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					4th Quarter 2005    A Review on Developments in the Hedge Fund Market




                   Event-Driven

                   Contents


                   Editorial | Christophe Grünig | Harcourt AG                         3
                   Quarterly Review | Dr. Philipp Cottier | Harcourt AG                4
                   Strategy Focus | Jens Föhrenbach | Harcourt AG                      9
                   Investors View | Guy Wyser-Pratte | Wyser-Pratte Management         17
                   News behind the News | Matthias Knab | Opalesque                    23
                   Special Feature | Jean-Louis Lelogeais | Strategic Value Partners   27
                                               th
                   Roundtable Discussion 4 Quarter 2005                                31
                   Events 2005/2006 | Harcourt Events | Upcoming Conferences           35




 swissHEDGE 0
Impressum



swissHEDGE | 4th Quarter 2005                                   swissHEDGE is a quarterly publication of Harcourt AG
Annual subscription: EUR200                                     intended for informational purposes and based solely on
Subscriptions: montalbano@harcourt.ch                           information and data supplied by either investment man-
Published by:                                                   agers or qualified third parties. No information contained
Harcourt AG                                                     in this review should be interpreted as a solicitation for an
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8006 Zurich | Switzerland                                       under no circumstance represents an endorsement of the
Tel.: +41 (1) 365 10 00 | Fax: +41 (1) 365 10 01                product or the manager by the publisher. A prospective
Editor: Marcel Herbst | herbst@harcourt.ch                      client for any product or service mentioned in this publica-
Visual Concept: Christian Forrer | forrer@c-forrer.ch           tion should independently investigate the investment man-
Printing: Maus Druck & Medien | Konstanz                        ager and/or service provider and consult with independent,
                                                                qualified sources before engaging in any activity. Investors
                                                                should also be aware that historical performance numbers
                                                                presented herein are not indicative of future performance
                                                                and furthermore, investments in hedge fund vehicles
                                                                involve significant risks, including loss of capital. Opinions
                                                                expressed in the publication are not necessarily those of
                                                                Harcourt and Harcourt assumes no responsibility for the
                                                                contents of contributed articles.


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Editorial | Christophe Grünig | Harcourt AG




Catalysts of change:
the evolving landscape of event-driven hedge funds




                          Christophe Grünig |
                          CIO, Harcourt AG

Currently, the global investing community finds                   many cases in which hedge funds build consortiums in
itself in an environment of medium GDP growth                     order to jointly have more clout in the boardroom.
for industrialised nations. At the same time,                     The caveat here, again speaking as a fund of funds, is that
companies have historically high cash reserves,                   while the natural propensity of event driven funds to collude
accompanied by exceptionally low debt-to-                         certainly increases their opportunity set due to enhanced
equity ratios. The combination of these two                       power (which is good), it also increases the correlations
elements results in increased M&A activity for                    between themselves (which is not). As such, coverage and
companies in pursuit of external growth, share                    portfolio construction of event-driven funds requires a
buyback programs, increased dividends, etc.                       global presence so that portfolios can geographically be
                                                                  diversified and appropriately monitored.
This activity currently creates exceptional opportunities for     With this regard, one should emphasize that Europe in
a group of strategies commonly defined as «event-driven»,         particular plays an ever increasing role for event-driven. As
which is why we have selected it as the topic for this issue      European capital markets move from being heterogeneous
of swissHEDGE.                                                    to homogenous, local funds benefit from an increased
Event-driven is not a hedge fund strategy per se but rather       appetite for cross-border mergers and other transactions,
describes a group of hedge fund strategies which are as           as witnessed by Banco Santander’s acquisition of Abbey
diverse as merger arbitrage, distressed securities, capital       National, or UniCredito’s acquisition of HVB.
structure arbitrage, and many more. What justifies the            This issue of swissHEDGE features an exciting array of
overall classification as «event-driven» is the dependency        prolific managers which share their views on the various
on transformational changes or «events» which materially          event-driven strategies they employ; the geographical mer-
alter the value of companies such as described above. This        its of the world’s global regions; as well as explain specific
dependency explains why event-driven is quite directional         trade examples. At Harcourt, we believe that the education
and exposed to the fate of the markets, since increased           of the investing community on hedge funds is important,
activity often coincides with benign market environments.         and we hope to have made another step in this direction
What makes event-driven interesting for us as a fund of           with the following pages.
funds, being constantly on the lookout for capacity: It is
one of the few areas in the hedge fund space where the size
of assets per hedge fund is not necessarily detrimental to
generating excess returns. Size is power; and some funds
are now even becoming the catalyst of change as opposed
to being the beneficiary of it. While there are of course
limits to assets that can be reasonably deployed due to
operational and liquidity risk, the size of assets dictates the
ability by which a manager can materially influence a com-
pany’s decision making process. Consequently, one finds



                                                                                                                         swissHEDGE 3
      Hedge Fund Industry Commentary: 3rd Quarter 2005 | Dr. Philipp Cottier | Harcourt AG




      Hedge fund industry commentary: third quarter 2005




      By: Dr. Philipp Cottier | Harcourt AG                         +7.73%. The Nordic region, driven by a strong oil services
                                                                    industry, was a clear winner. European small caps outper-
      General market environment in Q3 2005                         formed the large caps, with the HSBC Smaller Companies
                                                                    Index rising +13.06%. Although the energy and materials
      World equity markets powered ahead in Q3 on                   sectors were the best performers overall, European gains
      the back of an improved macro environment                     were more broad-based than in the US. The Topix gained
      and a healthy earnings landscape. The US                      +19.97%, with Japanese large caps for once outperforming
      economy and employment seemed to be grow-                     the small cap stocks. Upbeat data on earnings growth as
      ing and inflation fears abated. By and large,                 well as continued indications signaling the imminent end of
      earnings estimates were revised upwards, with                 deflation in Japan gave investors reason to cheer. The polit-
      companies generally being upbeat. However,                    ical landscape underpinned the optimistic macro outlook,
      regional divergences were pronounced, with                    with Koizumi's landslide election victory for the Lower
      the US underperforming the rest of the world                  House giving him and the LDP a clear mandate for reform.
      and Japan faring better than even the most opti-              Second quarter GDP data came in above expectations,
      mistic expectations indicated. Globally, the                  giving further credence to the possible return of positive
      energy sector was the clear outlier in relative               domestic demand in Japan. Emerging markets saw spec-
      performance as market participants focused                    tacular gains overall, with the MSCI Emerging Markets
      on the consequences of the devastating hurri-                 Free Index rising +17.01%. This performance was substan-
      cane season and ensuing capacity constraints.                 tially boosted by Eastern European markets.
                                                                    On the fixed income front, the US Treasury markets were
      The MSCI World rose +6.57% over the quarter. The US           characterized by a difficult trading environment. To put
      saw the S&P500 rise +3.15% over the quarter, but this is      this in perspective, the 10y Treasury sold off from 3.94% at
      mainly attributable to the strong performance of the energy   the end of June to 4.41% at the beginning of August. The
      sector that rose +17.7%. European markets enjoyed a           impact of Katrina was felt directly through a flight to qual-
      strong quarter with the MSCI Europe gaining a healthy         ity that left Treasuries rallying all the way back to 4.01%,



swissHEDGE 4
Hedge Fund Industry Commentary: 3rd Quarter 2005 | Dr. Philipp Cottier | Harcourt AG




finally closing the quarter at 4.32% as inflation fears began   Table 1 | Q3 returns of hedge funds

to shake investor confidence. Technical factors caused the
                                                                 Hedge Fund Strategy                                           Ret Q3 2005
credit markets to sell-off in the third week of September.       FTSEhx                                                           1.60%
The main factors were a flurry of new high yield supply on       HFR Funds of Funds                                               4.31%
                                                                 HFR Hedge Funds                                                  5.32%
the back of LBO activity, and a net withdrawal of mutual         CSFB/Tremont HF                                                  4.49%
funds from the high yield markets. Over the quarter, the JP      Emerging markets                                                 8.76%
                                                                 Sector specialists                                               7.48%
Morgan Global Bond Index lost -1.20% and the Lehman              Long/short equity                                                5.99%
Brothers High Yield Index (US) appreciated by +0.31%.            Event driven                                                     4.66%
                                                                 Distressed securities                                            4.45%
USD 3-month interest rates increased from 3.52% to 4.07%,        Relative value arbitrage                                         3.48%
which resulted in a further curve flattening with 2-year         Macro                                                            3.24%
                                                                 Convertible arbitrage                                            3.03%
benchmark bond yields ending the quarter at 4.17% and
                                                                 Statistical arbitrage                                            2.79%
10-year benchmark yields at 4.32%. In Europe, 3-month            Market neutral equity                                            2.57%
                                                                 High yield                                                       2.41%
rates ended the quarter at 2.17%, 2-year rates at 2.39%,
                                                                 Merger arbitrage                                                 1.87%
while 10-year rates remained around 3.13%.                       MBS arbitrage                                                    1.69%
                                                                 Fixed income arbitrage                                           1.58%
In the currency markets, the USD maintained its recent
                                                                 CTAs                                                             0.73%
strength against major currencies: the USD/EUR exchange          Short-selling                                                    0.69%
                                                                 MSCI World                                                       6.58%
rate oscillated around 1.20; the JPY weakened slightly from
                                                                 JPM Global Bonds                                                -1.20%
111 to 113; and the CHF fluctuated around 1.29. The energy
markets continued to make headlines, with WTI Crude Oil         Source: FTSE; HFR; CSFB; Barclay Trading Group Ltd.; MSCI; JP Morgan

reaching record highs of over USD70 per barrel, closing the
quarter at USD66. Gold increased to USD469 per ounce.           demand was also in the spotlight and managers exposed to
                                                                consumer stocks fared particularly well. Although
Performance of hedge funds in Q3 2005                           long/short emerging markets equity managers made good
                                                                gains overall (up +8.76%), exposures to Asia were not as
The third quarter of 2005 was a relief for the hedge fund       rewarding as other regions except for India and Korea,
industry after a prolonged period of rather mediocre per-       both of which saw double digit growth. Latin American and
formance. All three months of the quarter were positive.        Russian managers took advantage of the ample opportuni-
The FTSE Hedge investable hedge fund index returned             ties the market offered. Amongst the best performers this
+1.60% for the quarter. This compared to a return of            quarter were the global long/short managers who were able
+4.31% for the non-investable HFR Funds of Funds Index          to identify some of the more pronounced global trends
- the difference can largely be explained by a significant      early enough and positioned themselves accordingly.
selection and survivorship bias in the latter. All strategies   Relative Value Equity Strategies: Convertible arbi-
were positive in Q3, led by long/short equity, event driven,    trageurs continued their recovery from the turbulent first
and macro funds. Convertible arbitrageurs experienced a         half of the year and gained +3.03% during the quarter.
partial rebound. Short-selling, CTAs and fixed income arbi-     Although the market traded lethargically in August, July
trage lagged behind the other strategies.                       and especially September proved to be profitable months.
Directional Equity Strategies: Long/short US equity             Short term equity market volatility and the VIX volatility
managers fared well overall, with the relevant managers in      index both increased. However, this was not reflected in
the region gaining almost +6.00%. Those exposed to the          convertible prices as implied volatility of US bonds even
energy space were substantially rewarded, as well as those      decreased slightly from 25.3% to 24.3%. Profits of US con-
with a focus on corporate activity. European managers           vertible hedge funds were driven by credit exposure and
were up +4.29% as many maintained a long bias. Exposures        gamma trading. The Asian convertible market had a
to Nordic and Eastern European markets provided a healthy       remarkable rebound with strong performances in
boost. Also, positions in small caps, energy, materials and     September. The rally in the Asian equity markets caused
utilities were key in contributing to performance. Long/        strong buying interest in convertibles and higher implied
short Japanese equity managers also enjoyed a strong            volatilities. Realized volatility rose as well, as large accounts
quarter, being up +7.40%. Banking exposure proved very          with short volatility holdings through structured products
profitable as a play on Japan’s reflation story. Domestic       were forced to cover their positions. The primary market



