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“For the past 10 years, a traditional 60/40 portfolio did better than the hedgefunds; looking at that, it’s questionable whether hedge funds have anyplace in the portfolio.” - Simon LackQ&A with Simon Lack Continued:Simon Lack: Chris Vogt, formerly with Allstate Insurance,was one of the first to invest in hedge funds. In an interviewrecently with Reuters, he said that this is a make or breakyear for hedge funds, because the past five years have allbeen bad. When you put the five year returns into the meanvariance optimizer, hedge funds will start to look a lot lessattractive. Institutional investors are patient but I would betthat they'll be disappointed. The math is not going to work.Fund Counsel: There's a lot of conjecture behind the scenesthat there will be a compression of manager fees, so I'msuggesting that we're in a dynamic marketplace. Certainmanagers are closing down because they can't handle thevolatility of the markets, and many people blamegovernment interference in the markets. There’s no relyingon fundamental analysis.Simon Lack: There are a lot of really intelligent peoplerunning hedge funds. My book was not written for hedgefund managers; it’s investors who need help. The smartestpeople will probably always run hedge funds because that’swhere you can make the most money, and they will evolveand adapt. I certainly don’t expect the industry will go away,but in its present structure, I believe we’ll continue to getdisappointing results.“Is there not value in having hedge funds as adiversifying asset in a portfolio?”Alternative Investments Manager: You mentioned returncorrelation, but you didn’t talk about the downsideprotection hedge funds offer in portfolio construction. If youlook at that negative period of 2008 and 2009, where theyoutperformed, is there not value in having hedge funds as adiversifying asset in a portfolio?Simon Lack: In our interviews with people before 2008, oneof our common questions included: “What will a bad runlook like? How much can you afford to lose?10/10/2012 Hedge Funds Roundtable“Prior to 2008, any hedge fund money managerwould have said that to be down 12 -15% would bean absolute worst-case.“And so I was surprised after 2008 that hedge fund investorswere not even more upset, because I believe being down23% is a disaster for strategies that are supposed to hedge.But hedge funds blew up as well and investors justified their23% hedge fund losses by saying that their stock portfolioswere down 35%. So why didn’t hedge funds do what theywere designed to do? I believe it’s because the hedge fundindustry is six times the size it used to be; they don't providethat much uggestconcentrating on a very small number of hedge fundmanagers, but that's totally counterintuitive to most of us. Ifyou have just 2 or 3 managers, when one blows up it defeatsthe purpose of having them in the first place.Simon Lack: I'm not suggesting that you should have 20% inhedge funds. If you're only going to have two or threemanagers, be sure to have only 1-2% invested in hedgefunds. Go elsewhere; in fact, you can do a lot with stocksand bonds.For the past 10 years, a traditional 60/40 portfolio did betterthan the hedge funds; looking at that, it’s questionablewhether hedge funds have any place in the portfolio. I'mtaking the Capital Asset Pricing Model and applying it tohedge funds, recognizing that the hedge fund risk premiumis negative.When you put that into the CAPM, it produces a total totallydifferent result than if you assume that hedge funds have apositive risk premium. For institutional investors with longlife liabilities, hedge funds are not going to do it for them.The math just won't work. There’s a big concern about all ofthe public pension money going into the hedge funds. Thehedge fund industry can’t make money with 2 trillion; whywill it make money with 2.5 or 3 trillion?iief.orgPage 4

“If we assume that the bonds in a 60/40 portfolio are municipal bonds, and weassume a very inefficient tax structure for most hedge funds, am I correct thatthe numbers would be even worse?” - Wealth AdvisorQ&A with Simon Lack Continued:Wealth Advisor: As someone who was in the hedge fundbusiness for a long time, I completely agree with you, butnow I work with high net worth clients. I'm curious to knowif you’ve tax-effected your numbers. If we assume that thebonds in a 60/40 portfolio are municipal bonds, and weassume a very inefficient tax structure for most hedge funds,am I correct that the numbers would be even worse?Simon Lack: Yes, they would be much worse. And hedgefunds do a lousy job in generating ordinary income. Clearlyfor taxable investors, hedge funds are highly tax inefficient. Iwas once a taxable investor in an incubator fund andrecognized how bad that was; the only mitigating featurewas that I didn't have to pay the fees that we charged otherclients, because I ran the fund.Restructuring Counsel: Across the life of funds, fromperformance reporting to the redemption process tolitigation, we see issues around valuation. I wonder if youhave an industry-wide prescription for those valuationproblems, things that investors should be looking at tosafeguard their interests.