Hedge fund focus

1. Hedge fund focus A focus on the Hedge Fund Industry Milan, Università Bocconi, May 2011

2. Introduction

3. What are the alternative investments Real Estate Real Estate Assets REITS Absolute return strategies Derivatives Alternative Investments Single Managers Fund of Funds Hedge fund replicators Hedge Funds Private Equity Venture Capital Leverage Buyout Structured Products ABS CDO… Commodities Futures Options

4. The perfect storm on the markets September 2008

5. The perfect storm on the markets AIG nationalized Jp Morgan acquires Washington Mutual Chapter 11 di Lehman Brothers Hypo Real Estate e Dexia saved by govt interventions Short selling ban Central banks act together to face the crisis Fortis and Bradford&Bingley nationalized Morgan Stanley and Goldman Sachs become commercial banks Crack Madoff Real recession is reality Sep 08 Oct 08 Nov 08 Dec 08

6. The perfect storm on the markets Someone said “diversification benefits”? Source: Bloomberg

7. Investing in Alternatives Long term investment horizon Lockup was not an issue as well as poor liquidity terms. A manager must have enough time to make his investment ideas work. Low transparency Transparency was sacrificed and sometimes perceived as negative: a manager must defend his skills from competitors BEFORE THE CRISIS: RETURN WAS THE DRIVER Opportunistic approach Focus on more opportunistic managers (es: Even Driven Activist, Distressed, directional Long Short Equity , Direct Lending) High leverage Lots of players, few arbitrage opportunities, cheap credit

8. Investing in Alternatives Liquidity Funds must have good liquidity rules (monthly with no locks) Transparency Transparency is a value like the ability to generate alpha RISK IS THE DRIVER Maket neutral Need to find manager uncorrelated with the market (es: Equity Mkt Neutral, Risk Arbitrage, Global Macro) Low leverage No need to arbitrage with tons of leverage, credit is expensive and a lot of competitors are no more part of the game

9. Investing in Alternatives • Performance driven markets • Low Liquidity • Low Transparency • Big players, multistrategic approach • High Leverage • Low controls on operational risk • - Strong performances. • Rebound of the worst strategies of 2008 (es Convertible Arb). • Decrease in AUM • Restructurings stories • New investment solutions • Geopolitcal tensions • Liquidity on the markets • First singnals of inflation • Recovery in AUM • UCITS – Hedge • Liquidity • Transparency • Risk Management • New players (ex Prop desk and big hedge funds) • Advanced negotiations for new regulative framework 2008 2010 2009 • - Macro uncertainty • Peripheral Europe crisis • Double dip and deflation vs growth and inflation • Flat performance 2011 - Credit crisis. - Systemic Risk. - Deleveraging. - Liquidity crisis - Frauds. - Peak in correlation and volatility - Decrease in AUM • New approach in valuating investment • Many big players disappeared • Great opportunities for “survivors” • Need to find new ideas and a new regulative framework ?

10. New trends in the industry

11. 2011 drivers : Hedge Fund • Asset growth: • Total inflows and performance lead the industry AUM to 2,25 Tn USD (expected end of) 2011 • Net inflows expected: 210 bln USD • Asset increase four times more than 2010. • Institutional investors are back in the business • Direct investments in hedge funds instead that through a fund of fund • “Decoupling” • Growth in US • Europe still struggle • “Pre crisis strategies” are back on fire • Event Driven • Merger Arbitrage • Long Short Equity Fonte: 9° Annual Alternative Investment Survey – March 2011 Deutsche Bank

12. 2011 drivers : UCITS III hedge funds (Newcits) More regulated 1 The regulative framework is more restrictive compared to offshore hedge funds. Transparency 2 NAV is calculated daily or weekly and underlying assets are easier to price and evaluate (Level 1 or 2) Liquidity 3 Most UCITS funds have daily or weekly liquidity 4 Replicability Many hedge fund strategies could be replicated thanks to the use of derivatives that these funds can employ. 5 Low leverage UCITS funds have strict and rigid limits in terms of leverage Similar limits are also applied to the portfolio concentration. The overall risk management framework is, usually, stricter. 6 Risk management

13. 2011 drivers : UCITS III hedge funds (Newcits) Portfolio Concentration • No more than 10% of the NAV from a single issuer • No more than 5% of the NAV on a single issuer if the sum of all this issuers is higher than 40% of the NAV • No more than 20% of the NAV could be invested in instruments of the same group. Exposure limits • Maximum gross exposure 200% for non sophisticated funds, rigid VAR and risk management limits define maximum gross exposure for sophisticated funds. • Cannot short securities. Shorts allowed only trough derivatives Counterparty risk limits • 10% NAV counterparty limit OTC limit • OTC instruments limit: 10% NAV..

