Gresham Partners, Llc Market Review & Outlook

2Q 09 Gresham Partners, LLC Market Review & Outlook 2009 Second Quarter

While some economists claim to see the beginnings of recovery in economic tea leaves, we believe we are in the midst of a long-term, systemic deleveraging that will take years to run its course. While the government necessarily focuses on stabilizing the banking system, the health of the U.S. consumer and the extent to which they deleverage their personal balance sheets will have a significant impact on the eventual course of the economic recovery. In this regard, the news continues to be bleak as consumer credit recently contracted at a rate nearly 8 times greater than analysts’ expectations. While the market reacted positively to the new Public-Private Investment Program and some are seeing signs of the banking system stabilizing and market volatility subsiding, we still face the question of whether these efforts will ultimately succeed. The scale of the existing programs already borders on surreal and the IMF now expects the eventual cost of credit losses to exceed $4 trillion, or nearly double the estimate of only several months ago. Our growing fear is that consequences of these solutions may be as toxic as the assets they were designed to eliminate. Longer term, we continue to believe that a reordering of the global economic and political landscape is underway, and possibly accelerating, given the U.S.’s current problems and their potential cures. We remain concerned that the stimulus programs and their increased debt burdens will debase our currency, increasing the chance that the U.S. dollar will lose its place as the primary global reserve currency, and place at risk the global purchasing power of our clients.

Gresham Partners, LLC Market Review & Outlook 2009 Second Quarter

First Quarter Market Summary U.S. markets increased nearly 9% in March, thereby reducing the overall first quarter decline to 10.8% as shown in Exhibit 1. At the end of the quarter, U.S. equity markets had declined nearly 40% over the prior twelve months. However, these declines hide the largest six-week equity market rally since 1938, which started in mid-March and continued into April. International equities performed similarly, declining 10.7%, with a strong dollar accounting for over 3% of this decline. The near parallel declines of international and U.S. markets masked large divergences among different regions of the world. The developed world, including Europe and Japan, led the decline by losing 14.6% and 16.6% respectively, while emerging markets, and China in particular, actually 
increased during the quarter. Overall, the bond market was roughly flat for the quarter. In a reversal of recent trends, high yield bonds were the top performer, increasing 5.0%, while intermediate Treasuries declined 5.4%. These movements appear to be consistent with the market’s perception of the government’s bailout efforts, which is one of increasing effectiveness and cost. Hedged strategies were flat during the quar-

Exhibit 1: Historical Market Performance 15% 10%

-10%

3.1%

0.6%

0% -5%

5.8%

4.1%

5%

-4.6%

-0.7%

-15%

-0.1%

-3.1% -10.8% -10.7%

-13.6% -13.1%

-20%

-0.4%

-17.2%

-25% -30% -35% -45%

-38.2%

-40% -46.5%

-50% -55%

5-Year

3-Year

1-Year

YTD

-------------------------Annualized-----------------------Russell 3000 MSCI AC World ex US HFR FOF Conservative Barclays Aggregate Bond

ter, appearing to stabilize after their worst year on record. However, we continue to be skeptical of reported numbers in this area. We do not have comparable data to include in Exhibit 1 for nonmarketable real estate or private equity markets. We continue to see a dearth of transactions in the area, making valuation difficult. Anecdotal information suggests both areas continue to weaken and, in some cases, values are down significantly.

Second Quarter

2009

unclear. We remain convinced that we are in the midst of a reordering of the global economic and political landscape, which is likely accelerating given the challenges in many developed country economies. Additionally, we are growing concerned that the scale and scope of the solutions to the current problems may be as toxic as the assets they are designed to eliminate.

Overview As we examine economic and capital market conditions, it remains helpful to divide our discussion into near-term issues related to economic growth and the government’s bailout efforts and long-term themes and concerns, some of which are a direct result of the current solutions. The credit crisis continues to erode the global economy at a rapid pace. Some economists claim to see green shoots of growth, which may signal a recovery or simply the deceleration of the decline. However, we continue to agree with analysts who believe we are at the beginning of a long-term, systemic deleveraging that will take years to run its course. While the economy will eventually stabilize, a return to the relatively high growth rates of the last few decades seems unlikely, at least in the next few years. The process of the government attempting to orchestrate the largest stimulus effort in history to combat a banking crisis, a declining economy and a deleveraging consumer is likely to create a volatile investment environment, alternating between cycles of fear and greed. While this environment is creating attractive opportunities, we remain cautiously positioned. The longer-term picture remains equally

Credit Crisis and the Economy With the recession moving into its 16th month, economists are searching for signs of recovery. However, if we are in the midst of a long-term, systemic deleveraging, economic growth may face headwinds for years to come. While the government necessarily focuses on stabilizing the banking system, the health of the U.S. consumer and the extent to which they deleverage their personal balance sheets will have a significant impact on the eventual course of the economic recovery. In this regard, the news continues to be bleak. Consistent with our belief that we are facing systemic consumer deleveraging, consumer credit contracted by $7.5 billion during the month of February or nearly 8 times analysts’ expectations. Exhibit 2 illustrates de-

Exhibit 2: Signs of consumer deleveraging are becoming evident in declining demand for loans.

Exhibit 2: Consumer Credit Experiencing a Sharp Decline 250 Consumer Credit Outstanding 6-month Change-annualized, SA, Billions $ 200

150

100

50

0

-50 1968

1971

1975

1978

1981

1985

1988

1991

1995

1998

2001

2005

2008

© Gresham Partners, LLC

2005 2006 2007

2002 2003 2004

1999 2000 2000

1995 1996 1997

1992 1993 1994

1989 1990 1990

1985 1986 1987

1982 1983 1984

1979 1980 1980

1975 1976 1977

1972 1973 1974

1969 1970 1970

Source: Bloomberg

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Market Review and Outlook

mand for consumer credit, which has declined significantly over the last few months. Additionally, U.S. unemployment continues to rise, with the first quarter expected to reach 8.5%, and consumer spending continues to fall, as evidenced by a 1.1% decline in March. In a broader context, the retrenching consumer is exacerbating already weak economic conditions. Corporate earnings continue to soften, contributing to the global economic decline. The World Bank recently estimated that falling demand in wealthy countries would produce the first yearly decline in world trade in nearly 30 years and the largest decline since the Great Depression. On a positive note, the U.S. government continues to demonstrate its willingness to throw everything at the problem. Most analysts believe the stimulus efforts will not end until well after the economic contraction slows. This may constitute our best hope and our greatest fear.

Exhibit 3: Over the last 30 years, increases in consumer spending have been built upon leverage.

