain strategies, and highlights the potential alpha and diversification benefits
of a thoughtful emerging manager allocation.

Chapter 5: The Relationship between Various Hedge Fund Strategies


and Market Illiquidity
In this section, we revisit the notion of “illiquidity beta” and the implications for hedge fund
investing in a post-2008 environment. We explore this illiquidity beta concept in an effort
to assess the qualitative thesis that certain hedge fund strategies perform more poorly than
simple equity or credit betas would suggest in times of decreasing capital markets liquidity. We
observe the concept of an illiquidity factor in three different ways, measure the sensitivity of
various hedge fund strategies to this factor, and discuss the portfolio construction implications
of these results for well diversified fund of hedge fund portfolios.

4
Chapter 1: Distressed Investing Update
In our 2010 Strategy Outlook, we considered the implications of various distressed trading styles
on market exposures before and after a credit event. For this update, we included data through
the end of 2009 and the first three quarters of 2010. We again focus on three sub-strategies:
Long/Short and Capital Structure Arbitrage, Long-Biased Conservative Distressed and
Long-Biased Aggressive Distressed and a subset of the NB Alternatives Peer Group. Data for
the three sub-strategies are comprised of funds within our peer group where we have recent
return data and where we are confident we can identify the underlying sub-strategy.
As a brief review, Long/Short and Capital Structure Arbitrage includes managers who maintain
lower levels of net exposure, with long and short positions used either as outright or as part
of capital structure arbitrage trades. Long-Biased Conservative managers employ little or no
leverage, invest a majority of their assets in the senior-most portion of a company’s capital
structure (bank debt and senior secured bonds), and use less shorts. Long-Biased Aggressive
managers are similarly long-biased and use less shorts, but differ from conservative managers
in that they may use leverage, invest throughout a company’s capital structure (bank debt
down to equity), and have a more concentrated portfolio with larger average position sizes.
To understand if market exposure The analysis looks at the multifactor two-year beta of each sub-strategy for both equity
changes prior to and following (S&P 500 Index) and credit (Barclays High Yield Index) markets. To understand if market
exposure changes prior to and following major credit events (which often precede distressed
major credit events, we observe cycles or distressed opportunities), we observe the betas for two years prior to the credit spread
the betas for two years prior to widening and for two years following the event (including the period of spread widening).
the credit spread widening and In Figure 1.1, we consider betas for the following credit events: second half of 2000, Summer
2002, Spring 2005, Summer 2007 and the fourth quarter of 2008.
for two years following the event.
Figure 1.1: Multifactor Two-Year Beta for Each Sub-Strategy

S&P 500 Index Beta


Long/Short and Cap Structure Distressed – Conservative Distressed – Aggressive
Period Pre-Event Post-Event Pre-Event Post-Event Pre-Event Post-Event
Second Half 2000 0.07 -0.03 -0.08 -0.02 0.11 -0.01
Summer 2002 -0.03 0.03 -0.02 -0.01 -0.01 0.24
Spring 2005 0.23 0.05 0.11 0.01 0.27 0.12
Summer 2007 0.07 0.00 -0.01 -0.01 0.11 0.12
Q4 2008 0.00 0.12 0.05 0.03 0.17 0.22
Average 0.07 0.03 0.01 0.00 0.13 0.14

Barclays High Yield Index Beta (“HY Beta”)


Long/Short and Cap Structure Distressed – Conservative Distressed – Aggressive
Period Pre-Event Post-Event Pre-Event Post-Event Pre-Event Post-Event
Second Half 2000 0.18 0.05 0.54 0.23 0.69 0.32
Summer 2002 0.05 0.18 0.23 0.46 0.32 0.48
Spring 2005 0.10 0.38 0.35 0.19 0.26 0.14
Summer 2007 0.52 0.17 0.26 0.23 0.22 0.43
Q4 2008 0.23 0.12 0.14 0.22 0.15 0.41
Average 0.22 0.18 0.30 0.27 0.33 0.36

Source: NB Alternatives Peer Groups.

5
Similar to our analysis last year, we continue to see that managers who run the most hedged
portfolios, the Long/Short and Capital Structure Arbitrage managers, maintain the lowest
level of beta to both credit and equity markets. The average S&P 500 beta of these managers
across all events is 0.07 for the two years preceding the credit event and is 0.03 for the two
years following the event. The average HY beta is 0.22 pre-event and 0.18 post-event. For
long-biased managers, we observe that both the Conservative and the Aggressive managers
have a higher level of market beta than that of more hedged managers, which in the case of
the Conservative sub-strategy comes almost exclusively in exposure to credit markets, where
the pre-event average is 0.30 and the post-event average is 0.27 for HY beta while the S&P 500
beta average is 0.01 pre-event and 0.00 post-event. For the Aggressive sub-strategy, the market
sensitivity is driven again by the HY beta, with a pre-event average of 0.33, and 0.36 post-event,
but also shows a positive value in the equity beta as well, with a 0.13 pre-event average, and
0.14 post-event average. The increased betas of the Aggressive sub-strategy are likely a result
of their willingness to invest lower in the capital structure, to hold more market-sensitive
securities for longer and to take on higher levels of leverage, which may result in magnifying
market exposure. As we observed last year, and consistent with the typical tendencies of the
sub-strategy, Aggressive managers have the highest absolute beta levels to both equity and
credit markets.
Feasible factors that could help We also observe that the changes in pre-event and post-event betas are inconsistent. In some
explain both the direction and the periods, we see betas fall in the wake of an event while betas in other periods rise from pre-event
levels. Feasible factors that could help explain both the direction and the magnitude of the
magnitude of the change include change include 1) the exposure levels of managers, both gross and net, entering the spread
widening period, 2) the magnitude of the spread widening, 3) the length of time over which the
1) The exposure levels of managers, spread widening occurs and 4) the drivers of the spread widening. If we look anecdotally at the
both gross and net, entering the most recent period, we can see that for Long/Short and Capital Structure Arbitrage, post-event
credit beta has fallen, while for the Long-Biased sub-strategies, it has risen.
spread widening period.
While changes in other periods to manager exposure often explain changes in market betas,
2) The magnitude of the Figure 1.2 shows that this is not always the case. From November 2006 to September 2010,
spread widening. managers maintained relatively constant or reduced levels of pre-event and post-event net and
gross exposure. As such, it is more likely that the changes in market betas can be explained by
3) The length of time over which the strong performance of the asset class following the spread widening and the extent to which
the spread widening occurs. managers took advantage of the “beta” play over the past several quarters. Security selection
has been less relevant to market performance while absolute exposure levels have more directly
4) The drivers of the impacted performance.
spread widening.

6
Figure 1.2: Exposures by Sub-Strategy (November 2006 – September 2010)

Figure 1.2a: Gross Exposure: Long/Short and Figure 1.2d: Net Exposure: Long/Short and
Capital Structure Arbitrage Capital Structure Arbitrage
500% 150%
Fund 1 Fund 2 Fund 3 Fund 4 Fund 1 Fund 2 Fund 3 Fund 4
Fund 5 Fund 6 Fund 7 Average Fund 5 Fund 6 Fund 7 Average
100%
400%
50%

300% 0%

-50%
200%

-100%

100%
-150%

0% -200%
Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10

Figure 1.2b: Gross Exposure: Long-Biased Conservative Figure 1.2e: Net Exposure: Long-Biased Conservative
250% 120%

200% 80%

150% 40%

100% 0%

50% -40%

Fund 1 Fund 2 Fund 3 Average Fund 1 Fund 2 Fund 3 Average


0% -80%
Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10

Figure 1.2c: Gross Exposure: Long-Biased Aggressive Figure 1.2f: Net Exposure: Long-Biased Aggressive
160% 140%
Fund 1 Fund 2 Fund 3 Fund 4 Average Fund 1 Fund 2 Fund 3 Fund 4 Average

140% 120%

120%
100%

100%
80%
80%
60%
60%

40%
40%

20% 20%

0% 0%
Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10

Sources: NB Alternatives analysis, NB Alternatives Peer Groups.

7
Generally, the managers exhibiting the most market exposure performed the best in
the period following the spread widening. The best performing sub-strategy in 2009
was Long-Biased Aggressive with an average return of 52.36%, followed by Long/
Short and Capital Structure Arbitrage with an average return of 23.72% and lastly,
Long-Biased Conservative with an average return of 20.63%.2 The similar performance of
Long-Biased Conservative and Long/Short and Capital Structure Arbitrage managers may
be explained by similar levels of exposure, with Long-Biased Conservative managers
maintaining relatively high short and cash exposures, making them appear more hedged and
less market exposed.
The broadly positive performance Year-to-date performance through September 2010 is again led by Long-Biased Aggressive
of all sub-strategies, the positive with an average return of 9.79%, followed by Long-Biased Conservative with an average
performance of 8.90% and Long/Short and Capital Structure Arbitrage with an average
market betas and the positive return of 4.14%.3 The relatively analogous performance of the two Long-Biased sub-strategies
performance of the broader credit in 2010 may again be explained by similar levels of exposure. Given the “beta” nature of the
markets suggest that beta has been rally which continued into 2010, the specific securities the two sub-strategies owned exerted
less of an influence over performance. Further, as we are still relatively early in the cycle, both
a source of profits for managers Aggressive and Conservative managers will tend to be invested in similar parts of the capital
since the fourth quarter of 2008. structure, causing their portfolios to display a greater level of overlap than at other points in
the cycle. The broadly positive performance of all sub-strategies, the positive market betas and
the positive performance of the broader credit markets (the Barclays High Yield Index was up
58.21% in 2009 and 11.52% YTD 2010 through the third quarter) suggest that beta has been
a source of profits for managers since the fourth quarter of 2008. However, as spreads have
returned to their pre-Q4 2008 levels4 and there are fewer “cheap” high beta names to own,
dispersion of performance among managers and sub-strategies may rise going forward.

2
NB Alternatives analysis, Pertrac, TASS, Eurekahedge.
3
NB Alternatives analysis, Pertrac, TASS, Eurekahedge.
8 4
The Barclays High Yield Index OAS was 708 as of June 26, 2008, and 621 as of September 30, 2010.
The Opportunity Set
We believe a combination of decreased demand and ample supply is likely to create a compelling
and sustained opportunity set for distressed investing. The decrease in demand stems from
a number of sources, including 1) hedge funds operating at below average exposure levels,
2) investment banks’ diminished participation in direct investments due to the Volcker Rule,5
and 3) collateralized loan obligations (“CLOs”), the primary source of refinancing for loans,
are running out of cash.

Figure 1.3: Primary Market for Institutional Loans

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 1H10

Banks, Finance Prime Rate Fund Hedge, Distressed CLOs


and Insurance Co. and High Yield Funds

Source: J.P. Morgan.

Figure 1.4: Maturity of CLOs


($bn)
300
CLO Reinvestable Assets
CLOs out of Reinvestment
250
Window
200

150

100

50

0
’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17 ’18 ’19 ’20 ’21 ’22

Sources: Wells Fargo, Intex, TPGC Estimates.

While we have witnessed robust refinancing activity in 2009 and 2010 (approximately
$152.6 billion of high yield issuance occurred in 2009 and $209.2 billion in 2010),6 we have
also seen the maturity calendar pushed out by the “amend and extend” phenomenon, where
covenants are breached, or companies get alarmingly close and terms are renegotiated. This
typically extends the maturity, but also increases the cost to the companies. While the overhang
may have been pushed out a few years and some of the volume has been reduced, the overhang
remains considerable. We believe that the level of restructuring activity should remain above
average for several years, even with more modest default expectations.
5
The Volcker Rule prohibits a bank or a bank-holding company from engaging in proprietary trading and from owning
or investing in a hedge fund or private equity fund. The Rule also restricts the amount of liabilities the largest banks
can carry.
9
6
Barclays Capital.
Figure 1.5: U.S. Refinancing Overhang

($bn)
450
Leveraged Loans
400 High Yield

350

300

250

200

150

100

50

0
2011 2012 2013 2014 2015 2016 2017 2018

Sources: J.P. Morgan; Credit Suisse 2009 Leveraged Finance Strategy Update — May 31, 2010; and
Credit Suisse 2008 Leveraged Finance Outlook and 2007 Annual Review.

Figure 1.6: European Refinancing Overhang


($bn)
140
Leveraged Loans
High Yield
120

100

80

60

40

20

0
2011 2012 2013 2014 2015 2016 2017

Source: Credit Suisse.

At a relatively reasonable projected default rate of 5% (around the historical average of Moody’s
Speculative Grade Default Rate from 1990 to 2009),7 annual supply of defaulted paper in the
U.S. will reach $81 billion between the end of 2010 and 2014. A higher projected default rate of
8% produces $131 billion of supply.8

7
Moody’s Investors Service, “Corporate Default and Recovery Rates, 1920 – 2009.”
8
J.P. Morgan, S&P/LCD, TPG Credit estimates.

10
Figure 1.7: U.S. Projected Default Volume
($bn)
200 Projected Defaults
Historical Default Volumes Annual Supply:
180 5% Projected Default Rate @ 5%=$81 Billion
160 8% Projected Default Rate @ 8%=$131 Billion

140

Default Volume
120
100
80
60
40
20
0
’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14

Sources: J.P. Morgan, S&P/LCD, TPG Credit estimates.

In Europe, at a projected default rate of 6%, the volume of defaulted paper will reach
$20 billion. At 8%, this could rise to $27 billion between 2011 and 2014.9

Figure 1.8: European Projected Default Volume


($bn)
40 Annual Supply: Projected Defaults
@ 6%=$20 Billion
35 @ 8%=$27 Billion

30 Historical Default Volumes


6% Projected Default Rate
Default Volume

25 8% Projected Default Rate

20

15

10

0
’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14
Sources: J.P. Morgan, S&P/LCD, TPG Credit estimates.

Higher interest rates could also lead to increased opportunities for hedge funds, particularly
because of the number of corporates with floating rate debt. This, coupled with modest
growth expectations, 10 could mean corporates find their interest burden increasingly
problematic as rates rise and they are unable to “grow” their way out of bad balance sheets and
nearing maturities.

9
J.P. Morgan, S&P/LCD, TPG Credit estimates.
10
 group of 43 economists surveyed by the Federal Reserve Bank of Philadelphia forecast GDP growth of 2.5% in
A
2011 and 2.9% in 2012. http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-
forecasters/2010/survq410.cfm

11
While we have seen a substantial pickup in refinancing activity in 2009 and 2010, much of the
activity has been concentrated in larger companies as small and middle market companies
continue to find it difficult to access the capital markets. As demonstrated in Figure 1.9 below,
this is apparent in the diverging default rates for middle market versus large corporate issuers.
While default rates for larger corporates have fallen in 2010, they have continued to rise for
the middle market. As of June 2010, the 12-month default rate for middle market loans was
11.37%, compared to just 3.75% for large corporates.11 Until the capital markets reopen for
smaller and middle market companies, these corporates may continue to have trouble repaying
maturities and defaults may continue to remain high.

Figure 1.9: Default Rates

14%
Middle Market
12% Large Corporate

10%
Default Rate

8%

6%

4%

2%
0%
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Source: S&P Leveraged Commentary & Data, as of June 30, 2010.

Further, the number of maturities coming due in the next several years is much greater for
the middle market than for large capitalization companies. In 2011, middle market maturities
total 39 while large cap maturities are only 2; these numbers increase as we near the looming
maturity wall in 2014 – 2015 (see Figure 1.10). Additionally, middle market leveraged loan
defaults have historically exceeded large cap defaults (see Figure 1.11).12 This, coupled with
fewer players in this segment of the market and limited research analyst coverage, could lead to
interesting opportunities.

Figure 1.10: Number of Maturities by Issue Size

400 Middle Market 49


350 Large Cap
Number of Maturities

300
22
250

200
317
150 16
6 243 7
100
2 101 105
50 103 2
39 18
0
2011 2012 2013 2014 2015 2016 2017

Sources: J.P. Morgan, S&P/LCD, TPGC estimates.

11
S&P Leveraged Commentary & Data, as of June 30, 2010. The default rate represents the percentage of defaulted loans by
volume over the prior twelve-month period.
12
J.P. Morgan, S&P/LCD, TPGC estimates. Middle market loans defined as pari passu loans less than $1 billion.

12

14
Figure 1.11: Leveraged Loan Defaults

100
Middle Market 16
90 Large Cap
80

Number of Defaults
70
4
60
50
40 74
4
30 4 4 56 2
20 1
2 29 22 1
10 4 19 6 5 21
11 10 3
7
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Sources: J.P. Morgan, S&P/LCD, TPGC estimates.