                                                                                                                                          swissHEDGE 5
      Hedge Fund Industry Commentary: 3rd Quarter 2005 | Dr. Philipp Cottier | Harcourt AG




      remained unsatisfying, particularly in Europe. New issuance     kets debt managers performed extremely well in an envi-
      in the US was again not able to compensate for maturing         ronment of improving fundamentals. Credit spreads in
      bonds, but the terms of offered convertibles were more          emerging markets tightened across the board, even trading
      attractive than in the past two quarters, enabling funds to     through US high yield and crossover spreads for the first
      make small profits on new issues. The Japanese primary          time in history. The positive sentiment in emerging markets
      market had a strong increase during the quarter but at low      lead to significantly lower rates in Brazil, Mexico and Russia.
      levels. Interesting opportunities were available in newly       Relative Value Fixed Income Strategies: In a difficult
      issued Indian foreign currency convertibles. This trend is      trading environment marked by a volatile long end of the
      expected to continue, given Indian companies’ capital needs     USD yield curve, fixed income arbitrageurs performed rel-
      and the countries’ economic growth. Merger arbitrageurs         atively well (+1.58%). Greenspan continued his string of
      returned +1.87% during the quarter as deal activity             rate hikes and indicated that this trend would be followed
      remained strong. The highest volume was noted in Europe,        through in 2006. Relative value spreads widened slightly
      however risk arbitrage spreads remained more attractive in      during the quarter. Overall, MBS hedge funds were able to
      the US. The most profitable trades revolved around M&A          continue their steady run for the year with moderate per-
      transactions and restructurings. These event driven deals       formance (+1.69%). In particular the ABS managers expe-
      also benefited funds with an Asian focus, for example in the    rienced a difficult time in July as a surge of supply hit the
      Taiwanese and Korean financial services industry. Given         markets. In the US MBS market, the basis between US
      the increasing weight towards shareholder value creation        Treasuries and agencies widened in August, causing some
      and the active policies of reducing cross-shareholdings, this   underperformance.
      trend is expected to continue strongly. Activism by hedge       Commodities Strategies: Relative value commodity
      funds remained in the headlines during the quarter. Cash        managers were mostly negative over the quarter. The hur-
      rich corporate balance sheets and an increase in consolida-     ricanes generated extreme volatility and extraordinary price
      tion pressure due to declining global growth provide a          levels in US energy markets. This caused significant diffi-
      healthy outlook for the strategy, despite exposure to short     culties for energy managers as spreads and relationships
      term volatility. Statistical arbitrageurs were up +2.79%, as    were forced far outside historical levels. August marked the
      particularly short term trades benefited from stable vol-       nadir of this time as the natural gas and electricity relation-
      umes and higher intra-day volatility. Market neutral equity     ship in the US decoupled and positions were exposed to
      managers gained +2.57%, mainly based on value factors           soaring gas prices. The subsequent uncertainty over winter
      within their fundamental models, which worked particularly      energy supplies has left the markets nervous but also cre-
      well in Japan.                                                  ated opportunities as liquidity returned. Directional com-
      Directional Fixed Income Strategies: Long/short cred-           modity traders were positive over the quarter, with partic-
      it funds showed strong returns during the quiet summer          ularly strong gains in the first two months from long posi-
      months (+2.41%). Particularly in June, high yield managers      tions in grains and base metals. Directional energy trading
      were able to capitalize on the rebound in the market after      strategies were mostly positive in Q3. A long exposure to
      an unsettling Q2. Technical factors caused the credit mar-      ever increasing crude oil prices benefited accordingly, and
      kets to sell off in the third week of September, making life    added to the strong YTD returns from this area. Continental
      more difficult again for credit hedge funds. Distressed         European power markets were slightly down due to a poor
      managers performed well in each month of Q3 (+4.45%).           start in July and subsequent lacklustre performance, though
      A number of name-specific events drove performance, most        August saw a rebound of the UK power market.
      notably Drax Energy and Mirant, while the bankruptcies of       Directional Multi-Asset Class Strategies: CTAs ended
      Delta and Northwest did not come as a surprise. Directional     the quarter up +0.73%. They started Q3 with a small loss
      sovereign fixed income players were operating in a difficult    due to uncertainty in the global financial markets. The cur-
      environment. Higher energy prices started to make their         rency markets were rattled following first the London
      way into the inflation numbers, causing the yield curve to      bombings and then China’s revaluation of its currency. A
      move upward. However, weak economic data may point to           series of strong economic data releases hit long bond posi-
      an economic slowdown, which would imply lower rates. To         tions but helped to fuel a rally across global equity markets
      make things even more complicated, the after-effects of         producing positive performance for stock indices. In August,
      hurricane Katrina distorted economic data. Emerging mar-        the performance was dominated by the energy sector, where



swissHEDGE 6
Hedge Fund Industry Commentary: 3rd Quarter 2005 | Dr. Philipp Cottier | Harcourt AG




long positions reaped the benefits of record high oil prices.                                 special situations deals; as well as long/short Japanese equi-
The rally accelerated further during the month after hurri-                                   ties, due to the more favorable economic environment and
cane Katrina made landfall. Holdings in currency contracts                                    the potential of a more significant return of domestic
were particularly damaging to the strategy when the USD                                       investors to the local stock markets. Furthermore, energy
reversed sharply after having peaked at the end of July.                                      and commodities trading; distressed securities; and direc-
Copper profits dominated the metals sector, as expanding                                      tional sovereign fixed income trading are high on our list.
economic development and supply shortages fuelled                                             Our outlook is neutral for: long/short European and US
demand for copper. In September, the CTAs benefited                                           equities; multi-strategy arbitrage; convertible arbitrage;
mainly from the upward trend in global equity markets.                                        long/short credit; asset-based lending; insurance-linked
Moreover, currency markets recovered, supported by high-                                      risk trading; global macro; and CTAs. Last, we expect only
er interest rates. Furthermore, inflation concerns stimulat-                                  flat to moderately positive returns from fixed income arbi-
ed gold prices which reversed to reach a 17-year high by                                      trage, MBS arbitrage, and statistical equity arbitrage.
quarter end. Macro managers performed well in a market                                        Looking forward, the current macroeconomic environment
dominated by a number of clear trends and were up                                             seems to be getting less stable with a forecasted slowdown
+3.24%. September in particular turned out to be a strong                                     of global economic growth, increasing interest rates,
month, as markets settled down from the turbulent effects                                     increasing budget deficits, and an overpriced US property
of Katrina and Rita. Managers also took advantage of rally-                                   market. While corporate earnings are still high and stable,
ing equity markets across the globe, a stronger USD, and                                      both the US consumer and the US government are increas-
generally higher interest rates as inflation fears started to                                 ingly overleveraged and will be unable to drive domestic
be priced into the markets. Oil has been a dominant theme                                     growth going forward. While these global imbalances
during this year and proved this once more in Q3 by mak-                                      might be mitigated somewhat by the overall healthy and
ing the headlines on a daily basis.                                                           cash-rich state of the corporates, a restructuring of Europe,
                                                                                              and potential further Asian currency revaluations, we do
Outlook for Q4 2005 and 2006                                                                  expect more volatility in the financial markets going forward.
                                                                                              This will, as usual, provide both risks and opportunities to
The hedge fund strategies that, in our view, have the most                                    the hedge funds. Overall, we continue to expect returns
favorable outlook for the next six to twelve months certainly                                 from diversified funds of hedge funds in the range of Libor +
include event driven equity, due a stable flux of M&A and                                     400 to 600 bps pa with moderate volatility.

Table 2 | Hedge fund returns


 Hedge Fund Strategy                                                YTD              Ret pa 2000-2005         Ret pa 1994-2005   Stdev pa      Corr MSCI
 FTSEhx                                                            1.60%                     n/a                    n/a%           n/a            n/a
 HFR Funds of Funds                                                4.31%                   5.46%                    7.43%         5.83%          0.58
 HFR Composite                                                     5.32%                   7.48%                   11.65%         7.08%          0.75
 CSFB/Tremont HF                                                   4.49%                   7.15%                   10.63%         7.95%          0.49
 Emerging markets                                                  8.76%                   12.16%                  10.16%        14.51%          0.64
 Short-selling                                                     7.48%                   7.35%                    0.87%        21.65%          -0.70
 Sector specialists                                                5.99%                   4.49%                   14.27%        14.53%           0.6
 Long/Short Equity                                                 4.66%                   6.81%                   14.55%         9.01%          0.71
 Distressed securities                                             4.45%                   13.04%                  12.34%         5.44%          0.52
 Event driven                                                      3.48%                   10.34%                  13.59%         6.43%          0.69
 MBS arbitrage                                                     3.24%                   9.25%                    9.81%         4.54%          0.01
 Market neutral equity                                             3.03%                   5.91%                    8.11%         3.12%          0.17
 High yield                                                        2.79%                   7.48%                    7.56%         4.52%          0.49
 Statistical arbitrage                                             2.57%                   3.27%                    7.18%         3.86%          0.53
 Macro                                                             2.41%                   7.92%                   10.15%         7.29%          0.42
 Relative value arbitrage                                          1.87%                   8.19%                    9.68%         3.16%          0.44
 Merger arbitrage                                                  1.69%                   6.02%                    9.77%         3.61%          0.49
 Fixed income arbitrage                                            1.58%                   6.52%                    5.94%         3.90%          -0.0
 CTAs                                                              0.73%                   5.54%                    5.76%         8.26%          -0.10
 Convertible arbitrage                                             0.69%                   7.71%                    9.21%         3.72%          0.26
 MSCI World                                                        6.58%                   -2.56%                   7.28%        13.99%          1.00
 JPM Global Bonds                                                 -1.20%                   7.20%                    6.54%         6.31%          0.05


Data period: January 1994 to September 2005. Data source: FTSE; HFR; CSFB; Barclay Trading Group Ltd.; MSCI; JP Morgan




                                                                                                                                                         swissHEDGE 7
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Strategy Focus | Jens Föhrenbach | Harcourt AG




Event-driven strategies – adapting to a new opportunity set




By: Jens Föhrenbach | Harcourt AG                             a large variety of possible investments, with different
                                                              approaches ranging from a passive to an active style. While
As a result of their ability to adapt to changing             smaller funds often specialize on a region, large event-driven
opportunities, so-called «event-driven» hedge                 managers invest globally and use the whole opportunity set.
funds have experienced strong returns in the                  A basic characterization describes event-driven as invest-
last two years. This article examines successful              ments in companies that undergo a corporate event, from
trading strategies. First, the strategy is divided            strategic changes such as a merger with another company
into four styles. Subsequently, returns of the                to operational impacts like litigations.
manager universe and their drivers are discus-                In order to structure a definition of event-driven, graph 1
sed. The article closes with an outlook on the                shows a classification of the strategy into four styles: merger
sustainability of returns and an examination of               arbitrage, the classic arbitrage trade of companies involved
future trends.                                                in a takeover; special situations, which invests in corporate
                                                              events such as management changes or exploits opportuni-
Event-driven constitutes an important part of the capital     ties between different capital layers of a company; dis-
allocated within the hedge fund space. It has cross-overs     tressed, which can also be followed as a single strategy but
with other strategies such as equity long/short, credit and   benefits from an integration in large event funds; and
even private equity. Event-driven strategies are defined by   restructuring, which in common with special situations,



                                                                                                                     swissHEDGE 9
      Strategy Focus | Jens Föhrenbach | Harcourt AG




      Graph 1 | Classification of event-driven into four styles                price and the lower share price of the target is locked in
                STYLES                              TRADES
                                                                               and a gain will be realized when the merger closes as both
                                                                               converge. This spread is independent from general market




                                                                      Equity
                                                  Vanilla
             Merger Arbitrage                                                  moves as the idiosyncratic deal risk is isolated.
                                            Reverse Arbitrage
                                                                               An example that describes the necessary positions was
                                         Pre-announced Mergers                 the Procter & Gamble (P&G) merger with Gillette: On
                                            Holding Arbitrage                  January 28th 2005, P&G announced the offer of 0.975 of
            Special Situations
                                           Share Class Trades                  its own shares for each of Gillette’s. After the announce-
                                                Litigations                    ment, investors could buy Gillette for USD 51.60 while
                                          Management Changes                   P&G traded at USD 54.15, equivalent to an offered
                                        Capital Structure Arbitrage            price of USD 52.80 or a 2.3% premium over the current
                                             Pre-bankruptcy                    price of Gillette. An arbitrageur would buy Gillette and
                                                                      Debt
          Distressed Securities
                                             Post-bankruptcy                   finance it with a short position in P&G in the size of
                                                                               0.975 times the number of Gillette shares. As graph 2
                                             Recapitalizations
                                                                               shows, the premium based on closing prices between the
                                               Asset Sales
              Restructurings                                                   offered price and the trading price for Gillette increased a
                                                Spin Offs
                                                                      Equity




