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INVESTCORP

INVESTCORP ENVIRONMENT REPORT

SECOND QUARTER 2015

Lionel Erdely

Head and Chief Investment Officer

of Hedge Funds

Rebecca Hellerstein, Ph.D.

Head of Cross-Asset Investments

Cross-Asset Investments Team

Vincent Berthelemy, Todd Groth,

Yi Lu, Ph.D., Angela Leson

INVESTCORP Investcorp Environment Report | 2nd Quarter 2015

Table of Contents

Page

Section I: Overview 1

Section II: Global Macro and Markets 5

Section III: Alternative Beta 11

Section IV: Hedge Funds 17

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I. Overview

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Overview

We are delighted to introduce this new and

expanded edition of the Investcorp Environment

Report. Investcorp’s investment strategy has

historically been driven by our proprietary

research. For over a decade, the Hedge Fund

group has undertaken in-house quantitative

research across all major hedge fund and

Alternative Beta strategies. Starting in 2004, our

“Alpha Project” platform built out a proprietary

framework of systematic indexes to assess the

impact of potential or existing managers on our

fund-of-funds portfolios. We also used these

indexes to benchmark whether managers were

adding the requisite alpha or instead relying on

passive exposure to systematic risk premiums for

returns. This Environment Report takes selected

outputs from these internal models to illustrate

how we use these systematic risk premiums in our

investment process.

Other changes to this edition include broadening

the report’s focus out from hedge fund strategies

alone. We now include an in-depth analysis of the

outlook for the global macroeconomic

environment as well as for traditional beta

markets. We have also introduced a new section

analyzing the environment for Alternative Beta

risk premiums. The structure of this new edition

thus reflects our internal investment framework

that treats risk premiums as the fundamental

building blocks of asset allocation.

We would like to thank our many colleagues

throughout Investcorp who contributed to the

output or helped in the production of this report.

We very much hope you find this Environment

Report useful and insightful and look forward to

your suggestions for further improvement.

Risk Premiums as Building Blocks

Alpha is a zero-sum game. Only the most

innovative and sophisticated investors are able to

harvest this rare form of return. The figure below

illustrates how the hedge fund industry’s alpha

generation has decayed over the past decade, the

same period over which its assets under

management have ballooned.

HFRI Composite 3-year alpha generation

Source: Investcorp, Bloomberg

The returns to any investment strategy can be

decomposed into a systematic component, beta,

and this idiosyncratic component, alpha. Most

common investment strategies blend traditional

market betas (such as equity, credit spread, or

duration risk premiums), alternative betas (such

as Momentum, Value, Event, or Carry risk

premiums) and, last but not least, alpha, as

illustrated by the figure below.

Most Investment Strategies Blend Traditional,

Alternative Risk Premiums, and Alpha


As the usage of the term “Alternative Beta” varies

somewhat across the industry, it may be useful

briefly to set out our understanding of it. We think

of a risk premium as a persistent return stream

associated with a stable underlying economic or

behavioral rationale. Traditional beta risk

premiums are commonly associated with a

systematic long-only exposure to such asset

classes as stocks, bonds, currencies, or

commodities. For example, the equity risk

premium is the compensation an investor gets for

serving as the residual claim holder on a firm’s

expected cash flow. Alternative Beta risk

premiums are similarly associated with systematic

long-short exposures to these same asset classes

expressed in terms of a style-based investment

criterion. (e.g., Value, Carry, Quality).

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Total Alpha Security Selection Alpha Timing Alpha0% 20% 40% 60% 80% 100%

Systematic Macro

Discretionary Macro

Equity Market Neutral

Long Short US Equity

Mutual Fund-Active Fund

Mutual Fund-Index Fund

% of Monthly Return Variation Explained (Adj R^2)

Feb 2005 - Dec 2014

Traditional Beta Alternative Beta Alpha

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These traditional and alternative beta risk

premiums serve as the fundamental building

blocks of our asset allocation framework. Our

research process identifies, analyzes, and

forecasts the performance of these elemental

building blocks. Over the past ten years, the firm

has developed and refined a suite of factors that

spans all asset classes, regions, and strategies to

serve as return benchmarks for our fund of funds

and single manager product lines.

To give an example of our approach, we analyze

the return streams for two typical hedge fund

strategies, Event-Driven and Systematic Macro,

using Investcorp’s proprietary benchmarks. One

can use a simple linear regression to attribute a

return stream to traditional and alternative risk

premiums (the independent variables) and alpha

(the intercept). This exercise assumes that the

returns reflect a constant exposure to each risk

premium and to alpha. The first two figures below

compare the cumulative return of the benchmark

to the fitted value from this exercise for both

strategies. The close fit for each suggests the

model’s assumptions are reasonable. The second

set of figures shows 3-year rolling averages of

time-varying alphas and traditional and

alternative beta risk premiums from a random-

coefficients model. These results also confirm the

major role systematic risk premiums play in both

strategies’ returns.

The rest of the report proceeds as follows. The

next section begins with the basics of the

macroeconomic environment, assessing where we

are in the business cycle, reviewing major

developments over the previous quarter, and

drawing out the implications for traditional beta

markets. We then move on to an in-depth

assessment of the environment for alternative

beta risk premiums in Section III and for hedge

fund strategies in Section IV.

Event-Driven Strategy

Systematic Macro Strategy


Event-Driven Strategy

Systematic Macro Strategy


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II. Global Macro and Markets

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Global Macro and Markets Outlook

In the previous edition of our Environment

Report, we laid out our ten macroeconomic

themes for 2015 and their implications for

markets. These included global growth

accelerating while inflation decelerated over H1, a

sustained divergence in developed markets’

monetary policies, and rising US wages. Since

then, we have experienced a few surprises.

While we continue to expect global growth to

accelerate above trend over 2015, inflation has

recovered from the fall in oil prices somewhat faster

than we anticipated. A macro environment in which

growth accelerates while inflation decelerates is

generally a sweet spot for risk assets, with decent

mean returns and Sharpe ratios across traditional

and alternative asset classes. Once inflation picks up

and central bank tightening becomes a palpable

reality, however, the resulting volatility in risk assets

brings Sharpe ratios down considerably. As a result,

our views on risk assets, while still modestly positive,

remain muted compared to last year.

Global inflation nowcast bottomed in Feb ‘15

Source: State Street Global Markets

As illustrated in the figure below, State Street’s

PriceStats Global Inflation Diffusion Index generally

leads official CPIs by roughly three months. The blue

line in the figure above represents the monthly

global inflation rate, and clearly shows it bottoming

in early February. Note that this inflection point will

be reflected in the officially reported data in May.

US: At the start of the year, we expected global

growth to be led by an increasingly dynamic US

economy. Since then, however, it has

underwhelmed as illustrated in the figure below,

as a difficult winter and a prolonged dock

workers’ strike disrupted activity, albeit

temporarily. Our view was that steady job

creation, improving housing conditions, lower oil

prices, and a fiscal drag near zero would combine

to push US, and so global, growth above trend in

Q1. Meanwhile European and Japanese growth

would pick up gradually over the year supported by

the tailwind of additional monetary stimulus and

lower oil prices.

US surprised on downside in Q1, Europe on upside

Source: State Street Global Markets, I/B/E/S, Citi, Bloomberg

Euro area: Consistent with our view, the euro

area exceeded the market’s growth expectations

in Q1. While the region had been held back in

2014 by weak credit conditions, its banks

dramatically reversed course following the ECB’s

announcement in Q4 of the results of its Asset

Quality Review.

This expansion in bank lending was a key driver of

the region’s accelerating growth, along with newly

ebullient consumers. February’s manufacturing

PMIs rose broadly across the region, with Spain

remaining firmly in positive territory while Italy

saw a striking bounce, with a similar pattern in the

services PMIs. The strength of Spain’s recovery in

particular was a notable shift from last year’s

repeated disappointments. Only the French

economy remains stagnant for now.

European consumers take out their wallets


A third surprise was Mario Draghi’s aggressive

execution of the ECB’s QE program, with a full

commitment of EUR 60 billion in purchases per

month through at least September 2016, and

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possibly beyond. The size, pace, and duration of the

announced program was clearly larger than most

market participants expected, and likely spurred by

an unsettling decline in medium-term inflation

expectations. The ECB has also telegraphed a

relentlessly positive narrative for the euro area’s

growth outlook, with real GDP growth forecasts of

1.5%-2.1% from now through 2017, considerably

higher than Bloomberg consensus of 1.2%. The

resulting sharp depreciation of the currency, the

true target of QE, should continue to stimulate

real export growth through at least the second

half of the year.

A brief setback to this trend of improving

sentiment followed Syriza’s victory in the Greek

election. This reversed after the government

reached an agreement with the Eurogroup on

February 28th

to extend its bailout program for

four months and to raise its emergency liquidity

assistance limit (ELA) to EUR 3.3bn -- notably less

than one-third of the EUR 8-10bn requested by

the government. And while deposit outflows have

accelerated, the worst-case-scenario of a

sovereign default should have little effect outside

Greece. The institutional backstops in place now,

as opposed to in 2011-2012, not least the ECB’s

QE program, have radically reduced the risk of

contagion across the region’s banking systems.

Japan: Japan’s economy has shown some signs of

recovering from its consumption-tax-induced

downturn in Q2 of last year. While yen weakness

finally translated into earnings upgrades and

higher real export growth in Q1, this pickup

coincided with consumption and investment

activity moving sideways. Business sentiment has

been upbeat, particularly large enterprises with

significant overseas sales, but consumers may be

starting to deviate from Abe’s playbook. And

while the Government Pension’s Investment

Fund’s (GPIF) pledge to reallocate a large share of

its $1.2 trillion portfolio to Japanese stocks has

supported the market, decelerating inflation

threatens to return the economy to the liquidity

trap Abe has worked so feverishly to escape.

Japanese earnings surprising on the upside

Source: State Street Global Markets, Bloomberg

Emerging markets: The outlook for emerging

markets remains tepid at best. China begins 2015

hobbled by its troubled real estate sector, the

spare capacity in its industrial sector, and its

economy’s unhealthy reliance on credit over more

sustainable sources of demand. We expect the

recent easing in its monetary policy to continue –

particularly the slow ratcheting down of banks’

Required Reserve Ratio as in early February. A

number of Asian central banks made similar off-

cycle easing moves in Q1, taking advantage of the

window before the Fed starts to raise rates.

The normalization of Fed policy should be

particularly disruptive for those emerging markets

with significant levels of dollar-denominated

corporate debt. A strengthening US currency will

also translate into inappropriately tight monetary

policy in those emerging markets with pegs (de

facto or de jure) to the dollar. The Fed’s imminent

liftoff date is the primary reason why we see

growing downside risks to our core EM scenario of

muddle-through growth.

EM earnings below trend since 2012

Source: State Street Global Markets, Thomson Datastream

Monetary policy developments: In 2014, the Fed

embarked on its multi-year plan to normalize

policy by ending its QE purchases and revising its

forward guidance at the final FOMC meetings of

the year. At its March 2015 meeting, it went one

step further removing the word “patience” from

the FOMC statement, replacing it with the

observation that the Fed remains “reasonably

confident” that inflation will converge back to 2%

over the medium term. We continue to expect the

Fed to start raising the federal funds rate target

around the middle of this year as the US labor

market continues to heal and wages firm.

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As the Fed embarks on this historically

unprecedented tightening cycle, we expect the

Treasury curve to continue to flatten as demand

for US Treasuries outstrips net issuance by a

substantial margin. Thus far this year, the long

end of the Treasury curve has looked quite similar

to that of the bond conundrum period from 2003-

2006, as we expected. During this period, yields at

the long end of the curve declined even as the

FOMC hiked the federal funds rate multiple times.

More generally, we expect the ongoing

divergence in developed markets’ monetary

policies to generate uncertainty amongst market

participants and modest dislocations across global

bond markets throughout 2015.

Consistent with this view, the greatest surprise in

Q1 was without a doubt the Swiss National Bank’s

(SNB) decision to abandon its 1.20 floor for the

EUR/CHF exchange rate, which shocked markets.

The SNB was reportedly uncomfortable with an

expansion of its balance sheet to more than 80%

of GDP. It chose instead to cut the rate on sight

deposits to -0.75% and to readjust the range for

its 3m Libor to between -1.25% and -0.25%.