Managers also continue to Managers also continue to find value in holding the post-reorganization equities of recently
find value in holding the restructured companies. A fairly common practice in the course of a restructuring is a debt-for-
equity swap, where creditors are given equity, either in combination with cash or new debt or
post-reorganization equities of on its own in exchange for forgiving their current debt. Given the taint often associated with
recently restructured companies. recently restructured companies (even if the restructuring was due to a bad balance sheet rather
than a bad business), these new equity securities often trade at a large discount to their peers,
offering distressed investors who choose to hold the post-reorganization equity substantial
upside. For example, Visteon, which emerged in early October 2010, is trading around
2.5x 2010E EBITDA and 2x 2011E EBITDA. Delphi, which emerged in October 2009, is trading
around 3.25x 2010E EBITDA and 2.75x 2011E EBITDA. These compare favorably with average
multiples for the automotive supplier universe of roughly 5.3x 2010E EBITDA and 4.7x 2011E
EBITDA.13 The relatively attractive valuations of these companies may be further explained
by the relatively concentrated shareholder base at the time of emergence, as well as the lack of
research analyst coverage. Distressed investors will often hold these securities until they begin
trading more in line with their peers and the value has been realized. Figures 1.12 through
1.15 show the performance of recently emerged companies versus a few related competitors.
In many instances, the stock outperforms; in all instances, they are broadly in line with peers
generating positive profits in the period after their emergence.
Given the taint often associated
Figure 1.12: Spectrum Brands Holdings Inc.: Emerged 8/28/2009
with recently restructured
companies, these new equity $160
securities often trade at a large $140
discount to their peers, offering $120
distressed investors who choose to
Share Price

$100
hold the post-reorganization equity $80
substantial upside. $60 Proctor & Gamble Company (PG)
Energizer Holdings Inc (ENR)
$40
Centaurus 2002 SICAV (CENTA)
$20 Spectrum Brands Holdings Inc (SPB)
$0
Sept-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sept-10 Nov-10

Sources: Bloomberg, Imperial Capital.

13
NB Alternatives analysis, Bloomberg, Visteon Corporation, Delphi. The multiples are approximate as of December 2010.

13
Figure 1.13: Lear Corporation: Emerged 11/9/2009

Magna International Inc (MGA)


$250 Dana Holding Corporation (DAN)
$230 American Axle and Manufacturing (AXL)
$210 Lear Coporation (LEA)
$190

Share Price
$170
$150
$130
$110
$90
$70
$50
Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sept-10 Nov-10

Sources: Bloomberg, Imperial Capital.

Figure 1.14: CIT Group Inc.: Emerged 12/9/2009


$190
$170
$150
Share Price

$130
$110
$90
$70
$50
Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10

United Bankshares Inc (UBI) Bank of America Coporation (BAC)


Synovus Financial Corporation (SNV) CIT Group Inc (CIT)
BB&T Corporation (BBT)

Sources: Bloomberg, Imperial Capital.

Figure 1.15: Smurf-It Stone Container Corporation: Emerged 6/30/2010

$120
Weyerhaeuser Company (WY)
$115 International Paper Company (IP)
Smurf-It Stone Container Corporation (SSCC)
$110
$105
Share Price

$100
$95
$90
$85
$80
$75
Jul-10 Aug-10 Sep-10 Oct-10 Nov-10

Sources: Bloomberg, Imperial Capital.

14
Liquidity
Stricter liquidity terms are In response to the challenges in 2008, many investors have demanded increased liquidity from
reasonable considering the their underlying managers. However, we believe it is more prudent to focus on whether hedge
fund managers match their assets with their liabilities. When we consider the hedge fund
underlying strategy of distressed universe, distressed managers tend to have less favorable liquidity terms when compared with
managers and the situations in other hedge fund strategies. Distressed managers may only offer liquidity on an annual, or less
which they invest. frequent basis, while macro and long/short equity managers are often able to offer monthly
or quarterly liquidity. While these differences are material in terms of redemption frequency,
we think the stricter liquidity terms are reasonable considering the underlying strategy of
distressed managers and the situations in which they invest.
Between 1980 and 2010, the average duration of the 907 Chapter 11 filings was 521 days, while
the median duration was 401 days.14 In the more recent period of 2008 to 2010, the average
and median durations of the 161 Chapter 11 filings have come down, with an average duration
of 231 days and a median duration of 219.15 Figure 1.16 provides additional support for the
significant number of opportunities in middle market companies versus large cap companies,
given the larger number of filings of companies valued below $1 billion in assets in both
periods.

Figure 1.16: U.S. Chapter 11 Filings

2008 – 2010 1980 – 2010
Number of Average Median Number of Average Median
Chapter 11 Duration Duration Chapter 11 Duration Duration
Asset Size Filings (in days) (in days) Filings (in days) (in days)

Greater than $10 Billion 19 354 235 50 644 553


$1 – 10 Billion 60 266 282 317 590 457
$500 Million – $1 Billion 42 184 136 234 450 323
Less than $500 Million 40 198 181 306 488 378
Total 161 231 219 907 521 401

Source: UCLA School of Law – LoPucki Bankruptcy Research Database.

14
UCLA School of Law – LoPucki Bankruptcy Research Database. The UCLA School of Law’s Bankruptcy Research
Database contains data on all large, public company bankruptcy cases filed in the United States Bankruptcy Courts from
October 1, 1979, to the most recent update of the database. A case is “large” if the debtor reported assets of more than
$100 million (measured in 1980 dollars) on the last Form 10-K that the debtor filed with the Securities and Exchange
Commission before filing the bankruptcy case. A company is “public” if the company filed a Form 10-K with the Securities
and Exchange Commission in the three years prior to bankruptcy. A “case” includes all cases filed by or against members
of the 10-K-filing company’s corporate group provided that those cases are consolidated by the bankruptcy court for the
purpose of administration. Thus, a single “case” for the purpose of the WebBRD may be reported by the Administrative
Office of the U.S. Courts as dozens or hundreds of cases.
15
UCLA School of Law – LoPucki Bankruptcy Research Database.

15
To illustrate how a fund is involved in a more recent deal, we have provided a timeline and
trading strategy for Delphi below. Restructurings are time consuming and more successful
managers tend to match the duration of their underlying assets with the terms they offer their
investors.

Figure 1.17: Delphi Bankruptcy Timeline

July 2009:
Delphi’s board approves an offer to split the
company between GM and its lenders. Under the
modified plan, GM will pay a little more than
$3 billion totake back select U.S. plants and
operations, including $1.75 billion to receive 35%
of the new equity of the company. The DIP lenders
will receive cash and 65% of the new equity of the
company in exchange for forgiving their current debt.

October 2005: December 2008: November 2009:


Delphi files for Delphi obtains court Delphi stock trading
Chapter 11 Bankruptcy approval to extend the in the OTC market at
Protection. At the time of maturity of the DIP loan to $8,350 per share.
filing, Delphi obtains a June 30, 2009.
DIP loan to fund
operations through the
restructuring process.

2005 2006 2007 2008 2009 2010

June 2009:
June 2008: Plan of reorganization for Early October 2009:
Maturity date of the original Delphi is submitted. Under The sale of Delphi is finalized
DIP loan. Unable to pay, Delphi the plan the implied and the company emerges
refinances with a new DIP loan recovery to the DIP lenders from bankruptcy.
scheduled to mature on is approximately 15 to 20
December 31, 2008. cents on the dollar. DIP
lenders object to the plan
and gain approval for a
formal sale process of the
July 2009 –
company to obtain a Early October 2009:
higher bid. Certain DIP lenders, including the Fund,
provide a backstop commitment for the
new plan. Upon emergence, the Fund
October 2005 – June 2008: receives cash and new equity ($6,200/share
Delphi makes various unsuccessful attempts to exit bankruptcy prior
at conversion) per the plan of reorganization.
to the maturity of the DIP loan.
As a result of their participation in the
June 2008 – backstop, the Fund is able to buy
October 2008: additional equity at a discount
Fund purchases DIP loan in the (approximately $1,000/share).
secondary market.

November 2009 –
September 2010:
Fund scaling out of their position,
trading selectively
to realize profits.

Sources: NB Alternatives analysis, Delphi Corporation, Reuters, Bloomberg, Forbes.

16
Non-U.S. Distressed Investing
Unlike the U.S., where investors In our 2010 Strategy Outlook, we briefly discussed some of the challenges associated with
are accustomed to a “one-size-fits- distressed investing outside of the U.S., primarily due to the lack of a standard insolvency
regime. Unlike the U.S., where investors are accustomed to a “one-size-fits-all” Chapter 11
all” Chapter 11 bankruptcy bankruptcy process, insolvency outside the U.S. is country-specific, with the rights of creditors
process, insolvency outside the dictated by individual jurisdictions. While there have been no material updates in the insolvency
U.S. is country-specific, with the practices of individual countries, we have started to see some examples of workarounds for
bankruptcies taking place outside of the U.S.
rights of creditors dictated by
The U.K. is probably closest to the U.S. when it comes to insolvency processes, with
individual jurisdictions.
“administration” typically viewed as the most creditor-friendly process in Europe. Because of
this, the management and creditors of European companies, notably cross-border companies
with operations in multiple jurisdictions, have started to make strategic decisions about which
jurisdiction will be responsible for the insolvency process. For example, in 2009, Wind Hellas, a
Greek mobile phone operator, became the largest U.K. pre-pack administration16 after moving
its Centre of Main Interests (“COMI”) from Luxembourg to the U.K. to take advantage of
the U.K.’s insolvency laws. The COMI principle is important in the context of cross-border
restructurings and insolvencies because it determines the appropriate jurisdiction for the
insolvency proceedings. European Community (“EC”) Regulation requires that bankruptcy
proceedings take place in the COMI, which is typically the location of the company’s registered
office. However, it is worth noting that in the Wind Hellas case a judge ruled that the COMI
had been changed due to the following actions on the part of Wind Hellas, 1) a new head
office and principal operating address had been opened in London, where the company’s
board meetings were held and from which correspondence was sent, 2) Wind Hellas had
notified its creditors of the change of address, 3) a new bank account was opened in London,
4) Wind Hellas registered as a foreign company and as a U.K. establishment of an overseas
company, and 5) all of the negotiations surrounding the pre-pack administration had taken
place in London. The judge clarified that the purpose of the COMI was “to enable creditors
in particular to know where the company is and where it may deal with the company.”17 As
such, the judge deemed it appropriate to allow Wind Hellas to file in the U.K. This practice
is growing as companies consider the laws of various jurisdictions, the implications for the
efficiency of the administration process, the outcome of the administration and the viability of
future operations.
U.S. bankruptcies often have less U.S. bankruptcies often have less process risk and higher potential preservation of value
process risk and higher potential (particularly in Chapter 11 bankruptcies where reorganization is the explicit aim) when compared
with European and Asian processes due to the following factors: 1) the automatic stay, 2) access
preservation of value when to “debtor-in-possession” (“DIP”) financing,18 and 3) the retention of existing management.
compared with European and
The automatic stay provides a period of time in which the creditors’ right to enforce their claims
Asian processes. is suspended. The stay is implemented as soon as a company files for Chapter 11 protection
and remains in effect until the termination of the bankruptcy proceedings.19 While European
regulations provide limited coordination of European bankruptcy regimes, no single rule
exists that provides a worldwide effect similar to Chapter 11’s automatic stay. As previously
discussed, European regulations allow for cross-border companies to conduct bankruptcy
proceedings within the COMI. However, the rule does not prevent secured creditors or lien
holders from enforcing their rights wherever the secured asset may be located.20 Additionally,
the rule does not appear to prevent creditors from enforcing claims against subsidiaries or
assets located outside the E.U.

16
Pre-pack administration is the process of immediately selling a company once it has entered into administration. The
specifics of the sale are prearranged before the company enters into administration.
17
Hellas Telecommunications (Luxembourg) II SCA [2009] EWHC 3199 (Ch).
18
New debt incurred by a firm during the Chapter 11 bankruptcy process. This type of financing typically has priority over
existing debt, equity and other claims.
19
http://www.uscourts.gov/federalcourts/bankruptcy/bankruptcybasics/Chapter11.aspx.
20
h ttp://www.insolvency.gov.uk/freedomofinformation/technical/technicalmanual/Ch37-48/chapter41/part2/part_2.
htm#$#41.14#$#41.14.

17
A further benefit of the U.S. process is the concept of DIP financing. As discussed in our
2010 Strategy Outlook, DIP financing may be required to preserve the value of the company
during bankruptcy and provides fresh capital from new lenders to maintain the company as a
going concern.
The final advantage is the concept of management remaining in control. In the U.S., it is
typical for the debtor to keep possession and control of its assets during reorganization. The
appointment or election of a trustee occurs only in a small number of cases.21 Management
is expected to act in accordance with their fiduciary duties and can be held personally liable
for failing to do so. In most European countries, an external court-appointed administrator is
given authority over the management of the business during insolvency.
Distressed investing in Asia presents similar challenges with varying insolvency regimes
and varying creditor protection, as well as other issues such as a landscape dominated by
family-controlled companies and government intervention. Many investors avoid the region
altogether and those participating tend to rely on deep relationships in the region to source and
to understand opportunities. Each situation must be carefully assessed prior to involvement.

Conclusion
We believe that the distressed Given the large volume of debt maturing in the coming years and the relative lack of access
opportunity set will continue for to financing for middle market companies, we believe that the distressed opportunity set will
continue for a number of years and will remain diverse, both geographically and by size. As
a number of years and will remain distressed investing does not come without risks, particularly when investing abroad, manager
diverse, both geographically and selection is critical. Managers with expertise in valuation, risk management and the legal
by size. process will be better suited to make sound investment decisions.

21
http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics/Chapter11.aspx.

18
Chapter 2: Rising Interest Rates and
Hedge Fund Performance
Introduction
There has recently been a growing interest regarding the potential impact of a period of
rising interest rates on hedge fund performance. This interest has undoubtedly been fueled
by the current low absolute level of interest rates, coupled with concerns over the potentially
inflationary impact of a raft of expansive monetary policy measures. Investors are interested
in the potential opportunities and challenges this type of environment creates for hedge funds
and, more specifically, how different hedge fund strategies might perform in these conditions.
In this section, we consider whether the path of interest rates might be a relevant factor in
hedge fund performance and, if so, how interest rates may affect the level and distribution
of returns amongst certain strategies. We assess both outperforming and underperforming
strategies in periods of rising rates (compared with static or falling interest rate environments)
in addition to assessing whether the diversification properties of certain strategies within a
portfolio may change in a different rate regime.

Empirical Analysis
The issue of hedge fund The issue of hedge fund performance in a period of rising rates is particularly intriguing as
performance in a period of rising most measurable hedge fund data relates to a period of long-term declining rates. This fact, in
itself, raises interesting questions about the industry’s experience in a different type of interest
rates is particularly intriguing as rate regime. As a result, when looking at the empirical data available to us, we have tried to
most measurable hedge fund data balance observations with fundamental reasoning about whether the data make sense and
relates to a period of long-term whether the complete picture is actually being presented.

declining rates. We analyze data from January 2002 to October 2010 to capture a sufficiently large dataset of
managers by strategy and to investigate the possibility of a meaningful relationship between
the pattern of interest rates during the period and the performance of different hedge fund
strategies. For individual strategy performance, we utilize data from our proprietary hedge
fund peer groups, which collate performance data on a large number of different hedge
fund strategies over time. Our own investment team (not the manager or a third-party data
provider) defines the strategies of hedge funds to ensure that strategy descriptions accurately
reflect each hedge fund’s activities and that each peer group consists of comparable data. We
use the federal funds rate to look at interest rate patterns, given that the U.S. was the world’s
largest economy over the period in question and, just as importantly, the preponderance of
performance in mainstream strategies over the period related to activity in the U.S. market.
As a first step to assessing rate impact, we split the period January 2002 to October 2010
into two types of “regime,” as can be seen in Figure 2.1. The first regime — representing by
far the dominant share of the period in question — is characterized by static or falling federal
funds rates (January 2002 to May 2004 and June 2006 to October 2010). The second regime
is characterized by a rising federal funds rate, which we categorize as representative of a rising
interest rate regime (June 2004 to June 2006).

19
Figure 2.1: Federal Funds Rate: January 2002 – October 2010

6%

5%

Federal Funds Rate


4%

3%

2%

1%

0%
2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Bloomberg.