                                                                               few days later to 3.34%. Based on intraday prices, an even
                                               Carve Outs
                                                                               wider spread of more than 4% could be captured. A hedge
      Source: Harcourt                                                         fund would use leverage to generate a sufficient return on
                                                                               its equity.
      allows a diversification of trading opportunities. Each of               However, the strategy is not an arbitrage in its strict defini-
      the four styles has possible trading types allocated to it. The          tion - even when opportunity costs are ignored: the merger
      graph also shows the likely application of the styles within             arbitrageur bets on a closure of the deal. Its main risk is
      the capital structure, which often is the equity of a compa-             that the deal is cancelled for regulatory reasons, because of
      ny (the exception being «distressed»). Capital structure and             disapproval by shareholders or due to drastic market moves
      recapitalizations may either use debt or equity - or even                that necessitate a revaluation of the situation. If the deal
      both against each other.                                                 breaks, the investor may face losses on both its long posi-
                                                                               tion (as the share price is likely to drop) and on its short
      Event-driven styles                                                      position (as the acquirers’ price may rise). The possible losses
                                                                               of merger arbitrage situations are typically much higher
      Merger Arbitrage: Merger arbitrage is arguably the plainest              than the profits; in other words, the strategy has a left tail.
      style of event-driven hedge funds. The investment process                A critical skill of the investor is therefore the ability to
      is triggered by an announcement that a company with pub-                 assess the probability of success or failure of a deal. A delay
      licly traded equity is targeted in a merger. The buyer can               in the merger process constitutes another risk as it would
      either be strategic or financial, such as a private equity
                                                                               Graph 2 | Merger premium for Gillette shares
      fund. Generally, a situation with a strategic buyer is more
      favorable for an event-driven hedge fund as they tend to                 4.0%

      bid more aggressively for the target company than financial              3.5%

      institutions, due to operational synergies that can be incor-            3.0%

      porated in the offered price. Financial buyers without syn-              2.5%

      ergy potential have a lower break-even price and aim to                  2.0%

      exit within a defined horizon. The opportunity for merger                1.5%

      arbitrage arises to the extent that the offered price for the            1.0%

      target company is above its share price after the announce-              0.5%

      ment of the transaction.                                                  0%
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      If the acquirer pays with its own shares, the hedge fund
      buys the stock of the target company and shorts the shares
                                                                               Source: Bloomberg
      of the buyer. Thereby, the difference between the offered



swissHEDGE 10
Strategy Focus | Jens Föhrenbach | Harcourt AG




bind capital for longer and thereby reduce annualized             its shares could be de-listed. The major risk of the strategy
returns.                                                          lies in a disappearance of the link between parent and sub-
If the acquiring company is paying in cash instead of own         sidiary without convergence of the valuation. For example,
shares, the set up of the trade is simply a long position in      the parent firm could go bankrupt and use the subsidiary
the target firm without any shorts. A recent example is           shares as collateral. Another important risk of holding arbi-
Johnson Electric’s CHF1060 cash bid for each share of             trage is a recall of the borrowed short position (subsidiary)
Saia-Burgess Electronic. The hedge fund buys the target           that tends to materialize as it becomes more adverse.
without a short position and has no market risk as long as        Alternative investments in holding arbitrage appear in
the deal closes. The possible profit is the difference            trading the spread in the public shares of a non-operating
between the offered CHF1060 and the price paid for the            holding company versus its operating subsidiary. For
shares in the market.                                             example, Heineken Holding NV has only one asset, its 50%
Event-driven funds that invest in merger arbitrage situa-         stake in Heineken NV. However, the shares of both com-
tions are subject to mark-to-market risk as losses occur          panies trade at a spread of currently 8%. The volatility of
when the spread increases after the investment. On the            the price discrepancy - in 2000, the spread was 38% - allows
other hand, investors that foresee a spread widening gen-         managers to exploit it by betting on tightening spreads
erate gains if they had the opposite position to the original     reflecting the same economic exposure of both shares - or
set up: being short the target and long the acquirer. This is     alternatively on a widening reflecting the different liquidi-
called reverse merger arbitrage. These positions are used         ty in the listings. Holding arbitrage trades provide average
when the fund is convinced that there is either a high like-      annualized returns; however, opportunities are infrequent.
lihood of a deal break or that the market has an overly           «Share class trades» are long and short positions in two
aggressive assumption about the possible final price for the      stocks of the same company listed at two different
target company, for example if a bidding contest is expected.     exchanges. For example, the mining company Rio Tinto is
However, this type of merger arbitrage needs a strong con-        traded in the UK and Australia. The different institutional
viction about the outcome, as deal breaks have a lower like-      investor’s interest in both countries and the non-fungibility
lihood than deal closures.                                        of the local shares cause frequent divergence in FX adjusted
                                                                  share prices (see graph 3). The spread change between
Special Situations: The second event driven style is «spe-        both can be triggered by an event such as an inclusion into
cial situations», a vague term reflecting the large amount of     a local stock index. The rationale behind the investment
possible trading strategies around corporate events. Funds        can be a mean reversion that will align supply and demand
that buy shares of a company that the manager anticipates to      after the dislocation. In the Rio Tinto example, the fund
be involved in a transaction, trade in pre-announced mergers,     could bet on a tightening of the spread. The risk of this
an investment that requires significant work on the company       trade is that the position moves against the hedge fund and
and sector. It is not a classic merger arbitrage strategy as no   it cannot bear the mark-to-market losses as stop-losses are
transaction is announced. If the merger happens, it acts as       reached.
the catalyst to generate the profit. An important difference
                                                                  Graph 3 | Spread between Rio Tinto PLC and Rio Tinto Ltd. (in AUD)
to vanilla merger arbitrage is that the outcome of an event
has a lower likelihood but provides a larger return.              7

«Holding arbitrage» addresses situations where a firm’s           6

market value is less than the value of its ownership stake in     5

a publicly traded subsidiary, also referred to as negative        4

stub trade. The arbitrage position consists of a long position    3

in the undervalued parent and a short position in the sub-        2

sidiary. Opportunities can arise when there is a strong sector    1

trend in the business of the subsidiary, causing its share to     0

rise sharply within a short time horizon. There are several       -1

catalysts that could readjust the pricing: The parent can         -2
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distribute subsidiary shares to parent shareholders, the
parent could buy the remaining shares of the subsidiary, or       Source: Bloomberg




                                                                                                                                                                                                                                                           swissHEDGE 11
      Strategy Focus | Jens Föhrenbach | Harcourt AG




      Other catalysts that event-driven funds identify are man-          of a default increases, certain investors are forced to sell
      agement changes and litigations. Both are «soft catalysts»         their long holding of the debt. The distressed analyst focuses
      and require qualitative due diligence. A popular trade in          on bonds that trade below the recovery value, i.e. the
      2004 was in the shares of oil service company Halliburton.         amount of money that can be realized if the company is liq-
      Because of its asbestos liability, it traded at a 25% discount     uidated. While the recovery value is the floor, additional
      to its peers. Event-driven funds with the necessary legal          upside exists when the company successfully manages a
      expertise were buying the company in the expectation of a          turnaround and the distressed debt is swapped into equity.
      court approval of the bankruptcy reorganization plan of the        A significant position is usually taken to provide influence
      subsidiary which contained the asbestos liability. Typically,      on the restructuring process and avoid, for example, a cred-
      the market risk was hedged with a short position of the oil        itor committee discriminating in favor of certain classes of
      service sector index or with short positions of peers that left    bonds.
      the fund only exposed to the firm-specific event. After the        The fund manager needs experience in evaluating the
      expected favorable court ruling, event-driven funds exited         business of the distressed company, in estimating the
      the position with profits. The main risks lie in a misjudg-        enterprise value on a going concern and liquidation basis,
      ment of the outcome of the event, in a failure to isolate the      as well as in determining the value distribution across dif-
      event from the market risk, and in the probability of an           ferent creditors and equity classes. If the company is in a
      adverse corporate event.                                           Chapter 11 process - thereby protecting itself for a limited
      In most of the above examples, the investors will use equity       period of time from creditors and enabling a restructuring
      to initiate positions. But due to their highly flexible mandate,   instead of liquidation (Chapter 7) - the debt holders will
      hedge funds also examine the value of a company’s debt             choose a judge who has to approve most steps in the
      and its relative attractiveness compared to equity.                restructuring of the company. A thorough understanding of
      «Capital structure arbitrage» is a special situations strategy     the jurisdiction is therefore indispensable.
      that exploits opportunities between different layers of the        While there are dedicated funds focused completely on
      capital structure. Similar to share class arbitrage, the trades    distressed investing, the inclusion in an event-driven fund
      have typically a long and a short position of the same com-        reduces the dependency of the default cycle as most
      pany, however not between equity traded in the two different       opportunities are created when default rates increase. A
      locations but different types of debt against each other           recent investment example was the airline sector: United
      (such as senior secured versus junior debt, or simply debt         Airlines, operating under Chapter 11, had bonds outstand-
      versus equity). Often, the reason for the opportunity is a         ing that were trading significantly below the value of the
      segregation of the markets for the different capital layers.       aircraft securing them. Event-driven hedge funds partici-
      The capital structure arbitrage strategy requires more             pated in the negotiations of the restructuring process. The
      quantitative skills than other special situation trades and        position resulted in downside protection by the collateral in
      also calls for sophisticated modeling. The development was         the case of a breakup of the company and an upside if the
      initiated by ground breaking work of Nobel laureate                catalyst materialized in a successful completion of the
      Robert Merton, who published his first important paper in          restructuring.
      1974 setting a theoretical connection between debt and             The difference between pre- and post-bankruptcy trades
      equity. Event-driven funds active in capital structure arbi-       lies in the risk-reward profile. As the pre-bankruptcy trade
      trage make heavy use of derivatives. Analogous to equity           includes a larger uncertainty about the outcome, possible
      versus debt investments, trades between different debt             returns are larger if the necessary analysis by the fund man-
      instruments are common when spreads do not reflect the             ager correctly points towards aspects not reflected by the
      hierarchy an instrument has within a corporation’s capital         market.
      structure.
                                                                         Restructurings: Restructuring investments are trades that
      Distressed Securities: While capital structure arbitrage           are triggered by the announcement of a change in the
      concentrates on the relative value of instruments against          balance sheet. Recapitalization is a restructuring of a com-
      each other, «distressed securities» is an event driven style       pany’s debt and equity mixture. For example, a company
      that invests in the debt of a company driven by an absolute        may decide to save taxes by replacing preferred equity with
      mispricing. When companies have difficulties and their risk        bonds in order to gain interest deductibility. Recapitalization



swissHEDGE 12
Strategy Focus | Jens Föhrenbach | Harcourt AG




is an event on the liability side of the balance sheet. Asset   Graph 4 | Risk-return characteristics of event-driven trades
sale is the vending of parts of the company for cash, secu-
rities, or other considerations. Spin-offs and carve-outs are
                                                                Return




                                                                                                                                   Pre-filing distressed
divestitures of parts of the original company into a new                                             Restructurings


one. In a spin-off, the shares of the newly created firm are                                                          Pre-announced merger

distributed to the shareholders of the original company. In                                                                                        Activism


a carve-out the divesting company floats parts of the shares                           Capital Structure Arb.
                                                                                                                       Post-filing distressed


of the new company, retains some itself and investors have
                                                                               Holding Arbitrage
implicit exposure to the newly formed company via their                                                                                 Reverse Merger

investment in the original one. The catalyst for a trade is
the restructuring of the company. Trades can be done in                           Merger Arbitrage

the original company that is selling parts of their assets or
                                                                                                                                                    Risk
in the newly formed firm. A recent study for the German
                                                                Source: Harcourt estimates
market shows that investments in firms that use divesti-
tures strategically provide excess returns of up to 6% while
non-strategic divestitures are punished. An important part      Risks and returns
of the work of the investor is therefore an analysis of the
motivation for the divestures. A recent example was the         The described event-driven styles have different risk-
Lanxess spin off by Bayer AG.                                   return-characteristics (graph 4). Classical merger arbitrage



