ITEM 1. “BUSINESS-
PERFORMANCE OF THE COMPANY-Certain Considerations Relating to Limited Capacity of Potential Advisors”. Further, the Company and each Investment Fund and their methods of operation may differ in several respects from prior GS Group investment vehicles or accounts; e.g., there are different investment and return objectives and investment allocation strategies and the Company and each Investment Fund utilizes a different mix of Advisors and, in certain cases, investment techniques. Similarly, the past investment performance of any of the Advisors with which the Investment Funds will invest or with which other investment funds or accounts managed by the GS Group invest should not be construed as an indication of the future results of such Advisors or of the Investment Funds. Potential investors that desire performance or related information with respect to the Company, Investment Funds or other investment funds formed or managed by the GS Group should contact the Managing Member.
A Member’s Investment in the Company will be Affected by the Investment Policies and Decisions of Advisors Which are Outside the Company’s Control
Because the Company generally invests its assets in Investment Funds, which in turn allocate assets to Advisors, a Member’s investment in the Company will be affected by the investment policies and decisions of the Advisors in direct proportion to the amount of an Investment Fund’s assets that are invested, directly or indirectly, with each Advisor. The NAV of the assets allocated to Advisors, and as a result, the NAV of the Investment Funds and, in turn, the Company, will fluctuate in response to, among other things, investment decisions made by the Advisor, various market and economic factors related to the markets in which the Advisors invest and the financial condition and prospects of issuers in which the Advisors invest. These risks will be outside the control of the Company. Certain risks related to the investment strategies and techniques utilized by the Investment Funds and the Advisors are described under “-Investment Related Risks”.
Limitations on Ability to Invest in Advisors May Result in Assets Not Being Used to Pursue Investment Objectives
In the event that the Investment Funds are able to allocate assets to Advisors only at certain times, the Investment Funds may hold cash or invest any portions of their assets that are not invested in Advisors in cash equivalents, short-term securities or money market securities pending allocation to Advisors. During the time that the Company’s assets are not invested in Advisors, that portion of the Company’s assets will not be used to pursue the Investment Funds’ and, in turn, the Company’s investment objective.
Valuation of the Investment Funds’ Investments Will be Determined Utilizing Valuations Provided by the Advisors Which are Generally not Audited; Uncertainties in Valuations Could Have a Material Adverse Effect on the Company’s Net Assets
The valuation of an Investment Fund’s investments is ordinarily determined utilizing monthly valuations provided by the Advisors which are only audited annually. Many of the securities or other assets in which Advisors invest may not have a readily ascertainable market price and will be valued by the Advisors without an independent third party valuation. In this regard, an Advisor may face a conflict of interest in valuing the securities, as their value will affect the Advisor’s compensation. Valuations of the securities are very subjective and could prove in hindsight to have been wrong, and at times by significant amounts. Furthermore, the managing member of the Investment Funds may face a conflict of interest in overseeing the value of the Investment Funds’ investments, as the value of the Investment Funds’ investments will affect such managing member’s compensation. Although prior to investing in any Advisor, the managing member of the Investment Funds generally will seek to conduct a due diligence review of the valuation methodology utilized by such Advisor, no assurances can be given that the managing member of the Investment Funds will be given access to necessary aspects of the Advisors’ systems, that such due diligence review will ascertain whether accurate valuations will be provided by such Advisors to the Investment Funds, that the Advisors will comply with their own internal policies or procedures for keeping records or making valuations, or that the Advisors policies and procedures and systems will not change without notice to the Investment Funds. Moreover, the managing member of the Investment Funds will generally not have sufficient information in order to be able to confirm or review the accuracy of valuations provided by Advisors to whom an Investment Fund allocates assets. See “-General Risks-Risks Related to the Company and the Investment Funds’
Performance and Operation-Dependence on the Managing Member and the Advisors; the Managing Member Generally Has Limited Access to Information on or Control over Advisors’ Portfolios and Members Assume the Risk that Advisors May Knowingly Misrepresent Information Which Could Have a Material Negative Impact on the Company”.
From time to time, the Managing Member may have reason to believe that a valuation provided to the Company by an Advisor may be inaccurate. In such event, the Company may, in the sole discretion of the Managing Member, delay finalizing the Company’s NAV as of the end of the applicable accounting period until the Managing Member has had an opportunity to meet with the Advisor regarding the basis for such valuation and/or the valuation policies and procedures by which the Advisor arrived at the valuation. Any such delay would likely result in a delay in the payment of a portion of any redemption proceeds otherwise payable in respect of redemptions requested as of the applicable Redemption Date (although the Company would endeavor to pay out a portion of redemption proceeds within the normal timeframe).
The NAV of any Advisor Fund, Portfolio Company or Managed Account as of a particular date may be materially greater than or less than the NAV of such Advisor Fund, Portfolio Company or Managed Account that would be determined if its assets were to be liquidated as of such date. For example, if an Advisor Fund, Portfolio Company or Managed Account were required to sell a certain asset or all or a substantial portion of its assets on a particular date, the actual price that such Advisor Fund, Portfolio Company or Managed Account would realize upon the disposition of such asset or assets could be materially less than the value of such asset or assets as reflected in the NAV of the Advisor Fund, Portfolio Company or Managed Account. Volatile market conditions could also cause reduced liquidity in the market for certain assets, which could result in liquidation values that are materially less than the values of such assets as reflected in the NAV of the Advisor Fund, Portfolio Company or Managed Account.
The managing member of an Investment Fund may allocate assets to Advisors that invest in assets that lack a readily ascertainable market value, and the NAV of the Investment Fund will be affected by the valuations of any such assets (including, without limitation, in connection with calculations of any management fee or performance-based fee or allocation at the Investment Fund level). In valuing assets that lack a readily ascertainable market value, Advisors (or affiliated or independent agents thereof) may utilize dealer supplied quotations or pricing models developed by the Advisor, affiliates of the Advisor and/or third parties, including GS HFS or affiliates of GS HFS). Such methodologies may be based upon assumptions and estimates that are subject to error. Given the uncertainty inherent in the valuation of assets that lack a readily ascertainable market value, the value of such assets as reflected in the NAV of an Investment Fund, Advisor Fund, Portfolio Company or Managed Account may differ materially from the prices at which the applicable Advisor would be able to liquidate the assets.
The value of assets that lack a readily ascertainable market value may be subject to later adjustment based on valuation information available to the applicable Advisor at that time including, for example, as a result of year-end audits. Any adjustment to the value of such assets may result in an adjustment to the NAV of an Investment Fund and in turn the Company. See “-Risks Related to the Company’s Structure-The Company’s Financial Statements are, and in the Future Will Ultimately be, Based on Estimates of Valuations Provided by Third Party Advisors Which May not be Accurate or May Need to be Adjusted in the Future”.
The NAVs or other valuation information received by the managing member of the Investment Funds from an Advisor may require estimations of the value of certain assets and liabilities, and may be subject to later adjustment or revision by the Advisor, which adjustment or revisions may be significant. Any such adjustment or revision may result in either an increase or decrease in the NAV of the Company at the time the Company is provided with information regarding the adjustment, which adjustment or revision may be significant. If an Advisor’s valuations are consistently delayed or inaccurate, the managing member of the Investment Funds will consider whether the Advisor continues to be an appropriate manager of Investment Fund assets. However, the managing member of the Investment Funds may elect in its sole discretion to retain the Advisor. The Advisor’s information could be inaccurate due to Fraudulent Activities, misvaluation or inadvertent error. In any case, the Investment Funds may not uncover errors for a significant period of time. If this occurs in connection with an investment in an Advisor Fund, the Investment Fund may be unable to sell interests in an Advisor Fund quickly, and therefore could be obligated to continue to hold such interests for an extended period of time. In such a case, or in the event that the
managing member of the Investment Funds does not receive a valuation from an Advisor Fund on a timely basis, or determines, in its sole discretion, that a valuation is inaccurate or incomplete, the managing member of the Investment Funds may, in its sole discretion, determine the fair value of an Investment Fund’s interests in the Advisor Fund independently of the Advisor’s valuations based on the best available information, which may be the information most recently provided by an Advisor to the managing member of the Investment Funds, and any factors deemed relevant by, the managing member of the Investment Funds at the time of such valuation. Such determination may be materially inaccurate, including because the information available to the Managing Member was insufficient, inaccurate or out of date. It is not expected that the Fund will make adjustments to correct such determinations to reflect information that becomes available to the Fund at a later date, although the Managing Member may make such adjustments in its sole discretion. Members should be aware that situations involving uncertainties as to the valuations by Advisors could have a material adverse effect on the Company’s net assets and Members if the managing member of the Investment Funds or the Advisor’s judgments regarding valuations should prove incorrect. Members who are unwilling to assume such risks should not retain their investment in the Company. See “-Risks Related to the Company’s Structure-The Company’s Financial Statements are, and in the Future Will Ultimately be, Based on Estimates of Valuations Provided by Third Party Advisors Which May not be Accurate or May Need to be Adjusted in the Future”.
Investment Fund Allocations to Advisor Funds are Difficult to Monitor and Control
Each Investment Fund may invest all or a substantial portion of its assets in Advisor Funds, rather than allocating assets via Portfolio Companies or directly to Advisors pursuant to Managed Accounts. It is expected that the managing member of the Investment Funds generally will have less ability to monitor investments in the Advisor Funds, to obtain full and current information and to exercise control rights over such investments than with respect to allocations of assets to Portfolio Companies or Managed Accounts. This could have an adverse effect on the performance of such investments and, therefore, on the performance of the Investment Funds and the Company.
Trading in Investments May be Illiquid Which May Cause Substantial Losses and May Negatively Impact the Ability to Make Distributions to a Withdrawing or Redeeming Member
Some investment positions in which the Investment Funds have an interest will be illiquid. The Advisors may invest in restricted or non-publicly traded securities, securities on foreign exchanges and futures. These positions may be illiquid because certain exchanges limit fluctuations in certain securities and futures contract prices during a single day by regulations referred to as “daily price fluctuation limits” or “daily limits”. Under such daily limits, during a single trading day no trades may be executed at prices beyond the daily limits. Once the price of a particular security or futures contract has increased or decreased by an amount equal to the daily limit, positions in that security or contract can neither be taken nor liquidated unless traders are willing to effect trades at or within the limit.
The market value of an Advisor’s investments may fluctuate with, among other things, changes in prevailing interest rates, general economic conditions, the condition of financial markets, developments or trends in any particular industry and the financial condition of the issuers of the securities in which the Advisor invests. During periods of limited liquidity and higher price volatility, the Advisor’s ability to acquire or dispose of its investments at a price and time that the Advisor deems advantageous may be impaired. As a result, in periods of rising market prices, the Advisor may be unable to participate in price increases fully to the extent that it is unable to acquire desired positions quickly; conversely, the Advisor’s inability to dispose fully and promptly of positions in declining markets will cause its net asset value to decline as the value of unsold positions is marked to lower prices.
In addition, Advisors may invest a portion or all of the value of their assets in restricted securities and other investments that are illiquid. Restricted securities are securities that may not be sold to the public without an effective registration statement under the Securities Act or, if they are unregistered, may be sold only in a privately negotiated transaction or pursuant to an exemption from registration. These may include restricted securities that can be offered and sold only to “qualified institutional buyers” under Rule 144A of the Securities Act. There may be no limit to the percentage of an Advisor’s net assets that may be invested in illiquid securities.
The above-described circumstances could prevent the Advisors of an Investment Fund from liquidating unfavorable positions promptly and subject such Investment Fund and, in turn, the Company, to substantial losses. This could also impair the Company’s ability to redeem its membership units in an Investment Fund in order to make distributions to a withdrawing or redeeming Member in a timely manner.
Advisor Redemption Holdbacks and Other Advisor Fund Liquidity Restrictions May Adversely Affect Remaining Members
From time to time, the managing member of an Investment Fund may be unable to liquidate the Investment Fund’s assets as it otherwise deems advisable in order to pay redemption requests made by the Company due to a number of factors including, without limitation, minimum holding periods and restrictions on redemptions imposed by the Advisor Funds or Advisors (including but not limited to the use of longer notice periods and less frequent redemption dates than those offered by the Company and the Investment Funds, holdbacks, and the segregation of assets by the Advisors through the use of “side-pockets”). At any given time, assets of an Investment Fund that cannot be redeemed to meet current redemption requests may constitute a substantial portion of the Investment Fund’s portfolio. See “-Risks Related to the Units, Liquidity of Units and the Offering of the Units-The Company has Limited Liquidity and Limited Rights for Redemption”. As a result, the managing member of an Investment Fund may be required to redeem interests from more liquid Advisor Funds or Portfolio Companies in order to meet redemption requests, which could result in an Investment Fund holding a greater concentration of less liquid assets than was previously the case or in the Investment Fund incurring additional costs in connection with the redemption. This could have an adverse effect on the Investment Fund’s portfolio mix and liquidity for remaining members which could potentially include the Company. Significant amounts of redemption requests by investors in an Investment Fund that are not offset by new subscriptions could cause the Investment Fund to postpone or suspend redemptions. The Investment Fund’s inability to liquidate its interests in such less liquid assets may also have a material adverse effect on the Investment Fund’s ability to reallocate assets.
The Company will endeavor to pay redemption proceeds to a redeeming Member within 45 days following the applicable Redemption Date. For various reasons, however, including the suspension or delay in payment of redemption proceeds by Advisor Funds and the holdback of a portion of the redemption proceeds otherwise payable to the Company until after the applicable underlying Advisor Fund’s financial records have been audited, the Company may not receive redemption proceeds otherwise expected by it prior to the Company’s payout of proceeds to redeeming Members. Therefore, at the time the Company pays redemption proceeds to a redeeming Member, the Company may hold receivables that may not be paid to the Company for a significant period of time, may not accrue any interest, and ultimately may not be paid to the Company (as a result of post-audit adjustments or for other reasons). During the time that the Company’s assets include such receivables, that portion of the Company’s assets cannot be used to pursue the Company’s investment objective. In addition, in cases in which Investment Funds or Advisor Funds limit or reduce the Company’s redemption request, the Company may continue to have investment exposure to Advisor Funds or Advisors that it would otherwise have redeemed. This could have an adverse effect on the performance of the Company.
The NAV used by the Company to determine the redemption price payable to a redeeming Member generally will include the full value of any receivables due the Company without any discount or reduction, notwithstanding the fact that such receivables do not accrue interest and may ultimately not be paid to the Company by an Investment Fund. If an Investment Fund later determines that a portion or all of such a receivable is no longer payable to the Company or the value of the receivable is otherwise impaired, the Company and the non-redeeming Members may be adversely affected because the Company may be unable, or may elect not, to collect the amount of any overpayment made to a redeeming Member. See “-Risks Related to the Company’s Structure-The Company’s Financial Statements are, and in the Future Will Ultimately be, Based on Estimates of Valuations Provided by Third Party Advisors Which May not be Accurate or May Need to be Adjusted in the Future”. Any corresponding restatement of and reduction in the NAV of the Company will be borne by the non-redeeming Members.
Risks on Liquidation
Distributions in liquidation of the Company will be made in accordance with the Members’ respective capital account balances. Timing of such liquidating distributions will be based in large part on the Company’s ability to
withdraw from underlying Investment Funds, which will in turn depend in large part on the Investment Funds’ ability to withdraw from the applicable Advisor Funds. Since certain Advisor Funds may impose significant restrictions on withdrawal (including without limitation, minimum holding periods, infrequent withdrawal dates, holdbacks, and the segregation of assets by the Advisor Funds through the use of side-pockets), and other Advisor Funds may have suspended, delayed or otherwise limited redemptions, Members may not receive final liquidating distributions for a significant period of time following a determination to dissolve the Company, potentially several years. In addition to liquidation of the Company, the risks described above will also apply if the Managing Member determines to cease the Company’s operations and the Company compulsorily redeems Members.
Managed Account Allocations Expose the Investment Funds to Liability Exceeding Allocations
The Investment Funds may place assets with a number of Advisors by opening Managed Accounts (either directly or via Portfolio Companies). It is possible, given the leverage at which certain of the Advisors of an Investment Fund will trade, that allocations of an Investment Fund to an Advisor through a Managed Account could result in losses that exceed the amount the Investment Fund had allocated to such Advisor to invest. Therefore, Managed Accounts expose the Investment Funds to theoretically unlimited liability. This risk is also applicable to allocations made by the Investment Funds to Portfolio Companies because of the possibility that the limited liability provided by Portfolio Companies could be successfully challenged based on various legal theories which could be proffered.
An Investment Fund May Not be Able to Vote or May Limit its Voting Abilities
The managing member of an Investment Fund may determine, in its sole discretion, to limit the Investment Fund’s voting interest in certain Advisor Funds, including, without limitation, in order to allow other investment vehicles managed by the managing member or its affiliates to avoid becoming subject to certain prohibitions under the Investment Company Act with respect to affiliated transactions. To the extent the Investment Fund holds non-voting interests, or contractually forgoes the right to vote in respect of the voting securities of an Advisor Fund, the Investment Fund will not be able to vote on matters that require the approval of the interest-holders of the Advisor Fund, including matters potentially adverse to the interests of the Investment Fund and its members, including the Company.
Lack of Operating History of Certain Advisors; Past Performance of Advisors is not Indicative of Future Results
Certain of the Advisors have short or limited or even no operating histories. In addition, the information the managing member of an Investment Fund has and will obtain about an Advisor may be limited. As such, the ability of the managing member of an Investment Fund to evaluate past performance or to validate investment strategies of such Advisors will be limited. Moreover, even to the extent an Advisor has a long operating history, the past investment performance of any of the Advisors should not be construed as an indication of the future results of the Advisors or of the Investment Funds or the Company. In addition, the investment professionals within the Advisors and their strategies may change over time. This risk is related to, and enhanced by, the risks created by the fact that the managing member of an Investment Fund relies upon information provided to it by the Advisors that is not, and cannot be, independently verified.
Advisors Invest Independently and May Hold Economically Offsetting Positions
Each of the Advisors generally makes investment decisions wholly independently of other Advisors and may at times hold, or cause the Company and/or the Investment Funds to hold, economically offsetting positions. To the extent that the Advisors, the Company and/or the Investment Funds do, in fact, hold such positions, the Company’s portfolio, considered as a whole, may not achieve any gain or loss despite incurring fees and expenses in connection with such positions. In addition, an Advisor may be compensated based on the performance of its portfolio. Accordingly, there often may be times when a particular Advisor may receive performance based compensation in respect of its portfolio for a period even though an Investment Fund’s or the Company’s NAV may not have increased, or may even have decreased, during such period. Furthermore, it is possible that, from time to time, various Advisors may be competing with each other for the same positions in one or more markets. There can be no
assurance that choosing a combination of Advisors for an Investment Fund will prove to be any more successful than would the selection of a single Advisor for such Investment Fund.
Advisors May Have Limited Capacity to Manage Additional Investment Fund Investments, Which Could Cause Dilution or Concentration of the Company’s Investments or Negatively Affect Allocation of Investments
Certain Advisors’ trading approaches presently can accommodate only a limited amount of capital. Accordingly, each Advisor has the right to refuse to manage some or all of the Investment Funds’ assets that the managing member of an Investment Fund may wish to allocate to such Advisor. Further, in the case of Advisors that limit the amount of additional capital that they will accept from an Investment Fund, continued sales of membership units of such Investment Fund and interests of Advisor Funds in which such Investment Fund invests would dilute the indirect participation of existing members of such Investment Fund, including the Company, with such Advisors. See ITEM 1. “BUSINESS-PERFORMANCE OF THE COMPANY-Certain Considerations Relating to Limited Capacity of Potential Advisors”. Due to the asset-based fees that Advisors will normally be entitled to receive, Advisors may have an incentive to accept additional capital and may do so even where their respective investment programs cannot accommodate such additional capital.
In determining capital allocations among Advisors, the managing member of the Investment Funds may consider, among other factors, constraints on an Advisor’s capital capacity. See ITEM 1. “BUSINESS-PERFORMANCE OF THE COMPANY-Certain Considerations Relating to Limited Capacity of Potential Advisors”. Advisors may in their discretion also limit the capacity available to the Company or other investment funds or accounts managed by the Managing Member or its affiliates after a specific date. In these cases, the managing member of the Investment Funds, in order to provide for long-term management of the Investment Funds, may determine to increase the Investment Funds’ investments in an Advisor more than would otherwise be the case. Such allocations may result in the Investment Funds’ portfolio being more concentrated from time to time and for substantial periods of time. As a result of any such concentration, the Investment Funds’ portfolio may be subject to more rapid changes in value than would be the case if the Investment Funds’ portfolio were less concentrated and the economic returns of the Investment Funds and the Company may thereby be materially adversely affected.