14. 2011 drivers : UCITS III hedge funds (Newcits) • Growing more than offshore funds (Europe): • From 60 to 72% of major institutional investors (Wealth Managers, Family offices and private banks) prefer the UCITS than the offshore version. • Liquidity is key to invest in UCITS • Investors in UCITS tend to ne more sensitive to this element • Equity is the reference asset class • Long Short Equity, Event Driven and Emerging Markets are the core strategies of the Newcits world • Less efforts for a due diligence • The percentage of investors that need less than 3 months for a DD on a UCTS hedge fund is almost twice compared to traditional offshore HF. 2011 UCITS III Absolute Return Investment Survey – Feb 2011 Deutsche Bank

15. 2011 drivers : UCITS III hedge funds (Newcits) • Strategic limitations • Involve managers outside Europe is difficult • “UCITS is safe” • Regulatory limitation shouldn’t drive investors to lower their controls and their due diligence checks • Managing the crisis • High liquidity should be maintained despite market conditions Selection and monitoring is crucial like for hedge funds

16. Strategic focus

17. Hedge fund strategies focus: Merger Arb • Merger Arb manager base their returns on M&A flows • M&A could have many and different features: • All-cash • All-stock • Cash and stock • In its easiest form, Merger Arb managers tend to arbitrage the spread between the companies involved in the M&A just after the announcement of the deal. The spread is suppose to tight until the completion date. • Higher spread doesn’t mean necessarily that there is higher risk implied in the deal. A good arbitrageur knows and exploit the many market inefficiencies that the market offers. • The key alpha driver of a Merger Arb fund is to identify the correct probability of a deal closing • To evaluate and correctly price the risk al all the announced deals is crucial to build a good Merger Arb portfolio • For this reason the amount of skills required by a Merger Arb manager is very heterogeneous: • Legal and accounting (to better identify the deal structure and the antitrust rules) • Risk management (especially for leveraged portfolios) • Corporate strategy (is the business model sustainable?) • International legislation (for cross border deals) • The reward for a good Merger Arb manager is to run an absolute return portfolio with a lot of optionality

18. Hedge fund strategies focus: Merger Arb Complex deals Better arbitrage opportunities Increasing dealflow Increasing spreads and less competition for deals

19. Hedge fund strategies focus: Merger Arb • Deal flow is bottoming • European deal flow per sector Source: UBS

20. Hedge fund strategies focus: Merger Arb • Stocks are cheap • S&P 500 Price/Book Value Source: UBS

21. Hedge fund strategies focus: Merger Arb Trade EX: Jun 2008: Anheuser Bush announce to buy his controlled company Cash deal(the easiest) Target price 68,59 $ per share Source: Bloomberg Anheuser Bush price from the announcement to the close Closing: return +12% Announcement: Price 61,4 USD Vs Target price 68,59

22. Hedge fund strategies focus: Global Macro • Global Macro managers base their investment ideas on a top down analysis. The manager’s view should be implemented trough a complex, diversified and heterogeneous gamma of different financial instruments. Usually these instruments include: • Stocks • Govt bonds • FX • Corporate bonds • Commodity • Options • Futures • Forward • Swaps • A manager could implement his view taking long or short positions on a specific market or with a combination of both (relative value trade) • Macro managers tend to use leverage to implement their ideas. The role of the risk manager is crucial as with a big amount of leverage (also on a notional basis), portfolio diversification is very important as well as risk budgeting, in order not to be squeezed by unexpected market movements. • Global Macro funds and their historical trades: a) Quantum Fund George Soros 1992 (‘relative value’ Italian Lira (short) vs USD (long): crisis of BCE e BANKIT : Italy could be kicked off from EMU; 2 mln USD return); b) John Paulson in 2007-2008 (directional short position on subprime; +120% average performance in 2007)