Balance Sheet Recessions and Consumer Deleveraging It is worth revisiting the concept of consumer deleveraging to gain some perspective on the challenges we face. While it is tempting to draw on past recessions to predict the path of our current circumstances, there have been only a handful of recessions over the last 80 years from which to draw parallels. Moreover, this is not the typical business cycle recession. Rather, we are experiencing a balance sheet recession, fueled by the systemic deleveraging of consumer and banking balance sheets. Accordingly, we are wary of analysts’ predictions as to the length and severity of the downturn based on a few unrelated historical events. While the deleveraging process in financial institutions is well underway, consumer excesses that took years to build will likely unwind over a long period. Exhibit 3 shows that the buildup in private sector debt has tracked

Exhibit 3: U.S. Consumer Debt and Spending % of GDP

% of GDP U.S.

Private Sector Debt* (LS) Consumer Spending (RS)

72

220

68

180

64

140

60 *Excludes financial sector debt. Source: Flow of Funds

1950

1960

Source: © BCA Research 2009

3

1970

1980

1990

2000

Second Quarter

2009

consumer spending quite closely, illustrating Government Stimulus Programs that American households built a consider- As we discussed in our last Market Review, the able portion of their spending increases since U.S. Federal Reserve is expected to keep in1980 on borrowing. In the past, government terest rates low for some time. Additionally, officials have been able to stimulate spend- Federal Reserve Chairman Ben Bernanke is ing by simply making debt cheaper and more making good on his pledge to use “all available readily available. Reducing interest rates to tools” to contain the financial crisis. With no make debt more affordable is no longer an room to lower interest rates further, the Fedeffective option, as interest rates are essen- eral Reserve has expanded its balance sheet tially zero. at the fastest pace on record, more than dou Returning to a more normal balance to bling its size in the last few months (see Exhibit the ratio of household debt and personal in- 4, first panel) to purchase assets and provide come would require significant adjustments various guarantees. While turning on the spigto savings rates and consumption. One an- ots is necessary to stabilize the financial maralyst recently estimated that the return of kets and banking system, we will later discuss this ratio to its 1990’s average of 90% from our concerns that contracting the Fed balance its current 133% would require liabilities to sheet will be difficult given its declining quality fall by $4.7 trillion, equivalent to about one and lengthening maturity structure. third of U.S. GDP. The most important recovery effort that Recently, the National Bureau of Economic the U.S. Government announced during the Research (“NBER”) released an interesting first quarter was the Public-Private Investworking paper describing the aftermath of fi- ment Program (“PPIP”) designed to combine nancial crises and some of the common consequences that emerge. • Housing prices declined over 35% and declines continued for nearly six years. The curExhibit 4: Expanding the Federal Reserve rent housing price decline, measured by the Balance Sheet and Bank Reserves Case-Shiller index, is now 28% and we are just in the second year of the current decline. Tn.$ • Equity market declines are even steep- Tn.$ FEDERAL RESERVE BANK CREDIT 2.2 er, averaging 56% and lasting 3.5 years. The 2.2 current market declines did not (yet) reach this level and we’re only in the second year of 1.8 1.8 the drawdown. • Unemployment rates increase over 7 1.4 1.4 percentage points from pre-crises levels and last nearly 5 years before recovering to pre1.0 1.0 crisis levels. • On average, GDP declines a staggering 9.3%, but declines tend to be shorter Bn.$ Bn.$ than labor market corrections, lasting only 2 800 TOTAL BANK RESERVES years.
 W hile all the above statistics provide 800 sobering benchmarks for this crisis, the most 600 interesting aspect of the study showed that 600 real government debt, in the three years fol400 lowing the banking crises, increased an aver- 400 age of 86%. Interestingly, the cost of banking 200 system bailouts tends to be a minor contribu- 200 tor to the increased debt burdens, which were primarily driven by plummeting tax receipts 2006 2007 2008 2009 and large surges in government spending to fight the associated recession. It is this asSource: © BCA Research 2009 pect of these large financial crises that concerns us most.


© Gresham Partners, LLC

4

Exhibit 4: With interest rates near zero, the Federal Reserve has expanded its balance sheet to provide liquidity. Many analysts expect the increases to continue.

Market Review and Outlook

Exhibit 5: The VIX is indicating that the market has passed the recent panic stage, but volatility is expected to continue.

taxpayer money with private funds to buy real estate related loans and securities currently held by U.S. banks. Without using all the available space of this letter, the basic concept is as follows: the U.S. Government co-invests alongside private capital with significant non-recourse financing available through the Federal Reserve or FDIC Guaranteed Debt to leverage returns and increase prices for these assets at auction. While equity markets applauded the program, rather than the ad-hoc efforts of the past six months, many details are yet to be resolved. With a veritable alphabet soup of stimulus programs (AMLF, CAP, CPFF, MMIFF, PDCF, PPIP, TAF, TALF, TARP, TLGP, TSLF... and these are only the ones with acronyms!) combined with the rapid expansion of the Federal Reserve balance sheet through various programs, it is easy to lose track of all the initiatives. However, it is important to understand the magnitude of these programs, which already borders on surreal. Between guarantees, investment, recapitalization and liquidity provisions, Nouriel Roubini estimates that the U.S. Government has committed over $9 trillion to the stimulus effort. Additionally, most expect the Federal Reserve to expand its balance sheet by an additional $1 to $2 trillion in the coming quarters and the federal government to quadruple the annual fiscal deficit to $1.8 trillion or 12% of GDP in 2009, the highest ever for a peacetime economy. Consequently, U.S. Government debt and guarantees are expected to increase from 60% of GDP to over 100% of GDP. We have truly arrived at the beginning of what Byron Wien termed the 
“Age of Interventionism.” Is the Bailout Working? All this returns us to one central question: is the bailout working? On the positive side of the ledger, the stimulus efforts appear to have calmed capital markets, at least temporarily. Debt markets appear to have stabilized and equity markets staged a major rally in March and into April. One indicator of the equity market’s retracement to more normal conditions can be seen in the VIX, sometimes known as the Fear Index, which measures implied future volatility of U.S. stocks. The VIX recently retreated from its near all-time high of 80 in November to under 40 today (See Exhibit 5). Unfortunately, uncertainty remains