In determining how to allocate investment opportunities among the Investment Funds and any other investment funds or accounts, the managing member will take into account the investment objectives of each such investment fund or account, the capital capacity of the Advisors, and such other considerations as deemed relevant in its sole discretion. Certain Advisors to which the Investment Funds have previously allocated assets may be closed to new investments or may otherwise limit subscriptions (a “Closed Advisor”). The managing member of the Investment Funds may determine, for various reasons, including without limitation, strategic fit and other portfolio construction considerations, that a Closed Advisor is more appropriately included as part of the portfolio of another of its investment funds or accounts rather than the Investment Funds. In such event, the managing member of the Investment Funds may cause the Investment Funds to transfer interests in such Closed Advisor to another investment fund or account managed by the managing member of the Investment Funds, notwithstanding that such Closed Advisor may continue to be an appropriate investment for the Investment Funds. Any such transfer may give rise to potential conflicts of interest. Any such transfer would be effected at a price equal to the redemption price that otherwise would have been payable to the Investment Fund in respect of such Closed Advisor upon redemption of such interests. The transfer price will not take into account any value associated with the transfer of the Investment Fund’s investment holding period, if any, in a Closed Advisor, or the prior high NAV associated with the transferred interests.
Advisor Funds’ Securities are Generally Illiquid Which May Increase Costs and Limit Redemptions
The securities of the Advisor Funds in which the Investment Funds (directly or through Advisors) invest or plan to invest may be illiquid. Subscriptions to purchase the securities of Advisor Funds are generally subject to restrictions or delays. In addition, the Investment Funds may be limited in their ability to make changes to allocations due to potential redemption restrictions of the Advisor Funds, including notice periods and limited redemption dates, the ability of the Advisor Funds to suspend and postpone redemptions, and lockups on
redemptions of securities of the Advisor Funds. Further, the Advisor may not be able to dispose of Advisor Fund securities that it has purchased in a timely manner and, if adverse market conditions were to develop during any period in which the Advisor is unable to sell Advisor Fund securities, the Advisor might obtain a significantly less favorable price than that which prevailed when it decided to buy or sell such securities.
Frequent Trading and Turnover Typically Result in High Transaction Costs and the Investment Funds Have No Control Over This Turnover
It is expected that Advisors will make frequent trades in securities and other investments. Frequent trades typically result in high transaction costs. In addition, the Advisors may invest on the basis of short-term market considerations. The turnover rate within the Advisors may be significant, potentially involving substantial brokerage commissions and fees. The Investment Funds and, in turn, the Company will have no control over this turnover. As a result, it is anticipated that a significant portion of the Company’s income and gains, if any, may be derived from ordinary income and short-term capital gains. In addition, the withdrawal of an Investment Fund from an Advisor could involve expenses to the Investment Fund under the terms of the Investment Fund’s investment with that Advisor.
Indemnification of Advisors May Create Costs for the Company and the Investment Funds
The Company and the Investment Funds may agree to indemnify certain of the Advisors and their respective officers, directors, and affiliates from any liability, damage, cost, or expense arising out of or in connection with, among other things, (i) acts or omissions relating to the offer or sale of units by the Investment Funds and (ii) services provided by the Advisors directly or indirectly on behalf of the Company. In addition, Advisor Funds and Portfolio Companies in which the Company and the Investment Funds invest may also agree to indemnify Advisors and their respective officers, directors, and affiliates. Any such indemnification obligations incurred directly or indirectly by the Company may adversely affect the Company’s performance. Currently, neither the Company nor the Investment Funds is a party to any direct indemnification agreements with Advisors. Accordingly, the Company and the Investment Funds are under no direct contractual obligation to indemnify any of the Advisors against inaccurate or untimely valuations of investments or NAV and although the Company and the Investment Funds may, the Company and the Investment Funds currently do not intend to, enter into any such direct indemnification agreements with Advisors.
Allocation of the Company’s Assets May Not Protect the Company from Exposure to Economic Downturns in Any Investment Fund or Investment Sector
The Managing Member establishes allocations among the Investment Sectors in a manner consistent with the Company’s investment objective. The identity of, and relative investments of capital among, the Investment Sectors will be determined by the Managing Member, in its sole discretion, based on factors deemed relevant to the Managing Member, which may include the amount of the Company’s assets under management, constraints on the capital capacity of the Investment Fund and Advisors, the availability of attractive opportunities, and other portfolio construction considerations. There is no assurance that the Managing Member’s allocation decisions will be successful. In addition, the Managing Member’s ability to make ongoing changes to the allocation of the Company’s assets will be limited due to the redemption provisions of the Investment Funds in which the Company’s assets are invested, including limited redemption dates, notice periods, minimum holding periods, minimum holding amounts, and/or the possibility of postponement or suspension of redemptions. Any such limitation may be significant. These factors could have an adverse effect on the ability of the Company to successfully and efficiently achieve its investment objective or a market position appropriately reflecting its asset base.
Investment Related Risks
Following is a discussion of certain of the investments and strategies that are expected to be made or utilized by the Advisors of the Investment Funds and certain of the principal risks associated with such investments and
strategies. It is possible that an Advisor will make investments and utilize strategies that are not described below, and any such investment or strategy will be subject to its own particular risks.
Risks Related to Investment and Trading
An Investment in the Company Involves a High Degree of Risk That the Entire Amount Invested May be Lost; Investment Results May Vary Substantially over Time
An investment in the Company involves a high degree of risk, including the risk that the entire amount invested may be lost. The Advisors will invest in and actively trade financial instruments using highly complex strategies and investment techniques with significant risk characteristics, including risks arising from the volatility of the fixed income, commodity, currency and equity markets, risks of concentration, risks of short sales, risks of leverage, risks arising from the potential illiquidity of derivative instruments and the potential illiquidity of certain emerging markets, the risk of loss from counterparty and broker defaults, risk of inaccuracy of information received from Advisors and the risk of borrowing to meet redemption requests. No guarantee or representation is made that the Company’s, the Investment Funds’ or the Advisors’ investment programs will be successful, that the various investment strategies utilized or investments made will have low correlation with each other or that the Company’s returns will exhibit low correlation with an investor’s traditional investment portfolio. Each Advisor’s investment program may utilize such investment techniques as margin transactions, option transactions, short sales, forward contracts and futures contracts, which involve substantial volatility and can, in certain circumstances, substantially increase the adverse impact to which the Investment Funds and the Company may be subject. All investments made by the Company risk the loss of capital. Investment results may vary substantially over time. Certain Advisors may have no limits with respect to the types and sizes of investments that they may make. See ITEM 1. “BUSINESS-INVESTMENT PROGRAM”.
PAST RESULTS OF THE COMPANY, THE INVESTMENT FUNDS, AND THE ADVISORS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. NO ASSURANCE CAN BE MADE THAT PROFITS WILL BE ACHIEVED OR THAT SUBSTANTIAL LOSSES WILL NOT BE INCURRED.
The Advisors May be Unable to or May Choose not to Seek to Achieve their Investment Goals; Advisors May Not be Able to Locate Suitable Investment Opportunities
Many of the Advisors will, among other things, seek to utilize specialized investment strategies, follow allocation methodologies, apply investment models or assumptions, achieve a certain level of performance relative to specified benchmarks, and enter into hedging and other strategies intended, among other things, to affect the Advisors’ performance, risk levels, and/or market correlation. There can be no assurance that any Advisor will have success in achieving any goal related to such practices. The Advisors may be unable to, or may choose in their judgment not to seek to, achieve such goals. In addition, there is a risk that Advisors may invest outside their strategies, which could have a negative impact on the Advisors’ performance and in turn on the Company.
The success of an Advisor’s trading activities will depend on, among other things, the Advisor’s ability to identify overvalued and undervalued investment opportunities and to exploit price discrepancies in the capital markets. Identification and exploitation of the investment strategies to be pursued by an Advisor involve a high degree of uncertainty. No assurance can be given that the Advisors will be able to locate suitable investment opportunities in which to deploy all their capital. A decline in, or lack of volatility and pricing inefficiency of, the markets in which an Advisor seeks to invest, changing, evolving and maturing markets, the increased number of market participants in competition with the strategies deployed by Advisors, as well as other market factors, may reduce the number and scope of an Advisor’s investment opportunities available to an Advisor.
Competition
The Advisors compete with a large number of firms. Competitive investment activity by other firms tends to reduce the Advisors’ opportunities for profit by reducing the magnitude as well as the duration of the market inefficiencies which they seek to exploit.
The Use of Leverage May Substantially Increase the Adverse Impact to Which the Investment Funds’ Investment Portfolios May be Subject
As described under ITEM 1. “BUSINESS-PERFORMANCE OF THE COMPANY-Hedging, Leverage and Other Strategies,” it is expected that the Investment Funds and the Advisors will incur leverage in various forms. Such leverage may take the form of loans for borrowed money, trading on margin or other forms of direct and indirect borrowings, or derivative instruments that are inherently leveraged, including, among others, forward contracts, futures contracts, options, swaps and reverse repurchase agreements, and other instruments and transactions that are inherently leveraged. The utilization of leverage will increase the volatility of the Company’s investments. The managing member of the Investment Funds may seek to adjust the degree of leverage with which each Investment Fund as a whole invests by taking the Advisors’ anticipated leverage use into account when allocating and reallocating the Investment Fund’s assets among the Advisors. However, the managing member of the Investment Funds generally will not have any right to adjust the amount of leverage utilized by any of the Advisors, and generally does not exercise such right if available. In the discretion of its managing member, an Investment Fund may make an investment in an Advisor Fund through a swap, option or otherwise in a manner structured to provide greater leverage than a direct investment in the Advisor Fund, which may increase the risks to the Investment Fund relative to a direct investment in the Advisor Fund. In addition, the Advisors may buy and sell securities on margin and otherwise utilize leverage, further increasing the volatility of the Company’s direct or indirect investments.
The use of leverage by the Investment Funds, Advisor Funds, Portfolio Companies or Advisors can substantially increase the adverse impact to which the Company’s investment portfolio may be subject. Trading securities on margin results in interest charges and, depending on the amount of trading activity, such charges could be substantial. The amount of leverage or borrowings which the Company, the Investment Funds, the Advisor Funds, the Portfolio Companies and the Advisors may have outstanding at any one time may be large in relation to their capital. Consequently, the level of interest rates generally, and the rates at which the Investment Funds, Advisor Funds, Portfolio Companies and Advisors can borrow in particular, can affect the operating results of the Company. The low margin deposits normally required in futures and forward trading permit a high degree of leverage; accordingly, a relatively small price movement in a futures contract can result in immediate and substantial losses to the investor. Such a high degree of leverage necessarily entails a high degree of risk. In the event that an Investment Fund or a Portfolio Company enters into an investment management agreement with an Advisor that utilizes leverage in its investment program, the Investment Fund or Portfolio Company may become subject to claims by financial intermediaries that extended “margin” loans to such Advisor in respect of the applicable Managed Account. Such claims could exceed the value of the assets allocated to such Advisor by the Investment Fund or Portfolio Company. The risks involved in the use of leverage are increased to the extent an Investment Fund leverages its capital. The Company generally will not utilize leverage directly, although it may borrow to, among other things, fund redemptions and pay expenses.
The Company, Investment Funds, Advisor Funds and Portfolio Companies will incur expenses, which may include, without limitation, interest charges and commitment fees, in connection with any leverage that it utilizes, and such expenses could be significant. In addition, the rights of any lenders to the Company, Investment Funds, Advisor Funds and Portfolio Companies to receive payments of interest or repayments of principal will be senior to those of the investors in such entities, including Members or the Company, and the terms of any borrowings may contain provisions that limit certain activities of such entities or the Advisors, including the ability to make distributions.
In lieu of, or in addition to, obtaining a revolving credit line, the Company, Investment Funds, the Advisors, Advisor Funds and Portfolio Companies may determine from time to time to attempt to borrow funds as and when needed, as opposed to relying on committed facilities, with respect to all or a portion of their borrowing needs. Subject to applicable law, the Company, Investment Funds, the Advisors, Advisor Funds and Portfolio Companies may make borrowings from Goldman Sachs on this basis. Such borrowings would therefore generally not involve the payment of any commitment fees, but may result in a higher interest rate when borrowings are made than would have been the case had a committed facility been in place, and could leave the Company, Investment Funds, Advisors, Advisor Funds or Portfolio Companies at risk in situations where no such financing is available, or is only available at high rates. In addition, the terms of any such borrowings may provide that such borrowings may be
subject to repayment at any time upon demand by the lender, which could occur at a time when complying with such demand could have a material adverse effect on the Investment Funds, Advisor Funds or Portfolio Companies and, in turn, the Company. In addition, a lender may terminate such borrowings upon the occurrence of certain events, including, without limitation, events of default or termination events. Any such event with respect to a borrowing could materially adversely affect the Company. The Company, Investment Funds, Advisors, Advisor Funds and Portfolio companies will also be subject to other risks related to the use of leverage, which may have an adverse impact on the Company.
Depending upon the form of leverage utilized by the Company, Investment Funds, Advisors, Advisor Funds and Portfolio Companies, the applicable lender may impose certain restrictions or requirements on the operations of the Company, Investment Funds, Advisors, Advisor Funds or Portfolio Companies including, without limitation, restrictions relating to the permitted investments of the Company, Investment Funds, Advisors, Advisor Funds or Portfolio Companies and redemptions therefrom, and requirements with respect to the valuation procedures of the Company, Investment Funds, Advisors, Advisor Funds and Portfolio Companies, the liquidity of the Company, Investment Funds, Advisors, Advisor Funds and Portfolio Companies, and the performance or other reports or notices to be provided to the relevant lender by the Company or the applicable Investment Fund, Advisors, Advisor Fund or Portfolio Company. From time to time, a lender to the Company, Investment Funds, Advisors, Advisor Funds or Portfolio Companies may also require that such entity reduce its leverage ratio. This may occur as a result of the decline in the value of the assets of the Company or the applicable Investment Fund, Advisors, Advisor Fund or Portfolio Company or for other reasons. If this occurs, the Company may be required to redeem interests in Investment Funds or the Investment Funds may be required to redeem interests in Advisor Funds when they otherwise would not have done so.
Convergence Risk May Result in Significant Losses of the Investment Funds and the Company
Certain Advisors will take long positions in securities believed to be undervalued and short positions in securities believed to be overvalued. In the event that the perceived mispricings underlying one or more Advisors’ trading positions were to fail to converge toward, or were to diverge further from, relationships expected by such Advisors, the Investment Funds and the Company may incur significant losses.
Possible Effects of Speculative Position Limits Could Adversely Affect the Operations and Profitability of the Investment Funds and the Company
The CFTC, the U.S. commodities exchanges and certain non-U.S. exchanges have established limits referred to as “speculative position limits” or “position limits” on the maximum net long or net short (or, for some commodities, the gross) positions which any person or group of persons may own, hold or control in certain futures or options on futures contracts, and such rules generally require aggregation of the positions owned, held or controlled by related entities. For this purpose, trading by persons directly or indirectly under the same control or trading as one pursuant to an express or implied agreement or understanding must be aggregated. Therefore, each Advisor is generally required to aggregate all accounts it advises for purposes of determining its compliance with speculative position limits, which could limit the size of the positions the Advisor can maintain on behalf of the Company. In addition, under certain circumstances, two or more Advisors could be required to comply with applicable position limits as if they were a single trader. Although many of the major U.S. exchanges have eliminated speculative position limits outside of the month in which the futures contract becomes deliverable (the spot month) and have substituted position accountability rules which do not, in themselves, restrict the number of contracts an Advisor is permitted to trade, exchanges maintain the authority to direct an Advisor to reduce exposure (e.g., based upon concerns relating to potential market manipulation or the liquidity of the relevant contract). Position limits, especially in certain markets, may be quite restrictive, and the modification of trading strategies or liquidation of positions by the Advisors, if required to comply with position limits, could have an adverse effect on the operations and profitability of the Company.
The Dodd-Frank Act substantially expanded the CFTC’s authority in this area by (i) requiring the CFTC to impose position limits on futures and options contracts and swaps with respect to all physical commodities, as appropriate, within 270 days of its enactment and (ii) requiring the CFTC to impose aggregate position limits across certain derivatives positions established on designated contract markets, swap execution facilities, or foreign boards
of trade, or through bilateral trading. Following the enactment of the Dodd-Frank Act, the CFTC intends to publish a notice of rulemaking proposing CFTC-set position limits in accordance with the Dodd-Frank Act’s mandate. These forthcoming CFTC position limit rules may, among other things, incorporate more restrictive aggregation criteria and, if adopted, could restrict the investment and trading activities in which the Advisors may engage. Any rules or rule amendments adopted by the CFTC in the future may hinder the Advisors’ ability to trade such contracts and could have an adverse effect on the operations and profitability of the Company.
Short Selling Creates the Risk of Significant Losses
Advisors may engage in short selling. Short selling involves selling securities that may or may not be owned and borrowing the same securities for delivery to the purchaser, with an obligation to replace the borrowed securities at a later date. Short selling allows the investor to profit from declines in the value of securities. A short sale creates the risk of a theoretically unlimited loss, in that the price of the underlying security could theoretically increase without limit, thus increasing the cost of buying those securities to cover the short position. There can be no assurance that the security necessary to cover a short position will be available for purchase. Purchasing securities to close out the short position can itself cause the price of the securities to rise further, thereby exacerbating the loss.
Advisors may make “short sales against-the-box,” in which they will sell short securities they own or have the right to obtain without payment of additional consideration. If an Advisor makes a short sale against-the-box, it will be required to set aside securities equivalent in kind and amount to the securities sold short (or securities convertible or exchangeable into those securities) and will be required to hold those securities while the short sale is outstanding. Advisors will incur transaction costs, including interest expenses, in connection with opening, maintaining and closing short sales against-the-box.
Many jurisdictions have recently imposed restrictions and reporting requirements on short selling. In particular, in the fall of 2008, the SEC temporarily suspended short selling on stocks of over 950 publicly traded companies. These restrictions and reporting requirements may prevent the Advisors from successfully implementing their investment strategies, including without limitation as part of their long/short strategies or in connection with hedging their investments, and achieving their investment objective. In addition, reporting requirements relating to short selling may provide transparency to the Advisors’ competitors as to their short positions, which may have an adverse effect on the Investment Funds and, in turn, the Company; similarly, an Advisor, an Advisor Fund or a Portfolio Company may be required to redeem underlying investments when it otherwise would not have done so.
The Ability of an Investment Fund to Hedge Successfully will Depend on the Particular Advisor’s Ability to Predict Pertinent Market Movements Which Cannot be Assured
The Investment Funds, Advisors and Advisor Funds may or may not employ hedging techniques. There can be no assurance that such hedging techniques will be effective or that they will result in more favorable returns than would have been the case had they not been employed. Moreover, while such hedging techniques are intended to protect investors from changes in the valuation of the securities and other instruments in which the Company invests, the Company will not generally benefit when the value of such securities and other instruments increases.
Hedging techniques could involve a variety of derivative transactions, including futures contracts, exchange-listed and over-the-counter put and call options on securities, financial indices, forward foreign currency contracts, and various interest rate transactions (collectively, “Hedging Instruments”). Hedging techniques involve risks different from those of underlying investments. In particular, the variable degree of correlation between price movements of Hedging Instruments and price movements in the position being hedged creates the possibility that losses on the hedge may be greater than gains in the value of an Investment Fund’s positions. In addition, certain Hedging Instruments and markets may not be liquid in all circumstances. As a result, in volatile markets, transactions in certain of these instruments may not be able to be closed out without incurring losses substantially greater than the initial deposit. Although the contemplated use of these instruments should tend to minimize the risk of loss due to a decline in the value of the hedged position, at the same time they tend to limit any potential gain that might result from an increase in the value of such position. The ability of the Investment Funds and the Advisors to hedge successfully will depend on the ability of the Investment Funds and the Advisors to
predict pertinent market movements, which cannot be assured. There is also a risk that an Investment Fund or an Advisor may over-hedge or under-hedge a particular exposure because it has incomplete information regarding the amount of such exposure to which its investments are subject. The Investment Funds and Advisors are not required to hedge and there can be no assurance that hedging transactions will be available or, even if undertaken, will be effective. In addition, it is not possible to hedge fully or perfectly against currency fluctuations affecting the value of securities denominated in non-U.S. currencies because the value of those securities is likely to fluctuate as a result of independent factors not related to currency fluctuations. Finally, the daily variation margin deposit requirements in futures contracts that may be sold by the Investment Funds Advisors or Advisor Funds would create an ongoing greater potential financial risk than would options transactions, where the exposure is limited to the cost of the initial premium and transaction costs paid by the Advisor or Advisor Funds.