                                                                                                                                                      swissHEDGE 13
Strategy Focus | Jens Föhrenbach | Harcourt AG




trades have low returns, but also a limited standard devia-       Graph 5 | Returns of the event-driven index

tion. Reverse merger generates higher profits but due to a        300%
significant higher risk, the risk-return relationship is less
                                                                  250%
compelling. Holding arbitrage can be profitable with low
risk, but opportunities are rare. Capital structure arbitrage     200%

is attractive, however suffers under volatility spikes as those
                                                                  150%
disrupt modeled relationships between capital layers.
                                                                  100%
Distressed investing has high returns, but especially pre-
bankruptcy trades bear large risks. Restructurings tend to         50%

add beta into an event-driven portfolio, however with a sig-
                                                                    0%
nificant market-independent return that makes it one of




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                                                                                                                                                                                 July 05
the most attractive trades.
                                                                                HFRI Event-Driven Index                               HFRI Distressed Securities Index
The returns of event-driven funds have been strong for the                      HFRI Merger-Arbitrage Index
                                                                  Source: HFRI
last two years. As graph 5 shows, funds using the whole
investment universe outperformed those that specialize on
parts of it such as dedicated merger arbitrage or distressed      returns from 1996 to 2000. In the last two years, the aver-
funds due to flexibility, knowledge transfer and less             age annual return was a mere 5.3%, differentiating sharply
dependency on cycles.                                             with event driven funds’ performance of 15% p.a. within
Over the last 10 years, the HFRI Event-Driven Index per-          the same time.
formed on average 14% p.a., while the HFRI Distressed             The main return factor for the merger arbitrage strategy is
Securities Index gained 12.7% p.a. The HFRI Merger                the deal flow. Spreads are normally more attractive when
Arbitrage Index generated 9.6% over the same horizon,             the market for corporate governance is active as a large
however these returns were mainly driven by the strong            supply can disturb market forces and reward arbitrageurs
Strategy Focus | Jens Föhrenbach | Harcourt AG




with excess returns. However, the sharply decreasing num-         shareholder activism of hedge funds that culminated in this
ber of M&As after the tech bubble burst and the low entry         year’s corporate governance battle in Deutsche Börse AG,
barriers of the strategy caused an erosion in returns of pure     causing the CEO to resign over shareholder revolt led by
merger arbitrage strategies, forcing them to broaden their        hedge funds.
style towards the described event-driven strategies. While        The increased asset base of event driven hedge funds is
it made returns more attractive, it also added more market        turned into an advantage and enables hedge funds to
risk to portfolios: over a 10 year horizon, the HFRI Merger       receive more attention from companies’ senior manage-
Arbitrage Index has a beta to the MSCI World of only 0.13,        ment - if necessary by replacing management after acquiring
but the HFRI Event-Driven Index has a beta of 0.32.               a position that guarantees a successful proxy contest at the
Special situation and restructuring trades are more difficult     shareholder meeting. Another trend that will accelerate in
to isolate from market risk than merger arbitrage. The            the future is an increasing engagement in Asia, where typical
large alpha over the market’s return justifies this approach      cross-shareholding considerations are moved aside in
that can assimilate investments to the opportunities that         favour of shareholder value arguments. The current M&A
are driven by the business cycle.                                 wave in Europe puts pressure on other companies to con-
While the return drivers of the event-driven strategy are         solidate and will fuel the trend.
corporate activity, confidence in corporate boardrooms,           Further developments in the space are the move towards
and large corporate defaults, the risks are that market           less liquid investments with longer holding periods, mark-
volatility increases sharply. This situation can lead to costly   ing a convergence with the private equity universe.
deal breaks and tests relationships of spread trades based        Looking ahead, event-driven funds will also move into some
on historical correlations. The strategy is especially vulner-    areas covered by investment banks, for example providing
able to market declines, reflected by a higher downside           bridge financing in a merger transactions.
beta of the index of 0.4. For example, in April 2005, when        The ongoing transition of the strategy ensures that event-
the VIX volatility index spiked from 11.2 to 17.8, most           driven hedge funds will continue to provide an attractive
funds posted losses and the HFRI Event-Driven Index               risk-return profile for a diversified alternative investments
experienced its worst single month since 2002 as several          portfolio in the future.
transactions were canceled. Especially troubling was the
high correlation of managers, as most reported negative
returns. This outlines a problem of the strategy: event-driven
hedge funds tend to choose the same trading ideas. Most
funds have a correlation of 0.6 or higher to each other, with
outliers usually based on a specific regional concentration
such as Australia.
A fund of hedge funds needs to take these characteristics
into consideration when event-driven funds are added into
a portfolio. The argument for an investment is clearly per-
formance driven, not based on diversification. The correla-
tion of the event driven index with most other hedge fund
strategies is high.
                                                                  Readings:

Outlook                                                           ❯ Bartsch: Unternehmenswertsteigerung durch strategische Desinvestionen,
                                                                    Wiesbaden 2005.
                                                                  ❯ Daley/Mehrotra/Sivakumar: Corporate focus and value creation - evidence
Event-driven hedge funds have attracted large capital
                                                                    from spinoffs, Journal of Financial Economics, 1997
flows on the back of their strong performance. Medium-            ❯ Merton: On the pricing of corporate debt: The risk structure of interest
term returns seem to be immune to these asset flows as              rates, Journal of Finance, 1974
                                                                  ❯ Mitchel/Pulvino/Stafford: Limited Arbitrage in Equity Markets, Journal
event-driven managers are capable of adapting to a chang-
                                                                    of Finance, 2002
ing environment. With a larger asset base, hedge funds are        ❯ Mitchel/Pulvino/Stafford: Price Pressure around Mergers, Harvard NOM
now able to create catalysts themselves instead of passively        Working Paper, 2002
                                                                  ❯ Moore: Risk Arbitrage: An Investor’s Guide, John Wiley 1999.
awaiting them. This trend is reflected in the increasing



                                                                                                                                   swissHEDGE 15
Investors View | Guy Wyser-Pratte | Wyser-Pratte Management Co, Inc




Active value investing: creating Alpha in Europe




By: Guy Wyser-Pratte | Wyser-Pratte Management Co, Inc         Graph 1 | Finding the value zone

                                                               Corporate governance is cooperation; the alignment of management’s
                                                               interests with shareholders’ interests. Managers/Board decisions create
The United States of America has a well-organ-                 the Corporate Governance Profile.
ized army of investors that sniff out stakes in                                           Exogenous Factors           ▲
                                                                                      ▲




underperforming firms and then try to influ-
                                                                 Non-Market                                           Market
ence how they are run. The rest of the world is                  - Courts                                             - Shareholder Activists
                                                                 - Prosecutors                                        - Market for Corporate
less well endowed. As capital markets around                     - Outside Auditors             Shareholder             Control
                                                                 - Legislature                   Interests              (Takeover Scheme)
the world improve their infrastructures, laws,                   - Regulators                     (Equity)            - Corporate Governance
                                                                   (Enforcement)                    vs.                 Code (Enforcement)
regulations, and governance structures, invest-                                             Management Interests
                                                                                              VALUE ZONE
ment managers are beginning to take stakes in
                                                                                             Shareholder Model vs.
underperforming firms and are pushing for                                                     Stakeholder Model
                                                                                           Transparency vs. Secrecy
reform. Continental Europe is becoming an                                                 Independence vs. Cronyism
                                                                                              BEST PRACTICE
increasingly interesting forum for active initia-
                                                                                             Management/Board
tives and as successes increase in this realm,                                              ETHICS VS. GREED
the pressure for underperforming companies                                                           ▲
will only become more intense.
                                                                                          Endogenous Factors

                                                               Source: Wyser-Pratte
Active Investing

In graph 1, the reader will note three areas that define the   area above «Ethics» is called «Best Practice». This is also
corporate governance structure of the modern corporation.      not an area for active investing. We leave it to the CalPERS
At the base is «Ethics». This is not an area where we con-     of this world with their Focus Lists to identify companies
centrate because we assume that if the managers of a cor-      that have some issues with transparency, inappropriate cor-
poration have not been raised properly, there is nothing we    porate committee structure, director salaries, corporate
can do about it. You cannot teach people ethics. The next      jets, etc.



                                                                                                                                    swissHEDGE 17
      Investors View | Guy Wyser-Pratte | Wyser-Pratte Management Co, Inc




      The real issue for the active investor is what I call the          that the proposal would crimp competition and economic
      «Value Zone». This is the area in which the rubber hits the        growth». So what you have in effect is a parochial market
      road; i.e. where the value is truly created by aligning the        for corporate control that is preventing cross-border
      incentives of management with the anticipation of share-           rationalization of various sectors across Continental
      holders. This is the real struggle that is occurring in Europe     Europe. While this is unfortunate for strategic buyers, it is
      today between the owners of the business and its managers.         providing a windfall for financial buyers - private equity -
      This is defined as the principal-agent problem, which exists       which has invested pools of approximately EUR250b in
      due to the separation of ownership and control of the pri-         equity (imagine if you leverage that) seeking acquisitions
      vate corporation. The agency problem exists in economics           across the Continent. These are the natural allies of active
      when «principals» who own an asset must delegate respon-           investors, who, when they act as lightning rods or catalysts
      sibility for it to «agents», whose stake, interests and under-     surrounding a particular listed company, will often play
      standing are different.                                            into the hands of a private equity or LBO group. The
      Active investing then attempts to adequately harmonize             absence of strategic buyers because of the aforementioned
      the interests of both groups.                                      impediments to cross-border activity thus lays the ground-
                                                                         work for active investing.
      Why Europe?                                                        Secondly, there is a serious question of relative value
                                                                         between Continental Europe and the United States. In the
      There are a number of structural reasons why Europe is             latter, we have a situation where premiums over book value
      becoming increasingly attractive for active investors. I pointed   predominate. In Europe, there are substantial discounts to
      out one of the glaring discrepancies in a May 4, 2005 edi-         book or net asset values. Companies in Germany and
      torial in the Financial Times entitled, «Europe Balks at a         Switzerland have been over-reserving and hiding assets for
      Free Market for Bids». The central thesis of this article          over 200 years. Also, in the United States, there are more
      was: It is widely acknowledged in financial circles that an        lawyers than citizens... The US is therefore a very litigious
      effective guarantor of good corporate governance and               environment and poses a threat to any activist intervention.
      effective management oversight is an unfettered market             This is not the case in Europe, where lawsuits are not yet
      for corporate control. Corporate executives who consis-            part of the culture, and can involve serious penalties unless
      tently destroy value in a free market are replaced by good         the charges have merit. Also, on the legal front, resolutions
      managers, often through takeovers. Potential bids are a            proposed at annual meetings in Europe are binding resolu-
      «Sword of Damocles» dangling over incompetent man-                 tions. In the US, they are strictly voluntary, in most
      agers. And further on, a unified takeover code covering all        instances. Therefore, it is much more serious and much
      members of the EU was meant to ease cross-border acqui-            more dangerous for management to face shareholders at
      sitions and help the rationalization of many of Europe’s           annual or special meetings in Europe.
      fragmented industries. Frits Bolkestein fought valiantly           Thirdly, a number of European countries do not have ade-
      during his tenure as the EU’s Internal Market Commissioner         quate pension schemes. One hears that in most countries,
      to pass legislation that would enshrine such a code and pre-       40-50% of the total equity within a country is owned by
      vent managements from entrenching themselves with                  Anglo-Saxon portfolio managers. Why not? Who else would
      measures to deter takeover. But this effort was undermined         buy the shares, in the absence of local pension funds?
      by German members of the European Parliament eager to              America’s ERISA system and the British pension funds are
      sustain Lower Saxony's obtuse law protecting Volkswagen            replacing the non-existent local funds. What this means is
      from a takeover. The scheme eventually adopted by the EU           that you have a captive audience when an activist appears
      last year is a toothless hodgepodge that allows countries to       on the scene to create value for a particular company. This
      determine individually if anti-takeover measures can be            captive audience will naturally vote and may even increase
      applied locally.                                                   its stake as it follows the machinations of the active
      In a September 15 Bloomberg article entitled, «EU May              investor.
      Sue France Over Merger Defenses», Internal Market                  Fourth, because of Europe’s archaic voting system, which
      Commissioner McCreevey says, «The European Union is                requires shares to be blocked (immobilized) in order to be
      threatening the French government, which is planning to            able to vote at a shareholder’s meeting, the man on the
      block foreign takeovers in specified industries, indicating        street simply will not vote. Only the professionals and the



swissHEDGE 18
Investors View | Guy Wyser-Pratte | Wyser-Pratte Management Co, Inc




aforementioned Anglo-Saxon portfolio managers will vote.         which may be one of the reasons for the under-valuation.
The resulting quorum at most annual meetings is therefore        Second is a corporate governance analysis that attempts to
in the range of 40-45% of the shares. An active investor         determine the corporate governance breakdown that may
who has done his homework should not have too much               have occurred. The third is a merger-arbitrage analysis, which
trouble in forming a coalition with 25% of the shares,           seeks to establish the parameter of the value gap and the
which assures him a fairly easy victory in almost every cir-     time element involved in yielding the return on investment
cumstance. The local institutions simply do not have the         and risk-reward calculations. The final step is a technical
firepower to overcome the foreign, non-local interests.          analysis that aids in determining the entry points, the
                                                                 potential accumulation strategy, and the formulation of an
Identifying the «Value Gap»                                      exit strategy. All of these factors point to the reasons for the
                                                                 under-valuation. It is then the job of the active investor to
Given the above background factors relevant to Europe,           determine whether he can have an impact in closing that
the critical element for the active investor in any given sit-   value gap or spread and over what period of time. If there
uation is to identify the «Value Gap». This gap or spread is     is potential appreciation of 50% envisaged and the initiator
the difference between the current market price and the          believes he can capture that differential in a two-year period,
unencumbered potential or expected restructured value of         then he is obviously looking at a 25% return on investment.
a particular company’s shares. Four different types of
analysis are used to arrive at an assessment of the value        Friendly vs. Not
gap. First is obviously a fundamental analysis, as this is a
deep value strategy. This analysis determines what a more        Once the active investor has determined that a potential
traditional value investor would call the «margin of safety».    target is attractive, he discretely accumulates his position
Also, it is the fundamental analysis that determines the         and then, once he has crossed a reporting threshold, makes
strategic shortcomings or failures of a particular enterprise,   the appropriate filings with local government authorities,