5

and we expect elevated volatility levels to continue as we work through the credit crisis and the unfolding economic recession. In the banking sector, we see signs of improvement, but we have a long way to go before lending conditions return to normal. With respect to the recently enacted PPIP program designed to remove troubled assets from bank balance sheets, two significant questions remain unanswered: • Will the banks be willing (or able) to sell assets and suffer a corresponding loss on their balance sheets? Most analysts believe that, despite the massive writedowns of the last few quarters, banks still carry many loans and securities at values well above prices that would be attained at an auction such as that envisioned under PPIP. For the healthier banks, this will require them to raise additional capital to offset these losses. Others may be unable to take the losses for solvency reasons. In the end, no amount of non-recourse leverage will create incentives for the private sector to bid on something that is worthless,

Exhibit 5: The VIX: Equity Market Volatility 90

80

70

60

50

40

30

20

10

0 90

94

Source: Bloomberg

99

03

08

Second Quarter

as is the case with many mortgage derivatives. Furthermore, the recent relaxation of mark-to-market accounting rules lessens the incentive for banks to sell assets if they can continue to hold them at inflated prices.
 • Will private enterprise be willing to participate in TALF related programs for securities? If recent past is any indication, many investors may simply pass due to tedious paperwork, fear of legislative and regulatory interference, curbs on hiring foreign workers and fear of the rules changing mid-game. Much of the liquidity already provided to the financial system has yet to make its way into the broader economy. Banks are hoarding money to heal their balance sheets rather than resuming lending activity (see Exhibit 4, second panel). Banks are unlikely to resume lending until the value of housing collateral stabilizes. This may not matter much as when banks are ready and able to resume lending, they may find themselves pushing on a string if demand for loans is declining and savings rates are climbing. Unfortunately, it is becoming clear that recent estimates of global bank losses have been underestimated. A year ago, analysts estimated that total losses would exceed $1 trillion. At the beginning of the year, most estimates were closer to $2 trillion. The IMF now expects total global credit losses to exceed $4 trillion and some analysts believe this number will exceed $5 trillion when the full extent of losses from Eastern Europe and the commercial mortgage backed security area are known. In aggregate, banks have raised substantially less than the capital required to offset these losses. On a related note, Nouriel Roubini’s recent analysis on the government’s stress test for bank solvency revealed that our current economic conditions – GDP growth, unemployment rate, and home price depreciation – already lag behind both the government’s “baseline scenario” and their “alternative more adverse scenario.” With the efficiency of the “test” in question, it is highly likely that most, if not all 19, banks will pass this now meaningless test. It appears that officials continue to play catch-up in their stimulus effort. In the near-term, we are mindful of these solutions and their effectiveness. Our concern is increasingly turning to the long-term consequences of the solutions themselves as the size of the bailout continues to climb.

© Gresham Partners, LLC

2009

Our Approach Revisited While we believe the risk of a financial system collapse has diminished, the range of possible outcomes remains wide. The truth is that no one knows where this crisis will lead and investing exclusively for one extreme or the other can produce disastrous results if the unanticipated scenario were to occur. While we always attempt to understand risk as a core aspect of our investment activities, this approach is particularly important in the current environment. It is worth noting again, that this difficult period has reaffirmed many of our investment principles: • Find Managers who Share our Risk Conscious Approach: It is important that these managers are fundamental in their approach, believing when they buy an asset that they are paying a fair price in absolute terms. One of the most important idiosyncratic risks for any asset is price. Good assets, appropriately purchased, typically do not lose money over time, although they may temporarily decline from the value at which you purchase them. In the current market environment, their approach is often manifested in the patience to wait for even more attractive investment opportunities, positioning portfolios with lower market exposures, and finding investments that will produce attractive long-term returns, while surviving interim market volatility. • Opportunistically Find Attractive Investment Areas: Based on our view of the world, which our managers significantly influence through their bottoms-up ideas, we seek investments that may benefit from, or mute, the effects of any major downturn. While the flexible mandates of most of our managers allow them to rotate into opportunities, occasionally, we will augment an existing exposure or add a new exposure that is outside the scope of our current manager set. Our partnership-oriented investment structure facilitates this opportunistic approach in shifting capital to these areas. Our short subprime debt investment and current rotation into distressed debt are recent examples of this opportunistic approach. • Keep an Open Mind: For lack of a more eloquent way to describe this principle, the frameworks of the past are useful only to a limited extent. One must continually test to ensure that past relationships will endure and be mindful of intellectual laziness that allows

6

Market Review and Outlook

false conclusions from outdated constructs. A rigid approach prevents the appreciation of events that make historical practices unlikely to succeed in the future. Many of our longerterm themes and concerns described below are based on changing paradigms, highlighting the risk of rote extrapolation. Current Positioning and Investment Opportunities We are unsure about direction and the valuation of many markets, given the uncertainty in earnings and cash flows that are highly dependent on both the short-term and long-term impact of bailout efforts. However, we do believe there are a number of attractive investment opportunities on which both we and our managers are focused. A world short of debt and equity capital, such as today, tends to be a point from which investors have realized unusually good returns in the past. Given our expectations for ongoing market volatility, our equity exposure remains relatively low through the combination of the conservative positioning of our risk conscious managers and our opportunistic allocations to non-traditional strategies such as distressed

Exhibit 6: Debt markets have more fully discounted bad economic news as shown by historically wide credit spreads.

debt. Several of our long-only equity and distressed debt managers maintain large cash balances to protect capital and wait for even better pricing. Many of our long-short equity managers maintain low or even net negative market exposure. Additionally, we recently implemented a protective options-based overlay strategy to provide “insurance” against a sharp and significant monthly market decline. Somewhat counter-intuitively, we believe our largest risk is the possibility of underperformance should a sharp rally in stocks occur, as happened at the end of March and beginning of April. More specifically, we continue to focus on areas of the capital markets that we believe provide attractive risk/reward opportunities, more specifically: • Distressed Debt: Many holders of debt securities have become distressed sellers, driving yield spreads on both low quality and higher quality debt to near historic levels (See Exhibit 6). If the economy weakens significantly as expected, we should have a “gold standard” opportunity in distressed debt. In preparation for this, for over a year, we have been building our stable of proven distressed

Exhibit 6: Corporate Credit Spreads %

%

U.S. High-Yield Index* Spread U.S. Speculative Grade Corporate Bond Default Rate**

18

18

16

16

14

14

12

12

10

10

8

8

6

6

4

4

2

1985

1987

1989

Source: © BCA Research 2009

7

2

*Source: Merril Lynch; Option Adjusted Spread **Source: Moody’s Investors Service