Forward Contracts May Entail Significant Risks and Uncertainties Which Could Result in Substantial Losses to the Investment Funds and the Company
Advisors may enter into forward contracts, which are the purchase or sale of a specific quantity of a commodity, government security, foreign currency, or other financial instrument at the current or spot price, with delivery and settlement at a specified future date. Because it is a completed contract, a purchase forward contract can be a cover for the sale of a futures contract. The Advisors may enter into forward contracts for hedging purposes and non-hedging purposes (i.e., to increase returns). Forward contracts are transactions involving an Advisor’s obligation to purchase or sell a specific instrument at a future date at a specified price. Forward contracts may be used by the Advisors for hedging purposes to protect against uncertainty in the level of future foreign currency exchange rates, such as when an Advisor anticipates purchasing or selling a non-U.S. security. For example, this technique would allow the Advisor to “lock in” the U.S. dollar price of the security. Forward contracts may also be used to attempt to protect the value of an Advisor’s existing holdings of non-U.S. securities. There may be, however, an imperfect correlation between an Advisor’s non-U.S. securities holdings and the forward contracts entered into with respect to those holdings. Forward contracts may also be used for non-hedging purposes to pursue an Advisor’s investment objective, such as when an Advisor anticipates that particular non-U.S. currencies will appreciate or depreciate in value, even though securities denominated in those currencies are not then held in the Advisor’s portfolio. There is no general requirement that the Advisors hedge all or any portion of their exposure to foreign currency risks.
Forward contracts and options thereon, unlike futures contracts, are not traded on exchanges and are not standardized; rather, banks and dealers act as principals in these markets, negotiating each transaction on an individual basis. Forward and “cash” trading is substantially unregulated; there is no limitation on daily price movements and speculative position limits are not applicable. The principals who deal in the forward markets are not required to continue to make markets in the currencies or commodities they trade and these markets can experience periods of illiquidity, sometimes of significant duration. There have been periods during which certain participants in these markets have refused to quote prices for certain currencies or commodities or have quoted prices with an unusually wide spread between the price at which they were prepared to buy and that at which they were prepared to sell. Disruptions can occur in any market traded by an Advisor due to unusually high trading volume, political intervention or other factors. Arrangements to trade forward contracts may be made with only one or a few counterparties, and liquidity problems therefore might be greater than if such arrangements were made with numerous counterparties. Significant risks and uncertainties exist in dealing with counterparties in forward contracts. The imposition of controls by governmental authorities might also limit such forward (and futures) trading to less than that which the Advisors would otherwise recommend, to the possible detriment of the Advisor and therefore the applicable Investment Fund and the Company. Market illiquidity or disruption could result in major losses to an Investment Fund and the Company. In addition, Managed Accounts or Advisor Funds in which an Investment Fund has a direct or indirect interest may be exposed to credit risks with regard to counterparties with whom the Advisors trade as well as risks relating to settlement default. Such risks could result in substantial losses to the Investment Funds and the Company.
Swap Agreements May Increase or Decrease the Overall Volatility of an Investment Fund’s Portfolio
Advisors and Advisor Funds may enter into equity, interest rate, index, currency rate, total return, and other types of swap agreements. The transactions are entered into in an attempt to obtain a particular return without the need to actually purchase the reference asset. Swap agreements can be individually negotiated and structured to include exposure to a variety of different types of investments or market factors. Depending on their structure, swap agreements may increase or decrease an Investment Fund’s exposure to long-term or short-term interest rates (in the United States or abroad), foreign currency values, mortgage securities, corporate borrowing rates, or other factors such as security prices, baskets of securities, or inflation rates. Swap agreements can take many different forms. Advisors and Advisor Funds are not limited to any particular form of swap agreement.
Swap agreements are two-party contracts entered into primarily by institutional investors for periods ranging from a few weeks to more than a year. In a standard swap transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments, which may be adjusted for an interest factor. The gross returns to be exchanged or “swapped” between the parties are generally calculated with respect to a “notional amount” (i.e., the return on or increase in value of a particular U.S. dollar amount invested at a particular interest rate, in a particular foreign currency, or in a “basket” of securities representing a particular index).
Swap agreements will tend to shift investment exposure from one type of investment to another. For example, if an Advisor agrees to exchange payments in U.S. dollars for payments in foreign currency, the swap agreement would tend to decrease the Company’s exposure to U.S. interest rates and increase its exposure to foreign currency and interest rates. Depending on how they are used, swap agreements may increase or decrease the overall volatility of an Investment Fund’s portfolio.
Most swap agreements entered into by an Advisor or Advisor Fund would require the calculation of the obligations of the parties to the agreements on a “net basis”. Consequently, an Advisor or Advisor Fund’s current obligations (or rights) under a swap agreement generally will be equal only to the net amount to be paid or received under the agreement based on the relative values of the positions held by each party to the agreement (the “net amount”). The risk of loss with respect to swaps is limited to the net amount of interest payments that an Advisor or Advisor Fund is contractually obligated to make. If the other party to a swap defaults, an Investment Fund’s risk of loss consists of the net amount of payments that the Advisor or Advisor Fund contractually is entitled to receive. If a swap agreement calls for payments by an Investment Fund, an Advisor Fund or Portfolio Company, such entity must be prepared to make such payments when due. In addition, if the counterparty’s creditworthiness declined, the value of a swap agreement would be likely to decline, potentially resulting in losses to the Investment Fund and the Company.
The Prices of an Investment Fund’s Investments Can be Highly Volatile and Influenced by External Factors Outside the Control of Such Investment Fund
The prices of an Investment Fund’s investments, and therefore the NAVs of the Investment Fund and the Company, can be highly volatile. Price movements of forward contracts, futures contracts and other derivative contracts in which an Advisor may invest are influenced by, among other things, interest rates, changing supply and demand relationships, trade, fiscal, monetary and exchange control programs and policies of governments, and national and international political and economic events and policies. In addition, governments from time to time intervene, directly and by regulation, in certain markets, particularly those in currencies, financial instruments and interest rate-related futures and options. Such intervention often is intended directly to influence prices and may, together with other factors, cause all of such markets to move rapidly in the same direction because of, among other things, interest rate fluctuations. Moreover, since internationally, including certain of the markets in which the Advisors will invest there may be less government supervision and regulation of worldwide stock exchanges and clearinghouses than in the United States, Advisors also are subject to the risk of the failure of the exchanges on which their positions trade or of their clearinghouses, and there may be a higher risk of financial irregularities and/or lack of appropriate risk monitoring and controls.
The Company and the Investment Funds may be adversely affected by the recent deteriorations in the financial markets and economic conditions throughout the world, some of which may magnify the risks described herein and
have other adverse effects. Economic and financial market conditions began to deteriorate in 2008 which has resulted in increased volatility and illiquidity in the global credit, debt and equity markets generally. Market participants’ initial concerns were focused primarily on credit and valuation problems in the sub-prime mortgage market and resultant volatility and illiquidity in the sub-prime segment of the mortgage-backed securities market, but these concerns subsequently broadened to the global credit and interbank money markets generally, and a wide range of financial institutions and markets, asset classes and sectors, causing decreased risk tolerance by investors and significantly tightened availability of credit. As a result, certain securities have become less liquid and more difficult to value, and thus harder to dispose of. This deterioration has been exacerbated by, among other things, uncertainty regarding the extent of the problems in the mortgage industry and the degree of exposure of financial institutions and other market participants, increased aversion to risk, concerns over inflation, instability in energy costs, complex geopolitical issues, the lack of availability and higher cost of credit and the declining real estate and mortgage markets in the United States and elsewhere. These factors, combined with variable commodity pricing, declining business and consumer confidence, increased unemployment and diminished expectations for predictable global financial markets, have led to a global economic slowdown and fears of a global recession. The duration and ultimate effect of current market conditions cannot be forecast, nor is it known whether or the degree to which such conditions may worsen. The continuation or further deterioration of current market conditions and continued uncertainty regarding economic markets generally could result in further declines in the market values of potential investments or declines in market values. Such declines could lead to losses and diminished investment opportunities for the Company and the Investment Funds, could prevent the Company and the Investment Funds from successfully meeting their investment objectives or could require the Company and the Investment Funds to dispose of investments at a loss while such unfavorable market conditions prevail. While current market conditions persist, the Company and the Investment Funds will also be subject to heightened risks associated with the potential failure of brokers, counterparties and exchanges, as well as increased systemic risks associated with the potential failure of one or more systemically important institutions. See “-Failure of the Investment Funds’ Counterparties, Brokers, and Exchanges Exposes Investment Funds to Credit Risks in Various Forms”.
Failure of the Investment Funds’ Counterparties, Brokers, and Exchanges Exposes Investment Funds to Credit Risks in Various Forms
The Investment Funds will be exposed to the credit risk of the counterparties with which, or the brokers, dealers and exchanges through which, the Advisors deal, whether they engage in exchange-traded or off-exchange transactions. More than one of the Investment Funds at any time may be subject to the credit risk of the same counterparty or broker-dealer. An Advisor’s prime brokers or other parties may hold assets, including assets held as collateral for margin loans or other financing provided to such Advisor. Under the terms of such arrangements and under applicable law, a secured party may be permitted to rehypothecate such assets in connection with securities lending or other transactions entered into by the secured party. An Investment Fund may be subject to risk of loss of its assets placed on deposit with a broker by an Advisor in the event of the broker’s bankruptcy, the bankruptcy of any clearing broker through which the broker executes and clears transactions on behalf of the Advisor, or the bankruptcy of an exchange clearing house.
In addition, although the Commodity Exchange Act requires a commodity broker to segregate the funds of its customers, if a commodity broker fails to properly segregate customer funds, the Advisor may be subject to a risk of loss of its funds on deposit with such broker in the event of such broker’s bankruptcy or insolvency. An Investment Fund may also be subject to risk of loss of its funds on deposit with non-U.S. brokers because non-U.S. regulatory bodies may not require such brokers to segregate customer funds. An Advisor may be required to post margin for its foreign exchange transactions either with the foreign exchange dealers who are not required to segregate funds (although such funds are generally maintained in separate accounts on the foreign exchange dealer’s books and records in the name of the Advisor). Under certain circumstances, such as the inability of another customer of the commodity broker or foreign exchange dealer or the commodity broker or foreign exchange dealer itself to satisfy substantial deficiencies in such other customer’s account, an Investment Fund may be subject to a risk of loss of its funds placed on deposit with such broker or dealer, even if such funds are properly segregated.
In the case of a bankruptcy of the counterparties with which, or the brokers, dealers and exchanges through which, an Investment Fund deals, or in the case of a customer loss as described in the foregoing paragraph, the
Investment Fund might not be able to recover any of its assets held, or amounts owed, by such person, even property specifically traceable to the Investment Fund, and, to the extent such assets or amounts are recoverable, the Investment Fund might only be able to recover a portion of such amounts. Further, even if the Investment Fund is able to recover a portion of such assets or amounts, such recovery could take a significant period of time. Prior to receiving the recoverable amount of the Investment Fund’s property, the Investment Fund may be unable to trade any positions held by such person, or to transfer any positions and cash held by such person on behalf of the Investment Fund. This could result in significant losses to the Investment Fund and, in turn, the Company.
Many of the markets in which the Advisors effect their transactions are “over-the-counter” or “interdealer” markets. Participants in these markets are typically not subject to credit evaluation and regulatory oversight as are members of “exchange based” markets. To the extent an Advisor invests in swaps, derivatives or synthetic instruments, or other over-the-counter transactions in these markets, the Advisor may take a credit risk with regard to parties with which it trades and also may bear the risk of settlement default. These risks may differ materially from those involved in exchange-traded transactions, which generally are characterized by clearing organization guarantees, daily marking-to-market and settlement, and segregation and minimum capital requirements applicable to intermediaries. Transactions entered into directly between two counterparties generally do not benefit from these protections, which, in turn, may subject an Advisor to the risk that a counterparty will not settle a transaction in accordance with agreed terms and conditions due to, among other things, a dispute over the terms of the contract or because of a credit or liquidity problem. Such “counterparty risk” is increased for contracts with longer maturities when events may intervene to prevent settlement. The inability of the Advisors to transact business with any one or any number of counterparties, the lack of any independent evaluation of the counterparties or their financial capabilities, and the absence of a regulated market to facilitate settlement, may increase the potential for losses to the Investment Funds and the Company.
In addition, the Advisors may engage in direct or indirect trading of securities, currencies, forward contracts, options, swaps and repurchase agreements on a principal basis. As such, the Advisors as transferee or counterparty could experience both delays in liquidating the underlying security, future or other investment and losses, including: (a) the risk of the inability or refusal to perform with respect to such transactions on the part of the principals with which the Advisor trades including, without limitation, the inability or refusal to timely return collateral posted by the Advisor; (b) possible decline in the value of any collateral during the period in which the Advisor seeks to enforce its rights with respect to such collateral; (c) the need to remargin or repost collateral in respect of transferred, assigned or replaced positions; (d) reduced levels of income and lack of access to income during such period; (e) expenses of enforcing its rights; and (f) legal uncertainty concerning the enforceability of certain rights under swap agreements and possible lack of priority against collateral posted under the swap agreements. Any such failure or refusal, whether due to insolvency, bankruptcy or other causes, could subject the Advisor and, in turn, the Investment Fund and the Company, to substantial losses. The Advisor will not be excused from performance on any such transactions due to the default of third parties in respect of other trades which in the Advisor’s trading strategies were to have substantially offset such contracts.
Third Party Co-Investment with Advisor Funds
Advisors may co-invest or form joint ventures with third parties, including affiliates of Goldman Sachs. There is a risk that such a co-investor or co-venturer may default on its participation in an investment or otherwise encounter financial difficulty, may have or develop interests inconsistent with those of the Advisor (or the Company), or may be in a position to take action with respect to an investment that is not in the best interests of the assets managed by such Advisor (or the Company).
Reliance on Technology
Certain Advisors may utilize quantitative portfolio models to seek to allocate assets. These models, among other things, may forecast relative returns for, risk levels and volatility of, and correlations among, strategies and investments. However, these models may, for a variety of reasons, fail to accurately predict such factors, including because of scarcity of historical data in respect of certain strategies and investments, erroneous underlying assumptions or estimates in respect of certain data or other defects in the models, or because future events may not necessarily follow historical norms. In particular, substantial components of the strategies employed on behalf of
one or more of the Advisors may involve attempts at the analysis of market phenomena for which there is limited or otherwise unreliable historical data, and therefore, the risk of various statistical or other errors may be considerably higher under such circumstances. There can be no assurance that the predictive models of an Advisor are adequate or that the models will be adequately utilized by the Advisor. In addition, certain Advisors may employ investment strategies that are dependent upon various computer and telecommunications technologies. The successful implementation and operation of these strategies could be severely compromised by telecommunications failures, power loss, software-related “system crashes,” fire or water damage, or various other events or circumstances. Any such event could result in, among other things, the inability of an Advisor to establish, maintain, modify, liquidate or monitor its investments, which could have a material adverse effect on an Investment Fund, Advisor Fund or Portfolio Company and consequently, the Company.
Third-Party Use of Publicly Available Information or Similar Trading Strategies
Certain positions and the prices and terms of certain transactions undertaken by the Advisors may be required to be made publicly available. Because certain trades made by the Advisors may be based upon quantitative trading methods or other proprietary information, there is a risk that market participants may seek to reverse engineer the trading strategies implemented by the Advisors using data required to be made publicly available. The use of similar trading strategies by other persons may have a material adverse effect on the assets managed by such Advisors, and consequently the Company.
Risks Related to International Investments
Trading on Non-U.S. Exchanges May Involve Higher Risk of Financial Irregularities and/or Lack of Appropriate Risk Monitoring and Controls
Advisors may trade, directly or indirectly, futures and securities on exchanges located outside the United States. Some non-U.S. exchanges, in contrast to U.S. exchanges, are “principals’ markets” in which performance is solely the individual member’s responsibility with whom the Advisor has entered into a commodity contract and not that of an exchange or its clearinghouse, if any. In the case of trading on non-U.S. exchanges, the Advisors, and, in turn, the Investment Funds and the Company, will be subject to the risk of the inability of, or refusal by, the counterparty to perform with respect to contracts. Moreover, since there is generally less government supervision and regulation of non-U.S. exchanges, clearinghouses and clearing firms than in the United States, Advisors and, consequently, the Investment Funds and the Company are also subject to the risk of the failure of the exchanges on which their positions trade or of their clearinghouses or clearing firms, and there may be a higher risk of financial irregularities and/or lack of appropriate risk monitoring and controls.
Non-U.S. Investments Involve Special Risks not Usually Associated with Investments in U.S. Securities
The Advisors may invest in securities of non-U.S. issuers and the governments of non-U.S. countries, including issuers in and governments of emerging market countries. These investments involve special risks not usually associated with investing in securities of U.S. companies or the U.S. government, including political and economic considerations, such as greater risks of expropriation and nationalization, currency devaluation, debt default, regime change confiscatory taxation, the potential difficulty of repatriating funds, general social, political and economic instability and adverse diplomatic developments; the small size of the securities markets in such countries and the low volume of trading, resulting in potential lack of liquidity and in price volatility; fluctuations in the rate of exchange between currencies and costs associated with currency conversion; and certain government policies that may restrict an Investment Fund’s and its Advisors’ investment opportunities. In addition, because non-U.S. entities are not subject to uniform accounting, auditing, and financial reporting standards, practices and requirements comparable with those applicable to U.S. companies, there may be different types of, and lower quality, information available about a non-U.S. company than a U.S. company. There is also less regulation, generally, of the securities markets in many non-U.S. countries than there is in the United States, and such markets may not provide the same protections available in the United States. With respect to certain countries there may be the possibility of political, economic or social instability, the imposition of trading controls, import duties or other protectionist measures, various laws enacted for the protection of creditors, greater risks of nationalization or
diplomatic developments which could materially adversely affect the Advisors’ investments in those countries. Furthermore, individual economies may differ favorably or unfavorably from the U.S. economy in such respects as growth of gross national product, rate of inflation, capital reinvestment, resource self-sufficiency, and balance of payments position. An Advisor’s investment in non-U.S. countries may also be subject to withholding or other taxes, which may be significant and may reduce the Advisor’s returns.
Brokerage commissions, custodial services and other costs relating to investment in international securities markets generally are more expensive than in the United States. In addition, clearance and settlement procedures may be different in non-U.S. countries and, in certain markets, such procedures have been unable to keep pace with the volume of securities transactions, thus making it difficult to conduct such transactions.
Investment in sovereign debt obligations of non-U.S. governments involves additional risks not present in debt obligations of corporate issuers and the U.S. government. The issuer of the debt or the governmental authorities that control the repayment of the debt may be unable or unwilling to repay principal or pay interest when due in accordance with the terms of such debt, and an Advisor may have limited recourse to compel payment in the event of a default. A sovereign debtor’s willingness or ability to repay principal and to pay interest in a timely manner may be affected by, among other factors, its cash flow situation, the extent of its foreign currency reserves, the availability of sufficient foreign exchange on the date a payment is due, the relative size of the debt service burden to the economy as a whole, the sovereign debtor’s policy toward international lenders, and the political constraints to which the sovereign debtor may be subject. Periods of economic uncertainty may result in the volatility of market prices of sovereign debt to a greater extent than the volatility inherent in debt obligations of other types of issues.
Investment in Emerging Markets Involves Significant Risks, Including Inflation and Currency Devaluations
The Advisors may invest in securities of companies based in emerging markets or issued by the governments of such countries. Securities traded in certain emerging markets may be subject to risks due to the inexperience of financial intermediaries, the lack of modern technology, the lack of a sufficient capital base to expand business operations, and the possibility of temporary or permanent termination of trading. Political and economic structures in many emerging markets may be undergoing significant evolution and rapid development, and emerging markets may lack the social, political and economic stability characteristics of more developed countries.
As a result, the risks relating to investments in non-U.S. securities described above, including the possibility of nationalization or expropriation, may be heightened. In addition, certain countries may restrict or prohibit investment opportunities in issuers or industries deemed important to national interests and there may generally be a high degree of governmental involvement and control over the economy. Governments may decide to discontinue support for economic reform programs or impose centrally planned economies. Such changes may affect the market price, liquidity and rights of securities that may be purchased by Advisors. Settlement mechanisms in emerging securities markets may be less efficient and less reliable than in more developed markets, and placing securities with a custodian or broker-dealer in an emerging country may also present considerable risks. The small size of securities markets in such countries and the low volume of trading may result in a lack of liquidity and in substantially greater price volatility. Many emerging market countries have experienced substantial, and in some periods extremely high, rates of inflation for many years. Inflation and rapid fluctuations in inflation rates and corresponding currency devaluations and fluctuations in the rate of exchange between currencies and costs associated with currency conversion have had, and may continue to have, negative effects on the economies and securities markets of certain emerging market countries. In addition, accounting, auditing and financial reporting standards that prevail in certain of such countries are not equivalent to standards in more developed countries and, consequently, less information is available to investors in companies located in such countries. Similarly, it may be more difficult to enforce contractual obligations. Additional risks arise from social or health issues including an increase in the prevalence of AIDS and social and civil unrest, including terrorist attacks and other acts of violence or war.
Many of the laws that govern private and foreign investment, equity securities transactions and other contractual relationships for sophisticated investors in certain countries, particularly in emerging markets, are not yet fully established. As a result, the Advisors may be subject to a number of unusual risks, including limited
investor protection, contradictory legislation, incomplete, unclear and changing laws, ignorance or breaches of regulations on the part of other market participants, lack of established or effective avenues for legal redress, lack of standard practices and confidentiality customs characteristic of developed markets and lack of enforcement of existing regulations. Furthermore, it may be difficult to obtain and enforce a judgment in certain countries. There can be no assurance that this difficulty in protecting and enforcing rights will not have a material adverse effect on the Advisors and consequently, the Company and its operations. In addition, the income and gains of an Advisor and consequently, the Company may directly or indirectly be subject to withholding taxes imposed by foreign governments for which the Company or the Members may not receive a full foreign tax credit.