It should be noted that this type of empirical analysis on its own inevitably results in certain
weaknesses. First, the dataset for performance in the rising rates period is relatively short (i.e.,
24 data points). Second, the numbers on their own overlook the reason for rate regimes. Clearly,
if rates were hiked aggressively as an emergency reaction to an inflationary shock, this would
be a different environment than one characterized by relatively steady growth and a gradual
increase of rates. Similarly, the rate cuts in 2008 differ extensively from the constant rate observed
from June 2006 to June 2007 (discussed in more detail below). Finally, regimes defined using the
federal funds rate mean that rate changes are captured as they happen rather than as expectations
change (i.e., changes in market yields). We do, however, take a cursory look at 1-Year Treasury
prices, which incorporate expectations. Nonetheless, the data is sufficient to warrant preliminary
investigation. As always, the indicative data need to be accompanied by rational observations
in order to establish whether any numerical patterns identified are supported by fundamental
expectations.

Level of Returns
After splitting the time period by interest rate environment, we study the performance of a
variety of hedge fund strategies in each period. The contrast in the two periods is evident
in Figure 2.2, which illustrates the excess performance of each strategy in the rising rate
regime over the static or falling rate regime. A positive number conveys excess performance
in the period of rising rates relative to the static or falling, while a negative number reflects
underperformance.

Figure 2.2: Strategy Outperformance/Underperformance During Periods of Rising Rates


12%
10%
8%
6%
4%
2%
6
0%
-2%
5
-4%
Commodities

Distressed

Quant EMN

Event-Driven

Merger Arb

Stat Arb

Fundamental EMN

Macro

Credit Arb

Fixed Income Arb

LT CTA

Convert Arb
LS MC

3
Source: NB Alternatives Peer Groups.
20 2

1
A multitude of factors other than Obviously, a multitude of factors other than just interest rates impact hedge fund performance
just interest rates impact hedge through the period and we need to account for this in our analysis. As such, we can quickly
eliminate some of the results from further discussion. For example, some strategies are
fund performance. significantly impacted by their market exposure in 2008. For example, Multi-Cap Equity
Long/Short strategies in particular tend to exhibit a long equity bias and suffered significantly
in the financial crisis of 2008. When we eliminate 2008 from the analysis, outperformance drops
to less than 1%, so the “factor” driver here is primarily stock market beta (albeit recognizing
that equities and rates are not entirely unrelated). Broad event-driven strategies also often
exhibit strong market bias. When we eliminate 2008 from the analysis, relative outperformance
in the rising rates period actually turns slightly negative. However, certain other strategies and
characteristics are more persistent and are worth assessing in more detail.

Distressed
We found the data for distressed somewhat ambiguous. Although the data indicate a strong
outperformance for the rising rate period, a portion of the 2004 – 2006 gains actually stems
from the ongoing work-out of debt which had defaulted in 2002. Therefore, we cannot assume
a straight causal relationship. From a distressed debt perspective, it should be noted that rising
interest rates increase the burden of interest cost for companies and restrict the supply of credit.
Importantly, bank loans are generally floating rate and adjust quickly to rate changes, which
means that interest coverage ratios for companies with loans rapidly deteriorate when rates
rise, increasing the likelihood for bankruptcy. Similarly, the cost of new issuance for both loans
and bonds in the primary market increases with rising rates, as debt will be priced according
to an interest rate spread, making refinancing more expensive for companies. These factors are
likely to create an increased supply of distressed debt, should rates increase, offering greater
opportunity for investors.
We acknowledge the lag that typically exists between rising rates and a spike in defaults. For
example, the 2-Year Treasury yield peaked at 14.7% in February 1980 during the last period
of very significant rate rises (1976 – 1980). However, corporate defaults continued to escalate
through the early-to mid-1980s as rates fell. While rising rates can contribute to a default cycle,
monetary policy is likely to ease once the problems start; therefore, actual defaults may peak
during a period of falling rates, until the effect of the monetary policy is achieved. Additionally,
returns for distressed investors are often enhanced by rates falling as the increased liquidity can
facilitate easier exits from bankruptcy. This poses a counterargument to outperformance.
Concurrently, other aspects of rising rates support distressed credit performance. For example, if
rising rates restrict credit, hedge funds face less competition as other lenders pull in their balance
sheets, boosting returns for activities such as DIP financing or bridge lending. Meanwhile, if
distressed funds make floating loans, the absolute return increases as they benefit from the rate
rises (absent default). We believe there is some fundamental rationale to the assumption that
rising rates may increase the opportunity set for distressed debt funds. We find this particularly
relevant today, with $875 billion of U.S. leveraged loans and high yield debt scheduled to be
refinanced between 2011 and 2014, over 50% of which is floating rate debt.

Commodities
As inflationary concerns creep into The Commodities strategy bucket consists of a mixture of relative value and more directional
investor psychology, activity within commodities traders (distinct from CTAs, which we discuss separately below). Again, we
highlight that rates clearly are not the only factor that drive commodity strategy returns. We
commodities naturally tends to also note that the underlying data is skewed somewhat by the volatile nature of the directional
increase, creating opportunity for commodity strategy returns, and likely overstates the case for outperformance, albeit it remains
commodity hedge funds . positive. Broad market interest in commodities is being driven, in part, by the following: concerns
that monetary policy will drive inflation longer term, potential long-term weakening of the
U.S. dollar and demand from China. As inflationary concerns creep into investor psychology,
activity within commodities naturally tends to increase, creating opportunity for commodity
hedge funds — particularly as the investor composition and diverse investor make-up creates
inefficiencies and volatility. For example, passive index money, as well as speculative capital,

21
from those trying to create “inflation-hedges” has created inefficiencies in supply and demand
across commodity curves, generally distorting price action. The difficult question is how much
of this happens while rates are already low versus once rates rise? If we enter into a period of
rising rates, active investors in the space may initially be more concerned about inflation risk,
which might exacerbate volatility and opportunities for commodity hedge funds. However, if
rising rates effectively mitigate inflation and commodity prices fall, speculators on the long side
could be caught out and dynamics could change for the worse — after all, it is always easier for
traders to make money in any given asset class in a bull market, rather than in a bear market.
Therefore, rate rises are potentially a double-edged sword.
We also have to accept some “regime shift” in commodity strategy performance. Chinese demand
has increasingly become the pull factor on commodity pricing. This is not independent of the
U.S., as Chinese monetary policy is linked to that of the U.S. through currency management. It
appears that the Chinese government’s reluctance to allow meaningful currency appreciation
is a tacit acknowledgement that domestic demand is not yet strong enough to counterbalance a
drop in export competitiveness. However, while China can use other forms of policy to manage
the economy, such as lending quotas or property taxes, this can also be a major component on
the demand side, which could act in a similar way to rate rises on the other side of the world.

Merger Arbitrage
Merger arbitrage strongly Merger arbitrage also strongly outperforms in the rising rate environment, regardless of activity
outperforms in the rising in 2008. More than any other strategy, the relationship between interest rates and performance
is traceable by studying the path of rates and strategy performance (see Figure 2.3 for 1-Year
rate environment. Treasuries versus our merger arbitrage peer group performance).

Figure 2.3: The Link between Merger Arbitrage Performance and Interest Rates

7% 30%
Merger Arb Rolling 12-Month Returns
6% One-Year Rate 25%

20%
5%
15%
4%
10%
3%
5%

2%
0%

1% -5%

0% -10%
1999 2001 2003 2005 2007 2009

Sources: Bloomberg, NB Alternatives Peer Groups.

Plain vanilla merger arbitrage seeks to profit from monetizing the spread between target
and acquirer. As with any relative value strategy, as rates increase, absolute returns and short
rebates should also increase. This results in higher performance, albeit not necessarily on a
risk-adjusted basis. The more recent divergence, where merger arbitrage returns have improved
despite flat rates, may be attributable to a lower level of competition from hedge funds and
proprietary trading desks following the financial crisis. However, over a longer period of time,
interest rates and merger arbitrage returns do seem closely linked, so are there other factors
linking the two?

22
Intuitively, an increased cost of funding for debt-financed deals in a rising rate period might be
thought to lead to a slowing in deal flow. However, the relationship between deal volumes and
the federal funds rate between January 1998 and October 2010 actually demonstrates a modest
positive relationship over time — higher rates have meant slightly higher deal flow. While this
does not necessarily imply that rising rates will always result in higher deal flow, it suggests that
higher rates do not automatically lead to a reduction in corporate mergers and acquisitions
(“M&A”) and that volumes can still increase. Further, though greater volumes do not necessarily
equate better spreads, a statistically significant relationship exists between merger arbitrage
strategy performance and the levels of mergers over time, suggesting that higher volume does,
in fact, create more profitable opportunities, or, at the very least, the ability to be more selective
in terms of deal selection. If the ratio of hedge fund capital relative to deal volume declines
(due to an increase in deals), there is proportionately less money to soak up spreads. Another
factor at play relates to lower break rates. The thesis here is that corporate management is likely
to exercise more discipline on M&A strategy in a rising rate environment when arranging
financing and using valuable cash. As a result, management may be more committed to deals
that they sign up to in a rising rate environment than in a period of “easier” money. Consistent
with this, it is noteworthy that the break rate for deals in the rising rate period was 3.3%,
compared with 4.2% in the static or falling period. Therefore, on balance, there is a case that
healthy deal flow volumes and lower break rates could benefit merger arbitrage managers in a
rising interest rate environment.

Quantitative Equity Market Neutral


Quantitative Equity Market Neutral manager outperformance remains high even when we
exclude 2008 from our analysis. Our findings were mixed when we considered whether some
basic factor models such as value, quality or earnings revision work better in a rising rate
environment. In fact, a Fama-French analysis spanning over 40 years showed that high price-to-
book stocks have actually outperformed low price-to-book stocks during periods of higher
rates. This is contrary to what might be expected of outperforming quantitative managers,
who often buy low price-to-book stocks and short their higher-priced peers. More intuitively, a
“quality” factor analyzing balance sheet strength and, in particular, company debt levels might
be expected to perform well during rising rate periods, as more indebted companies begin
to run into problems. It could also be argued that increased rates may create higher levels of
stock dispersion, which benefits the fundamental factors selected by quantitative investment
programs. Consequently, while there may be a marginal case for quantitative equity market
neutral outperformance during a period of rising rates, we do not see sufficient fundamental
reasons to make the premise compelling.

Convertible Bond Arbitrage


Rising rates can create difficulties In contrast, Figure 2.2 suggests that convertible bond arbitrageurs struggle when rates rise.
for any strategy entailing a long We agree with this for several reasons: 1) the cost of leverage may increase disproportionately,
decreasing the profitability of arbitrage trades and increasing portfolio risk, 2) a crowded
portfolio of assets that requires unwind is more likely — while periods of low rates may encourage investors to crowd into
interest rate hedging because being trades, these same investors risk being shaken out as rates increase and the cost of funding grows,
under hedged becomes a cost causing exacerbated unwinds and related losses, and 3) increased interest rate risk (convertible
bond managers may hedge their interest rate risk or swap it out, but if part of the portfolio is
rather than a benefit. left unhedged, losses may result as rates rise and fixed coupon bonds lose value). In point of
fact, the problem does not necessarily disappear even when interest rates are “fully” hedged
because mark-to-market basis risk (between the interest rate hedge and the actual movement
of the bond) may still exist in a theoretically hedged portfolio. In addition to convertible bond
managers, credit arbitrage managers have also been impacted in the past — particularly at the
investment grade level. Corporate bond prices do not always behave exactly as their modeled
duration sensitivity would suggest during periods of interest rate volatility, creating mark-to-
market risk. Even if the manager asset swaps bonds, the availability and price of the asset swap
market may become challenging as rates rise. Therefore, rising rates can create difficulties for
any strategy entailing a long portfolio of assets that requires interest rate hedging because being
under hedged becomes a cost rather than a benefit.

23
Long-Term Commodity Trading Advisors (“Long-Term CTA”)
For these CTA strategies, the underperformance gives rise to some very relevant questions
regarding the changing distribution of returns and the function of these strategies in a
portfolio, discussed in more detail below.

Distribution of Returns
Do certain strategies become more While the analysis so far provides insight into how various strategies have fared on an
or less diversifying in a period of absolute basis in different interest rate regimes, hedge fund investors are also interested in the
distribution of returns and, particularly, in the correlation and beta of performance to various
rising rates than in a period of market factors and to broad hedge fund performance. Clearly, many hedge fund strategies aim
static or falling rates? to diversify investors — beyond equity risk, interest rate risk or even hedge fund risk — in order
to provide “uncorrelated returns.” As such, another way of analyzing the impact of interest
rates on hedge fund performance is to consider potential changes in the distribution of returns
in different regimes. Specifically, might certain strategies become more or less diversifying in
a period of rising rates than in a period of static or falling rates? This is particularly relevant
given that most hedge fund returns have largely been generated during a strong bull market for
bonds, notwithstanding the period of rising rates identified in this section. If expectations of
performance patterns are too backward-looking or entrenched in a regime not representative
of the future, this could lead to surprises in the way that strategies and portfolios behave
going forward.
Figure 2.4 shows the betas of different hedge fund strategies of the S&P 500, the Barclays Global
Aggregate and the HFRX Absolute Return Indices in the two different rate regimes.

Figure 2.4: Strategy Betas across Rising and Static/Falling Rate Regimes
Static or Falling Rising Difference
HFRX HFRX HFRX
Barclays Absolute Barclays Absolute Barclays Absolute
S&P 500 Agg Return S&P 500 Agg Return S&P 500 Agg Return

Macro 0.10 0.33 0.63 0.52 -0.56 1.31 0.42 -0.89 0.69
Event-Driven 0.33 0.06 1.26 0.53 -0.43 1.38 0.20 -0.49 0.12
Quant EMN -0.02 -0.02 0.37 0.06 -0.25 0.34 0.08 -0.23 -0.03
LT CTA -0.14 0.37 0.06 0.59 -0.50 1.40 0.73 -0.87 1.34
Commodities 0.12 0.86 1.18 0.32 -0.32 1.30 0.20 -1.18 0.12
Stat Arb 0.06 0.21 0.13 0.00 -0.11 -0.01 -0.05 -0.32 -0.14
LS MC 0.42 0.00 1.34 0.70 -0.50 1.28 0.28 -0.50 -0.06
Credit Arb 0.25 0.01 1.25 0.13 -0.20 0.54 -0.12 -0.21 -0.71
Distressed 0.27 0.03 1.42 0.27 -0.35 0.85 0.00 -0.38 -0.58
Fixed Income Arb 0.10 0.22 0.50 0.07 -0.33 0.25 -0.03 -0.55 -0.25
Merger Arb 0.14 0.13 0.47 0.29 -0.21 0.75 0.16 -0.34 0.28
Convert Arb 0.28 0.55 1.44 0.14 -0.42 0.88 -0.14 -0.97 -0.56
Fundamental EMN 0.05 0.03 0.38 0.17 -0.15 0.44 0.11 -0.18 0.06

Source: NB Alternatives Peer Groups.

The statistics for the Long-Term CTA strategies are noticeable. In the period where rates were
flat or falling, beta to equities was -0.14; this jumps to +0.59 in the rising rate period. Beta to
bonds (Barclays Aggregate) drops sharply from slightly positive to -0.5. Here, a strong rationale
supports the outcome — CTAs aim to catch trends. Therefore, if rates trend lower, CTAs are
likely buyers of bonds (they also may often be sellers of equities if bond buying comes at the
expense of equity investments). If rates trend higher, they are more likely to be short bonds.
Given that we have been in a long-term bull market for bonds, with rates essentially trending
lower over 20 years, CTAs have tended to be long bonds (and often short equities) much more
than the reverse. As a result, over the years, CTA strategies have gained a reputation as being

24
effective “portfolio diversifiers” because, in contrast to risky assets such as equities, credit, real
estate or many other hedge fund strategies, they have been profitable when bonds have rallied
and equities have fallen.
Although these funds may trade numerous asset classes and so have diversified portfolios,
this does raise a potential issue. Rates are currently very low, with little room in most major
economies for further decreases; thus the profitability for a long bond trade may be capped.
However, if rates rise, Long-Term CTAs will likely try to capture the trend by positioning short
bonds. A portfolio with a short bond bias clearly does not offer the same diversification against
risky assets as a portfolio that is long bonds. Therefore, if Long-Term CTAs can no longer
leverage a long-term bull market for bonds, the distribution of their returns relative to other
asset classes is likely to change. In fact, if rates are rising and they short bonds, they are more
likely to be correlated to risky assets. Additionally, as the data suggests, the correlation to other
hedge fund strategies could increase substantially in a period of rising rates (Figure 2.4 shows a
beta of 1.4 to HFRX Absolute Return Index in a rising rate regime compared with near zero in
a flat or falling rate regime). This does not mean that Long-Term CTAs cannot be profitable in
a rising rate environment (although they exhibit some underperformance in Figure 2.2), rather
that investors who have invested in Long-Term CTA strategies with the expectation of being
“long volatility” and diversifying away from risky assets could be surprised by the way their
portfolio behaves if rates start to rise. We would note, however, that shorter-term CTA managers
may be better positioned to continue to diversify returns, as a result of the significantly higher
turnover of their portfolios and their ability to catch much more momentary or shorter-term
price trends in the market.