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Second Quarter

2009

debt managers. We feel our specialist man- Realignment of the Global Landscape agers in this area have greater transparency We agree with the growing number of econothan in equity markets and hard catalysts, mists and analysts who support the thesis that such as coupon payments, sinking funds and we are in the midst of a fundamental realignmaturity dates, which provide a firmer foun- ment of global economic influence, includdation for valuation and risk assessment. Ac- ing a gradual handoff to a set of developing cordingly, we are allocating assets otherwise countries that previously had little systemic earmarked for equity strategies to these eq- influence. Accompanying this shift is a pronounced, continued accumulation of financial uity-like opportunities. • Bank Stocks: Valuations for banks have wealth by these emerging countries that inbeen devastated given the distress in finan- cludes some more accustomed to being debtcial institutions, and the tendency of investors ors than creditors. The continued growth of to paint every bank with the same negative these financial resources, including sovereign brush in a panic. While we expect to see con- wealth funds, and their desire to diversify tinuing negative news on banks, including an capital more broadly, will lead to a shift away increasing number of bank failures, we be- from their current U.S.-centric fixed income lieve a manager with a specialist’s expertise investments toward a more diversified basket can identify and purchase “survivor” banks of assets across a broader array of countries, at very attractive prices. We have initiated a asset classes and currencies. slow and disciplined process with such a man- As global leaders recently met to discuss ager to buy regional and community banks solutions to the crises, it was an acknowledgement of the shifting economic landscape around the U.S. • International Equity: Our clients will that it was the G-20, with significant influence recognize that we continue to emphasize from the BRIC countries, who set the agenda. international equity over domestic equity. The BRIC countries, led by China, are becomWe describe the rationale for this emphasis ing more aggressive in seeking and receiving more influence in determining the new global greater later. • Municipal Bonds: The primar y fixed economic order. It is also important to note income investment for most of our clients that the IMF, a nearly forgotten body just a now yields more than taxable treasury bonds. few years ago, gained renewed clout (and While we think inflation will eventually be- funding), rather than relying on the traditioncome a larger concern, current yields seem al G7 institutions to lead relief efforts. to justify this risk. As a result, we have re- Relatedly, the engine of worldwide economduced our long-standing underweight to mu- ic growth will be less dependent on the U.S. nicipal bonds and high quality fixed income consumer. Instead, emerging markets will constitute an increasingly independent driver generally.
 of growth, as they further evolve their economies from export-oriented businesses toward higher domestic consumption. This trend is well underway and should accelerate in the coming years (See Exhibit 7 on the following page). Additionally, the U.S. economy, which Long Term Themes and Concerns While we remain concerned about current has long been overly dependent on debt-ficonditions and the ability of the U.S. govern- nanced consumption, will need to make the ment to stabilize the financial system, the much needed and long delayed adjustment time to think about investing for this environ- to create better global economic balance and ment was a while ago, and we did. The returns reduce its financial vulnerability. earned by our clients on shorts of subprime The current economic and credit crisis cendebt and the ability of our managers to limit tered in the developed markets is accelerating losses in recent difficult markets are evidence these changes. The U.S.–China relationship of this. Now, it is important for us to look for- is at the core of this realignment, but every ward and consider opportunities created by nation will feel the impact of the realignment. the current market dislocations and from the Over the last 20 years, the global economy was built on the tightly integrated, but enormously stimulus package itself.

© Gresham Partners, LLC

8

Market Review and Outlook

lopsided twin pillars of U.S. over-consumption and negative savings financed by China’s production and excess savings. As evidence of the growth of this imbalance, the U.S. trade deficit with China has grown eight-fold over this period and China is on the verge of overtaking Canada as America’s largest trading partner (see Exhibit 8). With the U.S. consumer at the beginning of a long trend of deleveraging and increasing savings, it is clear this relationship is about to change dramatically. Unfortunately, the current administration’s strategy, like past administrations, kicks these problems into the future by failing to address these imbalances. Worse yet, the current solutions appear to be exacerbating the problems by creating significant new domestic imbalances. While unlikely, the bailout may be fabulously successful and the developed world may return to its days of leveraged U.S. consumption. In this case, we would be perpetuating

Exhibit 7: BRIC economic growth is at the heart of the broader realignment of the global landscape.

the imbalances that led us into this mess, and the next crisis will be even worse. Thus far, the solutions have yet to address the elephant in the room. How Do We Turn off the Spigots? While many can argue that the current level of support is required to ensure that we avoid a banking system collapse, the concern now becomes how we exit. Given their size, the solutions may be nearly as toxic as the assets that still clog the balance sheets of many financial institutions. Many analysts expect the Federal Reserve to continue to expand their balance sheet to $4.5 trillion or more, which is more than five times the level seen before the crisis. While the magnitude of the expansion is troubling, the composition of the Fed’s balance sheet may prove to be more challenging when the economy stabilizes. The Fed has two options to reduce these holdings and corresponding bank

Exhibit 7: BRIC Economies Continue to Grow %

% Share Of Total World GDP* U.S. Japan Europe** BRIC***

26

26

22

22

18

18

14

14

10

10

6

6 1980

1985

1990

1995

* On Purchasing Power Parity basis, includes estimates. IMF data. ** Includes France, Germany, Italy and the U.K. *** Includes Brazil, China, India and Russia. BCA estimate for Russia prior to 1992.

Source: © BCA Research

9

2000

2005

2010

Second Quarter

reserves; they can either let the bonds mature or sell these holdings in the o 
 pen market. • Historically, the Federal Reserve primarily purchased short-maturity securities. Today, 78% of the Fed portfolio matures in more than one year. If the Fed needed to drain reserves quickly, it would need to sell securities in the open market. This may be challenging with a dearth of investment capital in the world and the likelihood that these sales would be competing with a government that will be issuing more bonds to finance a growing deficit. • The Fed, which normally purchases treasury bonds, has purchased a wider range of assets, much of which is not nearly as liquid. These bonds would be more difficult to sell in the open market. At best, it is difficult to calibrate policy 
efforts under stable conditions. It will be even more difficult to withdraw liquidity in the correct amounts at the correct time under more difficult circumstances. If history is any guide,

2009

it is likely the Fed will err on the side of caution far too long. The composition of the Fed balance sheet makes it even more unlikely that the Federal Reserve will get it right. Compounding this problem is the massive expansion of federal government stimulus programs. As we mentioned earlier, most analysts expect the 2009 annual fiscal deficit to exceed 12% of GDP and this could expand further as the recession reduces government tax receipts. As the deficit expands and government debt burdens continue to mount, the government will be left with few choices to cure these internal imbalances: • Default/Restructure: This seems to be an unlikely option, but some analysts believe the U.S. could be forced to restructure its debt obligations to delay principal payments. China, as the largest owner of Treasury bonds, would lead these discussions. • Raise Taxes/Lower Spending: Ronald Reagan once said, “The government is like a

Exhibit 8: China’s Trade with the U.S. % of Total

% of Total

U.S. Imports From Japan Canada* China*

24

24

20

20

16

16

12

12

8

8

4

4

*Shown smoothed

1975

1980

1985

1990

1995

2000

2005

2010

Source: © BCA Research 2009

© Gresham Partners, LLC

10

Exhibit 8: The integrated, but imbalanced, relationship that has driven ChinaU.S. trade will likely change over the coming years.