23. Hedge fund strategies focus: Global Macro • Hypotesis: further tensions in Middle East/North Africa: • Far from a resolution in Libya. • High geopolitical risk across Middle East countries: tail risk in Saudi Arabia. • Inflationary cycle in Emerging Markets driven by commodities rally. • Asian and emerging markets in the middle of a prolonged tightening cycle. • Slowdown risk in China • Contagion risk in terms of inflation between Emerging and Developed. • Trade implemented: • Currencies: Short USD/EUR Vs Asian currencies (Korea) and Oil expoters (NOK) • Equity: long put options (o “best of put”) on Asian Indices • Commodities: long broad commodities. Oil e Ags still hot themes. • Interest rates: short US rates through swaptions (receiver variable rate)

24. Hedge fund strategies focus: Convertible Arb Convertible bonds have may interesting features • Increasing issuance: new paper is flowing in the market as converts are a good tool for firms to find new capital in a scenario still dominated by stricter financing rules • Many opportunities and low players: the best scenario for arbitrageurs. • Absolute return profile: their “optionality” make convertible bonds suitable for absolute return portfolios. Bond Hybrid Equity Source: Bloomberg Yield Equity Bond Convertible price Bond Floor Hybrid Hybrid Equity price Stock Price

25. Hedge fund strategies focus: Convertible Arb • MANY WAYS TO PLAY WITH CONVERTS • Volatility arbitrage • Gamma trading • Credit arbitrage • Distressed • Carry trade

26. Hedge fund strategies focus: Long Short Equity Day 1 Prime broker Lend 10 stocks “A” 10 € cad. (tot 100€) Investor (+100€) Sell 10 stocks “A” at 10€ each Market Receive 100€ Day 2: stock “A” lose 10% Prime broker Gives back 10 stocks “A” at 90€ Investor +10€ Buys 10 stocks “A” at 9€ Market Receives 10 stocks A for 90 € Day 2: stock “A” gain 10% Prime broker Call back his stocks Investor -10€ Buys 10 stocks “A” at 11€ Market Gives back 10 stocks “A” at 110€ Receives 10 stocks A for 110 €

27. Hedge fund strategies focus: Long Short Equity High correlation between stocks within the same sector High macro sensitivity Short term volatility spikes No sensibility to fundamentals Sectorial and intra-sector divergence is increasing More compelling risk premia compared to bonds High level of cash in US fims Lot of “cheap” stocks A RETURN TO A TRADITIONAL FUNDAMENTAL STOCK MARKET COULD CREATE LOTS OF OPPORTUNITIES

28. Selecting and Hedge fund

29. Selecting an Hedge fund: the process Market Analysis Preliminary analysis Operational and investment risk Asset Allocation Order Monitoring Organisation Management and investment team Strategy, trade flow, idea generation Track record Risk Management Transparency Etc Investment Counterparties Operational and administrative process NAV calculation Compliance Conflict of interests Etc Operational

30. Selecting an Hedge fund: the monitoring Official Documents Periodic update and review of all the fund’s official documentation (OM, DDQ, AFS, Presentation, Monthly letters…) Performance monitoring Daily performance monitoring through performance analysis, stress test scenarios, peer group comparison Brief “ad hoc” updates and reports in case of any significant event (outlier returns/losses, corporate actions, official news or simply “rumors” regarding the firm…) Brief Conference Calls updates Quarterly onsite meeting or update conference call with the fund manager, reviewing all the key issues of the fund (portfolio, outlook, firm ….). We tend to meet every manager in our approved list at least every six months. Periodic meetings and Conference Calls Annual Due Diligence At least, annual review, and Due Diligence of all the managers of our Approved List

31. Selecting an Hedge fund: skills required Fluent English Network Hedge fund analyst Analytic approach Experience on the field Multi-tasking profile

32. Luca Anzola Luca Anzola works since 2005 for Aletti Gestielle SGR, one of the largest Alternative Asset Management firms in Italy with more than 1 bln USD in Assets Under Management. Luca is in charge of a team dedicated to the Research and Due Diligence function and is member of the investment committee of the firm, with a key role both on the manager selection process and on the operational Due Diligence. He previously worked as financial analyst for RE Spa and E-Capital Partners, managing different projects with a focus on the real estate market (Italian Real Estate Closed-end funds and Real Estate financial plans). He’s a Adjunct Professor for the Portfolio Management and for the International Financial Markets course at MIP of Politecnico of Milan (MBA Elective 2011). He's a CAIA Charterholder and member of the Association since April 2008.