Event-Driven Strategies in Hedge Funds: Insights from Ezra Zask’s 2005 Discussion

1. Event Drive Hedge Funds Ezra Zask October 24, 2005

2. Event Driven Strategies • Bankruptcy (in and out of…) • High Yield/Distressed • Credit Swaps • Corporate reorganization; restructuring • Fundamental change in business environment; competition • Lawsuits; legislation • M&A • Structured Bonds (Mortgage Backed Securities)

3. High Yield/Distressed Debt Investing

4. Fixed Income Markets and Funds

5. Fixed Income Strategies • Relative Value • Long debt of one company and short debt of another in same industry; US and International • Capital Structure Arbitrage • Long municipal debt, short corporate debt • Long senior debt, short subordinated • Long high yield, short equity • Long 1 year short 10 year of same company • Event Driven • Relies on catalyst to release value • M&A arbitrage • Bankruptcy or exit from bankruptcy • Corporate restructuring, exchange offers, recapitalization, asset sales, debt buyback • Ratings trigger downgrading from investment to high yield • Credit/Distressed • Relies on mispricing of security risk • High yield • Corporate credit arbitrage • Distressed securities (debt and equity) • Directional Long/Short • Long • Safer end of distressed (between high yield and distressed) • Secured Financing • Loan syndicated debt • Short negative credit view of industry of issuer

6. Spectrum of Fixed Income Investing

7. Trade Strategies and Risk

8. Global Fixed Income Market

9. Credit/Distressed/High Yield Sector Opportunities • Stable credit markets and economic growth • Lack of integration across credit spectrum (inflection points) • Investment to high yield • High yield to distressed • Across capital structure • Across term structure of debt in a company

10. Correlation of Monthly Returns1991-2004 • Notes: • ML High Yield Master Index • ML 10 Year Treasury Index • ML Mortgage-Backed Index • (4) ML three-month Treasury Index • ML High Grade Index • (6) Wiltshire 5000 Stock Index

11. Benefits of High Yield and Distressed Investing • Capital appreciation and high current income • Diversified returns from various asset classes • Market liquidity • Lower volatility than equities, other

12. High Yield Investment Thesis • Record new capital inflows, migration from other asset classes • Interest rates near four decade lows • Search for yield, income • Rising rates hurt Treasury/Corporate debt • Default rate in decline after 2002 peak • New issue market biased to stronger credits • Improving corporate balance sheets, corporate governance, disclosure • Increase presence of commercial banks in underwriting and trading

13. High Yield Investment Thesis (Continued) • HY market remains inefficient • Long only charter of majority of investor base • Limited price transparency • Price sensitivity to funds flows • Dealer dominated market; liquidity “gaps” • Market not integrated to other parts of the capital structure

14. State of High Yield Distressed Markets • Historically low spreads • Near record level of issuance • Default rate in 2004 fell from 3.2% to 1.2% • Long term average of 4.4% • 1994-1998 average of 2.1% • Credit quality of new issues deteriorated by ratings, leverage and coverage ratio • Maintain discipline in high lead; leads to opportunities in distressed

15. Definition of Distressed Investing • Undervalued, under followed, out of favor of oversold securities • Small to middle market companies • “Distressed” segment • Companies in or near reorganization and/or default • Undervalued securities trading at deeply discounted prices resulting from severe financial, operational or economic problems • “Stressed” segment • Under followed or out of favor securities trading at discounted prices resulting from cyclical or sector downturns, financial stress and uncertainties

16. Distressed Debt Opportunities • Low interest rates, thirst for yield and improving economy led to record issuance of junk bond and leveraged loans in 2003-5 • Combined with mortality rates will yield high supply of distressed

17. Credit Markets and Credit Derivatives

18. Market Forces Change the Rules of Credit Investing • Equity declines drove re-allocations to fixed income • Simultaneously government yieldsdecreased to all time lows • Credit default rates neared all time highs • Pension fund shortfalls (Focus on ALM) • Credit markets are increasingly complex • Universe of assets is expanding rapidly • Spread products are becoming more complicated • Limited headcount to cover expandingnumber of issues

19. Currently Very Few Easy Opportunities • End of the bear credit market in 2003 • Spreads have tightened to extreme levels • Lowest since 1998 • Demand still high • Non-traditional investors Source: S&P

20. Outperformance Is More Demanding Than Ever • Are we being correctly compensated? • Risk premium close to zero • How does a long-only investor win/outperform? • Spreads have nowhere to go • Move to • Lower-quality / higher-yielding • Find names with value still • Asset selection is key

21. Discussion Outline • Recent market environment • New market-implied techniques to manage credit risk • Introduction to the BDP (Barra Default Probability) • Practical Examples • Questions and answers

22. Market-Implied Measures Provide Additional Insight Market-implied measures from the: • Equity Market – Barra Default Probabilities (BDP) • Bond Market – Barra Implied Ratings (BIR) • Derivatives Market – Credit Default Swaps (CDS) Coming soon… Crossover – Empirical Credit Risk (ECR) Equity Risk Implied Spreads (ERIS)

23. Merton’s Structural Model of Default • Default occurs at debt maturity if the firm valueis below the liabilities value • We thus need • A model of firm value process • Estimate of default point • Merton identified equity as being long a call option on the firm value • Merton identified a bond as being short a put option on the firm value