Privatizations
The Advisors may seek to invest in privatizations (i.e., foreign government programs of selling interests in government-owned or controlled enterprises). The ability of Advisors to participate in privatizations may be limited by local law or the terms for participation may be less advantageous than for local investors. There can be no assurance that privatization programs will be available or successful.
Foreign Currency Transactions and Exchange Rate Risk Create Additional Risks for Advisors Investing in Certain Financial Instruments
Advisors may invest in equity and equity-related securities denominated in non-U.S. currencies and in other financial instruments, the price of which is determined with reference to such currencies. Advisors may engage in foreign currency transactions for a variety of purposes, including to “lock in” the U.S. dollar price of the security, between the trade and the settlement dates, the value of a security an Advisor has agreed to buy or sell, or to hedge the U.S. dollar value of securities the Advisor already owns. The Advisors may also engage in foreign currency transactions for non-hedging purposes to generate returns. The Investment Funds will, however, value their investments and other assets in U.S. dollars. To the extent unhedged, the value of each Investment Fund’s net assets will fluctuate with U.S. dollar exchange rates as well as with price changes of an Advisor’s investments in the various local markets and currencies. Forward currency contracts and options may be utilized by Advisors to hedge against currency fluctuations, but the Advisors are not required to utilize such techniques, and there can be no assurance that such hedging transactions will be available or, even if undertaken, effective.
Non-U.S. Futures Transactions Afford Less Protection as Rules of a Non-U.S. Exchange May Not be Enforced by a U.S. Regulator
Non-U.S. futures transactions involve executing and clearing trades on a non-U.S. exchange. This is the case even if the non-U.S. exchange is formally “linked” to a U.S. exchange, whereby a trade executed on one exchange liquidates or establishes a position on the other exchange. No U.S. organization regulates the activities of a non-U.S. exchange, including the execution, delivery, and clearing of transactions on such an exchange, and no U.S. regulator has the power to compel enforcement of the rules of the non-U.S. exchange or the laws of the non-U.S. country. Moreover, such laws or regulations will vary depending on the non-U.S. country in which the transaction occurs. For these reasons, an Investment Fund may not be afforded certain of the protections that apply to U.S. transactions, including the right to use U.S. alternative dispute resolution procedures. In particular, funds received from customers to margin non-U.S. futures transactions may not be provided the same protections as funds received to margin futures transactions on U.S. exchanges. In addition, the price of any non-U.S. futures or option contract and, therefore, the potential profit and loss resulting therefrom, may be affected by any fluctuation in the foreign exchange rate between the time the order is placed and the non-U.S. futures contract is liquidated or the non-U.S. option contract is liquidated or exercised.
Risks Related to Securities and Other Instruments
Investing in Derivative Instruments Involves Risk of Loss to the Advisors That Could Materially Adversely Affect the Value of the Company’s Net Assets
Advisors may invest in, or enter into transactions involving, derivative instruments. These are financial instruments that derive their performance, at least in part, from the performance of an underlying asset, index, or interest rate. Examples of derivatives include, but are not limited to, futures contracts, options contracts, and options on futures contracts. A futures contract is an exchange-traded agreement between two parties, a buyer and a seller, to exchange a particular commodity or financial instrument at a specific price on a specific date in the future. An option transaction generally involves a right, which may or may not be exercised, to buy or sell a commodity or financial instrument at a particular price on a specified future date.
An Advisor’s use of derivatives involves risks different from, or possibly greater than, the risks associated with investing directly in securities or more traditional investments, depending upon the characteristics of the particular derivative and the Advisor’s portfolio as a whole. Derivatives permit an Advisor to increase or decrease the level of risk of its portfolio, or change the character of the risk to which its portfolio is exposed, in much the same way as the Advisor can increase or decrease the level of risk, or change the character of the risk, of its portfolio by making investments in specific securities. Certain swaps, options and other derivative instruments may be subject to various types of risks, including market risk, liquidity risk, counterparty credit risk, legal risk and operations risk. In addition, swaps and other derivatives can involve significant economic leverage and may, in some cases, involve significant risk of loss.
Derivatives may entail investment exposures that are greater than their cost would suggest, meaning that a small investment in derivatives could have a large potential impact on an Advisor’s performance. If an Advisor invests in derivatives at inopportune times or judges market conditions incorrectly, such investments may lower the Advisor’s return or result in a loss. An Advisor also could experience losses if derivatives are poorly correlated with its other investments, or if an Advisor is unable to liquidate its position because of an illiquid secondary market. The market for many derivatives is, or suddenly can become, illiquid. Changes in liquidity may result in significant, rapid, and unpredictable changes in the prices for derivatives.
Engaging in these transactions involves risk of loss to the Advisors that could materially adversely affect the value of the Company’s net assets. No assurance can be given that a liquid market will exist for any particular futures contract at any particular time.
The successful use of futures also is subject to the ability to predict correctly movements in the direction of the relevant market, and, to the extent the transaction is entered into for hedging purposes, to ascertain the appropriate correlation between the transaction being hedged and the price movements of the futures contract.
Equity Securities and Equity-Related Instruments May be Subject to Various Types of Risk, Including Market Risk, Liquidity Risk, Counterparty Credit Risk, Legal Risk and Operations Risk
Advisors may invest long and short in equities and equity-related instruments in their investment programs. Stocks, options and other equity-related instruments may be subject to various types of risk, including market risk, liquidity risk, counterparty credit risk, legal risk and operations risk. In addition, equity-related instruments can involve significant economic leverage and may, in some cases, involve significant risk of loss. “Equity securities” may include common stocks, preferred stocks, interests in real estate investment trusts, convertible debt obligations, convertible preferred stocks, equity interests in trusts, partnerships, joint ventures or limited liability companies and similar enterprises, warrants and stock purchase rights. In general, stock values fluctuate in response to the activities of individual companies and in response to general market and economic conditions. Accordingly, the value of the stocks and other securities and instruments that the Investment Funds hold directly or indirectly may decline over short or extended periods of time. The stock markets tend to be cyclical, with periods when stock prices generally rise and periods when stock prices generally decline. The volatility of equity securities means that the value of an investment in each of the Investment Funds and, in turn, the Company may increase or decrease.
Fixed Income Securities are Subject to Credit Risk and Price Volatility
Advisors may invest in fixed income securities. Investment in these securities may offer opportunities for income and capital appreciation, and may also be used for temporary defensive purposes and to maintain liquidity.
“Fixed income securities” are obligations of the issuer to make payments of principal and/or interest on future dates, and include, among other securities: bonds, notes, and debentures issued by corporations; debt securities issued or guaranteed by the U.S. government or one of its agencies or instrumentalities or by a non-U.S. government; municipal securities; and mortgage-backed and asset-backed securities. These securities may pay fixed, variable, or floating rates of interest, and may include zero coupon obligations. Fixed income securities are subject to the risk of the issuer’s or a guarantor’s inability to meet principal and interest payments on its obligations (i.e., credit risk) and are subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer, and general market liquidity (i.e., market risk). In addition, mortgage-backed securities and asset-backed securities may also be subject to call risk and extension risk. For example, homeowners have the option to prepay their mortgages. Therefore, the duration of a security backed by home mortgages can either shorten (i.e., call risk) or lengthen (i.e., extension risk). In general, if interest rates on new mortgage loans fall sufficiently below the interest rates on existing outstanding mortgage loans, the rate of prepayment would be expected to increase. Conversely, if mortgage loan interest rates rise above the interest rates on existing outstanding mortgage loans, the rate of prepayment would be expected to decrease. In either case, a change in the prepayment rate can result in losses to investors. The same would be true of asset-backed securities, such as securities backed by car loans.
Generally, mortgage-backed securities on commercial (in contrast to residential) properties are not subject to prepayment risk, but are subject to other risks, including without limitation the financial well being of large tenants, local or general business climate, and ability to raise and collect rents. Mortgage loans on commercial properties often are structured so that a substantial portion of the loan principal is not amortized over the loan term, but is payable at maturity. Therefore, repayment of the loan principal often depends upon the future availability of property financing from the lenders and/or upon the current value and salability of the property.
High Yield Debt Investments are Subject to Significant Risks of Default, Illiquidity and Volatility
High yield bonds (commonly known as “junk bonds”) and other debt securities in which Advisors may invest on behalf of certain of the Investment Funds will typically be junior to the obligations of companies to senior creditors, trade creditors and employees. The lower rating of high yield debt reflects a greater possibility that adverse changes in the financial condition of the issuer or in general economic, financial, competitive, regulatory or other conditions may materially impair the ability of the issuer to make payments of principal and interest. High yield debt securities have historically experienced greater default rates than investment grade securities. The ability of holders of high yield debt to influence a company’s affairs, especially during periods of financial distress or following an insolvency, will be substantially less than that of senior creditors.
As with other investments, there may not be a liquid market for certain high yield debt, which could result in an Advisor being unable to sell such securities for an extended period of time, if at all. In addition, as with other types of Advisor investments, the market for high yield debt has historically been subject to disruptions that have caused significant illiquidity and substantial volatility in the prices of such securities. Consolidation in the financial services industry has resulted in fewer market makers for high yield debt, which may result in further risk of illiquidity and volatility with respect to high yield debt, and this trend may continue in the future. Furthermore, high yield debt which is held by an Advisor is often not registered under the Securities Act and, unless so registered, will not be able to be sold except pursuant to an exemption from registration under the Securities Act. This may further limit the ability of an Advisor to sell high yield debt or to obtain the desired price for high yield debt.
Other Debt Instruments; CBOs and CLOs
Advisors may directly or indirectly invest in other debt instruments (both investment-grade and non-investment grade) of companies or other entities not affiliated with countries or governments, including but not limited to, senior and subordinated corporate debt; tranches of collateralized mortgage obligations, collateralized bond obligations and collateralized loan obligations; preferred stock; corporate securities; and bank debt. Advisors
may acquire debt securities on a private placement basis and may invest in loan participations. As with other investments made by Advisors, there may not be a liquid market for these debt instruments, which may limit the Advisors’ ability to sell these debt instruments or to obtain the desired price.
Advisors may also invest in collateralized bond obligations (“CBOs”) and collateralized loan obligations (“CLOs”) and other similar securities. These may be fixed pools or may be “market value” or managed pools of collateral, including commercial loans, high yield debt, structured securities and derivative instruments relating to debt. The pools are typically separated into tranches representing different degrees of credit quality, with lower rated tranches being subordinate to senior tranches. The senior tranches of CBOs and CLOs, which represent the highest credit quality in the pool, have the greatest collateralization and pay the lowest spreads over treasuries. Lower rated CBO and CLO tranches represent lower degrees of credit quality and pay higher spreads over treasuries to compensate for the attendant risks. The bottom tranches specifically receive the residual interest payments (i.e., money that is left over after the higher tiers have been paid) rather than a fixed interest rate. The returns on the junior tranches of CBOs and CLOs are especially sensitive to the rate of defaults in the collateral pool. In addition, the exercise of redemption rights, if any, by more senior CBO and CLO tranches and certain other events could result in an elimination, deferral or reduction in the funds available to make interest or principal payments to the junior tranches.
In addition, there can be no assurance that a liquid market will exist in any CBO or CLO when an Advisor seeks to sell its interest therein. Also, it is possible that an Advisor’s investment in a CBO or CLO will be subject to certain contractual limitations on transfer.
Structured Securities May Present a Greater Degree of Market Risk and May be More Volatile, Less Liquid and More Difficult to Price Accurately Than Less Complex Securities
Advisors may invest in structured securities. Structured securities are securities whose value is determined by reference to changes in the value of specific currencies, interest rates, commodities, indexes or other financial indicators (the “Reference”) or the relative change in two or more References. The interest rate or the principal amount payable upon maturity or redemption may be increased or decreased depending upon changes in the applicable Reference. Structured securities may be positively or negatively indexed, so that appreciation of the Reference may produce an increase or decrease in the interest rate or value of the security at maturity. In addition, changes in the interest rates or the value of the security at maturity may be a multiple of changes in the value of the Reference. Consequently, structured securities may present a greater degree of market risk than other types of securities and may be more volatile, less liquid and more difficult to price accurately than less complex securities.
Call Options Involve Significant Risks for Buyers and Sellers
Advisors may participate in, and there are risks associated with, the purchase and sale of call options. The seller (writer) of a call option which is covered (e.g., the writer holds the underlying security) assumes the risk of a decline in the market price of the underlying security below the purchase price of the underlying security less the premium received, and gives up the opportunity for gain on the underlying security above the exercise price of the option. The seller of an uncovered call option assumes the risk of a theoretically unlimited increase in the market price of the underlying security above the exercise price of the option.
The buyer of a call option assumes the risk of losing its entire investment in the call option. If the buyer of the call sells short the underlying security, the loss on the call will be offset in whole or in part by any gain on the short sale of the underlying security.
Put Options Involve Significant Risks for Buyers and Sellers
Advisors may participate in, and there are risks associated with, the purchase and sale of put options. The seller (writer) of a put option which is covered (e.g., the writer has a short position in the underlying security) assumes the risk of an increase in the market price of the underlying security above the sales price (in establishing the short position) of the underlying security plus the premium received, and gives up the opportunity for gain on the underlying security below the exercise price of the option. If the seller of the put option owns a put option covering an equivalent number of shares with an exercise price equal to or greater than the exercise price of the put written,
the position is “fully hedged” if the option owned expires at the same time or later than the option written. The seller of an uncovered put option assumes the risk of a decline in the market price of the underlying security below the exercise price of the option.
The buyer of a put option assumes the risk of losing its entire investment in the put option. If the buyer of the put holds the underlying security, the loss on the put will be offset in whole or in part by any gain on the underlying security.
Reverse Repurchase Agreements May Increase the Volatility of an Investment Fund’s and the Company’s Investment Portfolio
The Investment Funds or the Advisors may enter into reverse repurchase agreements. A reverse repurchase agreement typically involves the sale of a security by a party to a bank or securities dealer and the selling party’s simultaneous agreement to repurchase that security for a fixed price (reflecting a rate of interest) on a specific date, and may be considered a form of borrowing for some purposes. These transactions involve risks that the value of portfolio securities being relinquished may decline below the price that must be paid when the transaction closes or that the other party to a reverse repurchase agreement will be unable or unwilling to complete the transaction as scheduled, which may result in losses to the applicable Investment Fund and the Company. Reverse repurchase agreements are a form of leverage that may also increase the volatility of an Investment Fund’s and the Company’s investment portfolio.
There are Significant Risks Associated with When-Issued and Forward Commitment Securities
Advisors may purchase securities on a “when-issued” basis and may purchase or sell securities on a “forward commitment” basis in order to hedge against anticipated changes in interest rates and prices or for speculative purposes. These transactions involve a commitment by an Advisor to purchase or sell securities at a future date (ordinarily at least one or two months later). The price of the underlying securities, which is generally expressed in terms of yield, is fixed at the time the commitment is made, but delivery and payment for the securities takes place at a later date. No income accrues on securities that have been purchased pursuant to a forward commitment or on a when-issued basis prior to delivery to the Advisor. When-issued securities and forward commitments may be sold prior to the settlement date. If an Advisor disposes of the right to acquire a when-issued security prior to its acquisition or disposes of its right to deliver or receive against a forward commitment, it may incur a gain or loss. There is a risk that securities purchased on a when-issued basis may not be delivered and that the purchaser of securities sold by an Advisor on a forward basis will not honor its purchase obligation. In such cases, the applicable Investment Fund and, in turn, the Company, may incur a loss.
Derivatives with Respect to High Yield and Other Indebtedness Expose Advisors to Counterparty and Issuer Risk
In addition to the credit risks associated with holding high yield debt securities, with respect to derivatives involving high yield and other debt, an Advisor will usually have a contractual relationship only with the counterparty of the derivative, and not with the issuer of the indebtedness. An Advisor generally will have no right to directly enforce compliance by the issuer with the terms of the derivative nor any rights of set-off against the issuer, nor have any voting rights with respect to the indebtedness. An Advisor will not directly benefit from the collateral supporting the underlying indebtedness and will not have the benefit of the remedies that would normally be available to a holder of the indebtedness. In addition, in the event of the insolvency of the counterparty to the derivative, the Advisor will be treated as a general creditor of such counterparty, and will not have any claim with respect to the underlying indebtedness. Consequently, the Advisor will be subject to the credit risk of the counterparty as well as that of the issuer of the indebtedness. As a result, concentrations of such derivatives in any one counterparty subject the Advisor, and, in turn, the applicable Investment Fund, to an additional degree of risk with respect to defaults by such counterparty as well as by the issuer of the underlying indebtedness.
Credit Default Swaps
Advisors may enter into credit derivative contracts. The typical credit default swap contract requires the seller to pay to the buyer, in the event that a particular reference entity experiences specified credit events, the difference between the notional amount of the contract and the value of a portfolio of securities issued by the reference entity that the buyer delivers to the seller. In return, the buyer typically agrees to make periodic and/or upfront payments equal to a fixed percentage of the notional amount of the contract. Advisors may also purchase or sell credit default swaps on a basket of reference entities or an index. In circumstances in which Advisors do not own the debt securities that are deliverable under a credit default swap, Advisors will be exposed to the risk that deliverable securities will not be available in the market, or will be available only at unfavorable prices, as would be the case in a so-called “short squeeze”. In certain instances of issuer defaults or restructurings, it has been unclear under the standard industry documentation for credit default swaps whether or not a “credit event” triggering the seller’s payment obligation had occurred. In either of these cases, an Advisor would not be able to realize the full value of the credit default swap upon a default by the reference entity. As sellers of credit default swaps, Advisors incur leveraged exposure to the credit of the reference entity and are subject to many of the same risks they would incur if they were holding debt securities issued by the reference entity. However, Advisors will not have any legal recourse against the reference entity and will not benefit from any collateral securing the reference entity’s debt obligations. In addition, the credit default swap buyer will have broad discretion to select which of the reference entity’s debt obligations to deliver to an Advisor following a credit event and will likely choose the obligations with the lowest market value in order to maximize the payment obligations of the Advisor. Given increases in volume of credit derivatives trading in the market, settlement of such contracts may also be delayed beyond the time frame originally anticipated by counterparties. Such delays may adversely impact the Advisors’ ability to otherwise productively deploy any capital that is committed with respect to such contracts.
Risks of Spread Transactions
Where an Advisor enters into spread transactions, it is subject to the risk that the prices of the currencies underlying the positions comprising such spreads will not fluctuate in the same direction or to the same extent during the period in which the spread position is maintained. Under such circumstances, the relevant Investment Fund or Advisor Fund could sustain losses on one or both legs of the spread position.
The Company May be Prevented From Achieving its Objective During any Period in Which Assets are not Substantially Invested in Accordance with Principal Investment Strategies
Advisors may invest, for defensive purposes or otherwise, some or all of their assets in fixed income securities, money market instruments, and money market mutual funds, or hold cash or cash equivalents in such amounts as the Advisors deem appropriate under the circumstances. Pending allocation of the offering proceeds and thereafter, from time to time, the Company and the Investment Funds also may invest in these instruments. Money market instruments are short-term fixed income obligations, which generally have remaining maturities of one year or less, and may include U.S. government securities, commercial paper, certificates of deposit, bankers’ acceptances issued by U.S. branches of U.S. banks that are members of the Federal Deposit Insurance Corporation, and repurchase agreements. The Company and the Investment Funds may be prevented from achieving their objectives during any period in which the Company’s and the Investment Funds’ assets are not substantially invested in accordance with their principal investment strategies.
Restricted and Illiquid Investments May Prevent Prompt Liquidation of Unfavorable Positions Resulting in Substantial Loss
The market value of an Advisor’s investments may fluctuate with, among other things, changes in prevailing interest rates, general economic conditions, the condition of financial markets, developments or trends in any particular industry and the financial condition of the issuers of the securities in which the Advisor invests. During periods of limited liquidity and higher price volatility, the Advisor’s ability to acquire or dispose of its investments at a price and time that the Advisor deems advantageous may be impaired. As a result, in periods of rising market prices, the Advisor may be unable to participate in price increases fully to the extent that it is unable to acquire
desired positions quickly; conversely, the Advisor’s inability to dispose fully and promptly of positions in declining markets will cause its NAV to decline as the value of unsold positions is marked to lower prices.
In addition, Advisors may invest a portion or all of the value of their assets in restricted securities and other investments that are illiquid. Restricted securities are securities that may not be sold to the public without an effective registration statement under the Securities Act or, if they are unregistered, may be sold only in a privately negotiated transaction or pursuant to an exemption from registration. These may include restricted securities that can be offered and sold only to “qualified institutional buyers” under Rule 144A of the Securities Act. There may be no limit to the percentage of an Advisor’s net assets that may be invested in illiquid securities.