Global Macro
Global Macro strategies are very diverse and difficult to categorize with a single comment.
However, certain Global Macro managers could be seen to possess similar attributes to
the Long-Term CTA Peer Group discussed above. Figure 2.4 supports this, showing a much
more positive relationship to equities and a negative relationship to bonds in a rising rate
environment. We note that many successful macro players have also benefited from a long
bond trade over time and seek to capture asset class trends, albeit in a more discretionary rather
than model-driven manner. These strategies have also seen positive flows post-crisis, as many
investors have taken the view that Global Macro allocations will consistently offer diversification
in challenging market environments. However, the variable nature of Global Macro exposures
means that they will not necessarily diversify investors away from risky assets on a consistent
basis and, in particular, it may be much harder for them to do so in a period of rising rates.

Conclusion
The available evidence, combined Most hedge fund strategies have little measurable trading data during prolonged periods of
with fundamental reasoning, interest rate rises. The available evidence, combined with fundamental reasoning, suggests
that the opportunity set for distressed debt, merger arbitrage and commodity relative value/
suggests that the opportunity directional trading could benefit from rising rates. In such cases, the opportunity is somewhat
set for distressed debt, merger dependent on the path and the efficacy of rate rises. In the case of commodities especially,
arbitrage and commodity relative this could be hand-in-hand with an increase in risk profile. Leveraged strategies may struggle;
and investors should be more cognizant of unwind risk and also of how interest rate risk is
value/directional trading could being hedged in the convertible bond arbitrage and credit trading strategy areas. However,
benefit from rising rates. one of the more interesting effects of rising interest rates might be a change in the distribution
profile of Long-Term CTA strategy returns. The same could be said of Global Macro strategies,
although the dispersion of this universe is very wide and more difficult to generalize. If rates
were to trend upwards for a period of time, it is plausible that Long-Term CTAs in particular
might cease to exhibit the “long volatility” profile that has made the strategy popular with
investors and thus may become increasingly correlated to a broader universe of risky assets.
This could affect how a Long-Term CTA allocation might fit within a broader portfolio of
hedge fund strategies. It should be noted that this analysis refers to broad strategy groups and
clearly the distinct positioning of individual managers for differing environments will be a key
determinant in their success or failure.

25
Chapter 3: Asset-Backed Securities and the Factors
Influencing the Opportunity Set
Introduction
Mortgage-backed securities are bonds whose cash flows are secured by a collection of underlying
mortgage loans. The underlying mortgage payments are then used to pay both interest and
principal on the bonds. Other asset-backed securities (“ABS”) may be collateralized by pools of
other asset types, including commercial real estate, credit card receivables and student or auto
loans through a process known as securitization.
Typically, structured asset-backed securities are split into different tranches, with each
containing its own cash flow and risk characteristics. Both principal and interest repayments
as well as losses are allocated amongst these tranches based on seniority. Most asset-backed
issues assume a three-tiered approach of junior, mezzanine and senior tranches. This process
aims to bring liquidity to the otherwise illiquid assets. Pooling individual mortgages or assets
together into structural securities turns them into a tradable security available to a wider
range of investors. An increasing number of hedge funds started to invest in the mortgage-
and asset-backed space beginning in 2002. Several high profile hedge fund blow-ups propelled
the asset class into the headlines in 2008. That same year, 36 hedge funds with portfolios of
residential mortgages and other asset-backed securities went out of business, primarily due to
the magnifying effects of leverage.22 In addition, many funds realized large losses as a result of
significant redemptions in a period of increased illiquidity in the markets.
Simultaneously, the U.S. housing market suffered a severe downturn, the origins of which may
be traced back to the low interest rate environment between 2002 and 2006. During that time
period, financial institutions made loans to increasingly risky subprime and Alt-A borrowers.
Starting in mid-2007, U.S. real estate prices fell, resulting in an increase in delinquencies.
By December 2009, over 50% of all subprime mortgages issued between 2005 and 2007 were
60+ days delinquent.23 The deterioration of mortgage fundamentals resulted in massive spread
widening across all sectors in the asset-backed universe, and the substantial unwinding of
leverage added to these pressures. By late 2008, many types of residential mortgage-backed
securities (“RMBS”), previously regarded as relatively risk-free, were trading at distressed
prices in an environment with minimal liquidity.
Uncertainty surrounding future The housing market stabilized in 2009 and 2010, partially assisted by U.S. government
government policy and intervention intervention. A broad rally in asset-backed securities followed; however, $3.1 trillion of
outstanding mortgage balances are still delinquent or underwater,24 meaning that defaults
in the housing market is likely to may continue to occur while real estate prices continue to fall. Uncertainty surrounding
create additional volatility in the future government policy and intervention in the housing market is likely to create additional
mortgage-backed market. volatility in the mortgage-backed market. The landscape of both the mortgage-backed
securities market and the broader asset-backed market has changed significantly in recent
years. We will examine whether these dislocations can be successfully exploited by hedge funds
in the pursuit of attractive risk-adjusted returns.

Mortgage-Backed Market Structure


As previously stated, residential mortgage-backed securities are debt obligations that represent
claims to the cash flows from pools of residential mortgage loans. They are purchased from
mortgage companies and banks and then grouped together. Buyers have a claim to the principal
and interest payments made by the underlying borrowers of the loans in the pool. The U.S.
residential mortgage market currently stands at $11 trillion and is the second largest investable
asset class (see Figure 3.1).25
22
HedgeFund.net.
23
Bank of America Merrill Lynch Structured Products Research Department.
24
Amherst Securities.
25
http://www.federalreserve.gov/.

26
Figure 3.1: U.S. Market Value by Asset Class
($ Trillion)
18
16
14
12
10
8
6
4
2
0
U.S. Equities Residential Mortgages Treasury Securities Corporate Debt
Market

Source: http://www.federalreserve.gov/.

Broadly speaking, the universe can be split into agency and non-agency. Government-
sponsored enterprises (“GSEs”) Ginnie Mae (“GNMA”), Fannie Mae (“FNMA”) and Freddie
Mac (“FHLMC”) issue agency mortgage-backed securities. GNMA is fully backed by the
federal government while the others have only implicit backing. Until 2005, these entities were
responsible for the majority of new issues. Private institutions such as brokerage firms, home
builders and banks are also able to securitize mortgages, or private-label mortgage securities
and, by 2006, these accounted for over half of the total primary market at over $1.1 trillion
of new issuance. Without government guarantees, investors of these securities rely on credit
rating agencies to assign a level of risk to their investment. The role of the ratings agencies
during the financial crisis of 2008 was controversial; many AAA-rated mortgages were
downgraded. Standard and Poor’s downgraded the credit ratings on $1.9 trillion of mortgage-
backed securities between Q3 2007 and Q2 2008, many as a result of a potentially questionable
initial rating. The non-agency market is broken down in Figure 3.2.

27
Figure 3.2: Factors Influencing the Non-Agency Market
Less Risky Cash Flows

Jumbo Prime

Alt-A

Perceived Risk Pay Option


ARM

Front pay

Subprime Second pay

Last cash flow


More Risky Losses

Source: NB Alternatives analysis.

These mortgages may be fixed rate, floating rate or adjustable rate, based on a set of
predetermined triggers or variables. Mortgage-backed securities can also exist as principal-
only strips, which are issued at a considerable discount to par. The cash flows increase as the
principal component of the mortgage payments grow. Conversely, cash flows for interest-only
strips start high and decline over time.
The complex nature of the mortgage market means that the different underlying securities are
impacted by different external factors, which we consider later in this analysis. The cash flows
for these pass-through pools of securities depend on their position in the capital structure
and the security type (i.e., interest-only or principal-only). Interest and principal payments
are allocated on a top-down basis while losses are allocated starting from the bottom of the
capital structure. The largest risk associated with monthly cash flows is prepayment risk. The
right to prepay before final maturity is embedded in mortgages. When payments are made
early, interest payments cease on that portion of the principal, reducing the cash flow of the
bond. Prepayments can be affected by interest rates; when rates are low, prepayments increase
as borrowers are more likely to refinance. Defaults of the underlying loans also influence the
cash flows and weighted average life of the paper.
Mortgage-backed securities can Mortgage-backed securities can trade at levels where they are attractive based on yield alone, on
trade at levels where they are price upside or some combination of the two. In addition to owning a security on an outright
long basis, funds often pursue other trades which are more relative value in nature, including
attractive based on yield alone, on 1) spread and duration plays where investors believe they will ultimately receive principal or
price upside or some combination interest back over a time period that is shorter or longer than currently priced in, 2) capital
of the two. structure trades which look to benefit from structural differences between the different
tranches and their related cash flows and, 3) whole loan strategies, which involve the purchase
of individual mortgages rather than the bonds (i.e., the buyer acts as both the mortgage lender
and servicer).
Loan servicing, or collecting payments and managing foreclosures, is operationally intensive
and costly and, therefore, experience in servicing can be considered a competitive advantage.

28
The purchase of whole loans allows for more control and an informational edge; however,
the resource intensive nature, reduced liquidity, and added expense of loan servicing can be
a drawback.
The majority of hedge funds focus either exclusively or primarily on the RMBS space. We focus
our analysis in this area, and further narrow it by focusing on the U.S. market (the largest
for RMBS), although we believe that opportunities also exist in Europe and to a lesser extent
in Asia.

Supply and Demand


We examine the supply and demand imbalances in order to gauge the RMBS opportunity set.
In terms of supply, 2008 – 2010 has been a period of reduced new issuance, particularly in the
non-agency space.

Figure 3.3: The Pattern of New Issuance

($bn) Agency Mortgage-Backed Securities


1,200

1,000

800

600

400

200

0
2004 2005 2006 2007 2008 2009 2010

($bn) Non-Agency Mortgage-Backed Securities


1,200

1,000

800

600

400

200

0
2004 2005 2006 2007 2008 2009 2010

Source: Barclays Capital.

29
Once origination returns to the According to LoanPerformance, so far in 2010, $157 billion of non-agency residential mortgage
non-agency space, underwriting backed securities have been paid off either through default or prepayment. Coupled with the
lack of new issuance this means the asset class is contracting. Further, the supply outstanding
quality should be stronger than has declined from $2 trillion to $1.5 trillion in the last two years.26 Through October 2010,
pre-2008, providing a stable only one non-agency deal of any material size has been issued. In April, Redwood Trust issued
backdrop for future growth $237 million of bonds backed by home mortgage loans through Citigroup. Although this
indicates a recovery in the new issue market, tougher mortgage origination standards,
of the asset class. conservative rating agencies, muted home sales and refinancing means that new issuance is
likely to remain subdued in the near term. On the positive side, once origination returns to the
non-agency space, underwriting quality should be stronger than pre-2008, providing a stable
backdrop for future growth of the asset class.
We believe that the market is On the demand side, agencies such as FNMA and FHLMC, as well as collateralized debt
currently in a state where sufficient obligations (“CDOs”) and structured investment vehicles (“SIVs”), comprised a significant
percentage of the buyers market prior to 2008. FNMA and FHLMC are no longer alpha seekers
demand exists to drive asset-backed while CDOs are net sellers of mortgage securities. This phenomenon, coupled with the exit
prices higher, yet remains of proprietary desks and many hedge funds, leaves long-only funds and select hedge funds,
sufficiently uncrowded for skilled banks and insurance companies as the remaining players. This has created opportunities for
the sophisticated and experienced investor to seek value. However, the U.S. Treasury’s Public
investors to exploit mispricings Private Investment Program (“PPIP”) has recently increased demand by bringing nearly
that have resulted from market $16 billion of purchasing power to the market as well as $14 billion of dry powder to inject
dislocations. into the markets. Many participants have recently returned to the space as the housing market
appeared to stabilize. This has helped create positive supply and demand dynamics, which appear
to be driving up prices of mortgage-backed securities. Should forced selling reoccur, this balance
could be upset, though many believe the government would intervene to ensure a measured
supply of distressed inventory. Thus, we believe that the market is currently in a state where
sufficient demand exists to drive asset-backed prices higher, yet remains sufficiently uncrowded
for skilled investors to exploit mispricings that have resulted from market dislocations.

Liquidity within the Mortgage-Backed Securities Market


In addition to supply and demand dynamics, liquidity is also an important consideration,
given that illiquidity was a major contributor to the universe’s difficulties in 2008. Managers
have been quick to highlight the improved liquidity of the underlying asset-backed markets,
particularly in the residential space. In March 2009, we witnessed no bids for RMBS whereas
we are now seeing 10 – 20 bids per issue. However, inadequate transparency with respect to
pricing allows investors to exploit the wide divergence in bid/offers on the same security. One
manager estimates that the weekly trading volume of the total residential market currently
is approximately $5 – 10 billion. As previously discussed, banks, regional dealers, hedge funds
and large CDO liquidations are suppliers. In the non-agency market, weekly volumes have
remained fairly consistent throughout 2010, averaging $1.5 billion and peaking at $3 billion.27
We believe that the forced unloading of the asset-backed securities remaining on the balance
sheets of financial institutions or other significant news events pose a risk to the market and
could potentially cause volumes to spike. High volumes are synonymous with price weakness
in the market. One manager we spoke with highlighted that in the last 15 months, prices
have fallen sharply on the four occasions when the non-agency market traded in excess of
$3 billion per week. An example of this scenario was news of loan repurchases and foreclosures
in October. Although market liquidity has improved, RMBS remains a comparatively illiquid
asset class. We believe that matching assets and liabilities is crucial for hedge funds. We tend
to favor funds with an initial lock-up period to create a stable capital base and to reduce the
pressures of potential forced selling.

26
http://www.loanperformance.com.
27
NB Alternatives Manager Meetings with Managers who invest in ABS space.

30
Sources of Opportunity
The collapse of the U.S. housing market was partially responsible for the mortgage-backed
securities sell-off in 2008. As Figure 3.4 illustrates, the S&P Case-Shiller home price index
peaked in mid-2006 before falling 30% in mid-2008. During this period, quarterly foreclosures
rose from 300,000 in 2006 to over 900,000 in 2010. It is estimated that 31% of mortgages are
currently underwater compared with 5% in 2006; this negative equity has exerted knock-on
effects on home sales and refinancing activity.28

Figure 3.4: Case-Shiller Composite 20 Index

250

200

150

100

50

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Standard & Poor’s.

In most instances, managers have In Figure 3.4, we see the stabilization of home prices coincided with a decline in 30-day
built up conservative assumptions delinquencies. That said, the overhang of unsold homes makes it difficult to envision
any near-term house appreciation, particularly given higher down payment, FICO score
into their scenario analyses, so only requirements and generally stricter underwriting practices. Therefore, we believe that managers
an outsized decline in house prices need to structure RMBS deals to withstand declines in home prices and additional mortgage
would materially impact returns. foreclosures. In most instances, managers have built up conservative assumptions (i.e., fairly
large declines) into their scenario analyses, so only an outsized decline in house prices would
materially impact returns.
Forced selling and weak fundamentals in 2008 led to new lows in asset-backed securities prices,
as shown by the 07-02 and 06-01 ABX indexes29 in Figures 3.5 and 3.6. The forced selling has,
for the most part, passed as banks continue to stabilize. This improvement, along with increased
liquidity, improved supply and demand dynamics, and a more positive macroeconomic
outlook resulted in a strong rally in the asset-backed space through 2009 and 2010.

28
RealtyTrac.
29
The ABX.HE is a subprime mortgage-backed credit derivatives index. Four series were issued at six monthly intervals from
the beginning of 2006 and each comprises of 20 subprime underlying transactions issued during these periods.

250

31
200
Figure 3.5: ABX.HE.07-02

105
B-
95
BBB
85 A
75 AA
65 AAA
55

Price
45
35
25
15

5
-5
Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Source: Barclays Capital.

Figure 3.6: ABX.HE.06-01


105
95
85
75
65
Price

55
45 BBB-
35 BB
25 A
AA
15
AAA
5
-5
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Source: Barclays Capital.