We also expect more volatility over 2015 than over

the past few years as we move closer to the Fed’s

liftoff date. The availability of liquidity has fallen

in a number of markets with the shrinkage of

broker-dealer inventories to comply with Dodd-

Frank prop trading requirements. These structurally

lower inventories also act as an amplification

mechanism turning small shocks into sustained

market dislocations.

Treasury Market Turbulence Up By More


Markets Environment over Q1: Q1 price returns to

traditional asset classes are illustrated in the figure

below. Returns to traditional equity beta led the

pack at 3.3% for developed markets and 1.6% for

emerging markets. The greatest declines were to the

euro-dollar exchange rate, which fell 11.6% over the

quarter, and to Brent oil, down over 7%. The

divergence between the price returns of US and

German 10-year bonds is quite fascinating, an

almost 6-percentage-point difference. The decline in

copper prices primarily reflects a tepid growth

outlook for China this year.

Going forward, we expect the dollar to continue to

strengthen over 2015. Its movements with respect

to the yen and euro should reflect widening rate

differentials from the increasingly divergent

monetary policies of the Fed, the BoJ, and the ECB.

Its movements against EM oil importers should

reflect currency depreciations to address current

account deficits or to stimulate inflation, and

against oil exporters to rebalance demand away

from the energy sector. Technical factors should

also play a role in the dollar’s strength as FX

momentum strategies generally exhibit significant

autocorrelation. Their strong returns for the dollar

in 2014 suggest they should continue to perform

well at least through the first half of 2015. Likewise,

there is no sign that the current one-sided

positioning for further dollar strengthening will

dissipate at any point soon. This suggests that we

are headed for some overshooting of the dollar

over the next few years as the forces on the real

side that might bring it back to an equilibrium or

“fair value” level are notoriously limited in their

ability to impact the currency over a timeframe of

under one year.

Cross Asset Performance (USD, %)

Source: Bloomberg

Returns by Region: The figure below shows the

Q1 price return to regional MSCI indices.

Consistent with the pattern of surprises in the

macroeconomic data as well as the impact of yen

and euro depreciations on earnings, Japanese and

European equities have outperformed other

developed markets at 12% and 5%, respectively,

for the quarter. The turn in the global

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manufacturing cycle continues to support returns

to Asia-Pacific indexes while the US and EM

remain the laggards, returning 1.84% and 1.62%

respectively. It is worth noting that this is in line

with historical returns to US Large Cap which are

generally in the 7.5-8% range annually.

Global Market Performance (USD, %)

Source: Bloomberg

Returns by Sector: The Q1 variation in equity

returns across major sectors was driven primarily

by the impact of lower oil prices, either directly or

knock-on effects. While it is not surprising that the

two sectors with negative returns are Energy and

Utilities, it is fascinating that the second highest

returns went to Consumer Discretionary stocks,

over 6.5%, which were the beneficiary of the

windfall granted consumers by lower gasoline

prices. The high returns to health care stocks (the

sector is up over 10% for the quarter) reflect in part

the recent event-driven frenzy in this sector.

Returns should start to settle down over Q2 and Q3

as the peak in health care M&A may be past and

with some of the ongoing litigation regarding

Obamacare in the United States.

MSCI The World Sector Performance (USD, %)

Source: Bloomberg

11.96

5.113.43 3.25 3.10

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Asset Allocation Views for Traditional Beta Risk Premiums

Strategy

Change

from

previous

quarter Negative Neutral Positive Comments

Equity risk premium

�� Modestly positive view of market β over a 1-year horizon.

US �� Broad-based economic reacceleration offset by dollar headwinds.

Euro area - �� Weaker euro, acceleration in growth should support profits, valuations.

Japan �� GPIF equity purchases should support multiples despite deflation headwind.

Asia ex Japan

�� Reflects Chinese policy stimulus, positive turn in manufacturing cycle.

Duration �� Global growth prospects offset by $600bn demand>supply imbalance.

US 10-year �� Mid-cycle expansion offset demand-supply imbalance in Treasury market.

Euro area 10-year - �� ECB QE supports current low yields.

Japan 10-year �� JGB yields lower for longer as policy stimulus expected in H2 2015.

Credit �� Neutral on high yield but still opportunities in structured credit.

US high yield �� Reasonable carry offset by liquidity concerns, exposure to duration.

FX

�� Modest opportunities remain momentum trades as monetary policies diverge.

USD - �� Additional appreciation supported by positioning, no catalyst for reversal.

EUR + �� Additional depreciation supported by positioning, aggressive ECB QE.

JPY

�� Additional depreciation after policy action in H2 2015.

As of Q2 2015. Change in view is since Q1 2015.

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III. Alternative Beta

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Equity Alternative Beta

Market-Neutral Equity Factors

Risk premiums have been studied in equity markets

for almost a century, decades before the rise of

investable indexes. To track their performance over

market cycles we have constructed a number of

internal benchmarks that we follow daily. In this

section we use our internal Value, Quality, and

Momentum benchmarks to characterize the

investment environment for equity risk premiums

in recent quarters. These benchmarks are made up

of securities from the universe of global developed

equities (including the US, Europe ex-UK, Japan,

and UK markets). Over Q1, an exposure to our

Quality or Momentum risk premium earned

positive returns of 1.4% and 5.1%, respectively.

Returns to the Value factor were negative, in

contrast, at -0.9%.

Market Neutral Equity Factors, Last 8 Quarters

Source: Bloomberg, FactSet, Investcorp

Value and Momentum factors are generally

negatively correlated which reflects their

countervailing investment styles. Value strategies

can be considered analogous to ‘buying the dip’

while Momentum strategies ‘follow the trend’.

More generally, while returns to alt beta equity

factors are generally negatively correlated to one

another over longer horizons, over the near term

they may exhibit common responses to major

macro or market trends. For example, as investors

intensified their search for yield over the past five

years, our Dividend Yield factor, one of the

constituents of our internal Value factor, has

become less correlated with such other Value

factors as Price-to-Book (P/B) or Price-to-Earnings

(P/E). Going forward, we expect Dividend Yield in

turn to underperform these other Value factors as

the Fed starts to raise rates and investors turn to

less-risky fixed-income markets to source income.

US Value Factor Portfolio P/B Spreads

Source: Nomura Quantitative research. Chart shows the relative P/B

valuations of our Composite Value style and its individual components –

namely DY, P/B and forward P/E. The universe is FTSE US

At present, Dividend Yield is expensive relative to

P/B or P/E, as illustrated in the figure above. Over

the same period its correlations to broad market

aggregates have risen: It has become more

positively correlated with interest-rate movements

and negatively correlated with commodity price

fluctuations. Similarly, the correlation between

commodity prices and our Quality factor has

declined over the past quarter suggesting

commodity exposure is now a signal of low quality,

all else equal.

Our Quality factor also exhibits a striking

asymmetry that makes it attractive as a potential

equity hedge. The divergence in the P/B spreads of

the factor’s long and short baskets, as shown in the

figure below, suggests the valuations of low-quality

firms are expensive and at more risk of correction

than those of high-quality names.

Global Quality Factor Portfolio P/B Spreads

Source: Deutsche Bank AG, FactSet, Bloomberg, MSCI

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Multi-Asset Alternative Beta

Trend Following

Momentum risk premiums are among the oldest

and best-established systematic trading strategies

used by hedge funds. Using statistical analysis of

price and volume data across a range of markets,

momentum (‘trend-following’) traders capitalize on

a market anomaly in which recently-appreciating

assets continue to appreciate and recently-

depreciating assets continue to depreciate.

While there is no consensus on the rationale for

these persistent trends across markets, a number

of hypotheses have been proposed in the academic

literature. These include behavioral anomalies,

market technicals (for example, the spillover

effects of stop-loss limits), or the propagation of

underlying macroeconomic trends (such as growth

or inflation). Our internal trend-following

benchmarks use total-return-based signals that are

diversified across a range of look-back horizons

from one week to four years. These signals are

used to allocate across futures contracts on a

historically risk-adjusted basis.

As illustrated in the figures below, an investment

that follows these simple rules earns attractive

returns that are uncorrelated to the broader

market. Likewise, applying these rules to

commodity and currency markets produces a

pattern of positive returns that are uncorrelated to

their headline market betas.

Trend Following Across Asset Classes

Equity, Fixed-Income Trend Following,

Rolling 12M Return

Source: Bloomberg

Commodities, FX Trend Following,

Rolling 12M Return

Source: Bloomberg

Recent Performance of Trend Following

Q1 saw positive returns to trend-following

strategies across all major asset classes, a reflection

of the persistence in several underlying macro

trends. These include prolonged strengthening of

the USD currency as investors anticipate hikes in US

interest rates, sustained demand for fixed-income

instruments from new regulatory requirements,

and reflationary monetary policy in developed

markets with the exception of the US.

Equity, Fixed-Income Trend Following,

Last 8 Quarters

Source: Bloomberg

Commodity, FX Trend Following, Last 8 Quarters

Source: Bloomberg

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1992 1996 2000 2004 2008 2012

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1992 1996 2000 2004 2008 2012

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Comdty_TF FX_TF

Q2 2013 Q3 2013

Q4 2013 Q1 2014

Q2 2014 Q3 2014

Q4 2014 Q1 2015

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Outlook for Trend Following

The strong market trends observed across asset

classes since mid-2014 appear to be nearing

exhaustion, particularly falling oil prices and a

strengthening dollar. The unusual independence of

the macro trends affecting markets’ current pricing

suggests that a portfolio of trend-following risk

premiums should outperform one with exposures

to only one or two asset classes. The figure below

illustrates how a diversified approach should

perform better now than at any point over the past

five years – due to the decline in the explanatory

power of the first principal component across

multi-asset futures markets. While the huge

returns to trend-following in Q4 are unlikely to

recur, the increased breadth in trend-following

themes across markets suggests limited downside

to a diversified basket of these risk premiums.

Variance of Returns Explained by First Principal

Component across Major Markets, 2yrs Weekly

Source: Bloomberg

Carry

Another alt beta risk premium that has been

identified across major asset classes is Carry. Carry

strategies seek to harvest uncorrelated returns

from futures and forward markets by investing in

baskets of high-yielding currency pairs, bonds, or

commodities either outright or in a hedged pair-

trade relative to lower-yielding instruments. It

should be noted that the Carry factor is not as well

defined in equities as simple Carry rules tend to

overlap with several of its typical Value rules (such

as Dividend Yield).

An older academic literature argued that the

incremental yield to Carry strategies was

compensation for an expected future decline in the

underlying instrument (that uncovered interest-

rate parity held). Market participants and

academics now view this additional yield as an

insurance premium paid by hedgers in both

futures and forward markets for protection from

price volatility. To monitor the performance of the

Carry risk factor, we have constructed internal

benchmarks for fixed income, commodity, and

currency markets.

� For commodity markets, the rolling yield across

points in a commodity curve is compared across

the various commodity futures to form a simple

Carry signal. This signal produces a long basket

of commodities in backwardation (in which the

future price is expected to be lower than the

current spot price) and a short basket of

commodities in contango (in which the future

price is expected to be higher than the current

spot price). This simple strategy extracts the

commodity ‘roll yield’ while minimizing its

sensitivity to underlying price moves.

� Our Carry benchmark for fixed-income markets

starts by comparing yield curve slopes across

10-year bond futures of developed markets. The

resulting portfolio allocates a positive (negative)

weight to the three highest (lowest) yielding 10-

year futures to maintain a duration-neutral

profile.

� Our FX benchmark extracts Carry from the

universe of developed-market currencies by

borrowing from the lowest yielding currencies

to invest in the highest-yielding currencies,

all by US-dollar pair rank. This comparison to

the US dollar neutralizes any directional

exposure to it.

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15%

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25%

30%

35%

40%

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1994 1998 2002 2006 2010 2014

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Recent Performance of Carry

Across major asset classes, Carry strategies posted

positive returns in Q1.

� Commodity Carry led the group with a return of

1.4% with fixed income and G10 foreign

exchange returning 0.6% and 1.0%, respectively.

� Commodity Carry benefitted from being short

crude oil and lean hogs as both markets have

been in steep contango, which has coincided

with declines in their spot prices.