Positions in restricted or non-publicly traded securities, securities on non-U.S. exchanges and certain futures contracts may be illiquid because certain exchanges limit fluctuations in certain securities and futures contract prices during a single day by regulations referred to as “daily price fluctuation limits” or “daily limits”. Under such daily limits, during a single trading day no trades may be executed at prices beyond the daily limits. Once the price of a particular security or futures contract has increased or decreased by an amount equal to the daily limit, positions in that security or contract can neither be taken nor liquidated unless traders are willing to effect trades at or within the limit. This constraint could prevent the Advisors from promptly liquidating unfavorable positions and subject the Investment Funds and, in turn, the Company to substantial losses. This could also impair the Company’s ability to redeem its membership units from an Investment Fund in order to redeem Members’ units in a timely manner. An investment in the Company is therefore suitable only for certain sophisticated investors that will not be materially impacted by postponement of the Company’s redemption dates.
Risks Related to Issuers of Securities
The Issuers of Securities Acquired by Advisors will Sometimes Face a High Degree of Business and Financial Risk
The issuers of securities acquired by Advisors will sometimes involve a high degree of business and financial risk. These companies may be in an early stage of development, may not have a proven operating history, may be operating at a loss or have significant variations in operating results, may be engaged in a rapidly changing business with products subject to a substantial risk of obsolescence, may require substantial additional capital to support their operations, to finance expansion or to maintain their competitive position, or may otherwise have a weak financial condition.
Issuers of securities acquired by Advisors may be highly leveraged. Leverage may have important adverse consequences to these companies and the Company as an indirect investor. These companies may be subject to restrictive financial and operating covenants. The leverage may impair these companies’ ability to finance their future operations and capital needs. As a result, these companies’ flexibility to respond to changing business and economic conditions and to business opportunities may be limited. A leveraged company’s income and net assets will tend to increase or decrease at a greater rate than if borrowed money were not used.
In addition, such companies may face intense competition, including competition from companies with greater financial resources, more extensive development, manufacturing, marketing, and other capabilities, and a larger number of qualified managerial and technical personnel.
Expected Transactions May not Take Place or may Result in Substantial Losses
The Advisors of the Investment Funds, particularly those of GFS, may engage in merger arbitrage transactions. Substantial transaction failure risks exist with respect to companies that are the subject of publicly disclosed mergers, takeover bids, exchange offers, tender offers, spin-offs, liquidations, corporate restructuring, and other similar transactions. Thus, there can be no assurance that any expected transaction will take place. Certain transactions are dependent on one or more factors in order to become effective, such as market conditions which may lead to unexpected positive or negative changes in a company profile, shareholder approval, regulatory and various other third party constraints, changes in earnings or business lines or shareholder activism as well as many
other factors. No assurance can be given that the merger arbitrage transactions entered into by the Advisors will be profitable, and any such transaction may result in substantial losses.
Investments in Small Capitalization Companies are Speculative and May be Difficult to Value
Advisors may invest in securities of small capitalization companies and recently organized companies and, conversely, the Advisors may establish significant short positions in such securities. Historically, such securities have been more volatile in price than those of larger capitalized, more established companies. The securities of small capitalization and recently organized companies pose greater investment risks because such companies may have limited product lines, distribution channels and financial and managerial resources. In particular, small capitalization companies may be operating at a loss or have significant variations in operating results; may be engaged in a rapidly changing business with products subject to substantial risk of obsolescence; may require substantial additional capital to support their operations, to finance expansion or to maintain their competitive position; and may have substantial borrowings or may otherwise have a weak financial condition. In addition, these companies may face intense competition, including competition from companies with greater financial resources, more extensive development, manufacturing, marketing, and other capabilities, and a larger number of qualified managerial and technical personnel. Further, there is often less publicly available information concerning such companies than for larger, more established businesses. The equity securities of small capitalization companies are often traded over-the-counter or on regional exchanges and may not be traded in the volumes typical on a national securities exchange. Consequently, the Advisors or entities in which the Advisors invest may be required to dispose of such securities or cover a short position over a longer (and potentially less favorable) period of time than is required to dispose of or cover a short position with respect to the securities of larger, more established companies. Investments in small capitalization companies may also be more difficult to value than other types of securities because of the foregoing considerations as well as lower trading volumes. Investments in companies with limited operating histories are more speculative and entail greater risk than do investments in companies with an established operating record. Additionally, transaction costs for these types of investments are often higher than those of larger capitalization companies.
Investments in Issuers of Indebtedness May be Adversely Affected in the Event of an Issuer’s Insolvency
Various laws enacted for the protection of creditors may apply to indebtedness in which the Advisors of the Investment Funds invest. The information in this and the following paragraph is applicable with respect to U.S. issuers subject to United States federal bankruptcy law. Insolvency considerations may differ with respect to other issuers. If a court in a lawsuit brought by an unpaid creditor or representative of creditors of an issuer of indebtedness, such as a trustee in bankruptcy, were to find that the issuer did not receive fair consideration or reasonably equivalent value for incurring the indebtedness and that, after giving effect to such indebtedness, the issuer (i) was insolvent, (ii) was engaged in a business for which the remaining assets of such issuer constituted unreasonably small capital or (iii) intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature, such court could determine to invalidate, in whole or in part, such indebtedness as a fraudulent conveyance, to subordinate such indebtedness to existing or future creditors of such issuer, or to recover amounts previously paid by such issuer in satisfaction of such indebtedness. The measure of insolvency for purposes of the foregoing will vary. Generally, an issuer would be considered insolvent at a particular time if the sum of its debts was then greater than all of its property at a fair valuation, or if the present fair saleable value of its assets was then less than the amount that would be required to pay its probable liabilities on its existing debts as they became absolute and matured. There can be no assurance as to what standard a court would apply in order to determine whether the issuer was “insolvent” after giving effect to the incurrence of the indebtedness in which an Advisor invested or that, regardless of the method of valuation, a court would not determine that the issuer was “insolvent” upon giving effect to such incurrence. In addition, in the event of the insolvency of an issuer of indebtedness in which an Advisor invests, payments made on such indebtedness could be subject to avoidance as a “preference” if made within a certain period of time (which may be as long as one year) before insolvency. In general, if payments on indebtedness are avoidable, whether as fraudulent conveyances or preferences, such payments can be recaptured from the Advisor to which such payments were made.
The Company and the Investment Funds do not anticipate that the Advisors will engage in conduct that would form the basis for a successful cause of action based upon fraudulent conveyance, preference or equitable subordination. There can be no assurance, however, as to whether any lending institution or other party from which the Advisor may acquire such indebtedness engaged in any such conduct (or any other conduct that would subject such indebtedness and any Investment Fund, the assets of which such Advisor used to purchase such indebtedness, to insolvency laws) and, if it did, as to whether such creditor claims could be asserted in a U.S. court (or in the courts of any other country) against such Investment Fund.
Indebtedness consisting of obligations of non-U.S. issuers or U.S. issuers with respect to their foreign obligations may be subject to various laws enacted in the countries of their issuance for the protection of creditors. These insolvency considerations and the levels of protection provided will differ depending on the country in which each issuer is located or domiciled and may differ depending on whether the issuer is a non-sovereign or a sovereign entity.
Purchases of Securities and Other Obligations of Financially Distressed Companies Create an Enhanced Risk of Substantial Loss or Loss of Entire Investment
The Advisors may purchase securities and other obligations of companies that are experiencing significant financial or business distress, including companies involved in bankruptcy or other reorganization and liquidation proceedings. Although such purchases may result in significant returns, they involve a substantial degree of risk and may not show any return for a considerable period of time. In fact, many of these instruments ordinarily remain unpaid unless and until the company reorganizes and/or emerges from bankruptcy proceedings, and as a result may have to be held for an extended period of time. The level of analytical sophistication, both financial and legal, necessary for successful investment in companies experiencing significant business and financial distress is unusually high. There is no assurance that the Advisors will correctly evaluate the nature and magnitude of the various factors that could affect the prospects for a successful reorganization or similar action. In any reorganization or liquidation proceeding relating to a company in which an Advisor invests, an Advisor may lose its entire investment or may be required to accept cash or securities with a value less than its original investment. Under such circumstances, the returns generated from an Advisor’s investments may not compensate investors adequately for the risks assumed.
Investments in Certain Multi-Advisor Structures
From time to time, the Managing Member may cause the Company or the Investment Fund, as applicable, to allocate assets to an Advisor that allocates assets to investment funds that retain certain services and support from service providers retained by, or affiliated with, such Advisor (a “Multi-Advisor Structure”). As described under ITEM 1. “BUSINESS-PERFORMANCE OF THE COMPANY-Overview of the Investment Process of the Investment Funds,” the Advisor selection process generally includes an examination of the organizational infrastructure, including the quality of the investment professionals and staff, the types and application of internal controls, and any potential for conflicts of interest. However, where funds are allocated to a Multi-Advisor Structure, the Managing Member generally will have limited ability to examine the organizational infrastructure of the underlying managers and the investment funds in which the Company or the Investment Fund indirectly invests. In addition, the Managing Member will not be able to control the selection or removal of underlying managers. The risks described under “-Special Risks of the Fund of Funds Structure” are particularly applicable to investments in Multi-Advisor Structures, including, without limitation, the payment of multiple levels of fees. Any references in this Annual Report to strategies or techniques utilized by the Advisors include strategies or techniques utilized by investment funds and their managers in which Multi-Advisor Structures invest.
Additional Investment Risks of Certain Advisor Funds
Certain Advisor Funds to which the Investment Funds may allocate assets may invest in private equity investments, which involve a high degree of business and financial risk. These investments typically take many years to be realized or to become liquid. Certain Advisor Funds may also invest in real estate investments, which generally will be subject to the risks incident to the ownership and operation of commercial real estate and risks incident to the making of non-recourse mortgage loans secured by real estate including risks associated with
U.S. and non-U.S. general economic climates, local real estate conditions, dependence on cash flow and lack of liquidity.
Private equity and real estate investments may be difficult to value. The Investment Funds will generally value interests in Advisor Funds in accordance with the terms of the Advisor Fund’s governing agreement, as such valuations are reported to the Investment Fund. Such valuations will be, indirectly through the Investment Funds, utilized by the Company in calculating the NAV of the Company and the NAV per unit for purposes of subscriptions and redemptions, as well as for calculating the Management Fee, Incentive Allocation and administration fee. These calculations will therefore be directly affected by the valuations of any difficult-to-value assets.
In addition, the Investment Funds may from time to time allocate assets to Advisor Funds that require the Investment Funds to make capital commitments, which will be drawn down over time rather than paid at the time of the initial investment. If an Investment Fund fails to make a required capital contribution, the Investment Fund may be liable for costs incurred in collecting or attempting to collect such late payment, and could lose its entire investment in such an Advisor Fund. The Company, as a member of an Investment Fund, will not be required to make additional investments to fund capital contributions; these will come solely from the Investment Fund’s existing assets.
Advisor Special Investments
From time to time certain Advisor Funds may segregate from their portfolio of assets certain illiquid or difficult-to-value securities or instruments (each, a “special investment”) and hold them in special investment accounts. This practice is commonly referred to as “side-pocketing”. Interests in special investment accounts generally are allocated only to those investors that were investors at the time the relevant special investment was acquired or segregated and future investors in the Advisor Fund generally will not participate in such special investment. Investors (including the Investment Funds) that hold interests in special investment accounts generally will not be able to redeem their interests in such accounts until the relevant special investments are liquidated, deemed realized (because, for example, the special circumstances surrounding such investment ceases) or otherwise disposed of. Therefore, an Investment Fund may be required to hold its interest in a special investment account for a significant period of time. An Investment Fund’s inability to redeem its interests from such special investment account may have a material adverse effect on the Investment Fund’s ability to reallocate assets. In addition, significant amounts of redemption requests by investors in the Investment Fund that are not offset by new subscriptions could result in the Investment Fund holding a greater concentration of highly illiquid investments than was previously the case. This could have a material adverse effect on the Investment Fund’s investment mix, and could also cause the Investment Fund to postpone or suspend future redemptions.
Special investments generally are carried on the books of an Advisor Fund at the applicable Advisor’s or a third party’s determination of fair value (which may, under the relevant Advisor Fund’s organizational documents, be presumed to be the cost of such special investment). However, given the nature of special investments, such determinations may not represent the actual amount that would be realized by the Advisor Fund (and therefore the Investment Fund) upon the eventual disposition of such special investment or that would, in fact, be realized upon an immediate disposition of the special investment. As discussed above, an Investment Fund will generally value interests in Advisor Funds in accordance with the terms and conditions of the Advisor Fund’s governing agreement, as such valuations are reported to the Investment Fund. Unlike a typical Advisor Fund, however, which generally will not use the unrealized value of a special investment for purposes of subscriptions, redemptions and calculating performance-based fees or allocations, such valuations will be utilized by the Investment Fund in calculating the NAV of units in the Investment Fund for purposes of subscriptions and redemptions, as well as for calculating the management fee, incentive allocation and administration fees in respect thereof. Accordingly, indirectly through the Investment Funds, the NAV of the Company and the NAV per unit will be directly affected by the valuations of any special investments as reported to the Investment Funds. Valuations of special investments generally will not be adjusted retroactively when such special investments are sold or otherwise disposed of by an Advisor Fund.
Certain Advisor Funds may charge a performance-based incentive fee or allocation (i) at the time a special investment is designated and/or (ii) at the time a special investment is realized or deemed realized based solely on the gains with respect to such special investment, which could adversely affect investors in the Advisor Fund,
including an Investment Fund and, indirectly, the Company. Other Advisor Funds may have different procedures for calculating fees or allocations with respect to special investments that also could adversely affect the Company and its Members.
In the event of a cross transaction between an Investment Fund and another client of the Managing Member that involves the direct or indirect assignment of an interest in an Advisor Fund special investment (whether such interest is assigned by itself or together with a related interest in the relevant Advisor Fund), the Investment Fund or the other party which is a client of the Managing Member, as applicable, will receive an interest in such assigned Advisor Fund special investment that it would generally not have received had it made a new investment in the applicable Advisor Fund rather than obtaining an interest therein by means of a cross transaction. In the event of a cross transaction involving an Advisor Fund special investment, it is anticipated that the Advisor Fund special investment will generally be assigned for a price equal to the last value reported by the applicable Advisor to the holder of such Advisor Fund special investment. Because Advisor Fund special investments may be difficult to value, in any cross transaction involving an Advisor Fund special investment an Investment Fund will be exposed to the risk that it is paying more (in the event that the Investment Fund is the transferee) or receiving less (in the event that the Investment Fund is the transferor) for such Advisor Fund special investment than the value at which such Advisor Fund special investment might be realized if it were realized at the time of the transfer or the value at which such Advisor Fund special investment will ultimately be realized. In addition, in the event that the Investment Fund receives an interest in an Advisor Fund special investment through a cross-transaction, the Investment Fund will generally have a greater portion of its assets invested in Advisor Fund special investments following such cross transaction than it did beforehand, which will generally decrease the overall liquidity of the Investment Fund’s underlying investments.
In addition, in the event that the managing member of an Investment Fund determines to reduce the Investment Fund’s exposure to Advisor Fund special investments generally or to a particular Advisor Fund special investment, for liquidity reasons or otherwise, the managing member may cause the Investment Fund to sell its interest in one or more Advisor Fund special investments to a third party or, to the extent permitted by applicable law, to the managing member or an affiliate of the managing member. Any such sale may be of the Advisor Fund special investment by itself or together with the associated interest in the relevant Advisor Fund and may be effected through a broker or a matching or other service designed to bring together buyers and sellers of Advisor Fund special investments. In the event of a sale of an Advisor Fund special investment or other interest in an Advisor Fund, the Investment Fund will bear the associated brokerage and other expenses. Any such transfer may be made at a price that represents a discount to the last value reported by the applicable Advisor, and the Investment Fund may receive significantly less than the value at which such Advisor Fund special investment might be realized if it were realized at the time of the transfer or the value at which such Advisor Fund special investment will ultimately be realized.
The same or similar risks may also apply to the Company’s direct investments in Investment Funds and Advisor Funds.
Changes to the Trading and Investment Strategies Utilized by the Advisors
Advisors may, from time to time, without prior notice to the Managing Member, the Investment Funds or the Company, utilize additional investment strategies and sub-strategies, including investment strategies and sub-strategies that are not discussed herein, and/or remove, substitute or modify their investment strategies and sub-strategies or any of the types of investments then being utilized. Any such addition or change may result in the Advisors investing in other markets, securities and instruments than those described herein. Any such decision may result in all or a significant portion of an Advisor’s assets being allocated to a single investment strategy or sub-strategy or type of investment. There can be no assurance that an Advisor’s decisions in this regard will be successful or will not otherwise have an adverse effect on the assets managed by such Advisor and, in turn, the Investment Funds and the Company. The Company will not have an opportunity to evaluate such decisions or an opportunity to redeem its interests in the applicable Investment Fund prior to any such decision.
Limits of Risk Disclosure
The Company Should be Considered a Speculative Investment and Members Should Retain Their Investment Only if They Can Sustain a Complete Loss of their Investment
The above discussions relating to various risks associated with the Company, the units, the Investment Funds and the Advisors are not, and are not intended to be, a complete enumeration or explanation of the risks involved in an investment in the Company. Should the Managing Member invest the Company’s assets with Advisors other than through an investment in an Investment Fund, the risks described herein with respect to the Investment Funds will also apply to the Company. Members should read this entire Annual Report and the Company’s LLC Agreement and should consult with their own advisers before deciding whether to retain their investment in the Company. In addition, as the Company’s investment program or market conditions change or develop over time, an investment in the Company may be subject to risk factors not currently contemplated or described in this Annual Report.
In view of the risks noted above, the Company should be considered a speculative investment and Members should retain their investment in the Company only if they can sustain a complete loss of their investment.
No guarantee or representation is made that the investment program of the Company, the Investment Funds or any Advisor will be successful, that the Investment Funds or the various Advisors selected by the Investment Funds will produce positive returns, or that the Advisors selected by the Company or the Investment Funds will provide complete or accurate information to the Company or the Investment Funds, or that the Company, the Investment Funds or the Advisors will achieve their investment objectives.
Assets and liabilities of the Company may be attributable to certain classes of units and not others. If, in the future, the liabilities of a class of units exceed its assets, creditors of the Company in respect of such class may have recourse to the assets attributable to other classes.
From time to time, the Company may be subject to contingent liabilities (including liabilities for taxes), known or unknown. To the extent the Company is aware of these contingent liabilities, the Company may be required by applicable accounting standards, or may otherwise determine in its discretion, to accrue amounts for such contingent liabilities for U.S. GAAP or other purposes, including contingent liabilities that may never become payable. The accrual of any such liabilities will reduce the Company’s NAV.
In certain circumstances the Company may not accrue amounts for contingent liabilities, including because such accruals are not required by U.S. GAAP, or because the potential facts giving rise to such contingent liabilities are not known to the Company, because the Company otherwise does not anticipate that any payments relating to such contingencies will be required or for other reasons in the Managing Member’s sole discretion. In the event that the Company subsequently determines to accrue amounts for such contingent liabilities and/or is required to pay amounts relating to such contingencies, such accruals and/or payments will reduce the Company’s NAV.
Members that invest in the Company at a time during which contingent liabilities are not accrued (or for which there is not a sufficient accrual) will invest in the Company at a higher NAV than had such liabilities been accrued at the time of the applicable investment. In addition, Members that redeem from the Company at a time during which contingent liabilities are accrued will redeem from the Company at a lower NAV than if such liabilities had not been accrued at the time of the applicable redemption. In the event that amounts associated with accrued contingent liabilities do not subsequently become payable and the amounts of the liabilities are reduced, causing the NAV of the Company to increase, the benefits of such increased NAV will accrue to Members who remain in the Company, and Members who previously redeemed will not receive additional compensation or otherwise share the benefit of such increase. Similarly, Members in the Company at the time when a liability for which there is no accrual becomes payable will bear the entire amount of such liability (regardless of whether such liability occurred prior to the Member’s subscription to the Company), and the Company may be unable to, or may elect not to attempt to, recover amounts from Members that redeemed from the Company prior to the contingent liability becoming payable by the Company. Similar consequences as those described above may also occur when the Company under-accrues or over-accrues for such contingent liabilities.
The Advisors and Advisor Funds will also be subject to contingent liabilities, and the Company will be subject to similar (or potentially greater) risks as those discussed above through its investment in such Advisors and Advisor Funds.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
PROPERTIES
The Company does not own or lease any physical properties. The Company is operating at the Managing Member’s facility and is not being charged rent except indirectly through the monthly Management Fee.
ITEM 3.
LEGAL PROCEEDINGS
There are no material pending legal proceedings to which the Company or the Managing Member is a party or to which any of their assets are subject.
ITEM 4.
RESERVED
PART II
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Currently, there is no established public trading market for the units. Other than transfers to the Company in redemption, transfers of units are expressly prohibited by the Company’s LLC Agreement without the consent of the Managing Member.