Despite the strong recovery, particularly in the AAA tranches, prices remain far from historical
highs. In addition, uncertainties surrounding government policies and changing supply and
demand dynamics will likely result in volatility and price instability in this market.
In early 2009, it was possible to purchase senior prime and Alt-A securities with a 15 – 20%
yield. Following the rally in 2009 and, to date in 2010, yields have tightened to 5 –10%
(see Figure 3.7). An indiscriminate buy-and-hold strategy is no longer sufficient as the beta
rally has subsided. Investors can look to lower credit-quality securities where yields remain
higher, purchase seasoned securities still trading at distressed levels (and where fundamental
105 analysis reveals that they are undervalued), or employ financial leverage.
95 We believe that attractive returns may still be available in some select securities such as
85
subprime AAA Mezzanine, Alt-A and Option adjustable-rate mortgage and the riskier interest-
only strips (see Figure 3.7). Non-agency yields are higher than their corporate equivalents
75

65

55

45

35
32
25

15
despite the strong rebound in prices. Generally, the complexity and dislocation of the market
means that managers may still be able to isolate pools of collateral that remain undervalued
by the market and that trade at discounts, thereby allowing returns to be generated from both
cash flows and potential realized price appreciation.

Figure 3.7: Unlevered Yields in Residential Mortgage-Backed Securities


Agency
Jumbo SSNRs 7 – 8%
Alt-A SSNRs 10%
Re-remic SSNRs 5 – 6%

Non-Agency
Jumbo Fixed Rate 6 – 7%
Jumbo Adjustable Rate 5 – 6%
Alt-A Fixed Rate 8 – 9%
Alt-A Adjustable Rate 9 – 10%
AAA Mezzanine 20 – 25%
Second Pay Subprime 9 – 15%
Seasoned Subordinate Bonds 12 – 15%
Super Senior Pay Option ARM 12 – 13%
Option ARM Interest-Only 20%
Principal-Only 20%
Inverse Interest-Only 15 – 25%

Successful Loan Put-Back 40 – 50%

CMBS SD AAA 4 – 7%

Sources: Barclays, NB Alternatives research.

Individual Trades
Below, we highlight various trade ideas that take advantage of the most significant market
dislocations within the mortgage-backed space and, consequently, where we believe the best
risk/reward exists. We broadly divide these ideas into two groups: 1) where the fund believes
it will ultimately receive principal, but timing is uncertain due to potential volatility of the
cash flow, and 2) where the fund anticipates receiving cash flows only before liquidation or
loan payment. Prepayments, liquidation timelines and loan modifications will affect duration.
Duration contractions and a decrease in defaults and severities are favorable for some
instruments and detrimental to others. Figure 3.8 contains a detailed analysis of how various
instruments react differently to a medley of market variables. Detailed analysis of the cash
flows and their characteristics is crucial. Some funds are structured to distribute pro rata while
others are structured to distribute sequentially down the capital structure. The underlying
bonds have significantly different dollar prices and durations, enhancing a manager’s ability to
build a highly diversified portfolio.
•• Senior Alt-A Pass-Through: Value is driven by the ultimate recovery of principal. A trade
benefits from duration contraction because principal will be recovered earlier. In other
words, this trade is essentially a bet that principal will be recovered faster than is priced into
the bond. A second built-in assumption is that defaults and loss severities will be lower than
anticipated.
•• AAA Mezzanine: AAA Mezzanine sits lower in the capital structure and is therefore earlier
in line to take losses resulting from defaults. The bonds benefit from duration extension as
they continue to receive cash flows even as they are unlikely to receive principal. Typically,
the mezzanine tranche can tolerate a greater level of government intervention programs and
may even perform better with an increase in modifications because, by not seeking to receive
principal, they are unaffected if modifications reduce defaults (treated as prepayments in
cash flow models).
33
•• Super Senior Pay Option Adjustable Rate Mortgages (“ARMs”): These mortgage loans are
adjusted periodically based on a fixed set of indices, making ARMs particularly sensitive
to interest rate fluctuations. Similar to other mortgages, ARMs have an embedded prepay
right; however, prepayments of principal do not shorten the total duration due to the
embedded structure.
•• Interest-Only: These AAA-rated interest-only strips can be either agency or non-agency-
backed. They have a short-term life of 2 – 3 years and mirror the AAA tranche. Prepayment
risk stems from home sales or refinancing because cash flows cease once the mortgage is
paid. These instruments sit at the top of the capital structure and are largely unaffected
by defaults. They never look to receive principal, but benefit from delayed foreclosures as
servicers continue to advance payments until the liquidation is complete. These strips benefit
from slower prepayments due to declining home prices, the continued challenges involved
in securing refinancing and stricter mortgage underwriting standards.
•• Inverse Interest-Only: These instruments pay a fixed rate minus LIBOR on a declining
notional principal balance whose rate is determined by the speed of refinancing the loan
pool backing the bond. These securities benefit from slower refinancing and prepayment
rates. If refinancing remains low (e.g., during a low-interest rate environment) or U.S.
home prices decline, these securities could potentially possess higher yields because of their
sensitivity to interest rate fluctuations and prepayments.
•• Principal-Only: These strips are sold at a considerable discount to par. Cash flows start
out small and increase over time as the principal component of the mortgage increases.
They benefit from higher prepayments such that in a falling rate environment, price
appreciation occurs.
•• Monoline: Monoline-backed securities are a subset of RMBS where the paper has been
trading at significant distressed prices since 2008. Examples include wrapped deals issued by
Ambac, FGIC, MBIA and XLCA that guaranteed the payment of cash flows and principal.
These trades are usually hedged through equity or credit short positions for the monoline
insurers with perceived balance sheet weaknesses. Consequently, such strategies require
detailed fundamental analysis of the insurers.

Figure 3.8: Sensitivity of Various Tranches to Variables Allow for Diversified


Portfolio Construction
Interest Weighted Loss Liquidation House
Prepayment Rates Avg Life Severities Defaults Speed Prices
Rise Rise Rise Rise Increase Increases Decline

Jumbo Fixed Rate Negative Neutral Positive Neutral Negative Negative Negative
Super Senior Option ARM Neutral Negative N/A Neutral Negative Neutral Negative
Senior Alt-A Positive Positive Negative Neutral Negative Positive Negative
Subprime Senior Mezzanine Positive Positive Positive Negative Negative Negative Negative
Interest-Only Negative Negative Positive Neutral Negative Negative Neutral
Inverse Interest-Only Negative Negative Positive Neutral Negative Negative Positive
Principal-Only Positive Negative Negative Neutral Neutral Neutral Negative

Source: NB Alternatives analysis.

34
Nontraditional Strategies
“Loan put-backs,” a strategy that has recently gained momentum, involves putting loans back
to the mortgage originator at par when representations and/or warranties have been violated.
In late October 2010, a consortium of bondholders including Pimco, BlackRock and the
New York Federal Reserve, asked Bank of America for a put-back of 115 underlying RMBS worth
$47 billion. At that time, Bank of America had repurchased nearly $5 billion of loans as a result
of put-back requests. If bondholders can demonstrate that the bond underwriter breached fixed
underwriting guidelines, banks and other mortgage originators are required to buy back the
nonperforming mortgages at par. These breaches can include factual misrepresentations, such as
opening and closing discrepancies in loan-to-values, faulty debt-to-income ratios, and drifting
FICO scores. These breaches are particularly prevalent in loans originated between 2005 and
2007, when underwriting standards slipped in the rapidly expanding mortgage market.
The ability of the bondholder to source the loan files is a key factor in the success of a loan
put-back request. This is notoriously difficult because in order to make a formal request of
the trustee, a stated minimum percentage of bondholders must be in agreement. For private
labels, this is typically 25 – 50% of the voting rights, necessitating either large ticket sizes by an
individual manager or successful collaboration with other investors. More recently, the GSEs
have begun to pursue repurchases in the private label space. They often represent up to 75% of
the total bonds issued.
J.P. Morgan estimates total J.P. Morgan estimates total put-backs will be in the range of $55 – 120 billion,30 with losses
put-backs will be in the range of realized over a period of approximately five years. They assume that agencies and non-agencies
will attempt to put back 25% and 40% of loans, respectively, with a success rate of approximately
$55 – 120 billion, with losses 40% and 20%, respectively. The private market has a wider set of underwriting standards
realized over a period of where it is more difficult to prove a breach of terms. Supporting documentation also states that
approximately five years. breaches must be settled in a timely manner, which means that currently delinquent mortgages
have a greater likelihood of being put-back than foreclosures, although a small number of
hedge funds so far have anecdotally had success with both.
Access to loan files is the key challenge to put-backs. Even when requests are successfully met,
response times can be long and litigation may be required to gain access to the files or to
appeal the eventual put-back decision. Consequently, the estimated timeline for these trades is
18 months to three years. As shown in Figure 3.7, the projected yield on successful put-back
trades is 50% (based on discussions with hedge funds pursuing this strategy) while unsuccessful
trades will be in line with the underlying instruments. The long duration and resource-intensive
nature (e.g., legal fees) of the put-back strategy make it difficult for traditional RMBS managers
to pursue the opportunity set. The process echoes the restructuring trades that traditional
distressed hedge funds implement. The best-suited funds for this type of opportunity are those
with sufficient resources to conduct underlying analysis on the securities should the put-back
requests fail.

The Importance of Collateral and Fundamental Analyses


Loan level analysis is the common denominator tying the above trades together. The
characteristics of the underlying mortgages and the different vintages of origination can vary
dramatically. Detailed collateral analysis can help determine the quality of the mortgage pool,
including loan quality (indicated by the loan-to-value ratio), borrower profile (indicated
by the FICO score), vintage, geography, loan documentation, debt-to-income ratio and the
layered risk of the borrower. Within these factors, assumptions are made about prepayments,
modifications, foreclosure rates and loss severities. The manager typically sources this
information from LoanPerformance, which collects and collates data on all underlying
pools.31 Other fundamentals that may potentially influence cash flows include interest rates,
30
They break this down into $23-$35 billion in agency-wrapped loans, $40-$80 billion in non-agency and $20-$30 billion
in second liens.
31
LoanPerformance is the leader in mortgage finance, servicing, and securitization information and analytics. They created
and maintain the industry’s largest and most robust mortgage securities and servicing databases and provide analytical
tools that their banking, trading, and securities customers use to understand and manage their loan portfolios.

35
government programs and foreclosure timelines. Servicer behavior and the wide variance in
their efficiency can also influence returns. In a sequential pay structure, securities at the top of
the capital structure benefit from faster foreclosure rates, while securities at the bottom of the
capital structure benefit from duration extension.

Government programs can Recent reports of ‘robo-signing’32 on foreclosures have frozen foreclosures in several states,
resulting in longer timelines and extended foreclosure procedures even when the documentation
potentially cause atypical behavior
is correct. Barclays estimates that the delays will be in the range of 3 – 6 months, affecting
in prepayments and defaults, and option ARMs and subprime yields where liquidations comprise 25 – 50% of cash flows. On the
their impact must be monitored. other hand, interest-only paper should benefit from this extended timeline by extending the
cash flows. Improper documentation and ensuing legal claims would be a larger issue. On the
other side of the equation, faster loss cram-downs33 and short sales can decrease the duration
of a bond. Government programs can potentially cause atypical behavior in prepayments and
defaults, and their impact must be monitored. Finally, we may see an increase in delinquencies
due to the imminent wave of resets for ARMs due in late 2010 and into 2011.

Limitations and Risks


We believe that the key risk While meaningful opportunities appear to exist in the space, managers have anecdotally
factors threatening the recovery referenced the increased difficulty in sourcing some types of paper with the same return
characteristics experienced in early 2009. We believe that this is a function of the price rally and
of mortgage-backed securities the increase in market participants. While this does not decrease the potential for attractive
as a broad asset class include returns in the mortgage-backed securities space, it suggests that the returns in 2009 and 2010
larger-than-anticipated home price to date are not sustainable in the long run. We believe that the key risk factors threatening the
recovery of mortgage-backed securities as a broad asset class include larger-than-anticipated
declines significantly higher than home price declines (managers typically model a 15 – 20% decline assumption), significantly
projected defaults and high levels higher than projected defaults and high levels of forced selling by banks. Additionally, increased
of forced selling by banks. government intervention in the form of loan modifications and debt forgiveness can pose a
risk, as the impact and timing are hard to predict and will affect each tranche differently.

The Use of Leverage


In hindsight, overreliance on leverage hurt many asset-backed hedge funds in 2008
(e.g., Peloton was utilizing leverage of 4 – 5x).34 Since then, we have seen a significant shift in the
use of leverage. Although some strategies have resumed utilizing leverage, they are very much in
the minority. The vast majority of asset-backed funds either do not employ leverage or cap it at
1.5 – 2x. Those that do employ leverage tend to be pursuing relative value and basis opportunities,
including relative value trading of different maturities between mortgage-backed securities,
relative value trades versus the treasury market and opportunistic issuer swaps. These types of
returns tend to be only a few basis points, so leverage is required to make the strategy worthwhile
from a return standpoint. In January 2010, Reuters reported that Wall Street firms were offering
10-to-1 leverage on certain securities; we have seen funds pursuing these strategies using up to
16x on a notional basis. Although these trades are less risky, they may still be subject to systematic
risk and liquidity shocks that would be magnified with leverage. Yields in the last 18 months
have generated strong IRRs without the use of leverage. However, if yields continue to fall as the
market recovers, an increasing number of managers may resort to employing leverage.
We also note that in addition to the use of explicit financial leverage (i.e., borrowed money),
some mortgage-backed instruments have implicit leverage. Inverse interest-only strips are
particularly sensitive to changes in short-term rates and prepayment. Given that prepayments
fall when short-term rates rise, this makes inverse interest-only notes leveraged, even to small

32
Robo-signing refers to the practice of automatic document generation.
33
 cram-down refers to the involuntary imposition by a court of a reorganization plan over the objection of one or
A
more creditors.
34
Reuters, http://uk.reuters.com/article/idUKNidUKN2859650120080228.

36
price movements. A report by Fidelity suggests that interest-only paper may be more than
10x riskier than buying any other mortgage-backed security. For this reason, more conservative
managers tend to avoid these instruments. We advise that caution should be exercised when
evaluating a manager that has significant exposure to such instruments.

Hedging a Portfolio of Residential Mortgage-Backed Securities


Non-agency RMBS are exposed Managers have cited the challenges involved in constructing a short book in 2009 and 2010,
to a range of external factors, when the rally extended across asset classes regardless of fundamental differentials. Short trades
in a portfolio can be separated by alpha generative short positions and portfolio hedges. The
including correlation to broader latter can be further dissected to include both credit risk (idiosyncratic borrower-dependent)
credit and equity markets, and more general systematic risk. Non-agency RMBS are exposed to a range of external factors,
interest rate risk and its impact on including correlation to broader credit and equity markets, interest rate risk and its impact on
prepayment rates, and the risk of loan modifications and government intervention.
prepayment rates, and the risk of
In order to hedge against the first two risks, managers may use a combination of broad market
loan modifications and government
indices such as the Markit CDX and SPX indices. The risks associated with interest rates and
intervention. prepayments may be hedged using interest rate swaps or other interest rate derivatives. The
impact of government modifications is harder to mitigate, largely due to the idiosyncratic
nature of programs such as the Home Affordable Modification Program (“HAMP”)
announced in early 2009. Such interventions are difficult to hedge against and can create
counterintuitive behavior in the market. Arguably, this is a source of concern in the agency
space where government intervention is more likely.
With regard to the capital structure, the impact tends to be nonlinear because duration extensions
and contractions and changes to the principal balance do not impact all tranches equally. Buying
other bonds in the capital structure or exposure to bonds that act differently to changes in
variables such as prepayments may partially offset the risks. Being different from other RMBS,
interest-only and inverse interest-only paper is most commonly used for this purpose.
The ABX is the most common index utilized to hedge in the RMBS space. The ABX was
launched in January 2006 and is a subprime mortgage-backed credit derivative index. The
index was launched with four different series, each comprising 30 underlying subprime
transactions. A subset of the ABX, the TABX, is composed solely of BBB and BBB-tranches and
allows investors to hedge exposure to this specific tranche. The CMBX is an index comprising
25 different commercial mortgage-backed security tranches. The index is rolled over on a
biannual basis to bring in new securities and is consequently a relatively sound proxy for the
health of the underlying market.
Markit MBX and ComboS are total return swaps on for-interest-only and principal-only
securities. The introduction of the Markit PrimeX Index in April 2010 represents the first
prime mortgage credit default swap index, comprising of four baskets of synthetic credit
default swap on tranches of AAA-rated securities. The four subindices comprise 20 underlying
deals each across both fixed rate and hybrid adjustable rate mortgages. The index also increases
transparency within the market sector as participating dealers are required to provide daily
pricings. The most sophisticated managers can run different scenarios for their long portfolio
in terms of severities, defaults, modifications and house prices at the individual loan level in
order to customize a direct hedge, although this can be expensive with the ABX spread ranging
from 0.25 to 0.5 basis points.35

35
NB Alternatives Manager Meetings with Managers who invest in ABS space.

37
While there are a number of ways to potentially hedge a portfolio of mortgage-backed securities,
most hedge funds appear to be operating with a significant net long bias or what is essentially
a long-only strategy. Hedging this strategy can actually materially increase the risk profile of a
fund due to the inherent basis risk between the longs and the shorts, but the portfolios can be
structured or hedged to exhibit less sensitivity to interest rates and other variables.