                     For previous issues of the swissHEDGE and people & services of Harcourt AG.
      Investors View | Guy Wyser-Pratte | Wyser-Pratte Management Co, Inc




      and attempts to make contact with the management of the                                                                                                               friendly but very firm manner we told the entire Dutch
      target company. The purpose of this contact is to explain                                                                                                             community and Vendex management that there was some-
      what the active investor sees as strategies for enhancing                                                                                                             thing wrong with the Dutch being out voting in a general
      shareholder value and to attempt, in a cooperative manner,                                                                                                            election on the very day that we were sitting as sharehold-
      to convince management to pursue and apply these strate-                                                                                                              ers unable to vote, since shares incorporated under this
      gic changes. This is of course the preferred manner of                                                                                                                regime are not shares but only certificates requiring the
      operating.                                                                                                                                                            approval of the trust’s administrator to allow shares to vote.
      But there are times when managers resist to such an extent                                                                                                            Thus the discount: no accountability. We created such a
      that polemics lead to a more aggressive approach on the                                                                                                               furor that within three months the company changed its
      part of the active investor, meaning a more heated media                                                                                                              bylaws and allowed us to vote. Interestingly, a number of
      campaign or, at the bitter end, a proxy battle. This is of                                                                                                            Dutch companies followed suit.
      course what has recently happened in the IWKA situation                                                                                                               There was, however, still work to be done. For the next
      in Karlsruhe, Germany, where the President was forced to                                                                                                              annual meeting, we decided that the company was still
      resign, the Board of Directors subsequently resigned, and                                                                                                             trading at depressed levels and decided to attack the com-
      a new board is in the process of being selected for election                                                                                                          pany’s strategy, which involved spending EUR350m for
      at a special stockholder meeting to be held in early                                                                                                                  Capex on a market cap of EUR1b. Totally inappropriate.
      November.                                                                                                                                                             This time, however, we had the proxy of K Capital of Boston,
                                                                                                                                                                            representing now a total of 14%. We made a thorough slide
      Case Study: Vendex                                                                                                                                                    presentation at the annual meeting and undoubtedly the
                                                                                                                                                                            management decided that at the next annual meeting they
      Graph 2 depicts our participation in the Vendex situation,                                                                                                            would see me with a 50% coalition and decided enough
      which began when we determined the extreme undervalu-                                                                                                                 was enough. They shortly thereafter agreed to sell the com-
      ation of Vendex relative to its peer-group, and more inter-                                                                                                           pany to KKR, the LBO firm.
      estingly, an undervaluation due to what is known as the
      «Dutch discount» for shares incorporated under the                                                                                                                    Case Study: Taittinger
      «Structured Regime». Every company so situated trades at
      a discount to its peer-group. We purchased 2% of the shares                                                                                                           Taittinger was the most celebrated of the French patrimo-
      and went to the first annual meeting in June 2002. In a                                                                                                               nial companies controlled through interlocking holdings

      Graph 2 | Wyser-Pratte Euro Value Fund, Koninklijke Vendex KBB

                    EUR 18
                                                           VDX sells                                      Wyser-Pratte attends Vendex Shareholder                                                                                                                 VDX negotiates deal for
                                                         FAO Schwarz.                                     meeting. Calls for shareholder voting rights.                                                                                                             EUR16 per share.
                    EUR 16
                                                                                                                                                                                       K Capital takes 10%                            VDX outs 1800 jobs.
                                                                                                                                                                                       equity stake in VDX.                         Closes some V&D outlets.
                    EUR 14

                                                                                                                                                     Voting rights issued to
                                                                                                                                                     common stock holders.
      Stock Price




                    EUR 12
                                                        Wyser-Pratte discloses it holds
                                                         2 million depository receipts.
                    EUR 10
                                                                                                                                                                                                                                                                                Wyser-Pratte liquidates
                                                                                                                                                                                                                                                                                  Holdings in VDX.
                    EUR 8
                                      Wyser-Pratte makes
                                       initial investment.
                                                                                              Wyser-Pratte considers raising its stake in                                                                                                               Petercam forms the Shareholder
                    EUR 6                                                                      VDX, states VDX undervalued by 20%.                                                                                                                     Value Realization Committee, aim-
                                                                                              Wyser-Pratte introduces K Capital to the                                                        Wyser-Pratte attends Vendex                               ing to «substantially increase the
                                                                                                    investment bank Petercam.                                                                 shareholder meeting, criticizes                             value of Vendex KBB shares».
                                                                                                                                                                                                    Vendex strategy.
                    EUR 4
                             Nov 01

                                      Dec 01

                                               Jan 02

                                                          Feb 02

                                                                   Mar 02

                                                                            Apr 02

                                                                                     May 02

                                                                                                 Jun 02

                                                                                                            Jul 02

                                                                                                                     Aug 02

                                                                                                                              Sept 02

                                                                                                                                        Oct 02

                                                                                                                                                 Nov 02

                                                                                                                                                          Dec 02

                                                                                                                                                                   Jan 03

                                                                                                                                                                            Feb 03

                                                                                                                                                                                     Mar 03

                                                                                                                                                                                              Apr 03

                                                                                                                                                                                                       May 03

                                                                                                                                                                                                                Jun 03

                                                                                                                                                                                                                         Jul 03

                                                                                                                                                                                                                                  Aug 03

                                                                                                                                                                                                                                           Sept 03

                                                                                                                                                                                                                                                     Oct 03

                                                                                                                                                                                                                                                              Nov 03

                                                                                                                                                                                                                                                                       Dec 03

                                                                                                                                                                                                                                                                                  Jan 04

                                                                                                                                                                                                                                                                                           Feb 04

                                                                                                                                                                                                                                                                                                    Mar 04

                                                                                                                                                                                                                                                                                                             Apr 04

                                                                                                                                                                                                                                                                                                                      May 04




      Source: Wyser-Pratte




swissHEDGE 20
Investors View | Guy Wyser-Pratte | Wyser-Pratte Management Co, Inc




Graph 3 | Wyser-Pratte Euro Value Fund, Taittinger, S.A.

         EUR 850
                                 Wyser-Pratte and Verneuil Finance                                                Wyser-Pratte, Verneuil Finance                                                              Wyser-Pratte sells its holdings
                            announce that they have accumulated 6% of                                             and Hoche announce that they                                                                 in Taittinger to Albert Frere.
                                the outstanding shares of Taittinger.                                               have over 12% of capital.
         EUR 750
                                                            Wyser-Pratte and Verneuil                                                                                                Hicks, Muse, Tate & Furst sells Periot -
                                                           Finance announce that they                                                                                                Jouet for 12 times EBIT. Substantially
                                                             have over 7% of capital.                                                                                                     increasing Taittinger values.
         EUR 650
Stock Price




         EUR 550
                                                                                                                                                  Wyser-Pratte, Asher Edelman and                      At the EGM, Wyser-Pratte votes
                                                                                                                                                 Hoche announce that they have over                       against resolution allowing
                                                                                                                                                   11.36% of capital and 8.06% of                       Taittinger to increase its capital
         EUR 450                                                                                                                                           voting rights.                                      during a public offer.
                                                                                           Wyser-Pratte, Verneuil Finance and
                                                                                          Hoche announce that they have over
                                                                                                    11% of capital.
         EUR 350
                                                   Wyser-Pratte begins                                                              Wyser-Pratte and Hoche                                                         Wyser-Pratte prepares a new
                                                  accumulating shares in                                                            announce that they have                                                       report showing much higher net
                                                       Taittinger.                                                                   over 11.36% of capital.                                                         asset values for Taittinger.
         EUR 250
                   Jan 97


                                Mar 97


                                         May 97


                                                  Jul 97


                                                            Sep 97


                                                                     Nov 97


                                                                              Jan 98


                                                                                       Mar 98


                                                                                                May 98


                                                                                                         Jul 98


                                                                                                                  Sep 98


                                                                                                                           Nov 98


                                                                                                                                        Jan 99


                                                                                                                                                 Mar 99


                                                                                                                                                          May 99


                                                                                                                                                                   Jul 99


                                                                                                                                                                            Sep 99


                                                                                                                                                                                     Nov 99


                                                                                                                                                                                              Jan 00


                                                                                                                                                                                                          Mar 0


                                                                                                                                                                                                                     May 00


                                                                                                                                                                                                                              Jul 00


                                                                                                                                                                                                                                       Sep 00


                                                                                                                                                                                                                                                Nov 00


                                                                                                                                                                                                                                                         Jan 01
Source: Wyser-Pratte




between subsidiaries. This company was tremendously                                                                                     acquire a 30% total interest and have me placed on the
undervalued at the outset of our interest. Net Asset Values                                                                             Taittinger board. The strategy was eventually effective as
ranged anywhere between EUR1500 - 2000 per share ver-                                                                                   Anne-Claire Taittinger, Claude’s niece, convinced Albert
sus the then-current market price of EUR320. The compa-                                                                                 Frère, the famous Belgian industrialist, to buy our shares at
ny suffered from the dual discounts associated with the                                                                                 800 Euros (160 Euros post a five-per-one split) per share,
typical holding company structure and familial control. We                                                                              which we sold to him on December 29, 2000. This year,
sought to draw attention to the values inherent in the vari-                                                                            Frère forced the Taittinger family to sell the entire compa-
ous luxury brands and luxury hotels (Le Crillon) as well as                                                                             ny at EUR336.24 per share. He had in fact doubled the
its valuable champagne empire. We sought to ultimately                                                                                  price over a five-year period after our having tripled the
convince the majority owners to create value, or for poten-                                                                             shares in a four-year period.
tial bidders such as LVMH Moet Hennessy, Luis Vuitton,
Pinot Printemps and the European and US hotel compa-                                                                                    New opportunities
nies to make offers for various assets in order to increase
shareholder value. We began accumulating shares at                                                                                      In addition to the ideas that our research team develops
EUR320 in May of 1997 and eventually wound up acquir-                                                                                   through our internal screening process, we are often
ing a 5% interest which we declared publicly. The stock                                                                                 approached with potential ideas. In the course of the last
would eventually double in the following year. In February                                                                              two weeks we have been approached by a major European
of 2000, we changed tactics and joined forces with a well-                                                                              conglomerate to help management put internal pressure
known raider, Asher Adelman, who owned 15% of the 67%                                                                                   on the company in order to force change. We have also
Taittinger-held subsidiary, Société du Louvre, and with                                                                                 been approached by a major bank in order to help it effect
Hoche Participation announcing a concert-party action to                                                                                an acquisition of a competitor bank, which seems to be hid-
maintain pressure on Taittinger’s majority shareholder. This                                                                            ing behind the skirts of politicians. There is no end of
began to have an effect as I was subsequently invited to                                                                                opportunity for this kind of active investment in Europe.
meet Claude Taittinger in Rheims. Finally we changed tac-
tics in November of 2000 in order to increase the public
pressure on the company and to execute our exit strategy.
We launched a private road show with some of the leading
hotel and real estate operators in Europe, exhibiting newly
calculated asset values between EUR2500 and 3000 per
share. Our aim was to have someone join us in order to



