1. slide no.: 1 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Alternative Investment Strategies And Financial Market Stability Southwestern University of Finance and Economics Chengdu September 2006 „The only hope to produce a superior record is to do something different. If you buy the same securities as other people, you will have the same results as other people“ John Templeton Prof. Dr. Rainer Stachuletz Berlin School of Economics

2. slide no.: 2 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Contents oBusiness models of hedge fund investors and their current role in financial markets oTypical designs, mechanisms and conditions of hedge funds investment strategies oDo alternative investments jeopardize the stability of financial markets oSummary / Conclusions / What to do ?

3. slide no.: 3 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics The Universe of Alternative Investments Real Estate and Natural Resources Private Real Estate REITs Commodities / Energy Private Equity Strategies Venture Capital Buyouts Distressed Debt Mezzanine Public Market Strategies Hedge Funds Multy-Strategy Funds Arbitrage Managed Futures

4. slide no.: 4 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics General Characteristics of Alternative Investment Strategies Features of Trad. Investments (e.g. Investmentfonds)  Benchmark oriented  High correlation with equity- and/or bond markets  Must always be invested  Transparent, regulated markets  No investments in own funds  No levered investments  Striktly limited use of derivatives Features of Altern. Investments (e.g. Hedge Fonds)  Absolute Return  Low or no correlation with other markets  Short sales possible  Unregulated markets, offshore  Investments in own funds  High levered investments  Usage of derivatives

5. slide no.: 5 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Hedge Funds Business Model Mostly unregulated, offshore residing eclectic investment pools with aggressively managed short term portfolios. Hedge Funds employ investment techniques like short selling, leverage, and are allowed to create a variety of synthetic positions by unlimited usage of derivatives. Often hedge funds are set up as private partnerships, open to a limited number of investors and require a very large initial minimum investment. Typically hedge Funds are illiquid as they often require investors keep their money in the fund for a minimum number of years. Hedge funds managers typically charge a management fee (1-2% of asset value) and a performance fee of about 20% of the capital gains and capital appreciation.

6. slide no.: 6 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Development of Hedge Funds Number and Portfolio (in Bio US$)

7. slide no.: 7 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Risk and Return Hedge Funds Investment Strategies Relative Value ( Arbitrage ) Equity Market Neutral Convertible Arbitrage Fixed Income Arbitrage Global Macro Managed Futures Dedicated Short Bias Long/Short Equity Directional Event Driven Merger Arbitrage Distressed Securities

8. slide no.: 8 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics PROFIT LOSS P/E - Ratio 23,9 Short Lowe‘s at 23,9 Expected Market 16,7 Long Home at 16,7 Expected Market Relative Value Strategy Long / Short Equity – Hedge

9. slide no.: 9 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Enter spread position Relative Value Strategy Long / Short Equity – Hedge

10. slide no.: 10 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Directional Strategies Non Hedge Long-/Short Directional Strategies represent unhedged, directional speculations on growing (long) or declining (short selling) markets. By additional usage of debt (leverage) respectively completing short– or long-positions synthetically, the total risk and return – positions can be amplified. Exp. Market Leverage Expect. Market Short Call Long Put

11. slide no.: 11 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Event – Driven Strategies (Merger Arbitrage) Merger Declaration 1 3 End of Purchase Ad – hoc News at 28. April 2000 Hypovereinsbank Bank Austria 2

12. slide no.: 12 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Event – Driven Strategies Long–Short–Equity and Merger Arbitrage -20 -10 0 10 20 30 40 50 455055606570758085 Expected Share Price HVB Expected Share Price Bank Austria Long Bank Austria Short HVB

13. slide no.: 13 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Event – Driven Strategies (Merger Arbitrage) 9,80+ EUR 58,60-EUR 48,801 BankAustria Verkauf 28. Dezember 2000 Differenz Kauf 28. April 2000 Aktien Anzahl + 9,80 9,80+ EUR 58,60-EUR 48,801 BankAustria Sale 28. Dezember 2000 Profit / Loss Purchase 28. April 2000 Shares Number + 9,80 Traditional Investment Fund Trade: Due to the short selling, the Hedge Fund gains an approx. 100% higher profit than the trad. Fund.

14. slide no.: 14 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Three Popular Arguments on Hedge Fund Investments and Financial Market Stability ? 1.Hedge Funds operate high leveraged portfolios of mostly risky assets. As a result, market processes tend to be more volatile and more uncertain. Thus syestemic market risk will increase ! 2.Hedge Fund investments tend – because of their sheer size – to manipulate asset prices. This will directly compromise the pricing mechanism and thus lead to inefficient factor allocations ! 3.As Hedge Funds often do not have to follow any regu- lations that are used to be applied to onshore finan- cial institutions (transparancy of investment styles, accounting, disclosure and auditing, taxes etc.) investors are not sufficiently protected.