Detail of Asset-Backed Universe


It is worth noting that due to a number of hedge funds being forced out of the space in 2008,
the asset-backed peer group is likely to contain above average levels of survivorship bias. That
said, despite the considerable disparity in returns between funds and the high profile blow-ups
in 2008, the HFRI Asset-Backed Index finished the year up 0.05%, presumably bolstered by
the funds that gained from being short subprime. As Figure 3.9 indicates, the peer group has
performed well and in line with the wider beta rally for the rest of the class.

Figure 3.9: Asset-Backed Index Performance


55%
50% Barclays Mortgage-Backed Securities Index
HFRI Fixed Income Asset-Backed Index
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
-5%
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Source: Barclays Capital.

Total assets in the space peaked in Q2 2007, at an estimated $69.6 billion before falling below
$20 billion by late 2008 and then stabilizing in 2009.36 Currently, the HedgeFund.Net database
contains over 75 hedge funds that primarily invest in asset-backed securities. We have observed
a number of new launches, particularly for RMBS-focused hedge funds through 2009 and 2010.
With respect to the broader peer group, we track a more focused collection of 15 – 20 funds in
addition to exposure gained from within the distressed peer group. Many of these funds invest
primarily in residential and, to a lesser extent, commercial-based mortgage strategies. Assets
under management range from $15 million to $2.4 billion with an average size of $560 million.
Four funds predate 2007, while the remainder have since launched to take advantage of the
market dislocations.

36
HedgeFund.Net: MBS, ABS and Securitized Credit Funds Strategy Focus Report 2009.

38
These 15 to 20 funds performed well in 2009, posting an average annualized return of 23.37%
net of fees (up 14.39% year-to-date through October). The returns also show low correlation
and beta to the equity markets as shown in the table below, suggesting that the asset class could
act as a potential portfolio diversifier.

Figure 3.10: Average Correlation and Beta of Mortgage-Backed Peer Group to S&P 500
Since inception of the underlying funds
Correlation 0.16
Beta 0.04

Sources: NB Alternatives analysis, Pertrac.

Figure 3.11: Average Correlation and Beta of Mortgage-Backed Peer Group to S&P 500
Since January 2009 (or Fund inception, if after January 2009)
Correlation 0.08
Beta 0.02

Sources: NB Alternatives analysis, Pertrac.

A hedge fund focusing on asset-backed securities can essentially make money in three ways:
1) interest income, 2) realized gains from principal pay downs and 3) mark-to-market price
appreciation of the bond. While securities have rallied from their lows, we still believe a robust
opportunity set exists. Yields remain attractive on a relative value basis (compared with other
fixed income securities) despite their coming down in the last 18 months and often on an
absolute basis (helped by favorable supply and demand dynamics). Although bond prices have
rallied, they are still below historic highs. We believe that in certain instances, this is justified
and, thus, underscores the importance of fundamental analysis.

Conclusion
Managers will need to focus on With little sign of improvement in the housing market, these dislocations will likely remain
conducting detailed fundamental for the foreseeable future. Going forward, managers will need to focus on conducting detailed
fundamental analysis of the underlying collateral, both to reduce risk and to identify the
analysis of the underlying collateral, securities that remain the most mispriced. Further along this point, it is important to note
both to reduce risk and to identify that individual funds can take unique idiosyncratic bets that have low levels of the systematic
the securities that remain the risks associated with the broader strategy, thus making bottom-up selection of managers
increasingly significant. In general, despite a broadly positive outlook, the difficulty of hedging
most mispriced. a mortgage-backed portfolio coupled with potential illiquidity of the underlying instruments
reminds investors that prudent manager selection is crucial within a fund of funds portfolio.

39
Chapter 4: Emerging Manager Outperformance:
An Analysis of Renewed Importance
Introduction
Do emerging hedge fund managers tend to outperform their more established peers? This
question has long been the subject of debate within both the financial industry and academia.
Generally, the consensus is that emerging managers do tend to outperform for the following
intuitive reasons: 1) greater nimbleness to uncover off-the-run opportunities, 2) better
flexibility to redeploy capital, and 3) increased manager motivation (i.e., greater reliance on
performance fees as opposed to management fees, and the general psychological need to “make
it”). To be fair, potential downfalls of emerging manager investing exist, including the relative
lack of capital stability and deep infrastructure as well as the potential lack of meaningful
portfolio management experience. However, investors who possess the skill and resources to
assess both the manager’s investment acumen and the future potential for success may not
only benefit from the early stage outperformance frequently displayed by emerging managers,
but may also gain early access to some future marquee managers.
A multitude of recent industry shifts have shed new light on the positive effect a thoughtfully
constructed emerging manager allocation can wield in a portfolio:
•• Robust supply of talented, newly launched managers in need of funding. Due to the Volcker
Rule, headcount was significantly reduced for many proprietary trading desks. Additionally, a
number of existing hedge funds remain below their high water marks and/or have diminished
asset bases since 2008. These changes have resulted in a growing pool of talented, experienced
money managers looking to relaunch or create new hedge fund businesses.
•• Underperformance of a few, high profile hedge funds have demonstrated that sizeable assets
under management (“AUM”) is not necessarily better or safer. Generally, as AUM grows,
a fund’s investable universe decreases, and style drift and performance erosion can occur.
Large firms may devote more time to cultivating investor relationships (and management
fees), leaving less time to focus on return generation.
Providing capital to quality •• Hedge fund inflows overlook emerging managers. Asset flows in 2010 indicate renewed
emerging managers could result interest in hedge funds; $42.3 billion was allocated to hedge funds over the first three
quarters of the year (the first year of net subscriptions since 2007). However, allocations
in more favorable liquidity terms, were biased towards the most established managers: 90% of Q3 inflows went to managers
transparency and fee arrangements, with $500 million or more, with 75% concentrated in those managers with over $5 billion
short-run alpha generation, and a (representing less than 5% of the overall hedge fund universe).37 This implies that, all else
equal, established managers are disproportionately favored over emerging managers. As
unique source of diversification to such, providing capital to quality emerging managers could result in more favorable liquidity
more commonly held hedge funds, terms, transparency and fee arrangements, short-run alpha generation, and a unique source
of which the industry is increasingly of diversification to more commonly held hedge funds, of which the industry is increasingly
over-concentrated.
over-concentrated.
Interestingly, industry flows continue to flock to the largest funds despite the negative publicity
about industry overcrowding. The trend of asset flows to more established funds coupled with
the glut of experienced money managers seeking capital provides a unique opportunity for
those investors emphasizing prudent manager selection over the perceived safety of a brand
name fund.

37
HFR Global Hedge Fund Industry Report – 3Q 2010.

40
Defining an Emerging Manager
The fact that these managers are In this chapter, we seek to use empirical data to evaluate the notion that emerging managers
frequently overlooked is precisely tend to outperform their more established peers. We begin our analysis by defining “emerging
manager.” Despite the amount of industry research devoted to the topic, no universal definition
what makes them potentially of the term “emerging manager” exists. Many define emerging managers purely along the
appealing to those investors who metric of longevity: those funds possessing track records of less than two to four years. Yet
possess the infrastructure and the small group of high profile hedge fund launches — those launching with a critical mass in
assets such as Eton Park, TPG Axon, and Centerbridge — quickly attract institutional assets in
process to allocate capital at the their incipient years and are seldom considered “emerging” by the investment community. For
early stage of a fund’s lifecycle. this reason, we believe it is more useful to consider a manager as “emerging” when the manager
is both relatively new to the market and has yet to gain traction in terms of fundraising. Such
funds can frequently be overlooked or under-researched, as some investors face restrictions
regarding the length of a track record or face concentration limits, where their assets cannot
exceed a certain percentage of total fund assets. The fact that these managers are frequently
overlooked is precisely what makes them potentially appealing to those investors who possess
the infrastructure and process to allocate capital at the early stage of a fund’s lifecycle. For the
purpose of this study, we will define an emerging manager as a fund within its first 36 months
of operation and that manages less than $500 million.

Overall Analysis
To measure and compare the performance of emerging and emerged managers, we have
constructed two indexes from our universe of hedge fund investments since January 2002.
Survivorship and backfill biases have always complicated the emerging manager analysis,
as many funds only report to databases once they have generated positive returns, thereby
excluding those that have failed or performed poorly. We seek to mute these biases by using
our proprietary database which includes track records of several early-stage funds that
subsequently folded and failed to report to public data providers, a total universe of 288 hedge
funds across various strategies and geographies. Based on our emerging manager definition,
we created an equally-weighted track record for both emerging and emerged managers; as a
fund reached its 37th month of performance or exceeded the $500 million AUM threshold, it
moved out of the emerging manager track record and became a part of the emerged manager
composite (see Figure 4.1).

Figure 4.1: Summary Statistics Comparing Emerging Managers with Emerged


Managers and with the Overall Hedge Fund Universe
Emerging Emerged HFRX Global
Annualized Return 9.49% 7.61% 2.73%
Annualized Volatility 5.88% 5.70% 6.11%
Information Ratio 1.6 1.3 0.4

Correlation
S&P Index 0.53 0.69 0.65
MSCI World Index 0.60 0.74 0.70
Russell 2000 Index 0.51 0.67 0.64
Barclays HY Index 0.50 0.71 0.70
HFRX Global HF Index 0.78 0.95 –

Beta
S&P Index 0.19 0.24 0.25
MSCI World Index 0.23 0.27 0.27
Russell 2000 Index 0.14 0.18 0.18
Barclays HY Index 0.26 0.35 0.37
HFRX Global HF Index 0.75 0.89 –

Alpha
S&P Index 0.72% 0.56% 0.17%
MSCI World Index 0.71% 0.55% 0.16%
Russell 2000 Index 0.69% 0.52% 0.13%
Barclays HY Index 0.57% 0.35% -0.05%
HFRX Global HF Index 0.59% 0.41% –

Source: NB Alternatives Peer Groups.


41
The near-1 correlation and beta of Based on this analysis, the emerging manager’s trend of outperformance seems clear. On both
emerged managers to the HFRX an absolute and risk-adjusted basis, emerging managers perform better than their emerged
counterparts, notably with less correlation, less beta and more alpha to all major market
Global Hedge Fund Index indicate indices. The performance statistics to the HFRX Global Hedge Fund Index, an index designed
that the performance of larger to represent the overall hedge fund universe, are revealing: while correlation and beta metrics to
hedge funds tends to track the this index are admittedly high across both emerging and emerged classes, the near-1 correlation
and beta of emerged managers indicate that the performance of larger hedge funds tends to
overall hedge fund industry. track the overall hedge fund industry. However, both the emerging and emerged managers in
our database perform considerably better than the industry benchmark. It is notable that the
index is asset-weighted, with the performance of the largest funds having the most influence
on its performance statistics. Clearly, prudent manager selection can lead to emerged managers
that outperform the industry, but a thoughtfully constructed emerging manager allocation can
provide even stronger performance statistics.
In order to better evaluate the trend between longevity and performance, we performed an
analysis defining emerging managers along the same AUM guidelines, but on different time
horizons: less than 24 months, 36 months, and 48 months of track record (see Figure 4.2).
The side-by-side comparison of these performance streams brings to light the magnitude
of outperformance even earlier in the life cycle, as most of the performance statistics (e.g.,
returns, volatility, correlation, beta and alpha) are better for the youngest class, and deteriorates
marginally as the emerging manager definition embraces funds a year older.

Figure 4.2: Summary Statistics Comparing Emerging Managers at Different Stages in


their Life with Each Other
Equal to or less than Equal to or less than Equal to or less than
24 Months 36 Months 48 Months
Annualized Return 10.46% 9.49% 7.13%
Annualized Volatility 4.81% 5.88% 6.51%
Information Ratio 2.2 1.6 1.1

Correlation
S&P Index 0.45 0.53 0.57
MSCI World Index 0.54 0.60 0.63
Russell 2000 Index 0.43 0.51 0.55
Barclays HY Index 0.45 0.50 0.59
HFRX Global HF Index 0.78 0.78 0.84

Beta
S&P Index 0.14 0.19 0.23
MSCI World Index 0.17 0.23 0.26
Russell 2000 Index 0.10 0.14 0.17
Barclays HY Index 0.19 0.26 0.34
HFRX Global HF Index 0.62 0.75 0.90

Alpha
S&P Index 0.81% 0.72% 0.53%
MSCI World Index 0.80% 0.71% 0.52%
Russell 2000 Index 0.78% 0.69% 0.49%
Barclays HY Index 0.69% 0.57% 0.33%
HFRX Global HF Index 0.69% 0.59% 0.38%

Sources: NB Alternatives Peer Groups.

This broad analysis seems to demonstrate that emerging managers could contribute
meaningfully to portfolio diversification, given their relatively lower correlation and beta.

42
Strategy-Specific Analysis
Acknowledging that some periods Understanding that the prior analysis did not control for different strategies or geographies,
of time are more favorable to we decide to narrow our analysis within more specific peer groups to further test the thesis
and more reliably assess performance characteristics. We utilized our proprietary U.S. Long/
some strategies than others, one Short Peer Group of 182 funds and Distressed Peer Group of 64 funds to evaluate manager
hypothesis for emerging manager performance against their respective benchmarks. Acknowledging that some periods of time
outperformance is that a manager are more favorable to some strategies than others, one hypothesis for emerging manager
outperformance is that a manager could benefit from a strategy tailwind if the manager
could benefit from a strategy strategically chose to launch at the “right time.” For this analysis, we disregarded AUM in
tailwind if the manager strategically defining an emerging manager, as 1) AUM information for non-investments is harder to
chose to launch at the “right time.” rely upon, and 2) we were exploring the specific idea of “market-timing” a fund launch. For
instance, if we consider those funds with at least six years of track record and calculate a broad
average of the first three years of life compared with the average of its following three years, the
fund in its emerging state tends to generate more attractive returns than during the following
three year period. Evaluated alone, these results could support either the emerging manager
argument or could be interpreted as a sign that funds tend to launch at attractive times for
their strategy.

Figure 4.3: Returns Change Over Time

NB Alternatives U.S. Long/Short Peer Group1


Annualized Return Annualized Volatility Information Ratio
First Three years 20.94% 12.96% 1.6
Second Three years 11.64% 11.99% 1.0

NB Alternatives Distressed Peer Group2


First Three years 19.30% 6.93% 2.8
Second Three years 14.56% 8.61% 1.7

Sources: NB Alternatives analysis, Pertrac.


1
Analysis conducted from Jan. 1995 to Sept. 2010.
2
Analysis conducted from Jan. 2002 to Sept. 2010.

To investigate the market-timing issue, we attempted to strip out the impact of specific market
environments by analyzing how emerging and emerged managers performed in the same
exact market environment. To do this, we split markets into three-year blocks, during which
managers were both emerging and already emerged. Interestingly, the class of emerging long/
short funds outperformed their emerged equivalents on an absolute and risk-adjusted basis
across every three-year market environment since 1998 (see Figure 4.4). Furthermore, the
emerging managers were generally less reliant on beta and generated considerably more alpha
across all of these market environments as well.

43
Figure 4.4: Annualized Return and Alpha Comparison across Emerging and Emerged
U.S. Long/Short Managers
40% 9%
Emerging Manager Returns
35% Emerged Manager Returns 8%
Emerging Manager Alpha
30% 7%
Emerged Manager Alpha
25% 6%

Returns

Alpha
20% 5%

15% 4%

10% 3%

5% 2%

0% 1%

-5% 0%
Jan 1998 – Jan 1999 – Jan 2000 – Jan 2001 – Jan 2002 – Jan 2003 – Jan 2004 – Jan 2005 – Jan 2006 – Jan 2007 –
Dec 2000 Dec 2001 Dec 2002 Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009

Source: NB Alternatives Peer Groups.

While the long/short analysis refutes the idea of strategy lift and supports the general trend that
emerging managers outperform, the same analysis proved less conclusive for our Distressed
Peer Group. While emerged distressed managers outperform their emerging counterparts
earlier in the decade, emerging managers begin to outperform, albeit with higher volatility, in
more recent years.