Market Review and Outlook

baby’s alimentary canal, with a happy appetite the developed world does not exist in many of at one end and no responsibility at the other.” these economies. We do not mean to suggest Raising taxes will be part of the solution, but that these economies have decoupled from the U.S. already has among the highest cor- the rest of the developed world. These counporate and personal tax rates in the world. On tries remain highly reliant on developed marthe spending side, unfortunately, government ket consumption, but many of these countries programs, once started, are notoriously dif- have surplus funds to create immediate and ficult to shrink, much less eliminate. Both of credible stimulus, as most have done to stimthese options have the unfortunate side ef- ulate domestic lending and the acceleration of fect of slowing economic growth just as we local consumer demand. The emerging counare likely emerging from the current reces- try governments prioritize economic growth over controlling inflation to lift their populasion, when the economy will be quite fragile. • Inflation: By allowing excess stimulus to tions out of poverty. They will not hesitate to remain in the system and the Fed to remain allow higher inflation, as their growth potenhighly accommodative, the U.S. will eventual- tial exceeds that of developed economies and ly begin to debase the dollar and, as we work can overcome periods of elevated inflation.
 off excess capacity created in the current recession, return to a more inflation prone en- The U.S. Dollar vironment. Inflation can be helpful as debt is The U.S. begins this journey with a relatively denominated in nominal terms, allowing the healthy balance sheet, as direct obligations government to grow (inflate) its way out if the of the U.S. Treasury are below 50% of GDP. problem of given enough time and latitude by However, these rapidly growing obligations, which some analysts expect will increase the our larger debt holders, China and Japan. U.S. Treasury’s obligation to well over 100% of GDP in the coming years, place pressure on Inflation Our fears of inflation are likely to be a lon- the government’s ability to finance its spendger-term consideration. In the near term, the ing and ultimately the U.S. dollar itself. cur
r ent recession is creating excess capac- A reserve currency is the result of a long ity and slack in various parts of the economy, economic evolution. The concept of a single reducing the possibility of near-term inflation. paper currency as an international store of While actual inflation may be further in the value is a relatively recent phenomenon. After future, we are working on solutions today. We World War II, the U.S. dollar was the cornerbase our concerns of future inflation on sev- stone of the Bretton Woods system, with the U.S. government essentially guaranteeing eral factors: • As discussed earlier, history suggests it fixed-rate convertibility into gold. Since the will be difficult to remove the unprecedented early 1970s, when Bretton Woods disintelevel of stimulus in a timely fashion. One key grated, the U.S. dollar has retained its central question that remains is whether this excess importance primarily due to a lack of compeliquidity translates to real goods and services tition. While other freely convertible curreninflation (i.e. CPI inflation) or simply reverts cies might be considered a reserve currency, to its bad habits from earlier this decade and the U.S. dollar is still dominant, comprising 64% of global reserves. For comparison purcreates a series of asset bubbles. • Over the last few decades, the world poses, the euro accounts for 25% and the yen has benefitted from the opening of global labor accounts for less than 5%. Recently, China’s markets, which despite one of the longest pe- central bank called for the creation of a new riods of synchronized global growth in history, global reserve currency to replace the U.S. led to structural disinflation. While the world dollar. Importantly, the IMF would control the will continue to benefit from labor market glo- new system so that it would be “disconnected balization, the shrinking wage gap between from individual nations and is able to remain developed and developing countries will pro- stable in the long run, thus removing inherent deficiencies caused by using credit-based vide less deflationary benefits in the future. • It appears likely that the emerging national currencies.” While it is unlikely in the economies may lead the global economy out near-term, the dollar is eventually likely to of recession, as the banking crisis that grips lose its unilateral dominance as the primary

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Second Quarter

global reserve currency, consistent with the realignment of global economic power we discussed earlier.
 Many analysts expect that, if the dollar were to lose its special status as the world’s primary reserve currency, it could lead to relative declines. However, this inevitable evolution could be a positive for the U.S. economy. Devaluing a currency is an appropriate response by a government to stimulate domestic demand. Recently, BCA Research summarized this dynamic succinctly by saying that “if the U.S. economy and its assets cannot be devalued through a falling dollar, they must go through a period of real depreciation through falling asset prices, declining wages, constricting profits and shrinking output.” While a declining dollar and its possible diminution of its status as the primary global reserve may be a positive for U.S. economic growth, we must be concerned about preserving the global purchasing power and standard of living for our clients whose assets are largely denominated in U.S. dollars. Implications and Our Approach These concerns and questions create the need to look ahead and explore methods of protecting capital and exploiting opportunities. Many of these are long-term considerations without clear and immediate solutions, but are worth noting to clarify our current thinking and communicate our areas of investment exploration. • U.S. Dollar Debasement: Our concerns about the devaluation of the U.S. dollar are particularly acute for our clients, whose assets are predominantly dollar denominated. With a goal of preserving global purchasing power, we are more aggressively exploring ways to eliminate residual dollar exposure within our international equity investments and develop an effective method of explicitly incorporating a short dollar exposure within client portfolios. However, currency markets are the ultimate zero sum game, and are often driven by factors other than fundamentals. Therefore, we approach this question with caution. If we are concerned about the debasement of the U.S. dollar, one question we must answer is debasement relative to what? Many other freely exchangeable fiat currencies are encountering similar issues, as they also face

© Gresham Partners, LLC

2009

larger deficits and growing bailout expenses. Recently, our discussions have evolved to include gold, as many investors still view gold as a quasi-money standard, despite the elimination of all formal linkage to currencies nearly forty years ago. In all likelihood, there will not be a singular solution to this challenge. • International Investors: We expect that U.S. investors’ portfolios will begin to look like other international investors, as we work through the continuing shifts in the economic and capital market landscape. Historically, international investors have lived with currency risk and investing in, from their perspective, non-domestic markets (including the U.S. market). Many U.S. investors felt they did not need to seek investment outside the U.S. markets, which were the largest in the world. 
E xhibit 9 shows the U.S. markets’ declining percentage of global equity markets. While U.S. markets outperformed international markets and temporarily reversed this trend in 2008, we expect this secular shift to continue. We describe our interest in international equities in more detail below. • Commodities: As consumers in the emerging economies adopt developed nation consumption habits, the world will have an

Exhibit 9: The global equity markets continue to diminish the U.S. market’s primacy. To an increasing degree, U.S. investors will become more internationally oriented.