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News behind the News | Matthias Knab | Opalesque




Hedge funds and the press: A relationship
in perpetual crisis (pt.2)




«News behind the news» | Author Matthias Knab                   country’s flag. Instead, he drew highly detailed pictures of
edits Alternative Market Briefing (published by Opalesque       a grand piano.
Ltd), a daily premium news service on hedge funds and           Media reports in Britain then said the man had given «a
alternatives. In this column, exclusively available to swiss-   four-hour virtuoso piano performance». The man spent
HEDGE readers, he reflects and analyses what is behind          more than four months in a UK hospital’s mental-health
current topics that dominate the industry and the media.        unit without speaking a word, while staff tried to learn his
                                                                identity, dubbing him the «Piano Man».
This is the second of a series of two articles studying the     There had been months of speculation about the identity of
relationship between the hedge fund industry and the            the mystery man. Social workers and staff from the
media, particularly the press. This relationship is a serious   National Missing Persons Helpline spent months trying to
issue since we all - managers, advisors, service providers      identify him. More than 1000 people worldwide called
and particularly investors - are affected by the quality of     helplines and claimed the «Piano Man» as their ex-boy-
the press coverage.                                             friend, their neighbour, or their colleague. For example, in
                                                                May he was said to have been identified as a Czech musi-
What hedge funds can learn from the real                        cian called Tomas Strnad. But Strnad appeared on Czech
mystery of the «Piano Man»                                      TV to say it was not him.
                                                                In August, the «Piano Man» has been identified to be a 20-
On April 7th, 2005 a man was found wandering near a             year-old from Bavaria, government officials told The
beach on the Isle of Sheppey, Kent, southern England. He        Associated Press. The Daily Mirror wrote that the «Piano
was wearing a waterlogged dinner suit and tie, from which       Man» was something of a misnomer. In a blow to reports
all the labels had been cut out. Staff at Medway Maritime       that the man performed parts of Tchaikovsky’s «Swan
Hospital in Gillingham gave the tall, blonde man a pen and      Lake» and the music of John Lennon on the Medway
paper in the hope he would write his name or draw his           Maritime Hospital’s piano, the newspaper said he was able



                                                                                                                     swissHEDGE 23
      News behind the News | Matthias Knab | Opalesque




      only to tap repeatedly at the same piano key.                     Our free media world is an invitation for parti-
      A source described as «an insider» at the Little Brook hos-       cipation
      pital in Dartford, Kent, told the paper: «He said he drew a
      picture of a piano because that was the first thing which         Most hedge funds are afraid of the press. In my view,
      came into his head.» When he played the piano in the hos-         ignoring the press does not buy safety - more likely ignor-
      pital he didn’t play it that well, contrary to all the reports,   ing the press will create or contribute to substantial dam-
      but just kept tapping one key continuously.                       ages. Remember - the press needs stories - every day!
                                                                        Have you ever wondered why some people (hedge fund
      The human need for stories                                        managers, consultants, investors) get quoted regularly in
                                                                        the press? Why the same names show up all the time?
      So, a man has been found in a wet suit on UK beach, he            Since I am working in this field as well, I can tell you that
      does not speak, all labels from dinner suit and ties had been     some people, like in any other industry, are networking
      cut out, instead of speaking draws a piano, gives a four-hour     champions. They know about the needs of the press - to be
      virtuoso piano performance; and 1000 people call help             informed, to produce stories - and they help out. This can
      lines «identifying» the «Piano Man» as their ex-boyfriend,        also happen anonymously - these are then the famous «peo-
      neighbour or colleague. I think if you really «get» the           ple familiar with the matter» or «industry sources».
      implications of the story of the «Piano Man», you have            At the core of all things is always the need to produce the
      understood the workings of the press and why the press is         stories. As a financial insider, you can be an ally and a
      writing the way they write about hedge funds.                     friend to the journalists. The journalists covering hedge
      I believe that within the human psyche there is a deeply          funds have most likely never managed a hedge fund or allo-
      rooted need for stories. And every day the media are work-        cated to one before. More: I have heard of a journalist who
      ing, toiling, traveling and some times even inventing stories     began covering hedge funds for a global financial paper -
      in order to satisfy this unquenchable thirst.                     however he came straight from Iraq and has never done
      The story of the «Piano Man» has many traits and mysteri-         any writing on financial issues! They need you; they need
      ous touches of a fairy tale. Where did this man come from?        the «insiders», the «industry sources».
      What happened to him? Why doesn’t he speak? Where did             Even if you are an investor or advisor you may think to
      he learn to play the piano? Why were all labels cut out from      establish links with the media. These days, when CalPERS
      his clothes? Why was he found on the beach? Of course,            increases its hedge fund allocation, they’ll communicate it.
      the biggy here is the - apparently invented - story about his     Public and corporate pension funds, endowments and
      four hour virtuoso feats on the hospital piano. Yet, the real     wealth managers are popular speakers at conferences. Each
      mystery of the «Piano Man» is actually the even bigger            (public) communication re-affirms, strengthens, affects the
      enigma of our need for such stories.                              public perception. Some marketing people say in the end
                                                                        «we’re all brands». Brands are created and maintained by
      5 :1 for the disaster news                                        communication. Now, if you are a hedge fund or an investor,
                                                                        you rely on having the best people work for you. The
      Now, when the press writes about hedge funds, it’s about          stronger your brand, the more likely you will be able to
      the same thing - to deliver a story. Sure, there are back-        attract the people you want.
      ground articles about the different strategies, mergers,
      hires, all of this. But the BIG news is the awe-inspiring         ....they will write about you
      fairy tale type news (Edward Lampert made USD1b last
      year!) or, even better, the hedge fund disaster news.             If on the other side the press targets your fund, they will
      Let me come back to how the press handled the 2003 events         write about you. The press will always write when they
      at the Clinton Group, which we touched in my previous             want to write. So if you have the chance to influence or to
      swissHEDGE article. When the news about the regulatory            share information, it is better to take that chance (by being
      enquiries hit the press, of course this was covered on the        active) than to be at someone’s mercy.
      front pages, in one case by a financial paper with 551 words.     The time to build relationships to the press is always before
      The news that the regulators cleared the firm showed up           you need them. There is no insurance against headline risk.
      with 114 words somewhere in the middle of a minor section.        However, if you have media relationships, you have at least



swissHEDGE 24
News behind the News | Matthias Knab | Opalesque




a chance to positively influence the tone of the headlines,        received some «bad press» and you want to give this firm
and whatever is published after the headlines.                     an opportunity to speak for themselves - no avail - a 19
Let me explain with an example what I mean. What was               year old receptionist may tell you «we don’t speak to the
going on in the press when in August 2005 the Connecticut          press»...
based Bayou fund went bust was at the same time interest-          So again, always take calls from the press. You don’t have to
ing and amusing. The media was digging out who invested            comment, but take the call and speak to them.
in the fund and some hedge fund investors didn’t look too
smart. Suddenly you have to defend how you got there. On           How to build a relationship with the press: be
the other hand, others boasted they «got out over a year           proactive and smart
ago» or they sent out communiqués explaining «why Bayou
never made our due diligence».                                     In conclusion, here are some tips for those who really want
Talking to the press, or more, having a written press policy,      to master the art of networking and relationship building
means your firm is actively participating and influencing          with the press:
the media coverage about your firm. If you are a hedge fund
manager, institutional investor, fund of funds manager, ana-       ❯    Seek personal contact: Find out who are the key media
lyst, (multi) family office, service provider, broker, lawyer...        people for you or your firm, and establish a contact.
you have know-how and insights that the journalist does            ❯    Offer content /intelligence: Offer comments, analysis,
not have.                                                               alert to certain topics, interdependencies, consequences
                                                                        etc.
Why every hedge fund should take press calls                       ❯    Be a friend: Help the press now and then in their daily
                                                                        struggle to create stories.
I know in some jurisdictions lawyers will probably go crazy        ❯    Be creative: Some firms constantly invite for get-togeth-
reading this. And sure, some of you may think: But Matthias,            ers, drinks or activities.
we are under strict private placement rules and every lawyer       ❯    Don’t swamp them: Be smart. Don’t send out a press
and compliance person tells me not to speak to anyone except            release to every one when you’ve hired a new recep-
our investors. Correct, in some jurisdictions the rules are             tionist or moved office.
rather disheartening. But I say «take the calls» - be friend-      ❯    Have a written policy how you interact with the press:
ly, try to help, remain within the legal framework of your              It should be clearly defined who is taking press calls
jurisdiction. You may even tell them that you are forbidden             (make sure someone is always available) and what to
to share certain information with the press - but take the              communicate, or when indirect communication should
call. If you don’t accept press calls, you give away power and          be used.
influence.                                                         ❯    Train your staff in communication: People regularly
                                                                        underestimate how damaging and counterproductive
Do you know these sentences?                                            untrained staff and receptionists can be.
«Calls to Mr. X were not returned during press time.»              ❯    Build indirect communication channels: If for legal
«Mr. X did not return calls.»                                           reasons you or your firm«cannot talk» to the press, offer
«Mr. X could not be reached.»                                           alternative communication routes for the journalists.
«The firm did not comment.»                                             Indirect communication («with a little help from my
Etc.                                                                    friends») is the champions’ strategy. This can be through
                                                                        clients, former clients, business partners, industry
What is your gut reaction, what do you think or feel when               «friends», consultants, industry trade groups or associa-
you read something like this? The company does not look                 tions.
too good, does it? Or how about this: Imagine you are the
journalist and the receptionist or telephone operator tells
you: «We don’t speak to the press» or «Or policy is not to
                                                                   Matthias Knab is executive editor of Alternative Market Briefing published by Opalesque
accept press calls». So you call from the WSJ, the FT, NY          Ltd. (www.opalesque.com). Alternative Market Briefing is a premier international hedge
Times, the local county courier or from Opalesque - and            fund news service reaching more than 39’000 professionals worldwide. Interested readers
                                                                   may use promotion code «swisshedge» for sizable discounts.
they don’t even talk to you? It may even be that a firm has



                                                                                                                                                swissHEDGE 25
Special Feature | Jean-Louis Lelogeais, Partner | Strategic Value Partners, LLC




Event-driven credit opportunities




By: Jean-Louis Lelogeais, Partner |                               Are credit spreads too tight?
    Strategic Value Partners, LLC
                                                                  What drives credit spreads is the expected rate of defaults
For the past three years, high yield and dis-                     on high yield debt, the expected level of recovery on these
tressed have been among the best performing                       defaulted bonds, and an additional risk premium. Histori-
investment sectors, highlighted by the spectac-                   cally, US default rates have hovered between 2 and 4% for
ular 2003 returns. However, given the current                     long periods of time (1993-1998), and it has been only,
tight levels of credit spreads, the question on                   quite logically, during economic downturns that default
everyone’s mind these days is when, not if,                       rates spike up. This was the case in 1990-1991 and more
will spreads gap out again. This concern is                       recently in 2000-2002. Concurrently, high yield spreads
further magnified by what is often viewed as                      traded between 270 and 580 basis points during the 1993
unsustainable degree of leverage, as well as                      to 1998 period while they gapped out in 1990 as well as
significant systemic risks in the now very large                  from 2000 and 2001.
credit derivatives market.                                        Given current projections of default rates for high yield
                                                                  bonds of about 3%, there is no fundamental reason why
Earlier this year, we witnessed this scenario to a small          spreads should gap out dramatically. As in the past, the
degree when credit spreads gapped out from a record tight         scenario that would upset this expectation would be a sig-
of 271 basis points over Treasuries on March 9th to 456           nificant economic slowdown or a recession. This would
basis points 1 on May 17th, with General Motors and Ford          exponentially increase the likelihood of bankruptcies among
heading to junk, coupled with rumors of widespread losses         leveraged companies as their cash flows come under pres-
in credit markets around correlation trades contributing to       sure, causing them difficulties in meeting existing debt
this volatility.                                                  maturities.
Hence, the questions around distressed and credit related         While it is difficult to predict the exact path of the US eco-
strategies are: 1) is it time to reduce or exit ahead of a pos-   nomy, it seems rather resilient even in the face of rising oil
sible collapse in credit markets?; and 2) is it time to ear-
                                                                  1 Merrill Lynch U.S. High Yield Master II
mark capital for the next wave of distressed?