� Returns to fixed-income Carry came primarily

from long exposures to US, UK, and Italian 10-

year bond futures which were partially offset by

short positions in Australian, German, and

Japanese 10-year bond futures.

Outlook for Carry

One of the attractive features of multi-asset Carry

risk premiums is that their yield spreads are fairly

slow moving and so are decent leading indicators

of future returns.

The figure below shows why the current macro

environment is not particularly favorable for Carry

strategies in developed markets. Yield differentials

across developed markets have recently reverted

to post-2008-crisis lows. Over just the past year

their interquartile spread has compressed by

almost 100 basis points. Similarly, across developed

market currencies short-term interest rates have

fallen significantly to below their levels over the

1990-to-mid-2000 period.

As illustrated in the dashboard of our alt beta views

on the next page, we remain constructive on Carry

strategies across major asset markets, with

particular emphasis on currency strategies with a

regional-emerging-markets focus and commodity

strategies constructed via relative value pairs.

Returns to Multi-Asset Carry Strategies,

Previous 8 Quarters

Source: Bloomberg

Slopes across Developed-Market Yield Curves

Source: Bloomberg, Investcorp

-4%

-2%

0%

2%

4%

6%

8%

Comdty_Carry FX_Carry FI_Carry

Q2 2013 Q3 2013

Q4 2013 Q1 2014

Q2 2014 Q3 2014

Q4 2014 Q1 2015

0%

1%

1%

2%

2%

3%

3%

4%

4%

2009 2010 2011 2012 2013 2014 2015

Median Slope

75% Percentile

25% Percentile

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Investcorp’s Asset Allocation Views for Alternative Beta Risk Premiums

Asset class Strategy

Change

from

previous


Equities Value - �� Transition to momentum-led market suggests modest outlook for value strategies.

Quality �� Steady returns to European quality factor supports global factor, offset by

excessive volatility in US factor.

Low Beta �� Worst environment for low-beta strategies, hold minimum portfolio allocation.

Momentum �� Cross-sectional momentum-led rally has broadened, should be reinforced by

inflation’s rise. Best Sharpe ratio for Europe and the UK. Returns remain quite

weak to this factor in Japan, as has been the case historically.

Fixed Income Carry �� Steady returns to bond carry likely to persist with some upside risk.

Momentum �� Steady modest returns to rates trend-following strategies likely to persist.

Commodities Carry

�� Roll yield is alive and well, supply-demand imbalances should continue to support.

Momentum - �� Time-series momentum has run, cross-sectional generally picks up with inflation.

FX Carry

�� G10 carry solid upward trend with growing monetary policy divergences. EM crash

risk too great given advanced state of the credit cycle

Momentum - �� G10 momentum now quite volatile but still modest upside, as with EM

momentum.


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IV. Hedge Funds

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Investcorp’s Asset Allocation Views for Hedge Fund Strategies

Strategy

Change

from

previous


Hedged Equities

�� Reflecting positive view of market β over a 1-year horizon.

US - �� Broad-based economic reacceleration offset by dollar headwinds.

Euro area �� Weaker euro, acceleration in growth should support profits, valuations.

Japan �� GPIF equity purchases should support multiples, real exports picking up.

Asia ex Japan

�� Reflecting positive turn in global manufacturing cycle offset by rising wages.

Special Situations / Event �� M&A, buyout, buyback, spinoff activity remains robust. Energy in play.

Macro Discretionary �� Opportunities to play dislocations in rates, FX, and commodity markets.

Corporate Credit �� Defaults will pick up in energy sector. Limited liquidity, but still coupon to clip.

Equity Market Neutral �� Security-level dispersion of signals and returns still modest.

Macro Systematic �� Trend-following strategies less room to run.

Structured Credit

�� Concerns about liquidity-induced volatility: Bid-ask spreads have widened.

FI Relative Value + �� Opportunities picking up with volatility.

Convertible Arbitrage + �� A case to rent (not own) given valuations particularly in energy sector.

Corporate Distressed

�� Low distressed ratio limits returns, though opportunities remain in Europe.


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Hedge Fund strategy outlook

We maintain a “Positive” rating on Hedge

Equities. While the US had been the region with

the most macro momentum in 2014, expansionary

ECB monetary policy coupled with the continued

Euro depreciation should support profit growth in

the Eurozone with reduced downside risks from

deflationary dynamics in the periphery. Japanese

equities should benefit from the depreciation of

the yen as well as the pickup in domestic inflows

with the Government Pension Investment Fund’s

commitment to allocate into equities. While

valuations are not cheap, they are also not very

dear. We remain more constructive on European

and Japanese equities than on the US or EM.

We have a “Positive” rating on Special Situations /

Event Driven strategies predicated on strong

corporate balance sheets in the US that are flush

with cash in excess of $2.0 trillion. Corporate

profits for companies in the S&P 500 are near 10%.

We believe that shareholder pressure (or activism)

will lead to a period of sustained high levels of

event-driven activities including buybacks, mergers

and recapitalizations. 2014 was a strong year for

investor activism, and 2015 should be as well. We

continue to be positive about opportunities in

investing in special situations with the risk to the

downside from an expected increase in volatility in

equity & credit markets.

We are “Positive” on Macro Discretionary

strategies. We believe that the macro opportunity

set will richen as we see an increase in policy

divergences across the globe manifest itself in

reduced asset correlations and the formation of

time-series trends. We continue to see less

opportunities for pure fixed income macro

specialists than historically had been the case at

this point in the business cycle; we do, however,

see opportunities for emerging markets specialists

as the withdrawal of quantitative easing by the

Federal Reserve is expected to have a

disproportionate impact on leveraged emerging

market balance sheets and differentiation across

emerging markets will continue to play a vital role.

Broadly, we believe that managers with the ability

to play sovereign credit should have a rich

opportunity set.

We remain “Modestly Positive” on Corporate

Credit, as valuations fully reflect the low default-

rate environment and strong corporate balance

sheets in the US. The rise in spreads in High Yield

does provide expected returns higher than a few

quarters back and the strength of the corporate

balance sheet supports the thesis of a slow grinding

down of spreads.

We are “Modestly Positive” on EMN even as we

continue to see commoditized factor models

delivering sub-optimal alphas in developed

markets. However, returns to non-market factors

are attractive in other parts of the world, especially

the Asia-Pacific region. We favor managers who are

globally diversified and who can successfully time

their factor exposures. We continue to have a “wait

and watch” approach to statistical arbitrage

managers since realized volatility in equity markets

has ground lower except for brief spikes making it

difficult for programs to earn alpha harvesting

volatility over their transaction cost.

We remain “Modestly Positive” on Systematic

Macro strategies. The extraordinary 2014 year for

trend-following strategies is unlikely to be repeated

in the near term, but the return stream remains in

play, if a bit more modest than before. Recent

structural suppression of volatility, particularly in

fixed income markets due to quantitative easing,

combined with potential long-term reversals of

fixed income markets have hampered quantitative

trend-following models in the fixed income space

and the expected rate cut is a risk to the strategy.

With a modest increase in volatility expected in the

coming quarters, we continue to prize CTAs’ ability

to diversify risks and to provide downside

protection in periods of market turbulence.

We have a “Neutral” rating on Structured Credit

as a strategy. We expect Europe to outperform the

US on the back of the proposed purchases of Asset

backed paper by the European Central Bank, but

are in general concerned about the liquidity

induced volatility in the structured credit markets.

Structured credit has benefited from a one way

flow of long term money into the asset class over

the last four years which could reverse leading to

mark downs. We have anecdotally seen fairly wide

bid ask spreads on everything but the largest issues

traded in size.

of 49


We have upgraded our outlook to “Positive” for

Fixed Income Relative Value. We structurally like

Relative Value strategies as hedge funds step into

the void left behind by the exit of bank proprietary

trading desks. The structural change in fixed

income markets – with the Federal Reserve as the

largest holder of mortgage backed securities –

precludes the kind of volatility that marked

previous periods in which rates were raised. The

current environment has started to provide FIRV

managers with greater opportunities to trade

volatility and to profit from banks reducing

dealer inventory.

The “Modestly Positive” rating on Convertible

Arbitrage is an upgrade that follows the recent

energy-related sell-off and reflects more attractive

valuations. Our outlook for convertible bonds as an

equity substitute is modestly positive because of

the overweight in energy composition of the

convert universe. For arbitrage portfolios, credit

spreads remain fairly tight across all markets and

below the historical average, discounts-

to-theoretical levels are unattractive, and

volatility – both realized and implied – remains at

cyclical lows.

We maintain a “Modestly Negative” rating on

Corporate Distressed. A low distressed ratio of just

3% in bonds currently provides very little

opportunity to earn an outsized systematic risk

premium from this strategy. We do have a more

favorable view on European distressed versus US

distressed basically for reasons of supply from

deleveraging European banks. Higher expected

default rates and the fragmented jurisdictional

presence across the continent create an added

level of complexity, but also a more robust

opportunity set. We also remain cautious about the

increase in issuance of non-US high yield debt and

the deterioration in the quality of the loans being

made. We also expect to see more opportunities in

specific sectors such as energy that have faced

recent volatility in prices; the shakeout induced by

OPEC will create losers whose debt will need to be

restructured and worked out.

of 49


1. Median returns of Investcorp’s strategy peer group. Strategy peer

groups are created by Investcorp and are comprised of funds that

Investcorp has judged to be relevant for each strategy.

Source: Investcorp, US Federal Reserve

Hedge Equities

Driver of

Strategy

Returns

Change

from

previous


Valuation - ��

US and EM appear fairly priced while

European and Japanese multiples

suggest room to run.

Earnings ��

Tailwinds from QE, currency

depreciation supportive of earnings in

Europe, Japan. Headwinds to US

earnings from the strong dollar,

expectation of rising wages.

Stock Selection ��

Limited idiosyncratic risk across single

name equities: Exceptions include

small cap with structural inefficiencies

that support persistent dispersion, e.g.

low analyst coverage.

Momentum /

Sentiment - ��

Upside surprises in European, Japanese

earnings offset by anxiety regarding

the Fed’s first rate hike, impact of a

stronger dollar on US earnings.

Macro

Fundamentals - ��

Lower oil prices supportive of

accelerating consumer-led growth

across markets, but rising inflation

should also spur greater volatility,

lower Sharpe ratios. Q1 soft patch in

US data from temporary disruptions

due to weather, West Coast port strike.

Global monetary policy remains

generally supportive of risk assets

despite inflection point in Fed policy.

Liquidity &

Financing - ��

Not an issue for large and mid-cap

names in developed markets. Prime

brokers raising financing costs.

1

(24)

(18)

(12)

(6)

0

6

12

18

24

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Av

era

ge

Qu

art

erl

y E

qu

ity

Dis

pe

rsio

n

Av

era

ge

Me

dia

n Q

ua

rte

rly

Re

turn

s

US Hedge Equities Strategy

Average Median Quarterly Return

Average Quarterly Equity Dispersion

of 49


Hedge Equities

Equity Long/Short funds offer investors access to

equity beta across regions as well as to a variety of

alternative betas and alpha sources.

We start this section by discussing how equity

hedge funds have adjusted their net market

exposure and portfolio allocation across sectors

and regions. As the following chart highlights,

hedge funds have been net buyers of equities over

the past few months as they looked to cover

underweight positioning in US equity markets. As

of quarter end, Morgan Stanley estimates that the

net exposure of equity hedge funds is back to the

high 50%, in line with its historical average.

Buying Activity in US Equities – Hedge Funds

Similarly, equity hedge funds have been net buyer

of equities in Emerging Markets and Europe as the

following chart shows. The re-allocation towards

Europe was likely driven by the strong momentum

in European equities on the back of a looser

monetary policy. The strong activity in Emerging

Markets is a bit more surprising. Net exposure to

Japan stayed flat over Q1, consistent with our view

that the ongoing bull market in Japanese equities is

increasingly driven by domestic investors.

Buying Activity in EM Equities – Hedge Funds

Source: Morgan Stanley Prime Brokerage

Looking across the funds’ sectors allocation in the

US, some themes have emerged in portfolio

activity over the past months. First, the following

chart highlights equity hedge funds’ exposure to

the biotechnology sector. Clearly, hedge funds are

riding the bullish momentum trade in the biotech

sector. As most large pharmaceutical companies

have cut research & development budgets

following Valeant example, biotechnology stocks

offer one of the few ways for these majors to build

up their drug pipeline. This demand has fueled the

sector’s strong rally over the past two years.