25 Exhibit

9: U.S. Market Capitalization in Relative Decline

50

(%)

45

40

35

30

U.S. Market Cap 25 2004

2005

2006

2007

2008

2009

Source: Bloomberg

12

Market Review and Outlook

increased demand for infrastructure and re- Corporate Earnings Outlook sources of many types, including commodities. Current earnings forecasts remain subject Historically, our primary concern with invest- to massive revisions, rendering them nearly ing in this area has been the predominance useless. Exhibit 10 shows rapid declines for of momentum-driven and speculative strate- earnings forecasts for the last few quarters. gies that create bubbles and large drawdowns Most remarkable are the rapid declines over for investors. One positive is that the current rather short periods preceding each quarter, entry point seems much more attractive after highlighting the wide margin by which anathe commodity collapse during the second lysts continue to overestimate earnings. The good news is that the rate of decline appears half of 2008. • Interventionism: We have entered an to be slowing. age of unprecedented government interven- • Earnings forecasts continue to decline tionism that will lead to unexpected events, at a remarkable pace, such that future earncreating higher risk levels for all investors. ings estimates appear to be completely unreAdditionally, increasing economic power in liable. The estimated earnings growth rate for the hands of governments practicing state first quarter 2009 S&P 500 earnings is now capitalism and those who have shown that -38%. On October 1 of last year, the estimatthey are willing to change the rules of invest- ed growth rate was a POSITIVE 25% and as ing will only increase market volatility. Recent recently as January 1, the estimated growth examples are the U.S. government’s decision rate was -12%. to eliminate short selling in financial stocks • Downward earnings revisions are no and bailout certain industries and companies, longer limited to financials, as all ten sectors but not others, in part motivated by political in the S&P 500 are expecting year-over-year considerations. This increases volatility in the declines during the first quarter. markets and the risk of unforeseen outcomes • Second quarter earnings are now expected to decline over 32%, down from just by our managers. over -11% on January 1. Additionally, an unexpected headwind for corporate earnings is arising in the form of unfunded pension obligations. Similar to 2002, when interest rates declined (making pension Domestic Equities U.S. stocks declined nearly 11% in the first liabilities larger due to lower discount rates) quarter and were down nearly 40% over the and stock markets had fallen (making investlast twelve months. While declines may con- ment portfolios worth less), unfunded pentinue, it appears we have passed an acute sion liabilities are exploding. Early estimates phase of financial system peril and the market by analysts place the incremental short fall in may begin its fitful digestion of fundamental the hundreds of billions of dollars. Unfunded information, much of which may not be posi- liabilities are an additional claim on corporate tive. We expect that the market will remain assets at a time when many balance sheets highly volatile and even exhibit surprising are coming under pressure. Additionally, signs of strength at times. However, the fun- companies will need to increase annual plan damental economic challenges we face will contribution expenses to close the gap unless the U.S. government steps in to offer some likely take years to work through. Currently, we believe our greatest near- form of relief. This is not positive for future term risk is that the challenges are not nearly earnings.
 as great as we expected and the stimulus efforts work with great and rapid effect, caus- Valuation ing a strong rally in equity markets. Given our Valuation remains difficult to assess due to unconservative positioning, our equity strate- certain corporate profit expectations. Based gies would almost cer tainly lag in such a on analysts’ current full year 2009 earnings turnaround. In fact, due to the strong equity estimate of just under $60 for the S&P 500, markets of late March and April, many of our the stock market is trading between 13x and equity strategies have expectedly lagged dur- 14x earnings. On a positive note, this is still slightly below ing this 
period.

13

Second Quarter

2009

Exhibit 10: Declining Corporate Earnings Estimates 60.0%

40.0% 4Q08

20.0%

-0.0%

-20.0% 1Q09

-40.0%

4Q08

1Q09

-60.0% 19-Sep-08

10-Oct-09

31-Oct-08

21-Nov-08

12-Dec-08

2-Jan-09

23-Jan-09

13-Feb-09

6-Mar-09

27-Mar-09

17-Apr-09

Source: Bloomberg

the long-term valuation averages. Addition- other words, these markets have more agally, during difficult periods, price-earnings gressively discounted negative economic and ratios have typically been higher as the mar- business trends. Accordingly, we have shifted ket tends to discount “trough earnings” with significant equity capital to the distressed some expectation of a rebound. In the ten debt markets. market corrections since 1962, most trough multiples have been in the 10x – 15x range. Based on this information, one might conclude the stock market is fairly valued. On the other hand, the 1974 and 1982 trough International Equities multiples declined to roughly 8x trough earn- Foreign stocks performed similarly to U.S. ings. Additionally, some analysts believe we stocks during the quarter, declining 10.7%. have not yet reached trough earnings, with The dollar’s appreciation reduced returns estimates on the lower end reaching the $40 to U.S. investors by over three percentage to $45 range. If this were the case, the cur- points. The nearly parallel performance of inrent market, given the recent run-up, would ternational equity markets masked large divergences in returns among different regions be trading at nearly 20x. The truth is that no one knows if the mar- in the world. The developed world, including ket is cheap or rich given all of these uncer- Europe and Japan, led the decline by losing tainties. However, we feel that our current 14.6% and 16.6%, respectively. In contrast, managers are finding attractive investment emerging markets, in particular China, led opportunities at valuations that, regardless of international equity markets and actually innear-term market volatility, will perform well creased during the quarter. in the long run. It is worth reiterating that both we and our managers continue to view Opportunities and Relative Valuation the debt markets as having better transpar- Our continuing preference for foreign stocks ency and valuations than equity markets. In over U.S. stocks rests on several factors. The

© Gresham Partners, LLC

14

Exhibit 10: The rapid declines of estimated corporate earnings has been staggering. Recently, the rate of decline appears to have slowed.