15. slide no.: 15 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics monthly S&P 500 Volatility CSFB/Tremont Hedge Fund Index Returns Source: Bloomberg 1. Do Hedge Funds Increase Market Volatility ?

16. slide no.: 16 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics 1. Are Hedge Fund Strategies Risky Investments ?

17. slide no.: 17 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics 1. Do Hedge Funds Increase Systematic Risk ? 100% HF/ 0% TF 45 % HF / 55 % TP 0 % HF / 100% TP (Theoretical Portfolios of Traditional Assets (MSCI 50%, JP Morgan Global 50%) and the CSFB-Hedge Fund Index based on monthly figures between 1994-2004)

18. slide no.: 18 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics 2. Hedge Funds and Market Manipulation Hedge Funds do not rely on momentum – invest- ments and often take contrary positions. Thus, their engagement will support the pricing mechanism while providing liquidity and keeping the market process running. By this, Hedge Funds help substantially to rebalance the markets and smooth volatility. Hedge Funds, that operate in smaller markets general- ly have the potential of market manipulation. In the case of arbitrage trading or related relative value strategies, hedge funds activities target directly to change market prices. A „manipulation“ of prices back to the equlibrium is desired. This may be seen different concerning other investment strategies.

19. slide no.: 19 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics 2. Hedge Funds and Market Manipulation In fact, only 20% of the total investment is arbitrage tra- ding. The rest is more or less directional. The major part of directional investments is represented by directional equity-investments (long-/short-only).

20. slide no.: 20 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics The Hedge Funds market is dominated by well experienced, well informed and educated powerful investors (average entry investment at 630 T$ !) like banks, pension funds, endowments and wealthy individuals (HNI). As they are strong enough to take care of their specific information needs, no regulation is required. 3. Need Investors to be Protected ?

21. slide no.: 21 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Investor protection seems to be a week argument, if it is focused on the typical hedge fund investor as shown above. As hedge funds have started to copy the profitable investment model of private equity funds in a short term version, there are not the hedge fund investors that need to be protected, but those long term investors, who are affected by short term hedge fund investment activities. Therefore, to focus investor protection on the hedge fund investor is misleading. Investors should be protected against hedge fund investors. 3. Need Investors to be Protected ?

22. slide no.: 22 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Summary and Conclusions 1.Currently Hedge Funds control an investment volume of about 1.2 Trillion USD, which means a proportion of 12% of the total global fund investments. 2.Although they are powerful, Hedge Funds are widely un- regulated, e.g. they do not report their acitivities like other financial institutions, mostly they don‘t have to fol-low minimum capital requirements, minimum disclosure standards or minimum audit standards. In a strong sense they do not contribute to rational decision making. 3.Due to their characteristics – non regulated offshore residents, excessive leverage, short sales and unlimited incorporation of derivatives (synthetic assets) – their investment styles and their sheer size, hedge funds affect or have the potential to affect market processes.

23. slide no.: 23 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Summary and Conclusions 4.The total business model including investors who provide equity, hedge fund corporations that select investments and investment styles and investment banks which provide the loan is highly concentrated and interlinked. That high integrated and concen- trated business modell increases the probability of extensively widespread cascading effects in case of a failure (see the LTCM – Case in 1998). 5.As Hedge Funds have started to copy typically „Private-Equity-Engagements“ even those parts of the real economy that have not been direktly linked to capital markets, have become the target of short term financial investments and will be exposed to intensified leverage risks.

24. slide no.: 24 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Does The Market Need Hedge Fonds ?  Hedge Funds are in general non transparent, offshore located and tax avoiding investment strategies beyond any national jurisdiction.  With the today known market strategies that includes desireable arbitrage trading only to a proportion of approxi- mately 20% and the observable move to directional strategies concerning long equity positions Hedge Funds need to be regulated to support long term oriented micro- and macro-policy approaches.  Hedge Funds have not only the potential but also strong incentives to manipulate market processes e.g. to generate price movements that enhance the profitability of their underlying positions.

25. slide no.: 25 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Thank You Very Much

26. slide no.: 26 Prof. Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Private Equity Investments and Regulatory (Tax) Arbitrage „Private Equity“ means to invest in non-listed, frequently undervalued corporations and any other (undervalued) assets. Mostly returns result simply from tax arbitrage. Withdraw E. and replace by D. Assets 1.000 E500 D500 (r D : 4%) Assets 1.000 D (1) 500 (r D : 4%) D (2) 500 (r D 8%) Exp.: 60 Int. : 20 Tax:5 Profit:15 Sales 100 Exp.: 60 Int.: 60 Tax:0 Sales 100 Loss 20 Offshore Int. 40Tax 0 Profit 40