Units are subject to the restrictions on transfer contained in the Company’s LLC Agreement. Without the prior written consent of the Managing Member, which may be withheld in its sole discretion, a Member may not assign, pledge or otherwise transfer its units in the Company in whole or in part, except by operation of law pursuant to the death, adjudication of incompetency, insolvency or bankruptcy of the Member, or pursuant to the corporate reorganization or merger of the Member, nor substitute any other person as a Member. No transferee or assignee will be admitted as a Member without the prior consent of the Managing Member, which may be withheld in its sole discretion. A Member is permitted to redeem units upon 91 days’ prior written notice to the Managing Member (unless such notice is waived by the Managing Member in its sole discretion) as of the time immediately prior to the opening of business on each January 1, April 1, July 1, and October 1 occurring on or after the first anniversary of the purchase of such units by the Member, but may be limited or postponed under limited circumstances.
There are no outstanding options or warrants to purchase, or securities convertible into, units of the Company.
The high and low NAV per Unit of the initial series of units for Class A Series 1 of the Company during each quarterly period from January 1, 2009 through December 31, 2010 are as follows:
The units have not been and will not be registered under the Securities Act and may not be resold unless an exemption from such registration is available. Members have no right to require registration of the units and the Company does not intend to register the units under the Securities Act or take any action to cause an exemption (whether pursuant to Rule 144 of the Securities Act or otherwise) to be available.
Record Holders of Units of the Company
As of December 31, 2010, 4,849,206.06 units were held by 567 Members.
Distributions
The Company has not made distributions from January 1, 2010 to December 31, 2010 other than distributions to facilitate redemptions of individual Members. The Company does not presently intend to make distributions to Members other than in connection with redemptions of units.
Recent Sales of Unregistered Units and Use of Proceeds
From January 1, 2010 to December 31, 2010, aggregate subscriptions totaled $64,918,041. The Company previously reported sales of unregistered units during the 2010 fiscal year in the Company’s Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. In connection with each funding, the units were privately offered and old to accredited investors pursuant to Rule 506 of Regulation D and the sales were exempt from registration under the Securities Act. The Company has used substantially all the proceeds to make investments in the Investment Funds.
Purchases of Units by the Company and Affiliated Purchasers
Pursuant to the Company’s LLC Agreement, holders of units may redeem their units upon 91 days’ prior written notice to the Managing Member (unless such notice is waived by the Managing Member in its sole discretion), on each January 1, April 1, July 1, or October 1 occurring on or after the first anniversary of the purchase of such units by the Member (each, a “Redemption Date”). Units of a particular series will be redeemed at a per unit price based upon the NAV of such series as of the close of business on the day (the “Valuation Date”) immediately preceding the applicable Redemption Date (taking into account the allocation of any net appreciation or depreciation in the net assets of the Company for the accounting period then ending), after reduction for any Management Fee and Incentive Allocation (calculated as if the applicable Valuation Date was the last day of the fiscal year) and other liabilities of the Company to the extent accrued or otherwise attributable to the units being redeemed.
The Company previously reported redemptions of units during 2010 in the Company’s Quarterly Reports on Form 10-Q. The Company redeemed 142,384.48 units during the fourth quarter ended December 31, 2010. From January 1, 2010 to December 31, 2010, aggregate redemptions totaled $69,907,438. Redemptions of $18,895,114 will be effective on January 1, 2011 and are reflected in redemptions payable in the December 31, 2010 balance sheet. See ITEM 15. “EXHIBITS AND FINANCIAL STATEMENT SCHEDULES”.
Performance Graph
The line graph below compares the cumulative total return on the Company’s units during the period from January 2006 through December 31, 2010, with the return on the 3 Month LIBOR, the Barclays U.S. Aggregate Index, the MSCI World Index and the S&P 500 Index. These indices are unmanaged and the figures for an index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. The Members cannot invest directly in these indices.
The Company has not paid any cash dividends in the past and does not expect to pay any in the foreseeable future.
Cumulative Performance (January 2006 - December 2010)
Indices Source: Bloomberg, Bond.Hub
•
The performance of the Company is based on net returns for Class A Series 1 Units. The performance of the units shown in the graph is not necessarily indicative of future performance.
•
General: References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time (for purposes of this section, each an “index”) are provided
for your information only. Reference to an index does not imply that the portfolio will achieve returns, volatility or other results similar to the index. The composition of an index may not reflect the manner in which a portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, restrictions, sectors, correlations, concentrations, volatility or tracking error targets, all of which are subject to change over time.
•
MSCI World Index: The Morgan Stanley Capital International World Index is a price index of the total return with dividends reinvested monthly net of dividend withholding tax of a representative group of listed companies for each region, with each component market weighted on the basis of market capitalization relative to the total market capitalization of the market being measured and adjusted for changes in capital within the component firms.
•
S&P 500 Index: Standard & Poor’s S&P 500 Index is an index based on the prices of the securities of 500 different companies. Total returns are calculated by adding the dividend income and price appreciation for a given time period.
•
Barclays Aggregate Bond Index: Barclays Aggregate Bond Index represents securities that are U.S. domestic, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.
ITEM 6.
SELECTED FINANCIAL DATA
Set forth below is certain selected historical data for the Company as of and for the years ended December 31, 2010, 2009, 2008, 2007, and 2006. The selected historical financial data as of and for the years ended December 31, 2010, 2009, 2008, 2007 and 2006 were derived from the financial statements of the Company, which were audited by Ernst & Young LLP (“E&Y”). The information set forth below should be read in conjunction with the financial statements and notes thereto contained elsewhere in this Annual Report.
(1)
Members’ equity as of December 31, 2010 reflects redemptions payable in the amount of $18,895,114 at December 31, 2010.
(2)
Members’ equity as of December 31, 2009 reflects redemptions payable in the amount of $22,410,715 at December 31, 2009.
(3)
Members’ equity as of December 31, 2008 reflects redemptions payable in the amount of $28,982,893 at December 31, 2008.
(4)
Members’ equity as of December 31, 2007 reflects redemptions payable in the amount of $22,708,145 at December 31, 2007.
(5)
Members’ equity as of December 31, 2006 reflects redemptions payable in the amount of $23,701,199 at December 31, 2006.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
The following discussion should be read in conjunction with the audited financial statements of the Company and the related notes thereto appearing elsewhere in this Annual Report, ITEM 6. “SELECTED FINANCIAL DATA,” and ITEM 1A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative and Qualitative Disclosures About Market Risk
The following table lists the significant market risk sensitive instruments held by the Company, through the Investees, as of December 31, 2010 and as of December 31, 2009, as indicated by the Fair Value/Value at Risk column and the Net Trading Gain/(Loss) column from January 1, 2010 to December 31, 2010 and from January 1, 2009 to December 31, 2009. Because of the uncertain nature of the investments that the Company engages in through the Investees, the Managing Member believes the entire portfolio value of the Company is at risk. The Managing Member is unable to track the impact of market volatility, credit and interest rate risk on the units because in many cases it does not receive information on individual investments made by Advisors or their aggregate holdings and so is not in a position to track such risks on an aggregate basis.
(1)
Members’ equity, used in the calculation of the investments as a percentage of members’ equity, is reduced for member redemptions that are paid after the balance sheet date according to ASC 480, “Distinguishing Liabilities from Equity.” Member redemptions are included in Redemptions payable in the Balance Sheet of the financial statements.
(2)
Redemptions can be made quarterly with 61 days’ notice, or at the sole discretion of the Managing Member.
(3)
Redemptions can be made quarterly on or after the first anniversary of the initial purchase of the units with at least 91 days’ notice, or at the sole discretion of the Managing Member.
(4)
GFS Trust does not provide investors with a voluntary redemption right. Pursuant to the terms of the trust agreement for GFS Trust, distributions will be made to holders of interests in GFS Trust as GFS Trust receives proceeds in respect of its Advisors. The estimated remaining holding period of its remaining underlying investments range from one to six years.
(5)
GRV ceased its trading activities effective on July 1, 2009, and will dissolve at the time all assets are liquidated, liabilities are satisfied and liquidation proceeds are distributed through payment of a liquidating distribution. GRV suspended redemptions pending the completion of the liquidation proceedings. The estimated remaining holding period of its remaining underlying investments range from one to six years.
(6)
Redemptions can be made quarterly with 60 days’ notice, or at the sole discretion of the Managing Member.
(7)
HFPO’s current holdings consist solely of one illiquid investment in an Advisor Fund, which cannot be redeemed until the relevant Advisor liquidates such investment. The estimated remaining holding period of the illiquid investment is approximately two to five years.
(8)
The total value of the Company’s investment in the Investees was less than 100% of members’ equity because members’ equity reflected cash and cash equivalents greater than total liabilities.
Risk Management
In the ordinary course of business, the Managing Member, including in its capacity as managing member of the Investment Funds, attempts to manage a variety of risks, including market, credit and operational risk. The Managing Member, including in its capacity as managing member of the Investment Funds, attempts to identify, measure and monitor risk through various mechanisms including risk management strategies and credit policies. These include monitoring risk guidelines and diversifying exposures across a variety of instruments, markets and counterparties.
Market risk is the risk of potential significant adverse changes to the value of financial instruments because of changes in market conditions such as interest rates, foreign exchange rates, equity prices, credit spreads, liquidity and volatility in commodity or security prices. The Managing Member, including in its capacity as managing member of the Investment Funds, monitors its exposure to market risk at both the Advisor and portfolio level through various analytical techniques. At the Advisor level, market risk is monitored on a regular basis. Where position level detail is available, the Managing Member, including in its capacity as managing member of the Investment Funds, monitors its exposure to market risk through a variety of analytical techniques, including Value-at-Risk (“VaR”) and scenario analysis (stress testing). VaR is calculated for each Advisor using a Monte Carlo simulation with a one-year look back period. The Managing Member looks at VaR over a one-day horizon at
the 95% and 99% confidence intervals. As of December 31, 2010, the Managing Member had full position level transparency for approximately 38% (as a percentage of fair value investments) of the Advisors in which the Company invests through the Investment Funds. To determine position level transparency the Company uses a list containing all Advisors for whom the Company received position level details, whether or not the Advisors also provided pricing information for those positions. The Company believes that knowing its transparency on the position level details of its Advisors provides meaningful information about its underlying investments in its Advisors whether or not the Company also has transparency on the pricing information for these positions and therefore will continue to use such methodology for conveying information regarding the Company’s position level transparency in future quarters. The Managing Member believes that the VaR assumptions it utilizes are reasonable given that VaR is only one determinant in the Managing Member’s overall risk management. Where position level detail is unavailable, an Investment Fund relies on risk reports provided by the Advisors as well as through open communication channels with Advisors, which generally includes site visits and monthly conference calls. The Company’s maximum risk of loss is limited to the Company’s investment in the Investment Funds. The risks involved are more fully described under ITEM 1A. “RISK FACTORS-General Risks-Risks Related to the Company and the Investment Funds’ Performance and Operation-A Substantial Portion of an Investment Fund’s Assets May be Invested Utilizing Strategies That are Not Within its Investment Sector; Most Advisors do not Provide Detailed Position Information Regarding their Portfolios” and “-Dependence on the Managing Member and the Advisors; the Managing Member Generally Has Limited Access to Information on or Control over Advisors’ Portfolios and Members Assume the Risk that Advisors May Knowingly Misrepresent Information Which Could Have a Material Negative Impact on the Company”.
The managing member of the Investment Funds monitors Advisors to prevent style drift. “Style drift” is defined as Advisors changing their investment style from the Investment Fund’s expectations. Where position level detail is available, the managing member of the Investment Funds monitors leverage against predetermined limits. Position sizing limits are also monitored to ensure Advisors are properly diversified and risk normally is not concentrated in one or relatively few positions. In some cases, the managing member of the Investment Funds also has the ability to monitor approved trading instruments to ensure Advisors are not trading securities outside their mandate. Where position level detail is not available, the managing member of the Investment Funds relies on both written and oral Advisor communications. The risks involved are more fully described under ITEM 1A. “RISK FACTORS-General Risks-Risks Related to the Company and the Investment Funds’ Performance and Operation-A Substantial Portion of an Investment Fund’s Assets May be Invested Utilizing Strategies That are Not Within its Investment Sector; Most Advisors do not Provide Detailed Position Information Regarding their Portfolios” and “-Dependence on the Managing Member and the Advisors; the Managing Member Generally Has Limited Access to Information on or Control over Advisors’ Portfolios and Members Assume the Risk that Advisors May Knowingly Misrepresent Information Which Could Have a Material Negative Impact on the Company”.
At the Company’s portfolio level, the Company’s portfolio construction process is designed to provide for adequate diversification. Each Investment Fund is a portfolio of approximately 10-30 underlying Advisors and the managing member of each of the Investment Funds regularly reviews portfolio statistics, such as relative contribution to risk, to confirm that risk is not concentrated in any single Advisor. However, as of April 1, 2008, GFS is no longer prohibited from allocating 25% or more of its assets to any single Advisor. The managing member of GFS, in its sole discretion, may determine from time to time the number of Advisors with which GFS invests based on factors such as the amount of GFS’s assets under management, the availability of attractive opportunities, and other portfolio construction considerations. Any such greater concentration with any single Advisor or in any single investment strategy may entail additional risks. See Item 1A. “RISK FACTORS-General Risks-Risks Related to the Company and the Investment Funds’ Performance and Operation-Non-Diversified Status; the Managing Member may Allocate to One or More Advisors a Relatively Large Percentage of an Investment Fund’s Assets”.
Quantitative analysis is combined with judgment to determine weightings, strategic return, risk and correlation estimates to inform the quantitative analysis. Judgment is applied to both estimates and weights in an attempt to achieve exposure to hedge funds while delivering attractive risk-adjusted returns. The approximate weights of the material Investees were 39% GELS, 22% GFS, 6% GFS Trust and 26% GTT as of December 31, 2009 as a percentage of members’ equity. The approximate weights of the material Investees were 40% GELS, 25% GFS and
29% GTT as of December 31, 2010 as a percentage of members’ equity. This portfolio construction process is designed to create a diversified hedge fund portfolio with attractive return and risk characteristics. See ITEM 1. “BUSINESS-INVESTMENT PROGRAM-Allocation Among the Investment Funds”.
The Managing Member may, from time to time, vary or change materially the actual allocation of assets made by the Company, as it deems appropriate in its sole discretion, including without limitation by way of allocation of Company assets to any new Investment Fund or Advisor, complete or partial withdrawal of an allocation from any existing Investment Fund or Advisor, a reallocation of assets among existing Investment Funds or Advisors, or any combination of the foregoing. In carrying out any reallocation of Company assets, the Managing Member will have the sole discretion to determine the manner of such reallocation, including from which Investment Funds or Advisors to withdraw assets and to which Investment Funds or Advisors to allocate assets. Any reallocation of Company assets, for purposes of diversification, attempts to meet target allocations or otherwise, may take a significant period of time to implement due to the liquidity provisions and restrictions of the Investment Funds and the Advisors and for other reasons. There can be no assurance that market or other events will not have an adverse impact on the strategies employed by multiple Investment Funds and Advisors. Investment Funds and Advisors may at certain times hold large positions in a relatively limited number of investments. The Company could be subject to significant losses if an Investment Fund or an Advisor holds a large position in a particular investment that declines in value that cannot be liquidated without adverse market reaction or is otherwise adversely affected by changes in market conditions or circumstances. While the Managing Member currently expects to allocate assets to all the Investment Sectors (other than relative value) through allocations to the Investment Funds, since April 1, 2008, the Managing Member had no constraints with respect to the percentage of the Company’s assets to be allocated, directly or indirectly, to any single Advisor, group of Advisors, Investment Fund, or Investment Sector, or with respect to the number of Investment Funds and Advisors to which, directly or indirectly, assets of the Company are allocated at any time. The percentage of the Company’s assets to be allocated to any single Advisor, group of Advisors, Investment Fund or Investment Sector, and the number of Investment Funds and Advisors to which the Company allocates assets from time to time will be determined by the Managing Member in its sole discretion, based on factors deemed relevant by the Managing Member at the time of such allocation, which may include the amount of the Company’s assets under management, constraints on the capital capacity of the Investment Funds and Advisors, the availability of attractive opportunities, and other portfolio construction and portfolio management considerations.
The Company invests in the Investment Funds, and may from time to time redeem its membership units of the Investment Funds. Neither GFS Trust nor GRV provide investors with a voluntary redemption right. The Investment Funds, in turn, maintain relationships with counterparties that include the Advisors. These relationships could result in concentrations of credit risk. Credit risk arises from the potential inability of counterparties to perform their obligations under the terms of the contract, including, in the case of the Company’s investments in the Investment Funds, the potential inability of an Investment Fund to satisfy its redemption obligations. The managing member of the Investment Funds (currently, the Managing Member) has formal credit-review policies to monitor counterparty risk.
In addition to market risk and credit risk, the Managing Member, including in its capacity as managing member of the Investment Funds, allocates resources to mitigate operational risk. Operational risk is the potential for loss caused by a deficiency in information, communication, transaction processing, settlement and accounting systems. The Managing Member, including in its capacity as managing member of the Investment Funds, maintains controls and procedures for the purpose of mitigating its own operational risk but it does not have control over the systems of the Advisors. In addition, the Managing Member, including in its capacity as managing member of the Investment Funds, deploys resources to assess control systems, legal risk, compliance risk, operations and treasury risk, credit risk, accounting risk and reputational risk.
Fraud and other business risks cannot be eliminated; however, the Managing Member, including in its capacity as managing member of the Investment Funds, seeks to significantly reduce such risks. The portfolio risk management process includes an effort to monitor and manage risk, but should not be confused with and does not imply low risk. There can be no assurance that the Managing Member, including in its capacity as managing member of the Investment Funds, will be able to implement its risk guidelines or that its risk monitoring strategies will be successful.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For the Company’s financial statements, see the Financial Statements beginning on page of this Annual Report.
The following is a summary of unaudited quarterly results of operations of the Company for the period from January 1, 2009 to December 31, 2010.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There have been no changes in, or disagreements with, accountants on accounting and financial disclosure.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of the end of the period covered by this report, an evaluation was carried out by the Managing Member’s management, with the participation of its principal executive officer and principal financial officer (or persons performing similar functions), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, the Company’s principal executive officer and principal financial officer (or persons performing similar functions) concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Management’s Report on Internal Control over Financial Reporting
The management of the Managing Member of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Exchange Act, as a process designed by, or under the supervision of, the Managing Member’s principal executive and principal financial officers (or persons performing similar functions) and effected by the Managing Member’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for the Company for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The management of the Managing Member assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making this assessment, the Managing Member used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on this assessment, the management of the Managing Member believes that, as of December 31, 2010, the Company’s internal control over financial reporting is effective based on those criteria.
This Annual Report does not include an Attestation Report of the Company’s registered public accounting firm regarding internal control over financial reporting. The report of management of the Managing Member was not subject to attestation by the Company’s registered public accounting firm pursuant to rules of the SEC that permit the Company to provide only the Managing Member’s management’s report in this Annual Report.
Changes in Internal Control Over Financial Reporting
In addition, no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) occurred during the fourth quarter of the Company’s fiscal year ended December 31, 2010 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS OF THE MANAGING MEMBER AND REGISTRANT AND CORPORATE GOVERNANCE
The Company currently has directors but no executive officers, and historically had no directors, until April 1, 2009, or executive officers. The Managing Member is, and has historically been, responsible for the management and operations of the Company. Information about the Managing Member and the GS Group appears in ITEM 1. See ITEM 1. “BUSINESS-THE MANAGING MEMBER”. On April 1, 2009, the Managing Member established a board of directors of the Company (the “Board of Directors”) to supervise the affairs of the Company in lieu of the supervision previously provided by the Board of Directors of the Managing Member. The Managing Member, through its executive officers who have responsibility for the Company, currently is and will continue to be responsible for the operations of the Company. The following table sets forth the executive officers of the Managing Member who have responsibility for the Company and the directors of the Company.
Information about the executive officers of the Managing Member and the directors of the Company is provided below.
Kent A. Clark is a Managing Director of Goldman Sachs and Chairman of the Investment Committee of the Managing Member. Mr. Clark is also the Chief Investment Officer of the Managing Member, and performs the responsibilities of principal executive officer of the Managing Member. Mr. Clark joined GSAM in 1992 as a member of the Quantitative Equity team, where he managed Global Equity portfolios and equity market neutral trading strategies. In this capacity, he also developed risk and return models. Mr. Clark’s research has been published in the Journal of Financial and Quantitative Analysis and in Enhanced Indexing. Mr. Clark serves on the Board of Governors of the Graduate Faculty at the New School University, on the board of the Managed Funds Association, and is a member of the Chicago Quantitative Alliance. Formerly, he was president of the Society of Quantitative Analysts. Mr. Clark joined Goldman Sachs from the University of Chicago Graduate School of Business where he completed all but dissertation in the Ph.D. program and earned an M.B.A. He holds a Bachelor of Commerce degree from the University of Calgary.