Market Review and Outlook

long–term trend toward a new world order should favor international over domestic investment. As a natural outcome of this transformation, the opportunity set and the portfolio positioning of U.S. investors will continue to incorporate foreign investments to a greater degree. In addition to these broader structural changes, international equity markets remain generally cheaper than U.S. markets, trading at a 10%-20% discount. While risks to investors can be higher outside the U.S., and in some cases much higher, it is our belief that very experienced and risk conscious managers can effectively navigate such risks. The higher potential growth rates of the Asian ex-Japan countries and many other emerging economies provide wind at the backs of long-term investors. While these economies did not “decouple” the way many analysts anticipate, the BRIC countries will largely avoid the headwinds of structural deleveraging that developed economies face and benefit from a shift to a more balanced economy, driven

Exhibit 11: While G6 money velocity collapsed due to a clogged financial system, BRIC money velocity is accelerating, indicating stimulus efforts are working through a functioning financial system.

by increasing domestic demand. In fact, most analysts believe some BRIC economies are already beginning to show signs of recovery. Exhibit 11 shows that the velocity of money in BRIC economies did not suffer the abrupt declines associated with developed market banking crises, providing more stable monetary footing on which to recover. In addition to our expanding interest in international equity markets, we will also likely expand our interest in emerging markets at the expense of developed market international equity exposure if current trends continue. China We agree with those who believe that the industrialization of China and the emergence of its consumer class will rank as the world’s foremost economic change over the next few decades. As China becomes less reliant on exports and their rapidly expanding consumer class increasingly fuels growth, it should become a more stable economy. While China has

Exhibit 11: Money Velocity

Money Multiplier* BRIC** (LS) G6*** (RS)

13 10

12 9

11

8 10

9

2000

2002

Source: © BCA Research 2009

15

7

* Shown as M2 money suply relative to MO. ** Includes Brazil, Russia, India and China. *** Includes U.S., Japan, U.K. and euro area.

2004

2006

2008

2010

Second Quarter

a closed political system, it has a highly entrepreneurial culture with an increasingly vibrant society. At this point, these opportunities still involve high risks and can often be illiquid. However, we believe the potential for higher growth and profitability justifies the risks of long-term investments. Despite recent gains, valuations in the Chinese markets present the opportunity to capture higher growth rates without paying significant premiums. We expect to continue to increase our long-term exposure as we become more comfortable with the Chinese markets and managers. Japan From a valuation standpoint, Japan is the most attractive market in the developed world. For a number of years, we have been attracted to the valuations available in the Japanese markets. Unfortunately, valuations have remained cheap and became even cheaper. Exhibit 12 shows the market is now trading at a discount to book value, which is nearly a 30% discount

2009

to the global average. A number of companies are now trading below the level of cash on their balance sheet. We expect Japanese headlines to remain negative, as U.S.-dependent exporters struggle, but opportunities exist as corporate governance improves and ties to a growing China strengthen.

Bond Markets While U.S. Treasuries were the big winner in 2008, we experienced a bit of a reversal during the first quarter, as high-yield bonds produced a positive 5% return to offset the 5% decline of intermediate Treasuries. Municipal bonds continued to provide investors with positive, albeit modest results, increasing just over 2%. Importantly, it appears that the forced selling of the last few quarters is, at least temporarily, over and some stability has returned. However, we have not seen a

Exhibit 12: Japanese Equity Valuation

Japan Price to Book Ratio*

5

5

4

4

3

3

2

2

1

1 NOTE: MSCI Inc. DATA

1980

1985

1990

1995

2000

2005

2010

Source: © BCA Research 2009

© Gresham Partners, LLC

16

Exhibit 12: Japanese stocks remain the cheapest developed market in the world… and have recently become even cheaper.

Market Review and Outlook

rush of capital enter the market to buy heavily discounted loans and bonds. At best, the market has achieved some form of uneasy equilibrium.
 While the higher-yielding segments of bond markets appear to have stabilized and even improved slightly, credit spreads are still quite wide. At the end of the first quarter, high yield spreads remain nearly 1700 basis points up from 850 basis points at the end of the third quarter (see Exhibit 6). S&P predicts the default rate will climb from the current 5.5% to 14% within the year. However, current market prices, according to some analysts, imply nearly half of all companies in the U.S. will default over the next five years. This is a dramatically darker view than implied by equity markets and why we tend to favor debt markets in the current environment.

Municipal Bonds Municipal bonds have stabilized, after a bout of forced selling from leveraged closed-end funds and other municipal hedge funds. Municipal bond yields exceed those of comparable maturity Treasury bonds, despite their tax-free status. The absolute level of municipal yields provides some degree of insulation against our longer-term inflation fears and could provide appreciation potential in the short run if we enter a deflationary period as the global economy slows.
 As always, we remain focused on high quality bonds, as these yields may be partially due to investor perception of increasing credit risk as state and local budgets face massive deficits and potential defaults. We have seen seismic structural shifts in the municipal bond market, as municipal bond insurers, who once accounted for over 50% of outstanding issuance, were discredited and downgraded. We believe this shift provides a greater opportunity for active management to add value through original credit analysis within a municipal bond account. Recently, we partially reversed our longstanding underweight in fixed income, which we initiated in 2003 when yields hit what, at the time, was a 40 year low.

17

Hedged Strategies Hedged strategies were flat during the first quarter, rebounding from their worst year on record. History has shown that periods of poor performance in hedged strategies usually precede above normal returns, as spread relationships in arbitrage-type trades tend to exhibit strong reversion tendencies. Given the magnitude of the outflows and the significant reduction of risk seeking capital around the world over the last few quarters, we expect the reversion process to take some time. Late last year, the industry suffered from massive redemptions that created panic selling in securities that were crowded with hedge funds, exacerbating losses in a selfreinforcing cycle that caused further hedge fund selling. This is a symptom of too much money invested in the area. According to one hedge fund research group, the global hedge fund industry had $2.6 trillion of assets at the beginning of 2008. The same group estimated hedge fund assets would decline to well under $1 trillion by the end of 2009. Some analysts estimate that, if the disappearance of bank proprietary trading desks is included, risk-seeking capital available for investment has declined 90%. In the near-term, the industry may continue to experience outflows, as investors are dissatisfied with recent performance and less willing to tolerate reduced liquidity and paying incentive fees. Many expect a large number of hedge funds and funds-of-funds will close, while others will suffer significant reductions in assets. In fact, the exodus has already begun, as hedge fund-of-fund assets declined last year for the first time since 1996. We may not know for sometime whether this represents a secular change in the industry that may restore some of the very attractive risk/ reward characteristics investors enjoyed in the 1990s or simply a cyclical hiatus. However, we believe that the hedged strategies area may be more attractive, at least for a while.
 We remain concerned that returns in this category are systematically more correlated to other major asset classes, reducing the diversification benefit provided to investors. However, with the reduction in capital, many managers will operate with smaller asset bases, allowing them to return to exploiting niches left as commercially unattractive when asset gathering was simply easier to accomplish

Second Quarter

than investment performance. The pendulum may have shifted back in favor of the investor.