Funds’ Net Exposure to Biotechnology Sector

Funds’ Net Exposure to Oil Services Sector

On the other hand, hedge funds have continued to

reduce their exposure to the energy sector and

have turned net short on industry groups such as

oil services, as shown in the chart above.

The drivers and outlook for equity hedge funds

exposure to alternative beta is covered in-depth in

our Equity Market Neutral section. In aggregate,

our analysis shows that hedge funds currently are

INVESTCORP INVESTCORP

exposed to Growth, Momentum and Size as factor

and short

Turning to the environment for alpha, we believe

the environment to be neutral to slightly positive

in the near term with strong optionality in the

longer term.

The dispersion i

suggests that companies are currently being valued

at similar multiples despite very different growth

dynamics and quality attributes. This creates

positive convexity for managers who are able to

enter into long/short position

benefit from an eventual return to the mean in

valuation spreads. This is illustrated by the

following chart which shows valuation dispersion

below the 25

Valuation Dispersion

Source:

INVESTCORP


and short




longer term.

The dispersion i









below the 25


Source: Credit Suisse HOLT

INVESTCORP


and short Quality.




longer term.

The dispersion i









below the 25


Credit Suisse HOLT

INVESTCORP


Quality.




longer term.

The dispersion i









below the 25th

percentile as of the end of Q1.


Credit Suisse HOLT

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Credit Suisse HOLT

INVESTCORP





n valuation across US stocks










Valuation Dispersion – US Equity Market















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enter into long/short position now that should





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now that should





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now that should




On the positive side, the dislocation in energy and

the strong appreciation of the dollar in recent

months is also creating opportunities for talented

equity long/short managers. The market is

struggling to differentiate between individual

companies in the

This provides an edge to fundamentally

investment firms to anticipate future price action.

For instance, the Energy and Production (E&P)

sector in the US includes dozens of companies with

very different asset quality,

balance sheet liquidity. While the sell

most of these stocks in the same fashion, top

quartile hedge funds should be able to pick winners

from losers.

While we are positive on the outlook for the Equity

Long/Short strategy,






companies in the









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from losers.








companies in the











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companies in the same sector or industry group.










Long/Short strategy, we are somewhat concerned

Page 23






same sector or industry group.










we are somewhat concerned

23 of 49

















49











very different asset quality, hedging policy or
















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hedging policy or

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hedging policy or

off affected





Investcorp Environment Report







driven




hedging policy or

off affected






by the recent increase in crowdedness across the

long or short portfolios

Amongst a

indicators

most are currently indicating an

of

following chart

metrics historical values over the past twelve

months. It specifically shows a higher overlap in

names and a lower liquidity

overlapping names

as these names are more prone to risk of technical

selling pressures from hedge fund deleveraging

use this

construction exercises where we form forward

lookin

strategies and managers.

Crowding Indicator

Source:




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overlapping names



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Crowding Indicator

Source: Credit Suisse Prime Brokerage




Amongst a number of internal and external

indicators that we use to track hedge fund crowding,


overlap among equity fund

following chart




overlapping names



use this framework


g views on the covariance matrix between


Crowding Indicator

Credit Suisse Prime Brokerage




number of internal and external

that we use to track hedge fund crowding,


among equity fund

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overlapping names. We consider this a warning sign



framework




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among equity fund

below tracks the evolution of




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framework




Crowding Indicator – Long Portfolios




long or short portfolios of hedged equity funds




among equity fund

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Investcorp Environment Report | 2





most are currently indicating an increased

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creased

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Quarter 2015

of 49






Special Situations / Event-Driven

Driver of

Strategy

Returns

Change

from

previous


Market Beta ��

Returns to β modestly positive over a

1-year horizon given expected

headwinds from accelerating inflation,

Fed’s liftoff.

M&A Spreads ��

Spreads remains relatively attractive

historically as the October shock has

led some capital & leverage to exit the

space. Still recommend a tactical

approach to this strategy.

Corporate

Activity ��

Environment remains very supportive

with high levels of activity across

buybacks, spin-offs, and M&A driven

by cash-rich firms, attractive financing

conditions, and a relatively benign

macroeconomic environment

Activism ��

Activism continues to benefit from

institutional support and a wide range

of opportunities in US and Europe

Tax + ��

Tax inversion theme that drove activity

in 2014 is dead but recent IRS

communication suggests MLP/REIT

conversion trade may reemerge

Crowdedness ��

Overlapping positions across event

managers remains relatively high

compared to history, which is a modest

negative for the strategy

2

-20%

-10%

0%

10%

20%

30%

'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Median 12-Month

Rolling Returns1Event-Driven Strategy

251421 402 434 406 462

95

1,059

1,575 1,784 1,687 1,759

1,815

359

0

500

1,000

1,500

2,000

2,500

2009 2010 2011 2012 2013 2014 1Q 2015

Small-Cap ($200M-$1B)

Mid-Cap ($1B-$5B)

of 49


Special Situations / Event-Driven

The event driven space is a heterogeneous

strategy, covering a number of distinct sub-

strategies, each with its own specific mix of risk

premiums, such as merger arbitrage, activism or

themes including buy-backs, spin-offs and tax

related trades.

We remain constructive on the opportunity set for

event driven strategies as the confluence of

positive expected equity market returns and strong

corporate activity across certain themes should

help hedge fund managers deliver positive

performance in the coming months.

The following paragraphs discuss in greater detail

the ongoing themes expected to drive market

action in the space.

Merger Arbitrage

Merger arbitrage spreads remain at relatively

attractive levels this quarter as the major

dislocation that occurred in October reduced the

amount of capital pursuing the strategy and

reminded the market of the risks involved. We

continue to be marginally positive on this specific

opportunity set although we recommend a tactical

approach. We favor managers who are able to shift

capital aggressively across opportunities and

recommend a minimal allocation to fully dedicated

merger arbitrage players.

Historical Evolution of Merger Arbitrage Spreads

Source: Credit Suisse

The outlook for mergers remains bullish at this

stage of the cycle. As shown below, CEO confidence

is close to post-crisis peaks and almost back to

levels observed before the financial meltdown of

2008. As discussed in greater details in the credit

section of this book, credit spreads and yields are

near historical lows, allowing companies to make

acquisitions with very attractive financing terms.

While we monitor closely the level of valuations,

which could become a headwind on to corporate

activity, we remain confident that this is not yet the

case. Acquirers continue to benefit from their

acquisition announcements and targeted

companies have enjoyed a relatively strong

performance ahead of the acquisition

announcement. The exception here is energy. We

would not be surprised to see oil majors start

opportunistically buying assets in the US Shale

Exploration and Production (E&P) space, where

they have had a low presence so far. But this story

may start unfolding only later this year.

CEO Confidence Index

Source: Bloomberg

Activism

As part of our ongoing alternative beta project,

Investcorp has designed an investable systematic

strategy to track the positioning of US activist

funds. Activist investors build positions in equities

that offer strong valuation potential but with

management that is struggling or has failed to

unlock this value. Activists generally work closely

with management over several years to improve

business management, corporate strategy or

financial engineering of the target company to

attempt a full realization of this potential.

The chart below shows how the strategy

performed this quarter on a market neutral basis

-1%

0%

1%

2%

3%

4%

5%

6%

7%

Jan-13 Jul-13 Jan-14 Jul-14 Jan-15

0

1

2

3

4

5

6

7

8

9

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(dynamic beta-hedge). Equities currently invested

by activist funds have on average outperformed

their sectors by 2.7%. Value creation was

particularly strong in consumer staples, energy and

financials. On the contrary, the communications

sector detracted significantly year-to-date.

Average Activist Alpha by Sector


The pie chart highlights the key sector

concentration for this Activist replication

strategy. The consumer sector dominates, with

a total allocation of 46%, with industrial and

technology also contributing 14% and 10%

respectively.

Breakdown of Activist Portfolio by Sector


Looking forward, we remain confident that activism

will continue to outperform as a strategy,

particularly when it is executed by experienced

teams. Activist investors have gained a lot of

traction in the institutional investors’ community

and this is helping them push their agenda at the

board level and in proxy fights. Signs show that

activism could broaden to regions where it had

typically been more challenging. In Japan, recent

corporate governance changes including a greater

focus on shareholder value maximization have

been partly driven by a rise in soft activism.

Spin-offs

Morgan Stanley’s Special Situation Group recently

wrote a piece on the Return of the Spin for the US,

reporting anecdotal increased interest among their

clients for recent spin-offs including eBay, Axiall

Corp or SPX Corp. In the chart below, we show that

spin-offs have indeed outperformed the market, on

a beta-adjusted basis, by a few percentage points

this quarter.

Spin-offs generally help companies maximize

shareholder value by ensuring each business is

properly valued in the absence of major synergies.

It helps eliminate the holding company discount.

Empirical research has shown that spun-off

companies tend to outperform significantly the

market in the years following the event.

Recently, we saw this market effect as the

announcement from Barnes & Noble in March that

they would spin off their college books business

helped propel the stock +7% on the day.

Spin-off Alpha


Buy-backs

Share repurchases have been a popular thematic

trade over recent quarters and it continues to

perform well this quarter. If anything, companies

have been even more aggressive in their share buy-

back announcement programs, as can be observed

on the following chart. Companies with buy-back

programs have outperformed the market by

approximately 5% since the beginning of the year,

on a market-neutral basis. As the Return-of-Capital

play gains further traction, the opportunity set of

special situation funds widens as they anticipate

and capture the gains from these actions. We see

no end in sight for this major trend medium-term,

although the pace of buy-backs may slow in coming

months. The seasonality of these buybacks

suggests that companies will moderate their buying

in coming months and this may diminish the

2.7%

-10% -5% 0% 5% 10%

Basic Materials

Communications

Consumer, Cyclical

Consumer, Non-cyclical

Energy

Financial

Industrial

Technology

Grand Total

Average Alpha (Sector Neutralized)

7%

9%

21%

25%

6%

8%

14%

10%

Basic Materials

Communications

Consumer, Cyclical

Consumer, Non-cyclical

Energy

Financial

Industrial

Technology

97

98

99

100

101

102

103

104

105

Dec-14 Jan-15 Mar-15

of 49


expected return for this particular event strategy

for the coming quarter.

Buyback Basket Performance vs S&P500

Source: Deutsche Bank, Investcorp

MLP and REIT Conversion

Last year, the tax efficiency theme made headlines

in the US as companies conducted multiple

transactions to optimize their fiscal situations. This

led to a series of tax-inversions driven mergers and

acquisitions. Companies able to make the deal

gained a competitive advantage but in turn

generated public outrage. The US administration

reacted in the fall by closing certain loopholes and

amending regulations. This was the primary source

of turmoil in the event driven space in October,

with AbbVie ending its offer to acquire Shire.

However, while this theme ended painfully, other

tax-related strategies could make a come-back.

In April of 2014, the US Internal Revenue Service

(IRS) suspended its issuance of new letter rulings

(Private Letter Rulings) on MLP and REIT

conversions. This had placed on hold a popular

investment theme for most special situation funds.

On March 6th 2015, the IRS announced that the

pause had ended. This could re-launch the same

theme this year, with multiple companies already

awaiting a ruling. The two charts shown below

highlight the performance of a group of stocks that

have or are rumored to have filed for a change in

status to MLPs and REITs. The performance of

these baskets is dynamically hedged against the

Alerian MLP Index and the MSCI REIT Index to

isolate the alpha one could have received from

exposure to these equities. Both themes played

relatively well, with the MLP basket giving back

some gains in the later part of the quarter as

energy fell.