                                                                                                                         swissHEDGE 27
      Special Feature | Jean-Louis Lelogeais, Partner | Strategic Value Partners, LLC




      Graph 1 | High yield spreads and default rate                                                                                                                   Graph 2 | Historical global high yield issuance

      1200                                                                                                                                                     120%   180.000

                                                                                                                                                                      160.000
      1000                                                                                                                                                     100%
                                                                                                                                                                      140.000

      800                                                                                                                                                      80%    120.000

                                                                                                                                                                      100.000
      600                                                                                                                                                      60%
                                                                                                                                                                       80.000

      400                                                                                                                                                      40%     60.000

                                                                                                                                                                       40.000
      200                                                                                                                                                      20%
                                                                                                                                                                       20.000

      100                                                                                                                                                      0%           0
                                                                                                                                                                                 1996   1997   1998   1999   2000   2001   2002   2003    2004   2005
             1986
                    1987
                           1988
                                  1989
                                         1990
                                                1991
                                                       1992
                                                              1993
                                                                     1994
                                                                            1995
                                                                                   1996
                                                                                          1997
                                                                                                 1998
                                                                                                        1999
                                                                                                               2000
                                                                                                                      2001
                                                                                                                             2002
                                                                                                                                    2003
                                                                                                                                           2004
                                                                                                                                                  proj. 2005                BB                  B                   CCC                  NR
          Default Rate LTM                             Option adjusted spread                                         ML

      Source: Merrill Lynch, Moody’s                                                                                                                                  Source: Merrill Lynch




      prices and the aftermath of hurricanes Katrina and Rita. If                                                                                                     safely handle at least its first couple of years of obligations.
      the US GDP growth remains between 2 and 3% - which                                                                                                              And if the company can meet its liabilities past year three
      seems to be the general consensus view - even the low end                                                                                                       or four, it typically is generating enough cash flows to start
      of these estimates shouldn’t disrupt credit markets in any                                                                                                      paying down its debt and will make it in the long term.
      significant way. Nonetheless, the economy is vulnerable to                                                                                                      Taking this cycle into account and assuming that the US
      significant geo-political risks, and the recent hurricanes                                                                                                      economy holds up, the next wave of high yield defaults may
      have shown that even natural disasters can have conse-                                                                                                          be at least one to two years away.
      quences that we could not have foreseen just a couple of
      months ago. And oil prices at some level can undermine                                                                                                          Where are the opportunities in high yield then?
      the economy.
      Pending some of these exogenous, extreme developments,                                                                                                          If high yield spreads are around fair value, what are the
      it seems unlikely that the US economy will collapse any                                                                                                         investment opportunities in high yield as a hedge fund stra-
      time soon. And if this is true, on a fundamental basis, high                                                                                                    tegy? The US and European high yield market is estimated
      yield bonds are trading around fair value. Hence, being                                                                                                         to be around USD2.5 trillion between bank debt and bonds 2.
      long high yield at this juncture can be a risky proposition,                                                                                                    In addition, while there is essentially no credit curve in Japan
      but at a same time betting against high yield could prove                                                                                                       or an established leveraged loan and junk bond market, the
      dangerous as well. Risks also seem higher today since high                                                                                                      country has a large number of over-leveraged companies that
      yield markets have recently exhibited greater volatility than                                                                                                   should trade at high yield spreads. Finally, emerging markets
      they have historically - often trading on technicals rather                                                                                                     are of course an additional reservoir of high yield paper.
      than fundamentals.                                                                                                                                              While fundamental directional bets on US high yield spreads
      What about the argument that in the euphoria of 2003, the                                                                                                       may prove to be treacherous when the high yield market
      high yield market provided refinancing opportunities for                                                                                                        trades around fair value with noticeably higher volatility,
      companies that should have gone through proper restruc-                                                                                                         credit cycles vary around the world, and what is true in the
      turing, hence creating a bubble of lesser quality bonds that                                                                                                    US today may not be elsewhere.
      will be troubled again very shortly? There were indeed                                                                                                          Increased volatility in high yield markets can prove to be
      record levels of high yield issuance in 2003 and 2004.                                                                                                          fertile ground for astute managers and is certainly one way
      Though the quality mix did deteriorate somewhat, the ana-                                                                                                       to make money.
      lysis of default rates statistics show that defaults are gene-                                                                                                  What might be more interesting and less risky is the relati-
      rally low for one or two years following a new issuance and                                                                                                     vely recent ability to invest in the high yield markets in a
      tend to peak during the third and fourth ensuing years.                                                                                                         balanced way - by creating a long/short portfolio. The ability
      This stands to reason since investment bankers, when loo-                                                                                                       to short high yield has emerged in the past two to three
      king at how much debt to put onto the balance sheet of a
                                                                                                                                                                      2 Strategic Value Estimate
      leveraged buyout, will make sure that the company can



swissHEDGE 28
Special Feature | Jean-Louis Lelogeais, Partner | Strategic Value Partners, LLC




Graph 3 | Mortality rates by original rating - all rated coporate bonds   These price discontinuities are even more pronounced in
20%
                                                                          the bank debt market which tends to be much less trans-
18%
                                                                          parent than the public bond market. An experienced credit
16%                                                                       manager capable of making positive and negative individual
14%                                                                       credit selections should be able to exploit these inefficien-
12%                                                                       cies and generate pure alpha, an interesting way to invest
10% CCC                                                                   in credit markets at this point in the cycle.
8%

6%                                                                        What about distressed? Is it over?
4%     B
2%
      BB                                                                  After a spectacular 2003 performance, followed by a solid
0%                                                                        2004, many are probably thinking that the excess returns in
        1      2       3       4        5        6      7   8   9   10
                                   Years after issuance                   distressed are gone for now and that it may be better to stay
Source: Standard & Poor’s (New York) and NYU (Altman)
                                                                          on the sidelines until the next cycle.
                                                                          Distressed is indeed a cyclical business. What creates the
years and is developing. There are still constraints: shorting            opportunity is the supply/demand imbalance that typically
high yield bonds outright in size can be difficult; there is no           occurs when the economy slows down, accompanied by a
real way to short bank debt which remains the dominant                    spike of default rates with a lot of securities on the market
segment in high yield markets; and only a small fraction of               when there is not yet enough risk capital to absorb them.
high yield issuers has liquid credit default swaps (CDSs).                This was the case in 1991-1993 immediately following the
But despite these constraints, it is still possible to construct          1990-1991 crisis, and it happened again in 2003 after the
a robust long/short high yield portfolio that is neutral to               infamous summer of 2002, when credit markets experien-
credit spreads.                                                           ced perhaps their worst three months ever.
So how does one generate «alpha» in a long/short high yield               Given three years of a strong US economy (there was no
that is neutral to the credit spread?                                     double-dip recession after all in 2002), and a significant
One way is by exploiting the structural inefficiencies that               amount of capital raised for distressed from hedge funds,
are pervasive in global credit markets. As the «status» of                private equity funds and proprietary desks on Wall Street,
bonds change - i.e. when investment grade credits fall into               it is probably harder to generate excess returns in US
high yield («fallen angels»), when high yield credits go into             distressed. At the same time, there remain niches in the US
distressed and vice versa, when credits emerge from bank-                 where attractive returns are available for skilled managers.
ruptcy into high yield, or when high yield credits are upgra-             There are a few troubled sectors like autos, merchant ener-
ded back to investment grade - so does the investor base.                 gy, or airlines whose problems have less to do with the eco-
These shifts cause market price discontinuities, thereby                  nomy than with fundamental structural issues. For exam-
creating investment opportunities - a unique phenomenon                   ple, in the US auto sector, the loss of market share to the
to credit markets.                                                        foreign companies due to disadvantaged cost structures is
In equities, when a stock falls from USD60 a share to                     the root of Detroit’s problems. This has had a ripple effect
USD30, the same investor base will buy and sell the stock.                among auto parts suppliers, causing a number of them to
Not true in credit markets. When an investment grade                      file Chapter 11.
bond is downgraded to junk (GM/Ford most recently),                       The more attractive opportunities in distressed today may
investment grade mutual funds have to sell precipitously.                 well be outside of the US, particularly in Europe. What
And the same happens when high yield companies go into                    creates the opportunity is an interesting amount of supply
bankruptcy: CDO’s/CBO’s have to sell, high yield mutual                   coming onto the market while the field of competitors is
funds have to sell, and banks sell as well once they have                 much smaller than in the US. Germany in particular is in
taken the reserves. Conversely, when a company is about to                the early stages of what could prove to be a significant
emerge from Chapter 11, its bonds typically still trade at a              restructuring program. The German economy has been
discount because the credit is «tainted» and the traditional              troubled since the reunification with East Germany when
high yield investors cannot invest until it emerges from                  significant lending with sometimes lax credit standards
bankruptcy.                                                               occurred, resulting in a large accumulated bad debt pro-



                                                                                                                                swissHEDGE 29
      Special Feature | Jean-Louis Lelogeais, Partner | Strategic Value Partners, LLC




      Graph 4 | Total bad loans across European countries (estimated                     and 3) the merger between Dresdner, prompted by Allianz,
      face value), end of 2004 (USD Billions)
                                                                                         set a precedent. And next to the flow of distressed invest-
      $200                                                                               ment opportunities in Germany, there are only a few expe-
      $180                                                                               rienced managers with teams on the ground in Frankfurt
      $160                                                                               giving them a valuable edge over their competitors.
      $140                                                                               A global approach to investing in distressed, coupled with
      $120                                                                               the discipline of «rightsizing» the amount of capital to be
      $100                                                                               deployed, can yield good results.
      $80

      $60                                                                                Conclusions
      $40

      $20                                                                                While the «easy» and outstanding returns of 2003 are
       $0                                                                                behind us, high yield long/short and distressed strategies
               Germany          France     United Kingdom       Italy            Spain
                                                                                         can offer interesting opportunities to generate alpha. For
      Source: National Statistics, Mercer Oliver Wyman Benchmarks and Analysis
                                                                                         experienced investors, the appropriate strategies executed
                                                                                         by skilled and experienced managers have a strategic role
      blem estimated by some to be more than USD300b 3. There                            to play in any well diversified hedge fund investment port-
      is a confluence of events motivating the German financial                          folio.
      institutions into action and deciding to clean their balance
                                                                                         3 Strategic Value Estimate
      sheets: 1) Basle II is looming and requires the banks to equi-
                                                                                         Mr. Lelogeais is a Partner with Strategic Value Partners, LLC («SVP»).The
      tize; 2) the Landesbanks are losing their state guarantee                          views expressed herein are provided solely on an informational basis by him,
                                                                                         and do not necessarily represent the views of SVP.
      and will need to face the discipline of the capital markets;




swissHEDGE 30
Roundtable Discussion 4th Quarter 2005




Roundtable discussion



swissHEDGE regularly invites reputed profes-       Q: Which is the most compelling region for event-driven
sionals to join a roundtable discussion in            hedge funds?
which to share their views on a particular
topic. This time, we have invited three leading    HDH: In our opinion, Asia is undoubtedly the most exciting
event-driven hedge funds to share their views      region for event-driven hedge funds today. Growing
on the status quo as well as future develop-       economies, inter-region and intra-country M&As, holding
ments for the various strategies.                  companies divesting non-core assets, improving corporate
                                                   governance, restructuring opportunities, and trading volatility
HDH Advisors                                       are all the key ingredients for the current attractiveness of
Fund:           HDH Special Situations Fund Ltd.   event-driven in Asia.
AUM:            USD420m                            PAULSON: We find good opportunities globally. Our port-
Representative: Huy Hoang                          folio tends to run 60% to 70% US and 30% to 40% non-US.
                                                   TISBURY: As we are focused solely on European event-
Paulson & Co. Inc.                                 driven, it is hard for us to argue for one region over the
Fund:           Advantage Limited Ltd.             other. What we can say is that the prospects for increased
AUM:            USD4.7b                            corporate activity in Europe remain very strong. Several
Representative: John Paulson                       factors underlie this. First, the tepid economic outlook for
                                                   Europe, combined with the fact that cost cutting programs
Tisbury Capital Management LLC                     are largely complete, means that corporate boards are con-
Fund:           Tisbury Europe Fund Ltd.           sidering strategic alternatives to generate growth. Second,
AUM:            USD975m                            companies that have announced significant transactions
Representative: Gerard Griffin                     this year have been rewarded by the market, not penalized
                                                   as in years past. Finally, there appears to be an underlying