“I think the open-ended fund structure that'sprevalent in the hedge fund industry isdis-advantageous to many investors.”Simon Lack: The fact is that there's no mid-market; there’s abid and an offer. You have fund documents that assume aNet Asset Value based on mid-market value - and it's ahypothetical concept. In reality, any portfolio has a highNAV if you need to buy securities, and a bit lower NAV if youneed to sell securities for money coming out.I’ll give you an example. We invested 25 million of seedcapital in an equity market-neutral fund in San Francisco thatruns 3 to 1 leverage in a quantitative strategy. I had dailytransparency as a non-negotiable requirement.10/10/2012 Hedge Funds RoundtableOn the first day, the P&L was down 35 basis points and I wastold that was due to market impact costs. The month goesby and the fund is up a little bit. Another month goes by andanother 25 million comes in from another investor. We’redown 17 basis points on the first day, because the second 25 million is now invested with the same market impactcosts, but the costs are spread across twice the money.In fact, as money comes into a fund that is growing, thereare market impact costs incurred to employ new capital.Hedge fund managers totally understand this, but mostinvestors don't; hedge fund managers have no reason toexplain this to clients. It's the same thing in reverse whenmoney comes out. If you're in a hedge fund where assetsare declining and monies are coming out, you also pay partof the fees and expenses of the assets being sold to pay outcash to the departing investor.“There’s an inequitable allocation of costs.”So I suggested we should change this and charge an entryand exit fee for new money, and that fee should be ourestimate of the market impact costs of money coming in. Isuggested that the fee should go to the fund, not themanager, and be used to defray the cost of new moneycoming in and going out. This doesn't change the economicsoverall; it just makes sure that the costs are equitablyallocated. The company did a second fund with this entryand exit fee and they had a hell of a time convincinginvestors that it wasn't just another fee.The open-ended fund structure really should only exist forstrategies that are in liquid securities such as governmentbonds and large cap U.S. equities, where the market impactcosts of money coming in and going out are minimal. Everyhedge fund, in my opinion, should actually be a closed-endfund where investors get in and out based on whatever theprevailing discount is. The problem with that is thatclosed-end funds generally trade at a discount, and it's avery small, inefficient market in the U.S. They trade at adiscount for a reason, because of the value of that liquidity.iief.orgPage 5

“Investors will claim that they read the small print and the LPA,but you really pay attention to it only when things go wrong.”- Simon LackQ&A with Simon Lack Continued:Simon Lack: Here’s another example. We invested in aconvertible arbitrage fund called Acuity. We had the right totake money out intra-month, based on what the NAV was. Ibenefited from daily transparency. We had our own internalrisk management rule; if we were down more than 10%, wehad to take some of the money out. We saw the dailyresults go down the gutter and wanted to take half ourmoney out. All of a sudden, Acuity’s results accelerateddown. Knowing that they were going to be giving us backour money, they valued the portfolio using the mid-marketof convertible bonds - thereby depressing the NAV. This isall legal; it’s all within the discretion of the manager. I wasreally angry and said, “You guys are ripping me off; youshould be consistent.”There's no real consensus on this issue. Some people wouldsay that if they have to sell bonds to give you your money, ofcourse they should value the portfolio on the bid sidebecause that's where they have to sell the bonds. If money’scoming in, they should use the offer side because they haveto buy bonds to invest that new money. In our case, Acuityalready had cash, so they really did rip us off. They just gaveus the cash they already had, didn't sell any bonds andvalued our portfolio on the bid side – so all the remaininginvestors benefited from getting someone out at a bad price.“Hedge fund investors shoulddemand transparency.”I would never have known this if I didn't have completetransparency. I sat with a trader on the convertible bonddesk at J.P. Morgan to figure it out. Most investors don'thave this level of insight, which is one of the reasons whyhedge fund investors should demand transparency. There isa lot wrong with the current open-ended fund structure. Anopen-ended fund is great for the manager, because you setup one fund and create the illusion of a discrete NAV whereeverything can get done with no friction.10/10/2012 Hedge Funds Roundtable“Investors delude themselves into thinking thatthey really have 30-day liquidity.”If they understood more, they would ask for transparency.But they don't even know to ask for it, because if you haven'tactually traded and incurred market transaction costs, it’snot a normal thing to think about.Insolvency Administrator: Beyond transparency, did youdraw some conclusions about corporate governance?“I think investors have very weak rights, and it'svery hard for investors to act in concert – or evenget a list of other clients from the manager.