Potential MLP Conversion Situations


Potential REIT Conversion Situations


94

96

98

100

102

104

106

Jan

-14

Feb

-14

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Sep

-14

Oct

-14

No

v-1

4

De

c-1

4

Jan

-15

Feb

-15

Ma

r-1

5

94

96

98

100

102

104

106

108

110

112

114

De

c-1

4

De

c-1

4

Jan

-15

Jan

-15

Jan

-15

Jan

-15

Jan

-15

Feb

-15

Feb

-15

Feb

-15

Feb

-15

Ma

r-1

5

Ma

r-1

5

Ma

r-1

5

90

92

94

96

98

100

102

104

106

108

110

De

c-1

4

De

c-1

4

Jan

-15

Jan

-15

Jan

-15

Jan

-15

Jan

-15

Feb

-15

Feb

-15

Feb

-15

Feb

-15

Ma

r-1

5

Ma

r-1

5

Ma

r-1

5

of 49






Global Macro

Driver of

Strategy

Returns

Change

from

previous


Fundamentals ��

Divergent growth, inflation, and policy

outlooks across major developed

markets and also between developed

and emerging markets should provide

ample opportunities for macro

managers to play dislocations in rates,

commodities, FX, and vol.

Trends - ��

The extraordinary returns to trend-

following strategies in late 2014 are

unlikely to repeat, but divergent

monetary policy across major

developed markets should continue to

create attractive opportunities for

systematic macro strategies.

Correlation ��

Correlations across major asset classes

are sufficiently low enough to provide

managers with a broad opportunity set

Volatility ��

Global macro funds should benefit as

volatility continues to normalize with

monetary policy over 2015.

Crowding ��

A number of common themes

including a strengthening dollar or a

positive outlook for European equities

are currently being played by global

macro managers.

3

-5%

0%

5%

10%

15%

20%

25%

30%

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Jan

-08

Jul-

08

Jan

-09

Jul-

09

Jan

-10

Jul-

10

Jan

-11

Jul-

11

Jan

-12

Jul-

12

Jan

-13

Jul-

13

Jan

-14

Jul-

14

Jan

-15

Median 12-Month

Rolling Returns 1Global Macro Strategy

Median Returns - Macro Systematic

Median Returns - Macro Discretionary

RecessionRecovery

& Growth

Recession

Recovery

Slowdown/

RecessionRecovery

of 49


Global Macro

Global macro discretionary and systematic funds

source their returns from a wide array of both

traditional and alternative betas. These funds will

generally time their exposure to these premiums

using a combination of qualitative and/or

systematic models with inputs such as price &

volume data, investment flows, valuations or

positioning. As a group, we find that the strategy

exhibits a strong trend following bias. Certain funds

have also expanded their investment universe to

relative value opportunities, generally in the fixed

income and volatility space, which generally

complements the core set of macro strategies.

Over the past quarter, both strategies performed

well on the back of similar trends: the strength of

the dollar, positive equity performance in Europe

or rates trading in the US. The opportunity set for

the strategy has been particularly broad as a

number of individual trends developed across asset

classes, allowing funds to capture them in relatively

large size thanks to their diversification benefits.

This is well illustrated by the following chart, which

shows the inter-sector correlation of trend

following models across asset classes (equity, rates,

foreign exchange and commodities). Over the past

months, the correlation between the different sub-

strategies has reached historical lows, only seen

three times since the late 1990s. In this sense, the

current environment has generated an almost

perfect opportunity set for the strategy.

Correlation across Trend-Following Models

(Equity, Bonds, FX, Bonds)


Unsurprisingly, this substantial tailwind helped

propel the Sharpe Ratio of medium-term trend-

following funds to historical highs, reaching a high

of 2.03 in February and in comparison to a long

term historical Sharpe Ratio of 0.5-0.6. This

explains our more cautionary stance on the

strategy going forward. While we were skeptical

about claims that “momentum was dead” a few

quarters ago, we are also cognizant that the

strategy should gradually mean revert to its

historical risk/return profile. Trends across a

number of markets have already run a long way.

While a judgment on whether any/all of these

trends have become over-extended is difficult

to form, we anticipate that volatility around the

trend will be greater across commodity, foreign

exchange or even equities than it has been over the

past months.

Trend-Following Historical Rolling Sharpe Ratio


Another factor which has helped macro strategies,

in particular discretionary investors, is the pickup in

volatility as many discretionary macro portfolio

managers structure their trading views through

option structures. While this technique proved

challenging in recent years as volatility kept

dropping across asset classes, the pick-up in macro

volatility in recent months has helped these funds

aggressively monetize their positions. The following

chart illustrates how volatility has behaved across

asset classes over the past six months. Foreign

Exchange and Rates, which are the two largest

opportunity sets for discretionary macro funds,

have seen their volatility rise.

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

19

95

19

96

19

97

19

98

20

00

20

01

20

02

20

03

20

05

20

06

20

07

20

08

20

10

20

11

20

12

20

13

20

15


Volatility

Themes

Discretionary global macro funds continue to

pursue

divergence in monetary policy between the US and

the rest of the world again taking central stage this

quarter. The European Central Bank Quantitative

Easing program further

strengthened this trend, leading to a weakening of

the com

equity markets. The strength of the US economy

and the end of forward guidance is also impacting

emerging markets. A rallying dollar and the

potential lift

the year are affecting

markets creating a more fragile environment for

the countries heavily reliant on external financing.

Many global macro funds are positioned to benefit

from this effect through short exposures to EM

currencies. The end of formal fo

from the Fed has

“data

additional uncertainty regarding the timing and

INVESTCORP

Volatility

Themes


pursue






the com




potential lift







from the Fed has

“data-dependent” approach which is creating


INVESTCORP

Volatility across

Themes


pursue similar themes






the common currency and a rally in European




potential lift







from the Fed has

dependent” approach which is creating


INVESTCORP

across


similar themes






mon currency and a rally in European




potential lift-off of front end







from the Fed has



INVESTCORP

across Asset Classes


similar themes










off of front end







from the Fed has also



INVESTCORP

Asset Classes


similar themes










off of front end







also given way to the so



Asset Classes


similar themes as in 2014










off of front end

the year are affecting capital flows to emerging






given way to the so



Asset Classes


as in 2014










off of front end US rates by the end of

capital flows to emerging






given way to the so




as in 2014




confirmed and






rates by the end of






currencies. The end of formal forward guidance

given way to the so




as in 2014, with the




confirmed and






rates by the end of






rward guidance

given way to the so




with the




confirmed and






rates by the end of






rward guidance

given way to the so-called




with the




confirmed and






rates by the end of






rward guidance

called




with the




confirmed and






rates by the end of






rward guidance

called



pace of rate hikes. The following chart from

Morgan Stanley shows how the current S&P500

volatility

move. This pattern is likely to continue in the

coming quarters as the market interprets all

incoming macro

the Fed policy. This should provide an interesting

opportunity set for gl

monetize this volatility.

Rates Moves Explaining

While Greece continued to make headlines during

the quarter as the newly elected government

engaged in a new round of negotiations with its

public creditors, the inv

less concerned about the potential spill

effects than in 2011. While investors are divided

regarding the eventual outcome of ongoing

negotiations, the general consensus is that even a

Greek exit should not lead to the same spik

off sentiment as we observed in 2011. The ECB has

successfully ring

particular country. Many European banks have

already substantially cut their exposure to the



volatility



incoming macro















successfully ring





volatility is mainly explained by the amplified rates



incoming macro















successfully ring





is mainly explained by the amplified rates



incoming macro-















successfully ring



Page






-economic data in the context of















successfully ring-fenced the situation to this



Page 30






economic data in the context of


opportunity set for global macro funds able to


Rates Moves Explaining S&P Volatility




public creditors, the investment community seems







fenced the situation to this



30 of 49








obal macro funds able to

S&P Volatility




estment community seems










49









S&P Volatility






















S&P Volatility






















S&P Volatility









Greek exit should not lead to the same spike in risk

















less concerned about the potential spill-over




e in risk


















over




e in risk-






country, thereby reducing the systemic importance

of Gre

Geopolitical risk continued to make headlines this

quarter, complicating the task of global investors as

these risks are difficult to hedge. The situation in

Ukraine seems to have stabilized into a fragile

status quo but

militarily into

price of crude oil. The following map borrowed

from Ian Bremmer of Eurasia illustrates the

difficulties in the Middle East; roughly half of the

region’s airspace is currently

Map of Air Traffic

Source:



of Gre





status quo but

militarily into





Map of Air Traffic

Source: Eurasia Group



of Greece to the rest of the continent.





status quo but

militarily into





Map of Air Traffic

Eurasia Group



ece to the rest of the continent.





status quo but

militarily into





Map of Air Traffic

Eurasia Group








status quo but news that Saudi Arabia

militarily into Yemen temporarily pushed up the





Map of Air Traffic

Eurasia Group








news that Saudi Arabia

Yemen temporarily pushed up the





Map of Air Traffic


























region’s airspace is currently a no

Investcorp Environment Report |












a no-fly zone.

2nd Quarter 2015







news that Saudi Arabia has moved





fly zone.

Quarter 2015






has moved





fly zone.

Quarter 2015






has moved





Quarter 2015






has moved





Quarter 2015

of 49





Source: Investcorp

Corporate Credit

Driver of

Strategy

Returns

Change

from

previous


Valuation ��

Corporate credit currently trades close

to fair value. Valuations should not be

a major contributor or detractor to

returns over the near term.

Carry �� While close to historical lows, carry

remains a net positive for the strategy.

Credit Spreads ��

We expect credit spreads to remain

stable or to narrow marginally from

current levels.

Duration ��

US yields should rise gradually over the

coming quarters, detracting modestly

from total returns.

Dispersion + ��

Dispersion up with the heterogeneous

impact of a stronger dollar and lower

oil prices across the space.

Defaults �� Defaults should remain low, though

with some pick-up in energy sectors.

Liquidity - ��

Liquidity challenged as broker-dealers

hold structurally lower inventories in

response to regulatory curbs on

proprietary trading.

4

250

450

650

850

1050

1250

1450

1650

1850

2050

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Hig

h Y

ield

Bo

nd

Yie

ld (

bp

s)

Dis

tre

sse

d R

ati

o

Bond Yield & Distressed Ratio

Distressed Ratio Bond Yield

of 49


Corporate Credit

We hold a neutral view on credit as we see limited

room for significant upside at current levels.

Meanwhile, a shift in the cycle leading to a sell-off

and defaults does not appear imminent. US high

yield corporates continue to see their yields grind

tighter since the end of 2014, declining from

approximately 6.6% to 5.9% as of the end of

February, a period during which five-year TSY yields

fell approximately 0.16%. February saw the highest

monthly gains for HY bond and leveraged loans in

over three years as an agreement to extend funds

to Greece coupled with stabilizing oil prices and a

ceasefire in Ukraine helped drive global high yield

performance.

Year-to-date, HY bonds and loans have returned

approximately +1.9% and +2.0%, respectively.

Performance has been driven by higher rated

bonds as BB’s returned +2.2% while CCC’s are up

only +1.0%.

High Yield Credit Spreads

Source: Bloomberg

At prevailing levels, investors may be hard pressed

to achieve gains beyond clipping coupons as spread

tightening, if any, may be offset by rising rates as

the Fed contemplates a less dovish stance on

markets. Credit managers seeking to select winners

and losers among the low yielding environment

continue to find it difficult to outperform the

foregone carry due to their moderately hedged

positioning. We also note that tactical efforts to

trade across interim volatility have faced

headwinds of creeping illiquidity in recent months.

For instance, though the energy sector rallied

sharply at the start of the year, acquiring such

credits during their fourth quarter swoon proved

challenging as wide bid-ask spreads curtailed

trading. The following highlights the volatility of

the Bond-CDS basis over the past few months

and testifies to the illiquidity of the space during

that period.

CDS Bonds Basis

Source: Bloomberg

Nevertheless, there are reasons to be optimistic:

� First, liquidity may be returning to the market

with over $7bn of inflows to bond funds in

February alone. The new-issue market

rebounded as well, with $54 billion of new bonds

coming to market in the first two months of

2015, slightly ahead of last year’s issuance pace.

However, outflows have returned as March

experienced large individual daily withdrawals.

Assets under Management in High Yield ETFs

Source: Bloomberg

� The energy sector continues to offer higher yields

than can be found in most other sectors. A large

amount of capital is being raised by dedicated

distressed energy opportunity funds in

anticipation of a potentially severe dislocation.