                                                                                                          swissHEDGE 31
      Roundtable Discussion 4th Quarter 2005




      political will on the part of some European governments to      among the positions. We then overlay the portfolio with
      promote cross border champions to compete with larger           macro hedges to meet our overall portfolio risk limits. Most
      US corporates.                                                  importantly, we manage the deal specific event risk at the
                                                                      position level. Our portfolio is concentrated with an average
      Q: Did the move from pure merger arbitrage to a broader         of 30 situations. To ensure that the risk of each situation is
         event-driven investment set add more beta into portfo-       being monitored and reviewed on a daily basis, we have
         lios?                                                        dedicated each investment professional to be responsible
                                                                      for no more than 5 situations at any given time.
      HDH: Traditional merger arbitrage was never a viable long-      PAULSON: Generally, each event position has an event
      term strategy in Asia due to a number of factors including      that will affect the value of the security. It could be a spin-off
      limited stock borrowings, insufficient number of executable     (Ameriprise from American Express), a stock repurchase
      transactions, and tight deal spreads. For us, we focus on       (Time Warner), a reorganization (Kerr-McGee), litigation
      M&A and restructuring opportunities that capitalize on the      (Merck), legislation (Owens Corning) or another type of event.
      difference between the price today and the price we believe     The size of our position will be based on the value that would
      it should be once the acquisition terms are announced or the    be created if the event occurs, the downside if the event
      restructuring plan is executed. We make directional bets on     doesn’t occur, and the probability of the event occurring.
      an event and then hedge out the market risk and sector risk     TISBURY: It is difficult to isolate risk associated with an
      to the extent that it makes sense. We do have an element of     event, even post announcement, but the risk can be rea-
      beta to contend with and thus the ability of an event-driv-     sonably reduced through the use of sector, market and
      en manager to manage the market and sector exposures is         macro hedges.
      as important as the ability to analyze a deal event risk.
      PAULSON: We would expect the event-driven portfolio to          Q: How can you ensure to have different ideas from other
      have slightly greater volatility as well as slightly greater       funds?
      returns. In general, however, it is important for us to hedge
      out the market risk in an event trade by balancing our long     HDH: Our unique team background and investment
      positions with offsetting short positions to reduce market      approach set us apart from other funds when it comes to
      correlation.                                                    idea generation. We are very focused on M&A and restruc-
      TISBURY: This depends on the approach taken by an indi-         turing situations that are transformational to a company.
      vidual manager. In some cases, where the operating philos-      Our situations are mostly large cap and come from the
      ophy is to identify a valuation «floor», the answer would       more developed Asian countries such as Japan, Korea and
      have to be «yes». In other cases, managers are more agnostic    Taiwan. Large transactions are more complex, involving many
      about the concept of value, hedging even the cheapest           quantitative and qualitative issues. Without relevant on-the-
      stock, thereby keeping beta relatively minimal.                 ground Asian M&A and restructuring experiences as an
                                                                      investment banker, most fund managers would not know
      Q: How can you isolate the deal specific event risk?            how to approach the analysis of an M&A situation in Asia.
                                                                      PAULSON: While all event managers choose from a similar
      HDH: Asia’s capital markets and availability of instruments     universe of opportunities, we all will have different portfo-
      for hedging are still at the infancy stage and as such, we      lios based on our own skill set, experience and research.
      have to constantly be creative and flexible in order to bal-    We tend to do best in those situations we know best
      ance the cost associated with hedging versus the risk of        through our research, relationships, and past experiences.
      unhedged exposures. Every investment is situation-specific      TISBURY: If we could ensure that our ideas were both
      and thus, the hedging associated with each investment           unique and profitable, we would be unlikely to disclose the
      varies from one to the other. We use a number of different      method for doing so in an open forum. As it is, the event-
      mechanisms including pair trades, stock baskets, options        driven universe is a competitive one, populated by experi-
      and futures, etc. in order to isolate the deal specific event   enced, smart managers, and so it is difficult to imagine a
      risk. We employ Riskmetrics and other risk software pro-        wholly contrarian approach being successful. At the same
      grams to determine risk contribution of each position to        time, running with the crowd by definition cannot lead to
      the overall portfolio as well as the correlation variance       outperformance and can, as the first weeks of October have



swissHEDGE 32
Roundtable Discussion 4th Quarter 2005




reminded us, expose a fund manager to uncomfortable                 favorable outcome versus passively waiting for a favorable
systemic risk. The challenge for us, as with any manager, is        outcome to potentially happen. Activist investing can both
to find good ideas whose reward potential compensate for            increase the probability of a favorable outcome as well as
the risks undertaken, one of which may be that the invest-          cause that outcome to happen more quickly. The danger of
ment is populated by other hedge funds.                             an activist approach occurs when a manager takes concen-
                                                                    trated, illiquid and unhedged positions during a period in
Q: To what degree is asset size an advantage for your               which the market declines or in which the target’s prospects
   event-driven funds?                                              diminish. This situation can lead to sharp drawdowns.
                                                                    TISBURY: The advantage of an activist approach is that the
HDH: Asset size is critically important to our strategy.            hedge fund manager throws off the historical constraint of
Large asset size allows us to gain better services from the         passively relying on management of the investee company
broker community, easier access to senior management,               to create value, or for an interloper to put shareholders of
and certain private transactions for public securities. It pro-     the investee company out of their misery. Becoming a self-
vides the scale to hire the best talents and the resources to       generating value catalyst has tremendous appeal, particu-
generate the best ideas and to manage risks.                        larly for larger funds whose potential investment universe
PAULSON: Our increased size has allowed us to obtain                is limited by liquidity concerns. On the other hand, an
access to better information and to dedicate more                   activist approach requires considerable time and effort,
resources to individual situations. Our size has also given us      which may or may not be justified depending on the prob-
a greater ability to influence outcomes favorable for our           ability of success in the activist endeavour. This is particu-
funds’ positions.                                                   larly the case where failure in an activist stance carries the
TISBURY: A large asset base can be influential in securing          risk of reputational damage.
senior level meetings with large corporates giving the
advantage to a larger fund. It can also play a role in attracting   Q: What part of the capital structure offers you most
talent as well as invitations to participate in financing deals.       opportunities?
The obvious disadvantage to scale is liquidity. We attempt
to manage this by keeping the growth in idea generation,            HDH: Equity is still the main instrument for investments
analysis and risk management in line with asset growth.             in Asia given its depth, liquidity and the size of available
                                                                    opportunities.
Q: In your view, what are advantages and disadvantages of           PAULSON: Actually, all parts of the capital structure, equity
   an activist investment style versus being a passive investor?    as well as debt securities, can offer good opportunities
                                                                    depending on the situation. In addition, we look for oppor-
HDH: We strongly believe that having the opportunity to             tunities throughout the capital structure on both the long
communicate with senior management about our views                  and the short side. For instance, this year we have found a
and expectations as a public minority shareholder is an             good long opportunity in the debt of Drax during the same
important element to our investment process. However,               period we found a good short situation in the bonds of
the approach and the degree that a shareholder uses to              Delphi.
interact with senior management differentiate ones from             TISBURY: We trade across the full capital structure, taking
being classified as an activist or a passive investor. In Asia,     into account expected values and liquidity.
unlike most companies in Europe and the US, conglomer-
ates in general are still going through a process of share-         Q: What is the worst case scenario for your investment
holder diversification, which means that most companies                strategy?
are still controlled or significantly influenced by families,
governments, or banks. This ownership structure, com-               HDH: The most difficult part of managing a pan-Asia strat-
bined with unclear M&A regulations and Asia’s conciliatory          egy is one that often tends to be forgotten: Asia is not a single
culture, suggests that the aggressive shareholder activism          homogeneous market but a collection of more than ten
style being practiced in the Western world needs to be              individual markets in different cycles of respective eco-
adapted in order to be practical in Asia.                           nomic development. Each capital market remains fragile
PAULSON: The goal of activist investing is to influence a           and as such an external shock could easily reduce the trad-



                                                                                                                             swissHEDGE 33
      Roundtable Discussion 4th Quarter 2005




      ing liquidity of the region. For our strategy, we regard the     To some extent, this has offset new inflows to the strategy.
      lack of trading liquidity the greatest risk as events do not     In addition, as described above, the outlook on the supply
      get recognized until the overall market conditions stabilize.    side is positive. That said, if the supply of new investment
      PAULSON: The worst case scenario would occur if multiple         opportunities does not grow as expected, returns almost
      event situations were to go against us at the same time. The     certainly will be impacted negatively by capital flows into
      general movement of the overall markets in any direction         the strategy.
      should not have a material effect.
      TISBURY: The worst case scenario for us is one where             Q: What developments do you expect for the strategy in
      material uncertainty enters the corporate boardroom, caus-          the next two years?
      ing deal activity to cease, while the market trades sideways,
      leaving little scope for investment returns from trading or      HDH: We expect the convergence between hedge funds
      establishing positions at dislocated prices.                     and private equity funds will happen in the near term. As
      Q: Do you think the large allocations of investors to event-     assets under management for hedge funds in Asia reach a
          driven funds will erode future strategy returns?             certain critical mass, hedge funds will become a force in
                                                                       competing against private equity and buyout funds in M&A
      HDH: Large allocations of funds will erode returns in the        transactions.
      event-driven strategy only to the extent that there is a suf-    PAULSON: We are concerned about the US fiscal and
      ficient talent pool in Asia and/or the opportunity set stays     trade deficits, low savings rates and high debt levels. We
      constant or diminishes in the near term. We don’t think          believe that the current imbalances are not sustainable and
      either case is true in Asia at the moment.                       that the economy, stock market and credit markets will cor-
      PAULSON: No. We have been in business for eleven years           rect to the downside. Therefore, from our perspective, it is
      and our returns have been fairly consistent over either a        important to run a hedged portfolio. I would expect there
      three-year, five-year or a ten-year basis, even though capital   to be trouble with: 1) leveraged, concentrated long event
      flows in our strategy have varied significantly. Also, over      portfolios; and 2) levered fixed income strategies, even
      this period our capital ranged from only a few million at the    though both strategies may be showing good returns cur-
      beginning to USD5b currently while market conditions             rently.
      and merger activity varied widely.                               TISBURY: In addition to increased activism, we expect the
      TISBURY: The demand side of the business has witnessed           dividing line between private equity and hedge funds to
      flows in both directions, with some larger event-driven          continue to blur.
      funds undergoing a downsizing in their european business.



swissHEDGE 34
      HARCOURT EVENTS 2005/2006

      Quarterly HF Presentation                 08 November          08.30-10.00 / 12.15-13.45   Lugano / Milan
                                                09 November          08.30-10.00                 Geneva
                                                10 November          08.30-10.00                 Amsterdam
                                                11 November          08.30-10.00                 Zurich
                                                16 November          12.30-14.00                 Frankfurt
                                                17 November          08.30-10.00                 Kopenhagen
                                                18 November          08.30-10.00                 Stockholm
                                                23 November          09.00-10.30                 Paris
                                                24 November          09.00-10.30                 Madrid
                                                25 November          09.00-10.30                 Barcelona


      Quarterly HF Presentation                 06 February          12.15-14.00                 Milan
                                                07 February          08.30-10.00                 Lugano
                                                08 February          08.30-10.00                 Geneva
                                                09 February          09.00-10.30                 Paris
                                                10 February          08.30-10.00                 Zurich
                                                13 February          12.15-14.00                 Frankfurt
                                                14 February          08.30-10.00                 Copenhagen
                                                15 February          08.30-10.00                 Stockholm
                                                16 February          08.30-10.00                 Amsterdam
                                                23 February          09.00-10.30                 Madrid
                                                24 February          09.00-10.30                 Barcelona


          To register for any of Harcourt’s events, please go to www.harcourt.ch.




      UPCOMING CONFERENCES 2005/2006

      November        15 - 17          4th GAIM Invest
                                       Hotel President Wilson, Geneva, Switzerland, http://www.icbi-uk.com

                      21 - 23          Hedge Funds World Zurich 2005
                                       Park Hyatt Hotel, Zurich, Switzerland, http://www.hedgefundsworld.com/2005/zurich/

      March           27 - 29          GAIM Asia 2006
                                       JW Marriott, Hong Kong, http://www.icbi-uk.com/gaimasia/

                      20 - 21          Super Hedge 2006
                                       Congress Centre, Frankfurt, Germany, http://www.super-hedge.com/




swissHEDGE 0
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