Figure 4.5: Annualized Return and Alpha Comparison across Emerging and Emerged
Distressed Managers

35% Emerging Manager Returns 6%


Emerged Manager Returns
30%
Emerging Manager Alpha 5%
25% Emerged Manager Alpha
4%
20%
Returns

3%

Alpha
15%

10% 2%
5%
1%
0%
0%
-5%

-10% -1%
Jan 2002 – Jan 2003 – Jan 2004 – Jan 2005 – Jan 2006 – Jan 2007 –
Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009

Source: NB Alternatives Peer Groups.

The results for these two strategies highlight some of their fundamental differentiating
characteristics. Regardless of market environment, long/short emerging managers seem
to generate alpha-driven returns which highlight the relatively low barrier to entry in long/
short investing. While resources are of course necessary, the proverbial “manager and a
Bloomberg” could effectively identify “good” stocks and “bad” stocks with great success.
Distressed investing, on the other hand, tends to favor those institutions with the necessary
corporate, legal and technical infrastructure to better navigate situations with typically
poor information dissemination, and as such, emerged managers register some periods of
outperformance. However, the commonality between the two analyses is that the emerged

44
The fact that emerging managers managers in both strategies fared far worse in the recent crisis and have actually generated
were actually better-equipped to negative returns and low or negative alpha on average. The fact that emerging managers
were actually better-equipped to weather the storm — a dramatic change in the trend for
weather the storm points to the distressed managers — points to the benefits of the early years (i.e., a clean investment slate
benefits of the early years and devoid of troubled legacy positions) and presumably smaller size (i.e., having the nimbleness
presumably smaller size during to get out of crowded trades and only invest in one’s highest conviction ideas) during periods
of illiquidity and volatility. It would seem that market environments influence distressed
periods of illiquidity and volatility. managers more than they affect long/short managers, perhaps because of illiquidity differences
and the inherent cyclicality of default rates. The fact, though, that more established distressed
funds better trade a more normalized market environment tempers the emerging manager
argument; as mentioned in our earlier section on distressed investing, the strategy requires
robust intellectual capital resources — funded by the AUM that typically comes with age — to
manage the complicated nature of distressed deals efficiently. Of course, one cannot blindly
invest in newly launched funds without the appropriately tailored due diligence, particularly as
there seems to be different factors motivating strategy performance.
Finally, we compared the upside/downside captures of emerging and emerged managers over
each three-year period by using the Long/Short Peer Group, in which emerging managers
consistently outperform. As demonstrated in Figure 4.6, the relatively dispersed nature of
emerging managers in relation to the clustering of emerged managers underscores the variety
within emerging managers. This range highlights the importance of manager selection,
particularly in the evaluation of emerging managers. Most of the emerged managers are
clustered around the solid line which represents the point at which upside capture equals
downside capture. This reveals a tendency and an ability to “play it safe.” The scatterplot for
emerging managers reveals a focus on alpha generation: the relative higher upside capture, and
even a few periods of time with negative downside capture, point to the emerging managers’
need to establish a noteworthy track record.

Figure 4.6: Upside/Downside Capture of Emerging and Emerged Long/Short Managers


versus the S&P 500 Index Over Time

100%
90%
80%
70%
Upside Capture

60%
50%
40%
30%
20% Emerged – Long/Short
10% Emerging – Long/Short

0%
-60% -40% -20% 0% 20% 40% 60% 80% 100%
Downside Capture

Emerging Managers Emerged Managers


Average Upside Capture 66.86% 35.59%
Average Downside Capture 8.58% 15.51%

Sources: NB Alternatives analysis, Pertrac.

While it seems that well-selected emerging managers are a strong generator of alpha in spite
of market environments, and a potential source of diversification when markets are irregular,
their relative lack of predictability makes manager due diligence integral.

45
Conclusion
Emerging manager performance We believe that despite some of the qualifying points, there are clear benefits to investing in
appears to be more dependent emerging managers. Emerging manager performance appears to be more dependent on
manager-specific skills (leading to alpha) rather than broad exposure to a particular market
on manager-specific skills rather environment (market or strategy beta). This highlights why emerging managers are attractive
than broad exposure to a particular investments and why bottom-up due diligence and the ability to evaluate each emerging
market environment. manager on a case-by-case basis is so important. In doing so, we focus on the skill of the
manager and the manager’s background with a live portfolio across different historic market
environments, with a particular emphasis on risk management process. Operational due
diligence is also key to ensure the presence of a working infrastructure and a realistic business
plan to grow.
It is notable that the supply of emerging managers is persistent: even over the past three turbulent
years, managers within their first three years of life have comprised an average of 29% of
the overall industry and managers with less than $500 million in assets make up 17% of the
universe.38 These industry statistics highlight the desirability of actively monitoring emerging
managers on a continuous basis: on the one hand, the universe is robust enough to conduct ample
due diligence on a fund’s peer group and invest in the most desirable; on the other hand, these
managers represent a diversification of ideas away from the remaining 71% and 83% of industry
assets that are relatively concentrated in a smaller number of large managers. Within the broader
context of emerging managers’ alpha-generation and diversification capabilities, the increased
supply of talented, experienced managers looking to launch funds makes the emerging manager
opportunity particularly compelling for 2011. Today’s best-of-breed emerging managers could
become the more established, tenured managers of tomorrow; research and anecdotal evidence
suggests that investors could be rewarded for performing the deep due diligence necessary to
invest in these funds early in their development cycles.

38
HFR Global Hedge Fund Industry Report – Q3 2010, Q3 2009, Q3 2008.

46
Chapter 5: The Relationship between Various Hedge Fund
Strategies and Market Illiquidity
Introduction
Following the market events of 2008, we decided to revisit the concept of “illiquidity beta” and
its implications for portfolios of hedge funds due to the numerous monthly observations that
a considerable number of event-driven and relative value hedge funds lost money between
Q3 2007 and Q1 2009, despite the fact that the historical track records of these hedge funds
exhibited no measurable equity and/or credit beta, and the funds maintained net exposures
to the markets at the time of near zero. Whether it was quantitative equity market neutral
strategies in August 2007 or capital structure arbitrage funds in Q4 2008, a large number
of structurally factor neutral funds suffered large losses. Similar observations can be made
throughout the recent history of hedge funds (e.g., Fall 1998, Summer 2002, Spring 2005).
Our previous hypothesis was that an illiquidity factor, distinct from direct exposure to
common market factors such as equity or credit, was responsible for the consistent negative
performance of these hedge funds during periods of sharply rising volatility and falling equity/
credit markets.
The qualitative reasoning behind this thesis was that periods of forced selling often result in
widening bid/offer spreads, particularly when the positions being sold are widely held in hedge
fund portfolios. In these stressed periods, hedge funds typically suffer losses on their long
positions as bid prices decline on thin demand and large supply, while short positions, which
are marked to the offer price, are often the victims of covering-induced price rallies and fail
to provide the relied upon market “hedge.” Further, we can draw a connection between the
types of assets generally held by funds employing a given strategy and those funds’ sensitivity
to illiquidity shocks. For example, we can break down the broader strategy of Fixed Income
Arbitrage so that we have subgroups focused on global relative value, mortgage-backed
securities and asset-backed securities. Intuitively, some asset-based sub-strategies, such as
direct lending, will have greater illiquidity sensitivities than fixed income relative value because
a direct loan is less liquid than sovereign debt.
In the analysis that follows, we explore this illiquidity beta concept in greater detail in an effort
to test the qualitative thesis that certain hedge fund strategies, during times of decreasing capital
markets liquidity, perform worse than simple equity or credit betas would suggest. We explore
the concept of an illiquidity factor, measure the sensitivity of various hedge fund strategies to
this factor, and discuss the implications of these results for well-diversified, market neutral
fund of hedge fund portfolios.

Methodology and Analysis39


In order to assess various strategies’ sensitivities to market illiquidity (equity or credit-related),
we can utilize a number of different approaches. For the analysis that follows, we focus on
three different ways to measure a strategy’s sensitivity to illiquidity. First, we address equity
illiquidity by utilizing the average daily ratio of absolute stock return to dollar volume.40 Here,
we assume that in illiquid markets, small trading volumes can produce large absolute price

39
 e constructed strategy return series by utilizing our proprietary peer group database, where we group funds by
W
granular strategy level. For the period January 2000 through September 2010, we take the monthly average of all funds
with available return data within a given month, which comprises the returns of funds that are no longer in existence, as
well as funds that are active and still reporting earnings. We believe this provides a more realistic picture of the return
characteristics of a given peer group for each month. We will examine two levels of aggregated peer group return data:
a broad strategy return and more granular sub-strategy returns where appropriate. For example, we consider a combined
CTA return series that encompasses Short-Term CTAs, Long-Term Trend-Following CTAs, and Diversified, or Multi-Term
CTAs.
40
Using the average daily ratio of absolute stock return to dollar volume is a concept researched and introduced in
Amihud, Y., “Illiquidity and Stock Returns Cross-Section and Time-Series Effects,” Journal of Financial Markets
5,2002:31–56.

47
movements. Second, we examine the utility of the TED spread41 as a proxy for credit-related
illiquidity. Again, the concept is that during periods of widening credit spreads (which can be
the result of illiquidity), we can generally expect negative performance from certain strategies.
The traditional approach used to assess sensitivity to a given factor is a linear regression
model with the factor as the independent variable and the asset (in this case the strategy-level
returns) as the dependent variable. However, upon closer examination of the data, this type of
approach does not appear to be appropriate for this analysis. Specifically, the relationship is
generally flat when there is little or no illiquidity. When there is moderate to severe illiquidity,
the relationship is positive, flat, or negative, depending on the given strategy’s sensitivity to
illiquidity. Therefore, we employ a quadratic model to allow for the relationship, if it is present.
The model used is as follows:

return A B illiq + B  (illiq)ˆ2


where illiq is the equity illiquidity factor noted above.
Figure 5.1 shows some examples of the quadratic model fitting the equity illiquidity factor to
each set of strategy returns. In the various figures, the x-axis is the illiquidity factor value and
the y-axis is the return for the given month. It is notable that for the more illiquidity-sensitive
strategies, extremely high values of the illiquidity factor correspond to extreme negative
performance. This model appears to be more intuitive than the typical linear model. For
example, we would expect some relationship between returns and illiquidity when illiquidity
is present, but we would not necessarily expect a relationship to be present when illiquidity
is absent (i.e., we would not expect symmetrically high returns when markets are extremely
liquid). Similar patterns form when we charted the relationship between strategy returns and
the TED spread.42 As one can deduce from reviewing the trend lines, both factors for assessing
illiquidity generally provide similar conclusions across all strategies.

41
The TED spread is defined as the difference between the rates on U.S. three-month T-bills and the three-month London
Interbank Offered Rate (LIBOR).
42
Please refer to the appendix for the TED spread graphs.

48
Figure 5.1: Strategy Returns versus Equity Illiquidity Factor

Event-Driven — Distressed Event-Driven — Multi Global CTA — Diversified

10 10 10
Return (%)

Return (%)

Return (%)
5 5 5

0 0 0

-5 -5 -5

0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05
Illiquidity factor Illiquidity factor Illiquidity factor

CTA — Trend-Following CTA — Short-Term Equity Market Neutral

10 10 10
Return (%)

Return (%)

Return (%)
5 5 5

0 0 0

-5 -5 -5

0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05
Illiquidity factor Illiquidity factor Illiquidity factor

Long/Short Global Fixed Income Arb —MBS Credit Arb

10 10 10
Return (%)

Return (%)

Return (%)

5 5 5

0 0 0

-5 -5 -5

0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05 0.01 0.02 0.03 0.04 0.05
Illiquidity factor Illiquidity factor Illiquidity factor

Source: NB Alternative Peer Groups.

49
The final manner in which we chose to quantify illiquidity sensitivity was to observe the
relationship between illiquidity and positive autocorrelation through our own peer group
data.43 We examine both the long-run relationship of these factors with various hedge fund
strategy returns, as well as the time-varying relationship using rolling 36-month windows.
We use the average strategy return series for each strategy over the period from January 2000
through September 2010 (i.e., 129 months). Figure 5.2 provides the long-run basic summary
statistics for the different strategies under consideration.

Figure 5.2: Summary Statistics by Hedge Fund Strategy

Beta to Equity
Peer Group Autocorrelation Illiquidity Factor T-Stat Beta to TED Spread T-Stat
Distressed 58.20% -1.80 -5.73 -0.0082 -2.75
Credit Arb 61.90% -1.64 -5.69 -0.0066 -2.60
Event-Driven 48.20% -1.48 -4.62 -0.0106 -3.41
Long/Short Equity 29.80% -1.29 -3.40 -0.0139 -3.58
Fixed Income Arb — MBS 55.20% -0.51 -2.45 -0.0057 -2.71
Equity Market Neutral 16.40% -0.39 -2.15 -0.0035 -1.80
Macro — Discretionary -4.90% -0.61 -1.97 -0.0033 -0.95
Macro — Model-Driven 3.70% -0.45 -1.42 -0.0022 -0.66
CTA — Trend-Following 6.80% 0.23 0.38 0.0043 0.66
CTA — Diversified 11.50% 0.51 0.90 0.0061 1.04
CTA — Short-Term -7.40% 0.58 1.48 -0.0002 -0.04

Sources: FactSet, Bloomberg, NB Alternatives analysis.


Note: T-Statistics in italics are statistically significant at the 0.05 level of significance.

As expected, autocorrelation is highest for the known less-liquid strategies such as


Event-Driven, Credit Arbitrage, Distressed and the MBS sub-strategy within Fixed Income
Arbitrage; autocorrelation was lowest for the recognized more liquid strategies: Equity Market
Neutral (“EMN”), CTA and Macro.
The results of this autocorrelation Similarly, we find that the strategies with the largest negative sensitivities to the equity market
analysis seem to confirm our illiquidity factor are Event-Driven, Long/Short Equity, and Fixed Income Arbitrage, while the
strategies employing more liquid assets, CTA and Macro, exhibit closer to flat exposure to
intuition that the more liquid the this factor. Equity Market Neutral, by design, has close to flat exposure to the equity market
assets traded by a given strategy, illiquidity factor, but does have greater liquidity sensitivity than CTAs. The results of this
the less sensitive it will be to autocorrelation analysis seem to confirm our intuition that the more liquid the assets traded
by a given strategy, the less sensitive it will be to illiquidity shocks.
illiquidity shocks.

43
Lo, A., “Risk Management for Hedge Funds: Introduction and Overview”, Financial Analysts Journal 57,2001:16 – 33.
Getmansky, M., A. Lo, and I. Makarov, “An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund
Returns,” Journal of Financial Economics 74,2004:529 – 609. Khandani, A and A. Lo, “Illiquidity Premia In Asset Returns:
An Empirical Analysis of Hedge Funds, Mutual Funds, And U.S. Equity Portfolios,” Working paper, 2009.

50
Over most of the 36-month We now consider the time-varying versions of these same illiquidity measures by calculating
windows, most strategies have 36-month rolling versions of the same measures used above. In Figure 5.3, we show the rolling
36-month sensitivities to the equity illiquidity factor. We note that over most of the 36-month
negative sensitivity to equity windows, most strategies have negative sensitivity to equity market illiquidity.
market illiquidity.
Figure 5.3: Rolling 36-Month Sensitivities of Various Hedge Fund Strategies to the
Equity Illiquidity Factor

0.1
Quant meltdown — EMN
funds most affected
-0.0

Beta to Equity Illiquidity Factor


-0.1

-0.2
ping
slo
rd
-0.3 p wa d
u o
ve eri
ha his p Credit crisis — CTA funds
ds t
f un ring react with positive returns
-0.4 CTA d du
n
tre
CTA Fixed Income Arb
-0.5 Long/Short Event-Driven
Equity Market Neutral Macro
-0.6
Jan-07 May-07 Sept-07 Jan-08 May-08 Sept-08 Jan-09

Sources: FactSet, NB Alternatives analysis.

We find several noteworthy characteristics in Figure 5.3. First, the combined CTA Peer Group
shows a general increasing trend during the period from mid-2007 through early 2009,
a period of general market stress. Second, during the massive quant fund sell-off in August
2007, the Equity Market Neutral Peer Group shows a sharp increasingly negative sensitivity to
equity market illiquidity beta. Third, during the credit crisis in Fall 2008, Long/Short Equity,
Event-Driven, and Fixed Income Arbitrage funds all show sharp negative sensitivities to equity
market illiquidity, while CTA, EMN, and Macro funds show positive sensitivities.