Real Estate Unfortunately, the real estate indices we often quote are now useless. The NCREIF property index is particularly unhelpful given its backward looking appraisal-based methods, which incorporate new trends slowly. Even transaction-based indexes, which more quickly reflect price changes, are unreliable as transaction volume is at the lowest level in more than 15 years. As a result, our conversations with real estate professionals may provide better insight into market developments. Real estate operating fundamentals appear to be softening to various degrees in all sectors. Anecdotally, weakness is clearest in the hotel and retail sectors. Additionally, office vacancy is accelerating, with reports of 1% per month increases in economically sensitive areas such as New York. Cap rates appear to have increased significantly. One indicator is the cost of capital for publicly traded REITs, which are issuing debt and equity at rates that exceed 10%. One market participant believes these rates are too high and reflect some ongoing market distress, but agrees that cap rates have increased several points. Given this limited data, investors, who purchased properties at low cap rates and were highly reliant on debt financing to pay historically lofty prices, may face property value declines of 40% or more. Recently, the John Hancock Tower, arguably New England’s trophy commercial office property, traded at about half the price paid in 2006. While real estate continues to gain credibility as a mainstream asset class, many investors likely underestimated the impact of leverage on returns and the illiquidity associated with the asset class. The result are that many institutional investors are over-allocated with little prospect of near-term realizations. We expect to see the trend toward institutionalization to continue, but slow significantly as many investors have limited capacity to make additional commitments. In general, we like our position in commercial real estate. The frothy markets of recent

© Gresham Partners, LLC

years resulted in well below target investment levels for our clients due to a high rate of sale and a reluctance to chase rising prices by our risk-conscious managers. As a result, we have large unfunded commitments in the hands of very accomplished managers in an environment where pricing is becoming significantly more attractive for purchases. The most attractive opportunities in the near-term will likely arise through the debt markets as refinancing needs create a catalyst to force sales at attractive prices.

Private Equity Similar to real estate pricing, the appraisalbased data from private equity indices is largely useless now. Prices have undoubtedly declined, but with limited transaction activity, valuations are difficult to determine. Pricing for all transactions continues to decline and equity valuations for large buyout funds have become particularly vulnerable, given the significant leverage and the high prices paid in these deals. Investor interest in this area has declined significantly, given the over-allocation of institutional investors and the magnitude of price declines now being reported to investors. The secondary market continues to provide attractive opportunities, but not without risk. Buyers who purchased secondary interests at record discounts late last year may find themselves underwater when their next appraisal
comes from the general partners of these funds. The liquidity needs combined with investor over-allocation continues to drive distressed sales. While our portfolios have not been immune to markdowns, our insistence on avoiding the large buyout area appears to be paying some relative benefits to our clients. In the coming months, we expect to increase our commitment to the secondary market for private equity. Relatedly, we recently purchased a secondary market interest at a 100% discount in a fund we respect and have followed for a number of years. In other words, we received the underlying investments, in exchange for assuming the (admittedly significant) remainder of their capital commitment, for free.

18

2009

Summary The credit crisis continues to erode the global economy at a rapid pace. Some economists claim to see green shoots of growth, which may signal a recovery or simply the deceleration of the decline. However, if we are in the midst of a long-term, systemic deleveraging, economic growth may face headwinds for years to come. While the economy will eventually stabilize, a return to the relatively high growth rates of the last few decades seems unlikely, at least in the next few years. In the near-term, real questions remain about the effectiveness of the bailout and stimulus programs. The longer-term picture remains equally unclear. With a veritable alphabet soup of stimulus programs combined with the rapid expansion of the Federal Reserve balance sheet through various programs, it is important to understand the magnitude of these programs, which already borders on surreal. Unfortunately, it is becoming clear that recent estimates of global bank losses are low. The IMF now expects total global credit losses to approach $4 trillion and some analysts now believe this number will exceed $5 trillion when the full extent of losses from Eastern Europe and the commercial mortgage backed security area are known. However, it appears the government remains willing to throw everything at the problem. We are concerned that the scale and scope of these solutions to these problems may be as toxic as the assets they are designed to eliminate. Despite these concerns and ongoing uncertainties, we believe investment opportunities exist in several areas of the market: • While deflation may be the short run concern, we remain concerned about the potential for higher inflation further out. Despite this, we believe intermediate municipal bond yields adequately compensate investors. As a result, we have partially reversed our longstanding underweight in fixed income assets. • The problems in credit markets have created many attractive opportunities that our managers are exploiting. In many ways, given the hard catalysts and attractive valuations in this area, we find the corporate debt markets more attractive than the equity markets. Accordingly, we have allocated equity-oriented capital strategies away from traditional equity toward distressed debt investments

• We continue to emphasize foreign stocks over U.S. stocks. The rapidly growing emerging markets, especially the BRIC countries, offer attractive valuations, despite recent performance gains, and have the highest potential for earnings growth in the future. Our interest in China is an example. Additionally, our interest in Japan remains high, as it remains the cheapest market in the developed world. • Despite hedged strategies experiencing its worst year in 2008, we believe current spreads provide investors with a good opportunity over the coming quarters. We are still waiting to see if outflows in this area are the beginning of a secular unwinding of investor interest or simply a short-term reaction to recent performance and scandals. • While data for the real estate market is still somewhat thin, it is clear that both valuations and operating fundamentals continue to decline. We remain comfortable with our large unfunded commitment in the hands of experienced managers who patiently wait for better pricing as the market appears to be developing into one of the better real estate investment environments in years. • In private equity, valuations are declining, but like real estate, transaction volume is still low, decreasing the reliability of the data. Investing in the secondary market may be the most attractive opportunity, as many investors find themselves struggling to create liquidity and find themselves over-allocated to the area. • We and our managers remain conservatively positioned given our view of the uncertainties that remain in the global economy and capital markets. Currently, we believe our largest risk is that the performance of our equity strategies would lag during a sharp and sustained market recovery. • Longer-term, we are concerned that the solutions to the current problems fail to address the basic global imbalances that created the current problems. Worse yet, these solutions appear to be creating a new set of domestic imbalances. We are actively pursuing suitable ways to protect the global purchasing power of our clients, that may include hard assets, commodities and further increases in international investments. © 2009 Gresham Partners, LLC All Rights Reserved.

Gresham Partners, LLC | 333 W. Wacker Dr. Suite 700 | Chicago, IL 60606 | P 312.960.0200 F 312.960.0204 | www.greshampartners.com