“Simon Lack: Investors will claim that they read the smallprint and the LPA, but you really pay attention to it onlywhen things go wrong. I think investors have very weakrights, and it's very hard for investors to act in concert – oreven get a list of other clients from the manager. In a publiccompany, you can have a proxy fight where everyone has allthe same information. But in a hedge fund, you can’t requirethe manager to communicate information that you'd like toshare with other investors in the fund.Prior to ‘08, few people really thought that governancerights would be that important. But in recent years, I’vebeen quite shocked. One manager we had took a portfoliothat had been suspended for two years and sold it to aprivate equity group at a third off the NAV that he hadpresented to us. The investors never had the opportunity tosay, “Before you sell that portfolio, can we at least considerfiring you and finding someone else to manage theportfolio?” This illustrated for me how much control themanagers have.The program continued with aRoundtable Discussion (Beginning on Page 7)iief.orgPage 6

“The differences between a corporate structure and the typical operations of ahedge fund have a significant impact on the rights of investors and managers.”- Investors’ CounselRoundtable Discussion:Moderator Allan Bell announced that Chatham House ruleswould be followed to encourage frank and open dialogue.Only the keynote speaker’s and moderator’s comments areattributed by name in this discussion summary.Roundtable topics: Fiduciary Standards Governing Hedge FundsHow To Get Out Of A Zombie Hedge FundClawbacks: The Law Post–MadoffInsider Trading And Hedge FundsValuation Issues: Can You Trust Your NAVFiduciary Standards Governing Hedge FundsInvestors’ Counsel: This issue has gotten a lot of attentionrecently, both in the Delaware courts and in some offshorejurisdictions – including the Cayman Islands and the BVIs.Hedge funds, as everyone knows, are a completely differententity than traditional equities; they’re either governed by aforeign law, or by Delaware LLP or LLC law.The differences between a corporate structure and thetypical operations of a hedge fund have a significant impacton the rights of investors and managers. Delaware's LLCprogram essentially allows all the rights to be contractbased, whereas the corporate structure imposes fiduciaryduties. The default rule under Delaware law is that a hedgefund manager has all the fiduciary duties that a director of acorporation has, but Delaware law allows you to eliminate orrestrict those fiduciary duties by contract.As the industry has grown, managers and the people whocreate hedge funds have become increasingly adept atdrafting clauses and restrictions on shareholders’ rights toeliminate their fiduciary duties. Let’s take Simon’s exampleabout a manager who sold the portfolio at a dramaticdiscount without consulting the investors.10/10/2012 Hedge Funds RoundtableUnder typical fiduciary duty law, there would be significantrecourse, depending on how the sale was done. But if theLLC agreement was drafted in favor of the manager, theinvestors are stuck. With offshore funds, investors’ rightsare essentially limited to seeking a wind-up or liquidation ofthe fund under Cayman or BVI law, and it's often harder todo that in the BVIs than in the Cayman Islands.How much do hedge fund investors actually pay attention tothe LLC agreement and the underlying laws? Do they fullyunderstand the limitations on their liability and responsibility– and the differences between the remedies and rightsavailable in an equity investment versus the rights availablein a hedge fund context? Investors could positively impacttheir investments by choosing more responsible LLCorganizations - rather than ones that essentially create ablack box with no remedies.“After the convulsion of 2008,I thought we'd see a big shift in LLP termsprotecting investors, but that hasn't occurred.”Family Office Advisor: I do strategy work with families andwealth management firms, am chairman of a majorAmerican not-for-profit and I served in a state legislature.After the convulsion of 2008, I thought we'd see a big shift inLLP terms protecting investors, but that hasn't occurred. Ieven thought there would be a populist movement in thelegislatures, but that hasn’t happened either. Hedge fundsstill seem to control the game.Investors’ Counsel: I think that’s because the person writingthe documents wants maximum flexibility. It's a race to thebottom, just as it was in corporate law back in the 80s and90s.Family Office Advisor:But Simon was able to gettransparency with the San Francisco fund in which heinvested 25 million.iief.orgPage 7