51
Conclusion
The strategy level trend is clear and We have demonstrated the difference in sensitivity to various proxies of market illiquidity
can be informative from a portfolio for a number of different hedge fund strategies. Strategies such as Equity Market Neutral
and Macro demonstrate little or no negative sensitivity to market illiquidity; while CTA
construction perspective. strategies — particularly those with shorter holding periods and where mean reversion
models are a higher proportion of a fund’s exposure — actually exhibit positive sensitivity to
periods of market illiquidity (i.e., positive performance during illiquidity events). Conversely,
strategies such as Distressed, Event-Driven, Long/Short Equity, MBS Fixed Income Arbitrage,
and Credit Arbitrage are shown to have varying degrees of negative sensitivity to market
illiquidity (i.e., negative performance during illiquidity events), with Distressed, Event Driven,
and Credit Arbitrage having the worst performance during illiquidity events. It is worth noting
that individual funds within these negative illiquidity beta strategies could potentially generate
a positive illiquidity beta and attractive returns due to their idiosyncratic positioning; that
being said, though, the strategy level trend is clear and can be informative from a portfolio
construction perspective.
Inclusion of some of the more Inclusion of some of the more illiquidity-defensive strategies is important in trying to minimize
illiquidity-defensive strategies is the negative effects of illiquidity shocks. The benefit of diversification is well illustrated if
we compare the performance of our Credit Arbitrage Peer Group (which had the highest
important in trying to minimize the autocorrelation) and the Short-Term CTA Peer Group (which had the lowest autocorrelation)
negative effects of illiquidity shocks. across periods of market stress. The 2007 Quant crisis, the Lehman Brothers bankruptcy and
the resultant credit crisis, and the “flash crash” of May 2010 are all events that provide recent,
memorable case studies of illiquid markets.

Figure 5.4: Peer Group Monthly Performance during Recent Periods of Market Stress
6%

4%

2%

0%
Return

-2%

-4%

-6%

-8% Short-Term CTA Peer Group


Credit Arbitrage Peer Group
-10%
Jun-07 Jul-07 Aug-07 Aug-08 Sep-08 Oct-08 Nov-08 May-10 Average

Source: NB Alternatives Peer Groups.

The trend that Short-Term CTAs are either flat or positive during months of high illiquidity
and volatility is clear. On the whole, some of the worst months for the credit arbitrage strategy
correspond to strong monthly returns from Short-Term CTAs. The average return differential
over these eight months is a material 5.89%. Of course, every portfolio has a different risk/
return objective but, where appropriate, a considerable allocation to funds and strategies that
perform well (positive sensitivities) during periods of market illiquidity (e.g., futures trading
strategies, particularly short-term trading funds), can contribute meaningful returns when
they are needed most.

52
Appendix: Strategy Returns versus TED Spread

Event-Driven — Distressed Event-Driven — Multi Global CTA — Diversified

10 10 10
Return (%)

Return (%)

Return (%)
5 5 5

0 0 0

-5 -5 -5

0.1 0.2 0.5 1.0 2.0 0.1 0.2 0.5 1.0 2.0 0.1 0.2 0.5 1.0 2.0
TED spread TED spread TED spread

CTA — Trend-Following CTA —Short-Term Equity Market Neutral

10 10 10
Return (%)

Return (%)

Return (%)
5 5 5

0 0 0

-5 -5 -5

0.1 0.2 0.5 1.0 2.0 0.1 0.2 0.5 1.0 2.0 0.1 0.2 0.5 1.0 2.0
TED spread TED spread TED spread

Long/Short Global Fixed Income Arb — MBS Credit Arb

10 10 10
Return (%)

Return (%)

Return (%)

5 5 5

0 0 0

-5 -5 -5

0.1 0.2 0.5 1.0 2.0 0.1 0.2 0.5 1.0 2.0 0.1 0.2 0.5 1.0 2.0
TED spread TED spread TED spread

Source: NB Alternatives Peer Groups.

53
Definitions
Alpha (Jensen’s Alpha): A risk-adjusted performance measure that is the excess return of a portfolio over and above that
predicted by the Capital Asset Pricing Model (CAPM), given the portfolio’s beta and the average market return. Jensen Alpha’s
measures the value added of an active strategy.
Barclays Capital U.S. MBS Index:  Measures the performance of investment grade fixed-rate mortgage-backed pass-
through securities of Government National Mortgage Association (“GNMA”), Federal National Mortgage Association
(“FNMA”) and Freddie Mac (“FHLMC”) that have 30-, 20-, 15-year and balloon securities that have a remaining maturity of
at least one year, are investment grade, and have more than $250 million or more of outstanding face value. In addition, the
securities must be denominated in U.S. dollars and must be fixed-rate and non-convertible. The Index is a market capitalization
weighted, and the securities in the Index are updated on the last calendar day of each month.
Beta: A measure of the systematic risk of a portfolio. It is the covariance of the portfolio and the benchmark divided by the
variance of the benchmark. Beta measures the historical sensitivity of a portfolio’s returns to movements in the benchmark.
The beta of the benchmark will always be one. A portfolio with a beta above the benchmark (i.e. >1) means that the portfolio
has greater volatility than the benchmark. If the beta of the portfolio is 1.2, a market increase in return of 1% implies a 1.2%
increase in the Portfolio’s return. If the beta of the portfolio is 0.8, a market decrease in return of 1% implies a 0.8% decrease
in the Portfolio’s return.
Correlation: A statistical measure of how a portfolio moves in relation to its benchmark. Correlation values range from +1.0
to -1.0. A positive correlation implies that they move in the same direction. Negative correlation means they move in opposite
paths. A correlation of +1.0 means that the portfolio and benchmark move in exactly the same direction; 1.0 means they move
in exactly the opposite direction; 0.0 means they do not correlate at all with each other.
Downside capture ratio: A measure of the manager’s performance in down markets relative to the market itself. A value
of 90 suggests the manager’s loss is only nine tenths of the market’s loss. During the selected time period the return for the
market for each period is considered a down market period if it is less than zero. The returns for the manager and the market
for all down periods are calculated. The Downside Capture Ratio is calculated by dividing the return of the manager during the
down periods by the return of the market during the same periods.
Federal Funds Rate: The interest rate at which private depository institutions lend balances at the Federal Reserve to other
depository institutions, usually overnight.
HFRI Fixed Income – Asset Backed Index: Includes strategies in which the investment thesis is predicated on realization of
a spread between related instruments in which one or multiple components of the spread is a fixed income instrument backed
physical collateral or other financial obligations (loans, credit cards) other than those of a specific corporation. Strategies
employ an investment process designed to isolate attractive opportunities between a variety of fixed income instruments
specifically securitized by collateral commitments which frequently include loans, pools and portfolios of loans, receivables,
real estate, machinery or other tangible financial commitments. Investment thesis may be predicated on an attractive spread
given the nature and quality of the collateral, the liquidity characteristics of the underlying instruments and on issuance and
trends in collateralized fixed income instruments, broadly speaking. In many cases, investment managers hedge, limit or offset
interest rate exposure in the interest of isolating the risk of the position to strictly the yield disparity of the instrument relative
to the lower risk instruments.
HFRX Global Hedge Fund Index:  The Global Index is designed to be representative of the overall composition of the
hedge fund universe and is built on a “strategy-up” basis from the 8 Single Strategy Indices representing the main hedge fund
strategies. The Equally Weighted Index is equally weighted among the 8 Single Strategy Indices. All Indices are comprised
of hedge funds that are open for investment. The Global Index follows an asset weighted approach to accurately reflect the
changing opportunities in the hedge fund. Currently represented strategies are convertible arbitrage, distressed securities,
equity hedge, equity market neutral, event driven, macro, merger arbitrage and relative value arbitrage.
Information ratio: A measure of risk adjusted return. The average excess return (over an appropriate benchmark or risk free
rate) is divided by the standard deviation of these excess returns. The higher the measure, the higher the risk adjusted return.
The Information Ratio of the benchmark will equal zero.
London Interbank Offered Rate (“LIBOR”): A daily reference rate based on the interest rates at which banks borrow
unsecured funds, in marketable size, from other banks in the London wholesale money market or interbank market. The LIBOR
is fixed on a daily basis and is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates
for larger loans with maturities between overnight and one full year.
Market capitalization: The total market value of all of a company’s outstanding shares. Market capitalization of a company
is the product of the total number of shares outstanding and the current market price per share. The investment community
uses this figure to determine a company’s size, as opposed to sales or total asset figures.
Markit ABX.HE Index: Composed of the 20 most liquid CDS on U.S. home equity ABS. The ABX.HE index is the key trading
tool for banks and asset managers that want to hedge asset-backed exposure or take a position in this asset class.
Markit CMBX Index: A synthetic index referencing 25 commercial mortgage-backed securities. The Markit CMBX Indices
were created in response to the rapid pace of growth in the CDS of CMBS market, providing investors with an efficient,
standardized tool to quickly gain exposure to this asset class.
Markit PrimeX Index: A synthetic CDS index referencing non-Agency Prime RMBS. Each subindex references 20 Prime RMBS
deals from 2005, 2006, and 2007. The index launched on April 28th, 2010.
Markit TABX.HE Index: Constructed using the underlying names of the BBB and BBB- Markit ABX.HE Indices. The goal
of Markit TABX.HE is to provide investors with the ability to gain/hedge their exposure on the underlying names to specific
tranches of varying levels of risk within the portfolio structures.

54
MSCI World Index: A free float-adjusted market capitalization weighted index that is designed to measure the equity market
performance of developed markets. As of May 27, 2010 the MSCI World Index consisted of the following 24 developed market
country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel,
Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and
the United States.
Price-to-book ratio: The ratio is used to compare a stock’s market value to its book value, assessing total firm value. The
ratio is calculated by taking the market value of all shares of common stock divided by the book value of the company. (Book
value is the company’s total assets, less intangible assets and liabilities.) A lower price to book ratio could mean that the
respective stock is undervalued.
Russell 2000® Index:  Measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which
represents approximately 8% of the total market capitalization of the Russell 3000® Index. The index is market cap-weighted
and includes only common stocks incorporated in the United States and its territories.
S&P 500 Index: Consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market
value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate
to its market value. The “500” is one of the most widely used benchmarks of U.S. equity performance. As of September 16,
2005, S&P switched to a float-adjusted format, which weights only those shares that are available to investors, not all of a
company’s outstanding shares. The value of the index now reflects the value available in the public markets.
Upside capture ratio: A measure of the manager’s performance in up markets relative to the market itself. A value of 110
suggests the manager performs ten percent better than the market when the market is up. During the selected time period, the
return for the market for each period is considered an up market period if it is greater than zero. The returns for the manager
and the market for all up periods are calculated. The Upside Capture Ratio is calculated by dividing the return of the manager
during the up market periods by the return of the market during the same periods.
S&P/Case-Shiller® Home Price Index: Designed to be a reliable and consistent benchmark of housing prices in the United
States. Their purpose is to measure the average change in home prices in a particular geographic market. They cover ten major
metropolitan areas (Metropolitan Statistical Areas or MSAs), which are also aggregated to form a national composite. The
indices measure changes in housing market prices given a constant level of quality. Changes in the types and sizes of houses
or changes in the physical characteristics of houses are specifically excluded from the calculations to avoid incorrectly affecting
the index value.

Risk Considerations
While hedge funds offer you the potential for attractive returns and diversification for your portfolio, they also pose greater
risks than more traditional investments. There is no guarantee that any fund will meet its investment objective. An investment
in hedge funds is only intended for sophisticated investors. Investors may lose all or a substantial portion of their investment.
You should consider the risks inherent with investing in hedge funds:
Leveraged and Speculative Investments: An investment in hedge funds is speculative and involves a high degree of risk.
Hedge funds commonly engage in swaps, futures, forwards, options and other derivative transactions that can result in volatile
fund performance. Leveraging may increase risk in hedge funds.
Limited Liquidity: There are limited channels in the secondary market through which investors can attempt to sell
and/or purchase interests in hedge funds; and an investor’s ability to transact business in the secondary market is subject to
restrictions on transferring interest in hedge funds. Hedge funds may suspend or limit the right of redemption under certain
circumstances. Thus, an investment in hedge funds should be regarded as illiquid.
Absence of Regulatory Oversight: Hedge funds are not required to be registered under the U.S. Investment Company Act
of 1940; therefore hedge funds are not subject to the same regulatory requirements as mutual funds.
Dependence upon Investment Manager: The General Partner or manager of a hedge fund normally has total trading
authority over its respective fund. The use of a single advisor applying generally similar trading programs could mean the lack
of diversification and, consequently, higher risk.
Foreign Exchanges: Selective hedge funds may execute a portion of their trades on foreign exchanges. Material economic
conditions and/or events involving those exchanges may affect future results.
Fees and Expenses: Hedge funds often charge high fees; such fees and expenses may offset trading profits. Fees on funds
of funds are in addition to the fees of underlying funds, resulting in two layers of fees. Performance or incentive fees may
incentivize the manager of those funds to make riskier investments.
Complex Tax Structures: Hedge funds may involve complex tax structures and delays in distributing important tax
information.
Limited Reporting: While hedge funds generally may provide periodic performance reports and annual audited financial
statements, they are not otherwise required to provide periodic pricing or valuation information to investors.
Business and Regulatory Risks of Hedge Funds: Legal, tax and regulatory changes could occur during the term of a hedge
fund that may adversely affect the fund or its managers.
In addition to these risk considerations, specific risks will apply to each hedge fund based on its particular investment strategy. Any
investment decision with respect to an investment in a hedge fund or a private equity fund of funds should be made based upon
the information contained in the Confidential Private Placement Memorandum of that fund.
Hedge Fund Data and Analyses: The hedge fund data contained in this material is based upon internal analyses of
information obtained from public and third-party sources. Any returns shown were constructed for illustrative purposes only.
There are numerous limitations inherent in the data presented, including incompleteness and unavailability of hedge fund
holdings, activity and performance data (i.e., unavailability of short activity and intra-quarter activity), and the reliance upon
assumptions. No representation or warranty is made as to the accuracy of the information shown, the reasonableness of

55
the assumptions used, or that all assumptions and limitations inherent in such analysis have been fully stated or considered.
Changes in assumptions may have a material impact on the data and the results presented. The simulated, estimated and
expected returns and characteristics constructed for any hedge fund strategies are shown for illustrative purposes only, and
actual returns and characteristics of any fund or group of funds may differ significantly from any simulated, estimated and
expected returns shown. All return data is shown net of fees and other expenses and reflect reinvestment of any dividend
and distributions.
Any investment decision with respect to an investment in a hedge fund should be made based upon the information contained
in the Confidential Private Placement Memorandum of that fund. The information contained herein is not intended to be
complete or final and is qualified in its entirety by the offering memorandum and governing document for each fund.
The Neuberger Berman Group is comprised of various wholly owned subsidiaries, including, but not limited to,
Neuberger Berman LLC, Neuberger Berman Management LLC, Neuberger Berman Fixed Income LLC, NB Alternative Fund
Management LLC, NB Alternative Investment Management LLC, NB Alternatives GP Holdings LLC and NB Alternatives
Advisers LLC. “Neuberger Berman” and “NB Alternatives” are marketing names used by Neuberger Berman Group and its
subsidiaries. The specific investment adviser for a particular product or service is identified in the product offering materials
and/or applicable investment advisory agreement.
This document is for informational purposes only and is not an offer or solicitation with respect to the
purchase or sale of any security. This summary is intended only for the person to whom it has been
distributed, is strictly confidential and may not be reproduced or redistributed in whole or in part, nor may
its contents be disclosed to any other person under any circumstances. This summary is not intended to
constitute legal, tax, or accounting advice or investment recommendations. Prospective investors should
consult their own advisors about such matters.
We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed
herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some
states or countries, nor are they suitable for all types of investors.
This material has been prepared by NB Alternative Investment Management LLC and issued by Neuberger Berman Europe
Limited, which is authorized and regulated by the UK Financial Services Authority (“FSA”) and is registered in England and
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No part of this document may be reproduced in any manner without the written permission of NB Alternative Investment
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Not for use with retail clients in Europe, Asia and the Middle East.
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(Cap.571) (the “SFO”).

56
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This report was prepared by the NB Alternatives Fund of Hedge Funds global investment and operational due diligence teams.

NB Alternatives fund of hedge funds investment team and operational due diligence members
Eric Weinstein, Patrick Deaton, CAIA, Ian Haas, CFA, Fred Ingham, ACA, CFA, Jeff Majit, CFA, Matthew Rees, Jim McDermott, Ph.D., Paresh
Shah, Laura Hawkins, Avery Kiser, Sophie Steele, Junjie Watkins, CFA, Vishal Bhalla, Josh Myers, Declan Redfern, Justin Scott

Please contact your Neuberger Berman representative or hedgefundclientservice@nb.com for additional information.

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