� Credit spread differentials between split-rated

BBB’s and CCC rated bonds have risen to

approximately 7.5%, the highest level since the

0

200

400

600

800

2012 2013 2014

DJ CDX.NA.HY 100 On the run (5Yr) CDS Spread

CDX.EM On the run (5Yr) CDS Spread

iTraxx Europe Crossover On the run (5Y)

-150

-100

-50

0

50

100

Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15

High Yield Energy CDS-Bond Basis

High Yield All CDS-Bond Basis

15000

17000

19000

21000

23000

25000

27000

29000

31000

2013 2014 2015

of 49


end of 2011, suggesting an increasingly attractive

mean reversion compression trade.

Spread between CCC-rated and BBB-rated bonds

Source: Bloomberg

� Growing dispersion across credit indices suggests

prudent selection may be rewarded going

forward. This was primarily driven by the sharp

sell-off in crude oil which impacted individual

credits very differently. A number of consumer

and chemical names stand to benefit while

Energy & Production (E&P) companies and oil

services may suffer. Similarly, the stronger dollar

is creating dispersion as the outlook for net

exporting companies deteriorates relative to that

of net importing companies. The following chart

shows the at-the-money base correlation for the

CDX High Yield (series 21) index. It moved from

0.6 to circa 0.4 in recent weeks.

CDX HY Main Dec-18 (CDX.HY 5Y Ser21) 0-15

Base Correlation

Source: Bloomberg

� The Fed’s quantitative easing (QE) program

ended in October 2014. Despite recent spread

narrowing, HY credit spreads are nearly 70 bps

higher than they were a year ago and 15 bps

higher than at the conclusion of QE. Meanwhile,

equity markets reached all-time highs towards

the end of February, suggesting that a QE

premium remains embedded in equity pricing.

� The economic environment remains conducive

for steady credit performance. Despite the

recent turbulence in the energy sector driven

largely by oil prices, defaults and inflation remain

low as does inflation, GDP growth remains

stable, and near-term financing needs have been

largely addressed across the high yield market.

Defaults

Through March 20, year-to-date bond defaults

totaled $3bn across four companies, including

Altegrity, an employment screening company,

missed its coupon payments in January affecting

$1.4bn of HY bonds. RadioShack, an electronics

goods retailer, filed for Chapter 11 in February,

impacting $325mn in HY bonds. Quicksilver, an oil

and natural gas producer, missed interest

payments in mid-February affecting $1.1bn in HY

bonds. Dune Energy defaulted in early March on

$68mm.

The twelve month rolling par-weighted US HY

default rate held steady as of March 20 at 2.92%,

down slightly from 2.95% as of the end of 2014.

The default rate is expected to fall in April, when

TXU rolls out of the twelve-month calculation.

Our forecast is for defaults to remain muted with

only a gradual climb over the next few years.

Indeed, few asset managers, banks and rating

agencies see risks beyond the energy sector.

Default risk in the energy sector is rising and should

current oil prices remain in place both this year and

next year, this could lead to default rates in the HY

bond market.

0

500

1000

1500

2000

2500

2005 2007 2009 2011 2013 2015

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15

of 49





Source: Investcorp


Driver of

Strategy

Returns

Change

from

previous


Dispersion ��

Security-level correlations have not

come down as much as sectoral

correlations. This lack of dispersion

remains a headwind for the strategy.

Valuations ��

Valuations still distorted by investors’

persistent search for yield since the

onset of the Global Financial Crisis.

Capital ��

Capital in strategy has been reduced as

returns have not kept pace with long-

biased equity strategies and as prop

trading desks have exited the business.

Liquidity ��

Not an issue for large and mid-cap

names in developed markets. Turnover

constraints key to exploiting attractive

alpha opportunities in small cap and

emerging markets.

Financing ��

Increase in short term deposit rates

over 6-12m attractive for cash

collateral offset by increased financing

costs from prime brokers.

5

-4%

0%

4%

8%

12%

16%

'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Median 12-Month

Rolling Returns 1Equity Market Neutral Strategy

of 49



Equity market neutral is a fairly heterogeneous

strategy universe, and generally contains a small

amount of traditional equity beta with larger

exposures to alternative equity betas such as value,

and momentum premiums than their hedged

equity peers. Outside of exposures to traditional

and alternative beta exposures, the strategy set

also contains a number of distinct investment

styles, including fundamental, quantitative, and

statistical arbitrage investment styles which have

distinct excess return profiles across a full

market cycle.

Equity Market Neutral Universe Cumulative

Returns by Beta Exposures, 1999 – 2015 YTD

Source: Investcorp

Disaggregating the returns of the strategy universe

through traditional and alternative beta factors, we

can see that on aggregate the universe has

delivered positive returns from both traditional and

alternative equity beta return sources, while

cumulative alpha of the universe has decayed to

insignificant levels.

Opportunity Set for Stock Selection

While traditional and alternative beta equity

factors explain a moderate portion of the overall

equity market neutral universe of managers, we

believe top quartile hedge funds within the

universe produce and will continue to produce

alpha, after controlling for traditional and

alternative beta exposures. As mentioned

previously in the section on alternative equity

betas, we view select value factors as less

attractive as the search for yield has stretched

valuations for high dividend yield stocks, and

quality factors offer good upside potential from

stretched valuations within low quality stocks.

While alpha can be generated from the tactical

timing of exposures to market risk factors,

geographical regions and sectors, most alpha

generated within the equity market neutral

strategy is generated from stock-specific

opportunities identified through fundamental,

statistical, and/or technical analysis unexplained by

conventional risk factor models. One way to assess

the potential for opportunities to generate stock

specific alpha is to measure the amount of cross

sectional variation in equities which can be

explained by the MSCI BARRA risk factor model.

From the figure below we can see that stock-

specific risk has been increasing since late 2012 and

continues to be at a near post 2008 high.

However single stock volatility remains fairly low,

offering mixed signals for expected levels of stock

selection alpha.

Global Equity Cross-Sectional Opportunity Set

Focusing on US markets, the top chart on page 36

shows a similar story for US large cap equities, with

stock specific levels of variation back up to 2006-

2007 levels (stock-specific risk increases at the

expense of the ability of industry sectors to explain

variation in stock prices). However, when

comparing US large cap with US small cap, we find

that the opportunity set within small caps are

consistently more compelling than large cap

equities, as small cap stock prices vary more with

stock specific fundamentals and corporate events

and with less analyst coverage than their large cap

peers. A caveat to market neutral investors within

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

1999 2001 2003 2005 2007 2009 2011 2013 2015

Alpha

Traditional Beta Contribution


of 49


the small cap space is the reduced liquidity offered

in small cap and the increased borrowing costs for

shorts, which can reduce the overall realized alpha

realized within the market segment.

Large Cap US Cross-Sectional Opportunity Set

Small Cap US Cross-Sectional Opportunity Set

of 49






Structured Credit

Driver of

Strategy

Returns

Change

from

previous


Valuation ��

Prices have largely normalized since

the dislocation of late 2011. Bonds now

reflect a positive outlook on the

economy, so their risk/return profile

appears more balanced from a

valuation standpoint.

Flows ��

The search for yield coupled with

negative government bond yields

across numerous developed markets

have supported inflows

Carry ��

Yields have compressed but remain

attractive relative to other credit

sectors.

Idiosyncratic

Legal &

Structural + ��

Put-backs and monoline wrappers

creating optionality in selected issues

Liquidity - ��

The liquidity environment remains

challenged as broker/dealers have

scaled back market-making activities.

Strong demand from real money

investors has helped, but their

behavior in a severe market

environment is less predictable.

Financing �� Banks continue to offer attractive

financing terms.

6

(2,500)

(2,000)

(1,500)

(1,000)

(500)

0

500

1,000

1,500

2,000

2,500

-2%

-2%

-1%

-1%

0%

1%

1%

2%

2%

3%

'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Av

era

ge

Qu

art

erl

y H

igh

Yie

ld S

pre

ad

Av

era

ge

Me

dia

n Q

ua

rte

rly

Re

turn

s

Structured Credit Strategy

Dist - Struct Credit

Distressed Ratio

of 49


Structured Credit

The structured credit strategy generally exposes

investors to a combination of credit risk and

alternative risk premiums including carry, value and

liquidity in the credit space. We use these building-

blocks in forming our judgment for the opportunity

set of structured credit funds.

Our outlook for structured credit remains neutral

at this stage of the cycle. While additional upside

from spread compression is likely, the strategy no

longer provides this deep valuation discount and

the asymmetric payoff it used to offer. Carry

continues to decrease as spreads move tighter and

risks have risen as the liquidity environment

remains generally structurally challenged by the

new regulatory and capital requirements affecting

broker/dealers. The liquidity premiums that was

priced at very attractive levels in the fall of 2011

seems to have normalized closer to what we

believe is fair value.

In the following paragraphs, we discuss particular

overall market developments across the various

sectors.

US Non-Agency Residential Mortgage-

Backed Securities

The following chart shows the price appreciation

observed in the past three years across key sectors

of the US Non-Agency RMBS market. This highlights

how deeply discounted bonds have enjoyed a

meaningful recovery, with the ABX

07 AAA index doubling in value during that period.

This dramatic move is leading some hedge fund

managers to rotate their portfolios towards locked-

out cash flows including Re-REMIC mezzanine

pieces. Those assets offer attractive upside as they

currently trade in the 60-70cts range but the

liquidity risk attached to the bonds is also greater.

Cash Prices across US Non-Agency RMBS

Source: Bloomberg

While valuations are less attractive at current

levels, technicals have remained constructive for

the asset class. With the hunt for yield raging, Non-

Agency RMBS still offer some decent carry

opportunities that continue to attract domestic and

international investors. This is shown by the

following volume chart.

Volume in Structured Credit

Source: Bloomberg

Housing prices remain on a gradual uptrend as

shown in the following chart. However, we view

this development as already priced in the market

with limited upside potential from here.

S&P/Case-Shiller Comp. 20 Home Price Index

Source: Bloomberg

0

10

20

30

40

50

60

70

80

90

100

Ma

r-1

2

Ma

y-1

2

Jul-

12

Sep

-12

No

v-1

2

Jan

-13

Ma

r-1

3

Ma

y-1

3

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

Ma

r-1

4

Ma

y-1

4

Jul-

14

Sep

-14

No

v-1

4

Jan

-15

PRIMEX.ARM.2 Cash Price

ALT-A.FIXED.2 Cash Price

OPTIONARM.2 Cash Price

ABX.HE.07-2.PENAAA Cash Price

ABX.HE.07-2.AAA Cash Price

RE-REMIC.MEZZ Cash Price

0

500000

1000000

1500000

2000000

2500000

3000000

3500000

Non-Agency Below IG Volume

CMBS Below IG Volume

100

110

120

130

140

150

160

170

180

20

10

20

10

20

10

20

11

20

11

20

11

20

12

20

12

20

12

20

13

20

13

20

13

20

14

20

14

20

14

of 49


Noteworthy developments this month in the Non-

Agency market included the approval in full by an

appellate court of the $8.5 billion Bank of

America/Countrywide settlement. This is a positive

for the targeted bonds as cash could flow to the

trust as soon as late summer 2015. The theme was

played by a number of hedge fund managers that

therefore stand to benefit from this positive ruling.

The recent credit downgrade of Ocwen, the largest

non-bank servicer in the US could affect servicers

behavior going forward. Ocwen is expected to lose

some market share to other non-bank servicers

including Nationstar and Select Portfolio. Hedge

funds able to study meticulously the impact of

these changes in servicers’ behavior on the priority

of payments waterfall could benefit from this

increased uncertainty.

European Asset Backed Securities

Price action in European Asset Backed Securities

remains driven by the effects of the ECB

Quantitative Easing Program and its

Asset Backed Securities Purchased Program

(ABSPP). The direct effect relates to the negative

net issuance caused by the expected 90 billion

euros of purchases in the ABSPP, while only 20

billion euros is expected to be issued this year in

the market. Indirect impact could be even greater

as investors are displaced from their existing asset

allocation by the much larger QE program, and start

investing in riskier securities including ABS.

In European CLOs, the primary market has slowed,

with issuance running at circa 50% of the pace last

year. This is driven primarily by spread compression

across most European credit which makes the new

issue arbitrage less attractive.

of 49






Convertible Arbitrage

Driver of

Strategy

Returns

Change

from

previous


Valuation + ��

Following last year’s energy-related

sell-off, valuation has improved on

both an absolute and a relative basis

(versus high yield credit), and offer a

slightly more compelling proposition

for the strategy.