Jennifer Barbetta is a Managing Director of Goldman Sachs and is the Chief Financial Officer of the Managing Member and a Director of the Managing Member. Ms. Barbetta is also the Chief Operating Officer for Goldman Sachs Asset Management’s Alternative Investments & Manager Selection businesses, which include the Private Equity Group, Hedge Fund Strategies and Global Manager Strategies. Ms. Barbetta is responsible for client reporting, portfolio monitoring and analytics, cash and credit management, infrastructure development and overall administration of the groups’ products. Ms. Barbetta joined Goldman Sachs in 1995 as an analyst in the Finance Division where she supported the Real Estate Principal Investment Area, focusing on the financial and tax reporting of the Whitehall Street Real Estate Limited Partnerships. Ms. Barbetta joined the Private Equity Group in 1997 and became head of its Portfolio Analytics and Reporting team in 2003 and Chief Operating Officer in 2005, prior to expanding her role within GSAM. Ms. Barbetta earned a B.S. in Finance from Villanova University and was a member of the Beta Gamma Sigma honor society.
Westley D. Chapman is a Managing Director of Goldman Sachs and Head of Quantitative, Operational & Business Due Diligence of the Managing Member. Prior to joining the Managing Member, Mr. Chapman was the Chief Financial Officer of the Investment Management Division where he led the division’s financial management processes, including a strategic review of the infrastructure systems and processes supporting the Managing
Member. Prior to joining GSAM in 1997, Mr. Chapman was the Director of Financial Planning & Analysis at Travelers Group, focusing on their life insurance businesses, where he participated in the integration and evaluation of business acquisitions. Prior to joining Travelers Group in 1994, Mr. Chapman supported IBM as an auditor at Price Waterhouse where he led elements of the annual audit, performed control reviews of various Corporate Treasury systems and processes, and participated in a number of consulting projects. He obtained an M.B.A. in Finance from New York University in 1993 and a B.A. in Economics from Harvard College in 1989. Mr. Chapman is a Certified Public Accountant.
J. Christopher A. Kojima has been a director of the Company since April 1, 2009. Mr. Kojima is a Managing Director of Goldman Sachs and co-head of the Alternative Investments and Manager Selection businesses, which oversees the Private Equity Group, Hedge Fund Strategies Group, Global Manager Strategies Group and Portfolio Solutions Group. Previously, Mr. Kojima was the co-head of the Private Equity Group focusing on the private equity secondary market. Prior to joining the Private Equity Group, Mr. Kojima specialized in leveraged buyouts in the Leveraged Finance Group. Mr. Kojima joined Goldman Sachs in 1995 in the Investment Banking Division. Mr. Kojima is a trustee of The Juilliard School and The Asian Cultural Council, and serves as adjunct professor at Columbia Business School. Mr. Kojima earned a JD, cum laude, from Harvard Law School and is a member of the New York Bar. Mr. Kojima received an M.Phil. from The University of Cambridge, and a B.Comm. from The University of Manitoba.
A. Charles Baillie has been a director of the Company since April 1, 2009. Mr. Baillie is a Managing Director of Goldman Sachs and co-head of the Alternative Investments and Manager Selection businesses in the Investment Management Division, which oversees the Private Equity Group, Hedge Fund Strategies Group, Global Manager Strategies Group and Petershill Group. Prior to joining the Private Equity Group, Mr. Baillie worked in the Mergers & Acquisitions Group in London where he focused on restructurings. Mr. Baillie joined the firm as an analyst in 1991 in the Corporate Finance Department of the Investment Banking Division. Mr. Baillie received a BAH from Queen’s University, Canada, an MA from the University of Oxford, and an MBA from the Harvard Graduate School of Business Administration, where he graduated as a Baker Scholar.
Compliance with Section 16(a) of the Securities Exchange Act of
Section 16(a) of the Exchange Act requires the officers and directors of the Managing Member and persons who own more than ten percent of the Company’s units to file forms reporting their affiliation with the Company and reports of ownership and changes in ownership of the Company’s units with the SEC. These persons and entities are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. To the best of the Company’s knowledge, based solely on a review of the copies of such reports furnished to the Company, during the year ended December 31, 2010 all Section 16(a) filing requirements applicable to such persons and entities were complied with for such year.
Code of Ethics
The Managing Member has adopted a Code of Ethics for the Company that applies to the Board of Directors and the persons acting as chief executive officer and chief financial officer/chief accounting officer of the Company. A copy of the Company’s Code of Ethics was filed as an exhibit to the Company’s Form 10-K for December 31, 2004. If the Company makes any substantive amendments to the Code of Ethics or grants any waiver, including an implicit waiver, from a provision of the Code of Ethics as applicable to the persons acting as chief executive officer and chief financial officer/chief accounting officer of the Company, the Company will disclose the nature of such amendment or waiver in a report on Form 8-K. In addition, the Managing Member has adopted a Code of Ethics for the Managing Member that applies to, among others, the chief executive officer and chief financial officer/chief accounting officer of the Managing Member. A copy of the Managing Member’s Amended Code of Ethics was filed as an exhibit to the Company’s Form 10-K, filed April 2, 2007.
Corporate Governance
Nominating Committee and Compensation Committee
The Company is not a “listed issuer” as defined under Section 10A-3 of the Exchange Act and is therefore not required to have a nominating and compensation committee comprised of independent directors. The Company currently does not have a standing nominating or compensation committee and accordingly there are no charters for such committees. The Board of Directors believes that standing committees are not necessary and that the directors of the Board of Directors collectively have the requisite background, experience, and knowledge to fulfill any limited duties and obligations that a nomination committee and a compensation committee would have on behalf of the Company. In addition, no direct compensation is paid to any employees of the Company making a compensation committee not applicable. Furthermore, the Board of Directors has the power to engage experts or consultants as it deems appropriate to carry out its responsibilities.
Audit Committee and Audit Committee Financial Expert
The Company is not a “listed issuer” as defined under Section 10A-3 of the Exchange Act and is therefore not required to have an audit committee comprised of independent directors. The Company currently does not have an audit committee, and accordingly there is no charter for such committee, and the Board of Directors which performs the functions of an audit committee on behalf of the Company believes that the directors of the Company collectively have the requisite financial background, experience, and knowledge to fulfill the duties and obligations that an audit committee would have including overseeing the Company’s accounting and financial reporting practices. Therefore, the Board of Directors does not believe that it is necessary at this time to search for a person who would qualify as an audit committee financial expert. Furthermore, the Board of Directors has the power to engage experts or consultants as it deems appropriate to carry out its responsibilities.
The Board of Directors has:
•
reviewed and discussed the financial statements with management of the Managing Member responsible for the management and operations of the Company;
•
discussed with the independent auditors the matters required to be discussed by the Statement of Auditing Standards No. 114, as amended, as adopted by the Public Company Accounting Oversight Board in Rule 3200T;
•
received the written disclosures and the letters from the independent accountants required by the Public Company Accounting Oversight Board in Rule 3526, and has discussed with the independent accountant, the independent accountant’s independence; and based on the review and discussions referred to above, the Board of Directors recommended that the audited financial statements be included in the Company’s Annual Report for filing with the SEC.
Advisory Committee
In addition, pursuant to the Company’s LLC Agreement, the Managing Member is authorized to select one or more Members who are not affiliated with the Managing Member to serve on a committee, the purpose of which would be to, on behalf of the Members, approve or disapprove, to the extent required by applicable law, principal transactions and certain other related party transactions.
Board Meetings and Committees; Annual Meeting Attendance; Shareholder Communications
The Board of Directors is responsible for the management and operations of the Company. In 2010, the Board of Directors met frequently, including at regularly scheduled quarterly meetings, with employees of the Managing Member to discuss, among other things, the Company. As discussed above, the Company does not have standing audit, nominating and compensation committees.
The Company does not have a policy with regard to board members’ attendance at annual meetings of Members. The Company does not hold director elections and therefore does not solicit proxies for the elections of directors from Members (or by written consent) and the Company is not required under Delaware law nor under its
LLC Agreement to hold annual meetings for its Members. The Company did not hold an annual meeting for Members in 2010 and accordingly no members of the Board of Directors attended.
Members wishing to communicate with the Board of Directors may send communications to Ms. Kristin Olson, Goldman, Sachs & Co., 200 West Street, New York, New York 10282 who will forward all appropriate communications directly to the Board of Directors or to any individual director or directors, depending upon the facts and circumstances outlined in the communication. In addition, Members have the opportunity to receive the Company’s monthly report to Members which provides for information as to how Members can contact a designated contact person at the Managing Member with any questions relating to the Member’s investment in the Company and the Company’s performance. Moreover, the Memorandum provides for contact information for Members relating to their investment in the Company. The Managing Member believes that it is not necessary to have a more specific and detailed process and that providing contact information for the Managing Member provides for an appropriate means for communication for Members with the Board of Directors or with respect to their investment in the Company.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
The Company does not bear the costs of the annual compensation of its directors or the executive officers of the Managing Member. The Managing Member and its affiliates receive compensation from the Company for services provided to the Company and will not bear costs for the Company’s directors. Set forth below are the amounts of the different types of fees paid or payable by the Company, or allocable to the Managing Member and its affiliates during the year ended December 31, 2010. Information about the terms and conditions of the Management Fee and the Incentive Allocation and other fees and expenses appear in ITEM 1. See ITEM 1. “BUSINESS-FEES AND EXPENSES”.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Security Ownership of Certain Beneficial Owners
To the knowledge of the Company, no person beneficially owns more than five percent of the units.
Security Ownership of Management
GS HFS, the Managing Member of the Company, did not have a beneficial interest in the Company as of December 31, 2010 other than the Incentive Allocation and other fees payable to it by the Company.
The following table sets forth (i) the individual directors and executive officers of the Managing Member and the directors of the Company and (ii) all of the directors and executive officers as a group who beneficially owned units of the Company as of March 28, 2011.
Changes in Control
There are no arrangements, including pledges by any person of units of the Company, the operation of which may at a subsequent date result in a change of control of the Company.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The Managing Member is an advisory affiliate of Goldman Sachs and GSAM. Each of the Managing Member, Goldman Sachs and GSAM is a wholly owned subsidiary of The Goldman Sachs Group, Inc. See ITEM 1. “BUSINESS-POTENTIAL CONFLICTS OF INTEREST”.
The Managing Member also manages a number of other investment funds that have investment programs that are similar to those of the Company. See ITEM 1. “BUSINESS-POTENTIAL CONFLICTS OF INTEREST”.
From time to time certain qualified officers and employees of the GS Group may invest in the Company. Neither the Investment Funds’ Advisors nor any of their respective principals are presently expected to purchase units or membership units in the Investment Funds. See ITEM 1. “BUSINESS-POTENTIAL CONFLICTS OF INTEREST”.
The Company may from time to time, in the sole discretion of the Managing Member, invest in money market funds sponsored, managed or advised by the GS Group, and the Company will not be reimbursed for any fees accruing to any affiliate of the GS Group in respect of any such investment. See ITEM 1. “BUSINESS-INVESTMENT PROGRAM-Investment Objective and Approach”.
The Company pays the Managing Member a Management Fee. See ITEM 1. “BUSINESS-FEES AND EXPENSES”.
Some of the directors of the Company and executive officers of the Managing Member also are or may become directors and executive officers of Goldman Sachs which entities provided services for the Company, other than as an underwriter, during the year ended December 31, 2010 and are proposed to provide such services in the current year.
No directors of the Company and executive officers of the Managing Member, their spouses and entities owned or controlled by them invested an amount in excess of $120,000 in the Company during the year ended December 31, 2010. Certain directors of the Company and executive officers of the Managing Member, including their spouses and entities owned or controlled by them, may from time to time invest in the Company. In addition, certain of the directors of the Company and executive officers of the Managing Member from time to time invest their personal funds directly in other funds managed by the GS Group on the same terms and conditions as the other investors in these funds, who are not directors, executive officers or employees.
Under the Company’s Related Party Transaction Policy, which is a written policy adopted as of March 28, 2007, the Board of Directors is required to review all related party transactions for potential conflicts of interest. The Board of Directors shall approve each such transaction if it is consistent with the policy and is on terms, taken as a whole, which the Board of Directors believes are no less favorable to the Company than could be obtained in an arms-length transaction with an unrelated third party, unless the Board of Directors otherwise determines that the transaction is not in the Company’s best interests. The policy also provides for a ratification process if it is not practical for the Board of Directors to review the transaction in advance.
The types of related party transactions covered by the policy are those that are required to be disclosed pursuant to SEC Regulation S-K, Item 404(a). There were no transactions required to be reported under Item 404(a) since the beginning of the Company’s fiscal year where the Company’s procedures and policies did not require review or were not followed.
Pursuant to the LLC Agreement, the Managing Member is authorized by the Members to select on behalf of the Members one or more Members who are not affiliated with the Managing Member to serve on a committee, the
purpose of which will be to consider and, on behalf of the Members, approve or disapprove, to the extent required by the applicable law, principal transactions and certain other related party transactions.
Director Independence
The Company is not a “listed issuer” as defined under Section 10A-3 of the Exchange Act and is therefore not subject to a requirement that a majority of the board of directors be independent. The Managing Member is responsible for the management and operations of the Company. All of the directors of the Company are employees of Goldman Sachs and the Managing Member. Accordingly, under the Independence Test of the Corporate Governance Standards of the New York Stock Exchange and other comparable stock exchange standards, none of the directors of the Company are independent. Similarly, as discussed further under Item 10, the Company is not subject to the requirements under the Corporate Governance Standards of the New York Stock Exchange that the audit, nominating and compensation committees be comprised of independent directors and the Managing Member does not currently have and the Company is not expected to have separately designated audit, nominating and compensation committees.
Brokerage
The Advisors of the Investment Funds, managing their assets directly (including through Advisor Funds) or through Portfolio Companies, have the authority to select brokers and dealers from a list approved by the managing member of the Investment Funds, through which to effect transactions on the basis of various factors. The managing member of the Investment Funds requires such Advisors to select executing brokers on a best execution basis, taking into consideration such factors as price, commissions and commission equivalents, other transaction costs, quality of brokerage services, financing arrangements, creditworthiness and financial stability, financial responsibility, strength and clearance and settlement capability. The Company does not have oversight over broker and dealer selection by Investment Funds.
To the extent permitted under applicable law, the Advisors may, in their sole discretion, execute transactions on behalf of the Company and the Investment Funds, through Managed Accounts, Portfolio Companies and Advisor Funds, and with or through Goldman Sachs, and such transactions may, in some cases, be executed together with transactions on behalf of Goldman Sachs. The Advisors may also use Goldman Sachs for prime brokerage and other services for the Managed Accounts, Portfolio Companies and Advisor Funds, as well as their other clients.
Additionally, in selecting brokers and dealers to execute transactions for any Portfolio Company or Advisor Fund, or the Company or an Investment Fund through any Managed Account, certain of the Advisors may have authority to and may consider products or services provided, or expenses paid, by such brokers and dealers to, or on behalf of, such Advisors. Products and services generally include research items. In some circumstances, the commissions paid on transactions with brokers or dealers providing such services may exceed the amount another broker would have charged for effecting that transaction. “Soft dollar” payments or rebates of amounts paid to brokers and dealers may arise from exchange traded agency transactions, as well as over-the-counter principal transactions. In addition, such payments or rebates may be made by futures brokers in connection with futures transactions.
Research or other services obtained in this manner may be used in servicing any or all advisory clients of the Advisors of the Investment Funds, including each of the Investment Funds and the Portfolio Companies, and may be used in connection with advisory accounts other than those that pay commissions to the broker or dealer relating to the research or other service arrangements.
GS Group may also receive products or services, including research, from brokers and dealers that provide brokerage services to its clients. The brokers and dealers providing such products and services may include the brokers and dealers that Advisors select to execute transactions on behalf of Portfolio Companies and Advisor Funds, and the Company or an Investment Fund through Managed Accounts. Research products and services made available to GS Group through such brokers and dealers may include: performance and other qualitative and quantitative data relating to Advisors in general and certain Advisors in particular; data relating to the historic performance of categories of securities associated with particular investment styles; quotation equipment; and related computer hardware and software, all of which research products and services may be used by the managing
member of the Investment Funds in connection with its selection and monitoring of Advisors, the portfolio design of a mix of investment styles appropriate to investment objectives of clients, and the determination of overall portfolio strategies including asset allocation models.
Placement Agent
Goldman Sachs acts as placement agent for the Company (the “Placement Agent”). The Placement Agent is entitled to a fee (the “Placement Fee”) of up to a specified amount of each Member’s subscription. Historically, Goldman Sachs has not charged a Placement Fee, however, there can be no assurance that Goldman Sachs will not charge a Placement Fee in the future. Amounts paid in respect of the Placement Fee will not constitute assets of the Company. The Placement Agent may also receive compensation from the Managing Member that represents a portion of the Management Fee. The Placement Agent may enter into sub-placement agreements with affiliates and unaffiliated third parties, and the Company may engage one or more affiliated or unaffiliated successors or additional placement agents or distributors. At the discretion of the Placement Agent, all or a portion of the Placement Fee may be allocated to such sub-placement agents. The Managing Member or the Company may also pay certain expenses of the Placement Agent and certain fees and expenses of other Intermediaries. The Company may waive or impose different sales charges, or otherwise modify its distribution arrangements, in connection with the offering of units. Subject to applicable law, the Placement Agent and Intermediaries, at their discretion (with the approval of the Managing Member) may on a negotiated basis enter into private arrangements with a Member or prospective Member (or an agent thereof) under which the Placement Agent, an Intermediary or the Managing Member makes payments to or for the benefit of such Member which represent a rebate of all or part of the fees paid by the Company to the Managing Member in respect of such holder’s units. Consequently, the effective net fees payable by a Member who is entitled to receive a rebate under the arrangements described above may be lower than the fees payable by a Member who does not participate in such arrangements. Such arrangements reflect terms privately agreed between parties other than the Company, and for the avoidance of doubt, the Company cannot, and is under no duty to, enforce equality of treatment between Members by other entities, including those service providers of the Company that it has appointed. The Placement Agent, an Intermediary or the Managing Member shall be under no obligation to make arrangements available on equal terms to other Members. Pursuant to an agreement entered into between the Placement Agent and the Company (the “Placement Agent Agreement”), the Company has agreed to indemnify and hold harmless the Placement Agent, its affiliates and any agent against any losses, claims, damages or liabilities (or actions in respect thereof), joint or several (the “Covered Claims”), to which the Placement Agent may become subject, to the extent such Covered Claims arise out of or are based upon (i) an untrue statement or alleged untrue statement of a material fact contained in the Memorandum, or (ii) the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statement therein not misleading. The Placement Agent Agreement provides that the Company will reimburse the Placement Agent for any legal or other expenses reasonably incurred by the Placement Agent in connection with investigating or defending any such Covered Claims; provided, however, that the Company will not be liable to indemnify or reimburse the Placement Agent in any such case to the extent that any such Covered Claims arises out of or is based upon an untrue statement or alleged untrue statement or omission or alleged omission made in the Memorandum in reliance upon and in conformity with written information furnished to the Company by the Placement Agent expressly for use therein.
In addition, to the extent the indemnification provisions described in the preceding paragraph are unavailable or insufficient to hold harmless an indemnified party with respect to any Covered Claims, the Placement Agent Agreement specifies that the Company will contribute to the amount paid or payable by such indemnified party as a result of such Covered Claims in such proportion as is appropriate to reflect the relative benefits received by the Company and the Placement Agent from the offering of the units, unless otherwise provided by applicable law or the Placement Agent Agreement.
Goldman Sachs also acts as the placement agent on behalf of the Investment Funds. The Company will not be charged any placement fee by the Investment Funds.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
The following table presents fees for the professional audit services rendered by E&Y for the audit of the Company’s annual financial statements for the years ended December 31, 2010 and 2009 and fees billed for other services rendered by E&Y during those periods.
(1)
Tax services primarily involve assistance with the preparation of tax returns and K-1s.
The Board of Directors does not have an audit committee which is responsible for the oversight of the Company’s accounting and financial reporting practices. As the Company does not have a formal audit committee, the services described above were not approved by the audit committee and the Company does not have audit committee pre-approval policies and procedures. The Board of Directors as a whole is responsible for the oversight of the Company’s accounting and financial reporting practices and the Board of Directors is responsible for approving every engagement of E&Y to perform audit or non-audit services for the Company before E&Y is engaged to provide those services. The Board of Directors considers whether the provision of any non-audit provisions is compatible with maintaining E&Y’s independence.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Documents Filed as Part of this Annual Report:
1. Financial Statements.
2.
Financial Statement Schedules.
Certain schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
3.
List of Exhibits.