“An important shift has occurred in the last five years:over 90% of the assets in the alternative space are going to managers with 5 billion or greater in assets. ” - Fund CounselSimon Lack: That's because we were a seed investor andtransparency was non-negotiable. I think the reason whyLPs haven’t gotten better terms is that looking at thedocuments is the last thing investors do – and hedge fundsare not easily substitutable. Once you've selected a hedgefund and done all the investment analysis and research, thenyou review the offering documents and terms. It would beunlikely for an investor to say, “We like everything aboutyou, but we don't like the liquidity terms. If you won't give usthose terms, we’ll go with another hedge fund.” Maybeinvestors should start out by saying, “Here are the basicterms on which we invest; if you don't like them, we won'tdo any due diligence on you.” Investors are not doing that.Fund Counsel: At the SEC, I used to prosecute moneymanagers. I started a law firm and we represent over 800funds as well as investors. An important shift has occurred inthe last five years: over 90% of the assets in the alternativespace are going to managers with 5 billion or greater inassets.Last December, I worked on a 500 million allocation from astate government going into one manager. There are alimited number of managers large enough to take aninvestment of that size, so the big investors will investregardless of what the terms are. There's a large swath ofmanagers with whom they probably could negotiate muchmore friendly terms, but they’re not suitable investments byvirtue of their size. On the other hand, smaller investorswith 15-25 million are too small to have negotiating power.Family Office Advisor: You’re on to a big theme in my worldof family offices. While large families with 1 billion to investmight take a unit and invest it into an LP, it’s still a smallamount to some of these funds. There are no standards fordue diligence at the family office level. In fact, in contrast towhat you would think would be a movement towardstandardization, there is no real community emergence ofstandards in the family office world. There is actually amovement in the opposite direction.10/10/2012 Hedge Funds Roundtable“Investors may pay the fees buthedge funds are the real clients.”Simon Lack: Here's a true story. A very large hedge fundwas meeting with a big U.S. pension fund. The chief riskofficer of the hedge fund was presenting and the investorsaid, “We've been invested with you for two years, haveplaced 500 million with you, and I don't think you know myname.” The chief risk officer paused, left the room, cameback in and said, “I've been in this business 30 years, and noone's ever talked to me like that. You're going to apologizeto me right now.” The pension fund is still a client!That's why I went into the seeding business. In the 90s, Iinvested in big hedge funds as part of a proprietary portfolio.You have to put your kneepads on to become a client and Ididn't want that. I wanted to invest where I had a stronghand to negotiate. Don’t invest in a market where you havesuch a weak negotiating position; there’s a lot better thingsto do with your life.“When you buy a TV set, you don’t read the fineprint and say, ‘I don't like the way Panasonic limitsits legal liability, so I won’t buy a Panasonic.’ ”Institutional Investors’ Counsel: Unfortunately, it seemsthat investors deal with their hedge fund investments in thesame way. And that's why we need the protection oflegislative rules, because investors are not going to do it forthemselves. There need to be limits on how far funds can gointo abridging these rights.Fund Counsel: But isn’t that a slippery slope? Weunfortunately live in a world where people don't takeresponsibility for their own decisions, and sadly Dodd-Frankis going to make that worse. Investors expect registrationwill be a cure-all for fraud, and it's not. You need to knowwhat you're getting into and be willing to walk away fromthe deal.iief.orgPage 8

“Fairness should be a basic ground rule. But under the statutes now, you areallowed to eliminate even the most basic requirements for fairness.”- Investors’ CounselInstitutional Investors’ Counsel: Experience has shown thatinvestors are not going to adequately protect themselves.You have to have a default rule; the question is whether itwill be more protective or less protective of investors.Fund Counsel: There are rules in place; there are anti-fraudprovisions.Fund Counsel: I’d rather the government get involved ineducating investors. In the alternative space, accreditedinvestors make up just 8% of the entire population.Given that we’re in an environment where governmentseems to be growing, not shrinking, it’s a concern for me tohave government intervene further.Investors’ Counsel: There are some basic ground rules thatapply in normal business organizations that don’t have toapply in the LLP context.For example, I had a case several years ago in which the fundmanager transferred assets to the general partner. Underthe LLC agreement, they waived the manager’s fiduciaryduties and they argued that they also waived fiduciary dutiesto the general partner. And as a result, they argued, theasset transfer didn't have to be on fair terms to the fund orto the investors. We were able to argue that the agreementwasn't carefully drafted enough, and they wound up settling.Fairness should be a basic ground rule. But under thestatutes now, you are allowed to eliminate even the mostbasic requirements for fairness.Fund Counsel: One of the very basics of Delaware Law is toa

was one of the first to invest in hedge funds. In an interview recently with Reuters, he said that this is a make or break year for hedge funds, because the past five years have all been bad. When you put the five year returns into the mean variance optimizer, hedge funds will start to look a lot less attractive.