Issuance + ��

Issuance has accelerated year-to-date

with rising deal flow in healthcare.

Medium term, we expect energy

issuance to pick-up as well as

Exploration and Production firms seek

to raise their liquidity profiles.

Capital ��

Long-only buyers have become an

important part of the market, diffusing

returns to the long-short risk premium.

Liquidity ��

Liquidity remains a concern as the

strategy is affected by the overall

reduction in market liquidity with

broker-dealers’ scaling back of their

market-making activities.

7

(2,500)

(2,000)

(1,500)

(1,000)

(500)

0

500

1,000

1,500

2,000

2,500

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

'03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Av

era

ge

Qu

art

erl

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igh

Yie

ld S

pre

ad

Av

era

ge

Me

dia

n Q

ua

rte

rly

Re

turn

s

Convertible Arbitrage Strategy

Average Median

Quarterly Return

Average Quarterly

High Yield Spread



Convertible arbitrage

credit beta, an illiquidity premium and a volatility

arbitrage risk premium.

supplement these return streams by generating

alpha through security selection and trading

flow anticipation, liquidity provision and the

flipping of new issues.

Since the financial crisis, the US convertible bond

market has become dominated by outri

who have different objectives and constraints than

the traditional hedged investor base. The pie chart

be

quarter of the universe as of the end of 2014. This

is consistent with the trend in the st

under management:

base has roughly halved from peak, with estimated

assets of $30 billion versus $60 billion

financial crisis. While this structural change should

have helped compensate hedge fund

years, the environment remained challenging as

low volatility and limited new issuance

handicapped the opportunity set.

volatility picked up, it rarely lasted long enough for

funds to capture.

INVESTCORP













elow illustrates how



under management:









funds to capture.

INVESTCORP













illustrates how



under management:









funds to capture.

INVESTCORP













illustrates how



under management:









funds to capture.

INVESTCORP













illustrates how



under management:









funds to capture.

INVESTCORP


Convertible arbitrage offers investors exposure to











illustrates how hedge funds represent



under management: HFR









offers investors exposure to


arbitrage risk premium. Hedge funds typically








hedge funds represent



HFR data shows that the asset











Hedge funds typically











data shows that the asset





















is consistent with the trend in the strategy

















market has become dominated by outright buyers,





rategy



assets of $30 billion versus $60 billion prior to


have helped compensate hedge funds in recent



handicapped the opportunity set. Even when









ght buyers,



hedge funds represent only


rategy’s assets



prior to


in recent



Even when






alpha through security selection and trading via



ght buyers,



only a


’s assets



prior to the


in recent



Even when






via



ght buyers,



a


’s assets



the


in recent



Even when


However, a number of indicators have re

turned positive for the space and we

more confident in the strategy

deliver relatively attractive returns over the

coming quarters.

First, new issuance is accelerating notably this

quarter with $12.5 billion of new bonds issued

through

healthcare deals. T

energy could help fuel further issuance in the

coming quarters. A large number of Exploration &

Production (E&P) companies are expected to

liquidity in second

as the recent crude oil se

their balance sheets. Not only is the market

expanding, the aver

has

last year’s historical low of





coming quarters.



through

healthcare deals. T




liquidity in second



expanding, the aver

increased to 2.4% year






coming quarters.



through February, primarily driven by

healthcare deals. T




liquidity in second



expanding, the aver







coming quarters.



February, primarily driven by

healthcare deals. T




liquidity in second



expanding, the aver



Page





coming quarters.




healthcare deals. The ongoing dislocations in




liquidity in second-lien



expanding, the average cheapness for new issues



Page 41








he ongoing dislocations in




ien deals or convertible bonds

as the recent crude oil sell


age cheapness for new issues



41 of 49












deals or convertible bonds

ll-off left



increased to 2.4% year-to

last year’s historical low of 0.9%

49













off left



to-date compared to

0.9% (Source: Barclays)



more confident in the strategy’s










a sizeable hit on



date compared to

(Source: Barclays)



ability to










a sizeable hit on



date compared to

(Source: Barclays)

However, a number of indicators have recently


ability to




February, primarily driven by large




Production (E&P) companies are expected to raise


a sizeable hit on



date compared to

(Source: Barclays)


cently

turned positive for the space and we are

ability to




large




raise


a sizeable hit on



date compared to

(Source: Barclays).


Second, as the below chart shows, convertible

bonds generally offer a better carry profile than

their comparable high yield bonds, with an extra

yield of 60bps

illiquidity premium is therefo

across convertible bonds today relative to the

past two years. PineRiver recently conducted an

in

reviewing positioning across outright and hedge

fund portfolios to derive a view of valuation

across both investing communities. The chart

shows the history of Option

(OAS) in recent months for both outright and

hedge fund portfolios. These OAS are adjusted for

varying credit risk exposure between the two

model portfolios, providing

comparison. This supports our view that the

strategy currently offers a slightly better

performance outlook.





yield of 60bps




in-depth review of the strategy opportunity set,



cross both investing communities. The chart













yield of 60bps




depth review of the strategy opportunity set,
















yield of 60bps




















yield of 60bps, as of the end of this quarter. The




















as of the end of this quarter. The















































shows the history of Option-












illiquidity premium is therefore better valued







-Adjusted Spreads




a fair base for



2nd Quarter 2015





re better valued







Adjusted Spreads




a fair base for



Quarter 2015





re better valued







Adjusted Spreads




a fair base for



Quarter 2015





re better valued







Adjusted Spreads




a fair base for



Quarter 2015





re better valued







Adjusted Spreads




a fair base for



Quarter 2015

of 49


Convertible Bond Spread versus High Yield

Source: Bloomberg

Hedge Fund Portfolio Spread Profile versus Outright Convertible Bonds Investors

of 49







Driver of

Strategy

Returns

Change

from

previous


Valuations ��

Spreads have blown out across the

energy high yield sector creating

idiosyncratic opportunities to acquire

misperceived issues that sold off with

the rest of the sector

Supply

(Defaults and

Restructuring

Opportunities)

��

Corporate issuance trading at

distressed levels has risen to post-

financial-crisis highs thanks to the

dislocation in the US energy sector.

Other sources of supply remain tepid.

Capital + ��

The amount of capital chasing the

opportunity set is perceived to be large

and so a net detractor to the alpha

outlook for the strategy. Major market

players aggressively raising private

equity and hybrid distressed funds.

Risks - ��

Current pricing does not yet reflect a

lower-for-longer price of oil, therefore

downside risks still predominate.

Non-Corporate

Distressed

Opportunities ��

Investors willing to commit long-term

capital can benefit from dislocations

and idiosyncratic opportunities. Our

highest convictions include US

distressed municipals and Italian Non

Performing Loans (NPLs).

8

(0.8)

(0.6)

(0.4)

(0.2)

0.0

0.2

0.4

0.6

0.8

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Av

era

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istr

ess

ed

Ra

tio

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dia

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rte

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Re

turn

s

Distressed Strategy

Returns

Distressed Ratio

of 49



The corporate distressed strategy is currently

dominated by dislocations in the US energy sector.

This has driven more attention to the strategy in

recent weeks. In the following paragraphs, we

provide a high-level overview of the theme and

offer our views on investment implications.

Outside of energy, the opportunity set remains

limited and performance has been lackluster.

Shipping or Greek banks that had been large

themes in the strategy over past quarters have yet

to materialize. The situation in Greece is

particularly concerning and the “unknown

unknowns” of a potential Greek default and exit of

the European Union have led us to reduce

exposure over the past months.

Outside of traditional corporate distressed

situations, we see strong opportunities in Europe

playing the bank deleveraging theme through Non

Performing Loans (NPLs). Similarly, the US

distressed municipal sector offers compelling value

in the medium term. These investments generally

require a liquidity trade-off as capital that can be

locked-up for several years may reach IRRs of 12-

18% depending on the scenarios.

The US Energy Dislocation

The distressed community is buzzing about the

investment opportunities the recent dislocation in

energy prices have opened. The number of issuers

currently trading at distressed levels, i.e., at spread

levels of 1,000 basis points or higher, has

indeed risen to post financial crisis highs (confer

below chart).

Number of Distressed Issuers Traded (US)

Source: Bloomberg

In what may be the best opportunity since the

financial crisis, dozens of funds are launching

dedicated vehicles to capture this trade. Looking

back, the opportunity has its origins in the US

Energy Renaissance that propelled US energy

production to new highs, thanks to horizontal

drilling technological innovations. The energy

sector typically requires heavy capital expenditure

and Energy & Production and Oil Services

companies relied heavily on bond issuance to cover

their growth. Since 2009, those two sectors alone

were the largest issuers of high yield debt and

the broader energy sector currently accounts

for approximately 17% of the high yield bond

market with a face amount of ~$200 billion (confer

chart below).

Energy High Yield Outstanding (as a % of Total

High Yield; Developed Markets)

Source: Bloomberg

However, while these companies were largely

profitable when crude oil was standing in the $100

price range, the picture changes dramatically at

today’s prices. The sharp sell-off observed in the

last quarter of 2014 led credit spreads in the

energy sector to double in a matter of weeks.

Spread Dislocation in Energy

Source: Bloomberg

0

50

100

150

200

250

300

350

400

2012 2013 2014 2015

0.00

0.05

0.10

0.15

0.20

0.25

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

0

200

400

600

800

1000

Ma

r-1

4

Ap

r-1

4

Ma

y-1

4

Jun

-14

Jul-

14

Au

g-1

4

Sep

-14

Oct

-14

No

v-1

4

De

c-1

4

Jan

-15

Feb

-15

Ma

r-1

5

JPMorgan Domestic HY Energy Spread to Worst

JPMorgan Domestic HY Summary Spread to Worst

of 49


The market is complex and fragmented, with

hundreds of issuers and a large range of different

situations with regards to balance sheet strength,

liquidity, hedging policy and asset quality. This

creates an attractive opportunity set for distressed

hedge funds, with deep expertise in credit

underwriting and in-depth knowledge of the

bankruptcy process that may await some of

these companies.

Our view is that the current dislocation is best

captured in the liquid long/short credit space.

Longer term, we are optimistic about the

opportunity set for long-biased distressed and

loan-to-own strategies but the future is likely to

offer better entry points. Many companies have

enough liquidity and hedges to go through the year

before running into trouble. The market is still

pricing in crude oil at the forwards, with a very

steep contango (approximately $10/barrel one

year forward as of March end). Long-biased

investing may do well if crude oil were to converge

to forward prices, however the downside risks are

formidable if oil were to stay lower for longer.

Private equity and debt funds have raised

substantial amounts of capital that should help

extend the lifeline for the industry through equity

and second-lien financing deals. This creates a

relatively high risk of priming for current debt

owners in the space. We recommend being patient

and continuing to monitor new developments

closely.

of 49






Fixed Income Relative Value

Driver of

Strategy

Returns

Change

from

previous


Opportunity Set + ��

As rates volatility picks up, more

constructive on front-end trades offset by

less attractive curve trades since 2011.

Macro

Fundamentals + ��

Divergent global monetary policies,

accelerating inflation, and the approach

of Fed’s lift-off date should continue to

support higher volatility over 2015.

Capital �� Limited capital chasing opportunities with

downsizing of prop desks.

Liquidity ��

Lesson of October 2014 sell-off: In Dodd-

Frank regulatory environment, liquidity

may prove ephemeral even in markets

with little liquidity risk historically.

Valuation ��

Absolute yields and global spreads remain

at generational lows, offset by the recent

repricing of convexity

Financing ��

2015 increase in short term deposit rates

attractive for cash collateral offset by

prime brokers raising financing costs.

9

(120)

(60)

0

60

120

180

240

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Av

era

ge

Qu

art

erl

y M

err

ill

Ra

te I

mp

lie

d V

ol

Ind

ex

Av

era

ge

Me

dia

n Q

ua

rte

rly

Re

turn

s

Fixed Income Relative Value Strategy

Average Median Quarterly Returns



G8 10yr Swap Rates

Source: Bloomberg

Within the global opportunity set, swap rates

across developed markets continue to move lower

as the BoJ

Easing programs and global central banks remain

willing to support lower rates.

increasing demand for safe assets from stricter

banking collateral criteria

demographics

and have also

differentials across regional developed market

rates.

reduced the carry per unit of effective duration as

well as the potential carry pick

matched global relative value trades, reducing our

outlook for carry oriented fixed income strategies.