24. Merton’s Structural Model of Default No Default V0 D Default Probability of Default T 0

25. Agenda • The Credit Market • Single name credit • Correlation products • Latest Innovation • Risk Vision

26. Agenda • The Credit Market • Single name credit • Correlation products • Latest Innovation • Risk Vision

27. The Market of Credit • Size and sophistication of market has grown enormously • Notional exceed $2 trillion • Single name (CDS, CLN) to full blown portfolio based instruments (FtD, Synthetic loss tranches, CDO squared) • Initially used by bank loan managers to hedge • Now: insurance companies, hedge funds, asset managers, etc

28. Credit Derivatives • Instruments whose payoff is a function of a reference assets credit characteristics • Transfer the ownership of credit risk between buyers (of protection) and sellers (of protection) • Diversification, yield enhancement • Credit risk is traded independently of the instruments that generate the risk

29. Agenda • The Credit Market • Single name credit • Correlation products • Latest Innovation • Risk Vision

30. Single Name Credit Modelling • Structural approach: default when the company asset value is less than its liabilities • Spread relies on the internal structure of the company • Can’t exactly fit a spread curve and can’t be used to price complex credit derivatives • Reduced-form approach: the credit process is directly modelled via its probability of occurence • Flexibility to fit a spread curve and extendable to price complex credit derivatives

31. Credit Default Swaps • Most common credit derivative (over 50% of the market) • Provides protection against default of a reference entity (isolates credit risk component) • Protection buyer retains market exposure of reference entity • Protection seller gets leveraged exposure to reference entity

32. Agenda • The Credit Market • Single name credit • Correlation products • Latest Innovation • Risk Vision

33. Correlation Products Modelling • Contracts that reference the default of more than one obligor • One of the fastest growing areas of credit derivatives • nth-to-Default Baskets • CDO’s (static, managed, synthetic etc) • Methodologies used to price these instruments • Default-time simulation (Normal, t, Archimedean copulas) • Semi-analytical approach • The normal copula is the “benchmark” model for multi-obligor credit derivatives

34. Collateralised Debt Obligations • Application of securitisation technology • Synthetically transferring assets off balance sheet via credit derivatives • Asset pool is divided into tranches • Tranches have different risk/return characteristics • Payment to tranches is subordinated • Risk on a CDO arises from the loss distribution of the underlying asset pool • Characteristics of individual underlying’s • Joint correlated behaviour of underlying’s

35. Agenda • The Credit Market • Single name credit • Correlation products • Latest Innovation • Risk Vision

36. Latest Innovation • CDS options • Default Swaptions • Credit Default Swap Index (Trac-x, iBoxx) • CDO squared • Option on CDO tranches • Constant Maturity Default Swap (CMDS)

37. Growth of Credit Default Swaps

38. Special Situations/Events • Identify Drivers/Destroyers of Value • Overcapacity • Cyclical downturns • Rising raw material costs • Outsourcing manufacturing and service • Elimination of trade/tariff barriers • Aging populations in developed nations • Extraordinary events • Re-capitalization • Restructurings • Liquidations • Spin-offs • Management Changes • Contests for Control; Proxy Contests • Stock Repurchase; Special Dividend • Business Repositioning • Regulatory review/investigation

39. Credit Analysis • Net income is not cash • EBITDA • EBITDA/Interest Expense • Long Term Debt/EBITDA • (EBITDA-Capital Expenditures)/Interest • EBITDA/Revenues • Interest Expense • Capital Expenditures • Free Cash Flow • Long Term Debt • Debt Repayment Requirements • Qualitative Analysis • Quality of management • Equity sponsors • Event Risk (Consolidation; IPO; Technology or Regulation issues; Refinancing • Cyclical vs. Defensive industry • Ranking and Capital Structure • Bond Covenants

40. Examples of Multi-Strategy/Event Funds

41. Examples of Multi-Strategy Funds • Concordia • 25% to distressed, 12% to credit relative value and 11% to volatility arbitrage. • Wexford • 35% net long high yield against which they are carrying a 15% duration weighted short in treasuries and a 25% long position in the distressed book; 25% net long special situation equities. • Deephaven • 30% in relative value equity, 25% in convertible arbitrage, 20% in event driven, 10% in distressed/ capital structure arbitrage, 5% in global macro and 5% in credit opportunities.

42. Etolian Capital Credit Arbitrage

43. Kellner DiLeo Cohen & Co • Investment Strategies (market neutral) • Merger Arbitrage Fund • Convertible Arbitrage Fund • Distressed and High Yield Securities Fund • Special Situations Fund • Multi-Strategy Fund • 40% Distressed/high yield • 23% Convertible Arbitrage • 27% Merger Arbitrage • 10% Special Situations • Investment Professionals • CIO • Three Portfolio Managers • Four analysts Distressed Analyst • $600 mm under management

44. Pinewood Capital Partners • Long, short and long/short positions in high yield & investment grade debt, commercial and industrial loans, municipal bonds and exchange traded and OTC derivatives • Staffing • CIO • Director of Reseach + 3 analysts • Head Trader • Risk Manager

45. Dickstein Partners • Event Driven Situations • Merger Arbitrage • Distressed/High Yield Securities • Event Driven Strategies • $450 Capital • Six Investment Professionals

46. Dickstein Partners

47. Canyon Capital

48. Canyon Organization

49. Canyon Credit Culture

50. Canyon Capital