No

min

al

Yie

ld (

%)

INVESTCORP


G8 10yr Swap Rates

Source: Bloomberg



as the BoJ





demographics

and have also


rates. This compression in global interest rates has





0

1

2

3

4

5

6

7

8

9

10

1999

No

min

al

Yie

ld (

%)

INVESTCORP


G8 10yr Swap Rates

Source: Bloomberg



as the BoJ and ECB continue to pursue Quantitative





demographics

and have also


This compression in global interest rates has





1999 2001

INVESTCORP


G8 10yr Swap Rates




and ECB continue to pursue Quantitative





demographics, inte

and have also







2001

INVESTCORP


G8 10yr Swap Rates

, Investcorp








interest nominal rates

and have also







2003

INVESTCORP


G8 10yr Swap Rates

, Investcorp








rest nominal rates

compressed relative yield







2005








banking collateral criteria and changes in investor

rest nominal rates








2007





willing to support lower rates. Combined with an


and changes in investor

rest nominal rates





well as the potential carry pickup from duration



2007 2009





Combined with an



rest nominal rates





up from duration



2009 2011

Mean Yield

-1 Std

+1 Std





Combined with an



have reduced





up from duration



2011 2013

Mean Yield

-1 Std

+1 Std





Combined with an



have reduced





up from duration



2013

Mean Yield





Combined with an



have reduced





up from duration



2015





Combined with an



have reduced





up from duration


PCA Analysis of US Swap Curve, 90d Rolling

Source: Bloomberg

Within the US yield curve relative value space, the

movement of the US swap curve has becoming

increasingly sensitive to parallel shifts in rates, with

less variation being explained by both movements

in short term vs long term rates, and shifts in yield

curve curvature

first principle component has explained 84% of the

daily variations in yield across the curve since 1998,

while it has recently increased to post 2008 highs

of 90%, suggesting that we should expect less

differentiation and diversification across the swap

curve as the market prepares for lifting off the zero

bound of the Fed Funds rate.

dimensionality currently experienced in the yield

curve suggests an increased efficacy of empirical

durat

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%


Source: Bloomberg






urve curvature





ferentiation and diversification across the swap





duration matched hedges, it also suggests lower

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1998








urve curvature










ion matched hedges, it also suggests lower

1998 2000


, Investcorp






urve curvature (see figure above











2000 2002

PC1

Page


, Investcorp






see figure above











2002 2004

PC1 PC2

Page 47







see figure above











2004 2006

PC2

47 of 49







see figure above











2006 2008

PC3

49







see figure above).







bound of the Fed Funds rate. While this reduced




2008 2010

Residual







). On average the







While this reduced




2010 2012

Residual







On average the







While this reduced




2012 2014







On average the







While this reduced




2014







On average the







While this reduced





volatility in classic flattener/steepener trades,

requiring higher degrees of leverage to achieve

similar return targets as the recent 2011

period.

appears to have ample li

between the On the Run, Off the Run 10yr

Treasuries remains continues on a secular trend

downward and is near decade lows

On

Source: Bloomberg

Within the

we have begun to see a re

across developed market swaptions after a recently

calm 3 year

volatility can be attributed to the current transitory

state of US monetary policy an

divergence with other global central banks, which

continue to ease and fight deflationary pressures.





period.





On-the

Source: Bloomberg

Within the



calm 3 year





0

2

4

6

8

2000





period. Fortunately the market environment





the-Run, Off

Source: Bloomberg

Within the



calm 3 year





2002





Fortunately the market environment





Run, Off


Within the global interest rates



calm 3 year period. T





2002 2004










Run, Off-the

, Investcorp

global interest rates



period. T





2004

10-Year OTR / OFR

+ 1 SD










the-Run 10yr Treasury Spread

, Investcorp




period. This pick up in interest rate





2006

10-Year OTR / OFR

+ 1 SD










Run 10yr Treasury Spread


we have begun to see a re-


his pick up in interest rate





2006 2008

10-Year OTR / OFR






appears to have ample liquidity, as spread






-emergence of volatility







2008 2010






quidity, as spread



downward and is near decade lows.


global interest rates derivative markets

emergence of volatility




state of US monetary policy and the US policy



2010

2nd Quarter 2015





quidity, as spread




derivative markets





d the US policy



2012

Mean

- 1 SD

Quarter 2015





quidity, as spread




derivative markets





d the US policy



2012 2014

Mean

- 1 SD

Quarter 2015



similar return targets as the recent 2011-2013


quidity, as spread




derivative markets





d the US policy



2014

Quarter 2015



2013


quidity, as spread




derivative markets,





d the US policy



Quarter 2015


This pickup in rate volatility is beneficial for interest

rate volatility relative value and directional trades,

and indirectly benefits o

value trades which depend on increases in realized

volatility (such as basis trades).

Implied Volatilities across DM Rates

Source: Bloomberg

When we compare this pick

relative to other asset cl

INVESTCORP







Source: Bloomberg



10

20

30

40

50

60

70

80

90

3m

10

y S

wa

pti

on

AT

M V

ola

tili

ty

(bp

s)

INVESTCORP







Source: Bloomberg



0

10

20

30

40

50

60

70

80

90

2001

(bp

s)

INVESTCORP










2003

USD Implied Vol

G8 Median Implied Vol

INVESTCORP







, Investcorp



2003 2005

USD Implied Vol


INVESTCORP







, Investcorp



2005

USD Implied Vol




and indirectly benefits other fixed income relative





relative to other asset classes

2007

USD Implied Vol




ther fixed income relative




When we compare this pick-up in rate volatility

asses (see figure below

2009







up in rate volatility

see figure below

2009 2011







see figure below

2011






see figure below

2013






see figure below),






),

we see that this move upwards is corroborated by

commodities and currency markets but is at odds

with current leve

equity markets.

divergences across asset class

reverting in nature and

multi

Implied Volatility across Assets, 8w MA

Source: Bloomberg

10

20

30

40

50

60

70

80

1m

AT

M V

ola

tili

ty (

%)



with current leve

equity markets.



multi-asset volatility trades.


Source: Bloomberg

0

10

20

30

40

50

60

70

80

2001



with current leve

equity markets.



asset volatility trades.



2003



with current leve

equity markets. Historically we’ve found that these





, Investcorp

2003 2005

Equities

Currencies

Commodities

Rates (RHS)

Page



with current levels of implied volatility within

Historically we’ve found that these





, Investcorp

2005

Equities

Currencies

Commodities

Rates (RHS)

Page 48



ls of implied volatility within



reverting in nature and are



2007

Commodities

Rates (RHS)

48 of 49






are positive



2009

49





divergences across asset class volatility are mean

positive


2009 2011





volatility are mean

positive indicators


2011 2013





volatility are mean

indicators


2013





volatility are mean

indicators

0

50

100

150

200

250






volatility are mean

indicators for

50

100

150

200

250

1m

AT

M N

orm

al

Vo

lati

lity

(b

ps)


Overall

constructive for Fixed Income Rela

repricing of rate volatility is beneficial for

systematic risk

towards a more data

supportive of the monetary policy specialists, as

the markets view on rate hikes continue to dive

from released Fed projections

Expected Fed Funds Rate


Overall



systematic risk

towards a more data






Overall, we believe these developments to be



systematic risk

towards a more data






we believe these developments to be



systematic risk

towards a more data









systematic risk premiums

towards a more data









premiums

towards a more data









premiums trades

towards a more data-dependent US Fed is









trades

dependent US Fed is



from released Fed projections (see figure below

Investcorp Environment Report |


constructive for Fixed Income Relative Value as the


trades. In addition,

dependent US Fed is



see figure below

2nd Quarter 2015


tive Value as the


. In addition,

dependent US Fed is



see figure below

Quarter 2015


tive Value as the


. In addition,

dependent US Fed is



see figure below

Quarter 2015


tive Value as the


a shift

dependent US Fed is


the markets view on rate hikes continue to diverge

see figure below).

Quarter 2015


tive Value as the


a shift

dependent US Fed is


rge

Quarter 2015

of 49


Disclosure Research

Investcorp conducts proprietary research. The information contained herein is being provided on a confidential basis and is for informational purposes only. This document may not be

reproduced in whole or in part, and may not be delivered to any person without the prior written consent of Investcorp. Proprietary research is developed, produced, and prepared by

Investcorp Investment Advisers LLC and Investcorp Investment Advisers Limited.

The hypothetical models used to describe the portfolios and indices contained herein were created for illustrative purposes only and there can be no assurance that investment objectives

of an actual model will be achieved and actual investment results of such a model may vary substantially. The returns are hypothetical and were achieved by means of application of

model(s) developed and applied with the benefit of hindsight. The returns do not reflect actual trading of any portfolio or index. The hypothetical model portfolio or index returns do not

reflect the impact of factors that may have adversely affected Investcorp’s decision-making process if actual investments had been made at that time.

The hypothetical models may not reflect fees and expenses at the portfolio level, and can only incorporate estimates of historical transaction costs. The analyses provided rely on

proprietary models which are based on a certain set of parameters and assumptions and do not reflect actual investment experiences. Analyses based on other models or different

assumptions may yield different results. All views and opinions contained herein are current as of the date of this document but subject to change. Investcorp has no obligation to update

the information contained in this document.

Risk

The analyses provided herein are done using proprietary models based on a certain set of parameters and assumptions. Information used to generate the model results are from third-

party sources, including hedge fund managers, the prime brokers, and/or administrators, that we believe to be reliable but we make no warranty as to accuracy of such information. We

also make use of third-party providers of risk analytics and pricing tools in our proprietary models to generate the information provided herein. We make no warranty as to the reliability

of such third-party tools nor make any representation as to the effectiveness of such tools in measuring risks or prices.

This analysis is being prepared by Investcorp and the views expressed are those of Investcorp only. Analyses based on other models or different assumptions may yield different results.

There are many ways to measure risks in various asset classes and strategies. While we believe that the information contained herein is a reasonable representation of managing risks, we

make no representation that the information contained herein is the correct view of how risks should be managed or measured.

Additional Disclaimer

The information contained in this document may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that reflect our current

views with respect to, among other things, future financial and business performance events, strategies and expectations. We generally identify forward-looking statements by

terminology such as “outlook,” “believe,” “expect,” “potential,” “continue,” “may,” “will,” “should,” “seeks,” “approximately,” “predicts,” “intends,” “plans,” “estimates,” “anticipates” or

the negative version of those words or other comparable words. Any forward-looking statements contained in this document are based upon the historical performance and market

information, and on our current plans, estimates and expectations. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person

that the future plans, estimates or expectations contemplated by us will be achieved.

Such forward-looking statements are subject to various risks and uncertainties, including but not limited to global and domestic market and business conditions, our ability to successfully

compete for fund investors, investment opportunities and talent, successful execution of our business and growth strategies, our ability to successfully manage conflicts of interest, and

tax and other regulatory factors relevant to our structure and status as a public company, as well as assumptions relating to our operations, financial results, financial condition, business

prospects, growth strategy and liquidity. If one or more of these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, our actual results may

vary materially from those indicated in these statements.

These factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements and risks that are included in this document and any relevant

offering materials. Any forward-looking statements, views, and opinions contained in this document are current as of the date of this document but subject to change. We do not

undertake any obligation to update or review any forward-looking statement, views, and opinions, whether as a result of new information, future developments or otherwise.

The reports or commentaries that constitute part of this document may rely on public information and sources. Information used to generate model results, reports or commentaries are

from third-party or public sources that we believe to be reliable but we make no warranty as to accuracy of such information. Data from hedge fund indices reflect returns net of fees and

expenses. Databases are used to gather qualitative and quantitative information from a variety of sources to allow paid subscribers to conduct analysis of managers, indices and their

related performance.

INVESTCORP Hedge Funds Environment Report | 2nd Quarter 2014

Investcorp

280 Park Avenue, 37th Floor

New York, NY 10017

(212)-599-4700

[email protected]

INVESTCORP

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