See Index of Exhibits included on page E-1.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
(Registrant)
By: Goldman Sachs Hedge Fund Strategies LLC
Managing Member
By:
/s/ Jennifer Barbetta
Name: Jennifer Barbetta
Title: Managing Director and Principal Financial Officer
Date: March 28, 2011
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX OF EXHIBITS
*
Previously filed
E-1
INDEX OF FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Members
Goldman Sachs Hedge Fund Partners, LLC
We have audited the accompanying balance sheets, including the schedules of investments, of Goldman Sachs Hedge Fund Partners, LLC (the “Company”) as of December 31, 2010 and 2009, and the related statements of operations, changes in members’ equity and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Goldman Sachs Hedge Fund Partners, LLC at December 31, 2010 and 2009, the results of its operations, the changes in its members’ equity and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
New York, New York
March 28, 2011
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
Schedule of Investments
December 31, 2010 and December 31, 2009
The Company’s aggregate proportionate share of the following underlying investments of the Investees represented greater than 5% of the Company’s member’s equity at December 31, 2010 and December 31, 2009.
(1)
Members’ equity, used in the calculation of the fair value of each of the investees and the underlying investment as a percentage of members’ equity, is reduced for member redemptions that are paid after the balance sheet date according to Statement of Financial Accounting Standards ASC 480, “Distinguishing Liabilities from Equity.” Member redemptions are included in Redemptions payable in the Balance Sheet. Excluding Redemptions payable, total investments would represent 95.63% and 94.57% of members’ equity at December 31, 2010 and December 31, 2009, respectively.
(2)
Affiliated investment fund with a monthly liquidity term.
See accompanying notes.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
BALANCE SHEET
December 31, 2010 and December 31, 2009
(1)
Refer to Note 8 for units outstanding and NAV per unit amounts by series.
See accompanying notes.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
STATEMENT OF OPERATIONS
For the years ended December 31, 2010, 2009 and
See accompanying notes.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
STATEMENT OF CHANGES IN MEMBERS’ EQUITY
For the years ended December 31, 2010, 2009 and
See accompanying notes.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
STATEMENT OF CASH FLOWS
For the years ended December 31, 2010, 2009 and
See accompanying notes.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS
December 31,
Note 1 -
Organization
Goldman Sachs Hedge Fund Partners, LLC (the “Company”) was organized as a limited liability company, pursuant to the laws of the State of Delaware, and commenced operations on April 1, 2002 for the principal purpose of investing in the equity long/short, event driven, relative value and tactical trading hedge fund sectors (the “Investment Sectors”). Currently, substantially all of the Company’s assets are allocated to Goldman Sachs Global Equity Long/Short, LLC (“GELS”), Goldman Sachs Global Fundamental Strategies, LLC (“GFS”) and Goldman Sachs Global Tactical Trading, LLC (“GTT”) (collectively, the “Investment Funds”). The balance of the Company’s assets are invested in Goldman Sachs Global Fundamental Strategies Asset Trust (“GFS Trust”), Goldman Sachs Global Relative Value, LLC (“GRV”) and Goldman Sachs HFP Opportunistic Fund, LLC (“HFPO” and, together with GFS Trust, GRV, and the Investment Funds, the “Investees”). Each of these Investees invests indirectly through investment vehicles (“Advisor Funds”) managed by such trading advisors (the “Advisors”). In addition, the Company may, directly or indirectly, allocate assets to Advisors whose principal investment strategies are not within one of the Investment Sectors. Goldman Sachs Hedge Fund Strategies LLC (“GS HFS”), a wholly-owned subsidiary of The Goldman Sachs Group, Inc., is the managing member (the “Managing Member”) and commodity pool operator of the Company and a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended. SEI Global Services, Inc. (“SEI”) serves as administrator of the Company.
Note 2 -
Significant accounting policies
Basis of presentation
The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”), and are expressed in United States dollars.
Use of estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.
Fair value of investments
The Company is an investment company for financial reporting purposes and accordingly carries its financial assets and liabilities at fair value. The fair value of the Company’s assets and liabilities that qualify as financial instruments approximates the carrying amounts in the Balance Sheet. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
U.S. GAAP has a three-level fair value hierarchy for disclosure of fair value measurements. The fair value hierarchy prioritizes inputs to the valuation techniques used to measure fair value, giving the highest priority to Level 1 inputs and the lowest to Level 3 inputs. A financial instrument’s level in the fair value hierarchy is based on the lowest level of any input that is significant to its fair value measurement.
The Company uses net asset value (“NAV”) as its measure of fair value for investments in Investees when (i) the fund investment does not have a readily determinable fair value and (ii) the NAV of the investment fund is calculated in a manner consistent with the measurement principles of investment company accounting, including measurement of the underlying investments at fair value. In evaluating the level at which the fair value measurements of the Company’s investments have been classified, the Company has assessed factors including, but not limited to, price
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 2 -
Significant accounting policies (continued)
transparency, the ability to redeem at NAV at the measurement date and the existence or absence of certain restrictions at the measurement date. The three levels of the fair value hierarchy are described below:
•
Level 1-Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
•
Level 2-Quoted prices in markets that are not active or financial instruments for which significant inputs are observable (including investments in Investees that can be redeemed at the measurement date or in the near-term at NAV), either directly or indirectly; and
•
Level 3-Prices or valuations that require significant unobservable inputs (including investments in Investees that will never have the ability to be voluntarily redeemed or are restricted from redemption for an uncertain or extended period of time from the measurement date).
See “Note 3-Investments in affiliated Investees” for further information.
Realized and unrealized gain/(loss) on investments in affiliated Investees
Realized and unrealized gain/(loss) on investments in affiliated Investees includes the change in fair value of each Investee. Fair values are determined utilizing NAV information supplied by each individual Investee, which includes realized and unrealized gains/losses on underlying investments of the Investees as well as management fees and incentive fees charged by the Advisors, administration fees and all other income/expenses of the Investees. See “Note 3-Investments in affiliated Investees” for further information.
Cash and cash equivalents
The Company considers all highly liquid investments with a maturity of less than 90 days at the time of purchase, which are not held for resale, to be cash equivalents. Cash equivalents, consisting of investments in money market funds, are held at financial institutions to which the Company is exposed to credit risk. Money market funds are valued at net asset value per share.
Allocation of net income/(loss)
Net income/(loss) is allocated monthly to the capital account of each member in the ratio that the balance of each such member’s capital account bears to the total balance of all members’ capital accounts. The Managing Member earns an annual incentive allocation equal to 5.0% of any new net appreciation in the NAV of each series. Any net depreciation in the NAV of a series for a fiscal year must be recouped prior to the Managing Member earning an incentive allocation in future years.
Subscriptions and redemptions
Subscriptions to the Company can be made as of the first day of each calendar month or at the sole discretion of the Managing Member. Redemptions from the Company can be made at the end of each calendar quarter, upon 91 days prior written notice after a twelve-month holding period or at such other times as determined in the sole discretion of the Managing Member, as provided for in the Company’s limited liability company agreement.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 2 -
Significant accounting policies (continued)
Income taxes
The Company is taxed as a partnership for U.S. federal income tax purposes. The members include their distributive share of the Company’s taxable income or loss on their respective income tax returns. Accordingly, no U.S. federal income tax liability or expense has been recorded in the financial statements of the Company.
The Managing Member has reviewed the Company’s tax positions for the open tax years by major jurisdictions and has concluded that no provision for taxes is required in the Company’s financial statements. Such open tax years vary by jurisdiction and remain subject to examination by the foreign taxing authorities. The tax liability is also subject to ongoing interpretation of laws by taxing authorities.
Recent accounting developments
Improving Disclosures about Fair Value Measurements (ASC 820). In January 2010, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820)-Improving Disclosures about Fair Value Measurements.” ASU No. 2010-06 provides amended disclosure requirements related to fair value measurements. Certain disclosure requirements of ASU No. 2010-06 were effective for the Company beginning in the first quarter of 2010, while other disclosure requirements of the ASU are effective for financial statements issued for reporting periods beginning after December 15, 2010. Since these amended principles require only additional disclosures concerning fair value measurements, adoption did not and will not affect the Company’s financial condition, results of operations or cash flows.
Note 3 -
Investments in affiliated Investees
The Investees seek capital appreciation over time by investing primarily within one of the following Investment Sectors: the equity long/short sector, the event driven sector, and the tactical trading sector. The Company’s investments in affiliated Investees are subject to the terms and conditions of the respective operating agreements. The investments in affiliated Investees are carried at fair value. Fair values are determined utilizing NAV information supplied by each individual affiliated Investee. GS HFS is the managing member of each of the Investment Funds. GS HFS does not charge the Company any management fee or incentive allocation at the Investee level. Realized gains/(losses) on the redemption of investments in affiliated Investees are calculated using the specific identification cost method. Because of the inherent uncertainty of valuation, estimated fair values may differ, at times significantly, from the values that would have been used had a ready market existed.
Performance of the Company in any period will be dependent upon the performance in the relevant period by the affiliated Investees and the weighted average percentage of the Company’s assets in each of the affiliated Investees during the period. In addition, performance is determined by the allocation by the Investment Funds of their assets with the various Advisors and the performance of each of their Advisor Funds and interests held by GFS Trust, GRV and HFPO. In the normal course of business, the Advisor Funds may trade various financial instruments and enter into various investment transactions with off-balance sheet risk, which include, but are not limited to, securities sold short, futures, forwards, swaps and written options. The Managing Member generally has limited access, if at all, to specific information regarding the Advisor Funds’ portfolios and relies on NAV provided by the Advisors. Generally, the NAV provided by the Advisors is only audited on an annual basis and is not subject to independent third party verification. Typically, audited financial statements are not received before issuance of the Company’s financial statements. GS HFS, in its capacity as managing member of the Company, performs additional procedures including Advisor due diligence reviews and analytical procedures with respect to the NAV provided by the Advisors to ensure conformity with U.S. GAAP. The Managing Member has assessed factors including, but not
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 3 -
Investments in affiliated Investees (continued)
limited to, Advisors’ compliance with U.S. GAAP applicable to fair value measurements and disclosures, price transparency and valuation procedures in place, the ability to redeem at NAV at the measurement date, and existence of certain redemption restrictions at the measurement date. NAV provided by the Advisors may differ from the audited values received subsequent to the date of the Company’s NAV determination. In such cases, the Company will evaluate the materiality of any such differences.
The following tables set forth by level within the fair value hierarchy the Company’s assets and liabilities by investment strategy at fair value measured at December 31, 2010 and December 31, 2009:
Included in cash and cash equivalents on the Balance Sheet are investments in money market funds with a fair value of $29,919,410 and $35,440,838, which were classified as Level 1 assets as of December 31, 2010 and December 31, 2009, respectively.
The following table summarizes the changes in fair value of the Company’s Level 3 investments for the year ended December 31, 2010:
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 3 -
Investments in affiliated Investees (continued)
Transfers into and out of Level 3 are effective as of actual date of the event or circumstances that caused the transfer. Transfers into Level 3 are due to HFPO’s sole investment in an Advisor Fund which implemented restrictions on redemptions during the year.
The following table summarizes the changes in fair value of the Company’s Level 3 investments for the year ended December 31, 2009:
Transfers into and out of Level 3 are effective as of actual date of the event or circumstances that caused the transfer.
The following table summarizes the cost of the Company’s investments in the affiliated Investees at December 31, 2010 and December 31, 2009:
The following table summarizes the Company’s Realized and unrealized gain/(loss) on investments in affiliated Investees for the years ended December 31, 2010, 2009 and 2008:
(1)
Redemptions can be made quarterly with 61 days’ notice, or at the sole discretion of the Managing Member.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 3 -
Investments in affiliated Investees (continued)
(2)
Redemptions can be made quarterly on or after the first anniversary of the initial purchase of the units with at least 91 days’ notice, or at the sole discretion of the Managing Member.
(3)
GFS Trust does not provide investors with a voluntary redemption right. Pursuant to the terms of the trust agreement for GFS Trust, distributions will be made to holders of interests in GFS Trust as GFS Trust receives proceeds in respect of its underlying investments. The estimated remaining holding period of its remaining underlying investments range from one to six years.
(4)
GRV ceased its trading activities effective on July 1, 2009, and will dissolve at the time all assets are liquidated, liabilities are satisfied and liquidation proceeds are distributed through payment of a liquidating distribution. GRV suspended redemptions pending the completion of the liquidation proceedings. The estimated remaining holding period of its remaining underlying investments range from one to six years.
(5)
Redemptions can be made quarterly with 60 days’ notice, or at the sole discretion of the Managing Member.
(6)
HFPO’s current holdings consist solely of one illiquid Advisor Fund, which cannot be redeemed until the relevant Advisor liquidates such investment. The estimated remaining holding period of the illiquid investment is approximately two to five years.
The investment strategy for each Investee is as follows:
Goldman Sachs Global Equity Long/Short, LLC
GELS seeks risk-adjusted absolute returns with volatility lower than the broad equity markets, primarily through long and short investment opportunities in the global equity markets. Strategies generally involve making long and short equity investments, often based on the Advisor’s assessment of fundamental value compared to market price, although Advisors employ a wide range of styles. Strategies that may be utilized in the equity long/short sector include catalyst-activist, consumer, diversified, energy, growth, long-bias, real estate, multi-strategy, short-term trading and value. Other strategies may be employed as well.
Goldman Sachs Global Fundamental Strategies, LLC
GFS seeks risk-adjusted absolute returns with volatility and correlation lower than the broad equity markets by allocating assets to Advisors that operate primarily in the global event driven sector. Event driven strategies seek to identify security price changes resulting from corporate events such as restructurings, mergers, takeovers, spin-offs, and other special situations. Corporate event arbitrageurs generally choose their investments based on their perceptions of the likelihood that the event or transaction will occur, the amount of time that the process will take, and the perceived ratio of return to risk. Strategies that may be utilized in the event driven sector include catalyst-activist, merger arbitrage/special situations, credit opportunities/distressed securities and multi-strategy investing. Other strategies may be employed as well.
Goldman Sachs Global Fundamental Strategies Asset Trust
The managing member of GFS, GS HFS, created GFS Trust, a Delaware statutory trust, for the benefit of its investors, including the Company. Goldman Sachs Trust Company, a Delaware Corporation, is the trustee of GFS Trust (the “Trustee”). The Trustee appointed GS HFS as the “Special Assets Direction Advisor,” responsible for, among other duties, disposition of GFS Trust assets. On March 31, 2009, GFS transferred to GFS Trust its interest in certain illiquid investments, including illiquid investments made by Advisor Funds, as well as liquidating vehicles that the Advisors formed as liquidity decreased for previously liquid investments, such as certain credit instruments. GFS transferred to GFS Trust the economic risks and benefits of its interests in such assets. In connection with such
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 3 -
Investments in affiliated Investees (continued)
transfer, each investor in GFS, including the Company, was issued its pro-rata share of GFS Trust interests based on its ownership in GFS as of the transfer date. The transfer was accounted for as an in-kind transfer at a fair value of $47,730,311, which resulted in a realized gain of $3,179,237. In connection with the transfer, the historical cost of the Company’s investment in GFS of $44,551,074 was transferred to GFS Trust including an unrealized gain of $3,179,237. Distributions from GFS Trust in respect of GFS Trust interests will be made to holders of GFS Trust interests, including the Company, as amounts in respect of the assets transferred to GFS Trust are received from the Advisors. However, the actual timing of these distributions will be dependent on the Advisors’ ability to liquidate positions as market conditions allow, and it could be a significant period of time before such positions are realized or disposed of.
Goldman Sachs Global Tactical Trading, LLC
GTT seeks long-term risk-adjusted returns by allocating its assets to Advisors that employ strategies primarily within the tactical trading sector. Tactical trading strategies are directional trading strategies that generally fall into one of the following two categories: managed futures strategies and global macro strategies. Managed futures strategies involve trading in the global futures and currencies markets, generally using systematic or discretionary approaches. Global macro strategies generally utilize analysis of macroeconomic, geopolitical, and financial conditions to develop views on country, regional or broader economic themes and then seek to capitalize on such views by trading in securities, commodities, interest rates, currencies and various financial instruments.
Goldman Sachs HFP Opportunistic Fund, LLC
HFPO’s investment objective is to make opportunistic investments in underlying Advisor Funds in order to (a) increase the weighting of a particular Advisor Fund which had a low weighting in the Company due to a lower target weight in one of the other Investees or (b) add an Advisor Fund that is not currently represented in any of the other Investees.
Goldman Sachs Global Relative Value, LLC
GRV ceased its trading activities effective July 1, 2009 and will dissolve at the time all assets are liquidated, liabilities are satisfied and liquidation proceeds are distributed through payment of a liquidating distribution. Investors in GRV (including the Company) will receive proceeds from the liquidation over time as GRV receives redemption proceeds from Advisor Funds.
GRV seeks risk-adjusted absolute returns with volatility and correlation lower than the broad equity markets by allocating assets to Advisors that operate primarily in the global relative value sector. Relative value strategies seek to profit from the mispricing of financial instruments, capturing spreads between related securities that deviate from their fair value or historical norms. Directional and market exposure is generally held to a minimum or completely hedged. Strategies that may be utilized in the relative value sector include convertible arbitrage, equity arbitrage and fixed-income arbitrage. Other strategies may be employed as well.
Management fees and incentive allocations/fee
GS HFS does not charge the Company any management fee or incentive allocation at the Investee level. The underlying Advisor Funds held by the Investees charge management and incentive allocation/fees to the Investees. The following table reflects the contractual weighted average Advisors’ management fee and incentive allocation/fee rates at the Investee level for the years ended December 31, 2010, 2009 and 2008. The weighted average is based on the period-end fair values of each investment in the Advisor Fund in proportion to the Investee’s total
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 3 -
Investments in affiliated Investees (continued)
investments. The fee rates used are the contractual rates charged by each Advisor. The Advisors’ management fees and incentive allocations/fees are not paid to the Managing Member.
(1)
The sole Advisor Fund within HFPO is illiquid and the Advisor has elected to forego the management and incentive fees.
Note 4 -
Fees
The Company incurs a monthly management fee paid in arrears to GS HFS equal to 1.25% per annum of the net assets of the Company as of each month-end.
Effective August 1, 2010, the Company incurs a monthly administration fee payable to SEI equal to one twelfth of 0.02% of the net assets of the Company as of each month end which is included in Other expenses in the Statement of Operations. For the period from August 1, 2010 through December 31, 2010, the Company incurred an administration fee of $66,145. The Company also continues to incur an indirect monthly administration fee to SEI at the Investee level which is included in Realized and unrealized gain/(loss) on investments in affiliated Investees in the Statement of Operations. For the years ended December 31, 2010, 2009 and 2008, the Company’s pro-rata indirect share of the administration fee charged at the Investee level totaled $324,908, $295,484 and $337,223, respectively.
Note 5 -
Risk Management
The Investees’ investing activities and those of the Advisor Funds in which they invest expose the Company to various types of risks that are associated with the financial investments and markets in which the Investees and such Advisor Funds invest. In the ordinary course of business, GS HFS, in its capacity as Managing Member of the Company and the Investees, attempts to manage a variety of risks, including market, credit, operational and liquidity risk and attempts to identify, measure and monitor risk through various mechanisms including risk management strategies and credit policies. GS HFS monitors risk guidelines and diversifying exposures across a variety of instruments, markets and counterparties.
Item 1A of Part I of this Annual Report on Form 10-K provides details of these and other types of risks, some of which are additional to the information provided in these financial statements.
Asset allocation is determined by the Company’s Managing Member who manages the allocation of assets to achieve the investment objectives. Achievement of the investment objectives involves taking risks. The Managing Member exercises judgment based on analysis, research and risk management techniques when making investment decisions. Divergence from target asset allocations and the composition of the Company’s investments is monitored by the Company’s Managing Member.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 5 -
Risk Management (continued)
Market risk
The potential for changes in the fair value of the Company’s investment portfolio is referred to as market risk. Commonly used categories of market risk include currency risk, interest rate risk and price risk.
(i) Currency risk
The Advisor Funds may invest in financial investments and enter into transactions denominated in currencies other than its functional currency. Consequently, the Company, its Investees and their Advisor Funds may be exposed to risks that the exchange rate of its functional currency relative to other foreign currencies may change in a manner that has an adverse effect on the value of that portion of the Company’s or Investees’ assets or liabilities denominated in currencies other than the functional currency.
(ii) Interest rate risk
The Advisor Funds may invest in fixed income securities and derivatives. Any change to the interest rates relevant for particular securities may result in the Advisors being unable to secure similar returns on the expiration of contracts or the sale of securities. In addition, changes to prevailing interest rates or changes in expectations of future rates may result in an increase or decrease in the value of the securities held. In general, if interest rates rise, the value of the fixed income securities and derivatives will decline. A decline in interest rates will in general have the opposite effect.
(iii) Price risk
Price risk is the risk that the value of the Investees’ and Advisor Funds’ financial investments will fluctuate as a result of changes in market prices, other than those arising from currency risk or interest rate risk whether caused by factors specific to an individual investment, its issuer or any factor affecting financial investments traded in the market.
As all of the Company’s investments in Investees and the Investees’ investments in Advisor Funds are carried at fair value with changes in fair value recognized in the Statement of Operations, all changes in market conditions will directly affect net assets. The Company’s maximum risk of loss is limited to the Company’s investment in the Investees. The Investees’ maximum risk of loss is limited to the Investees’ investment in the Advisor Funds.
The Investees’ investments in the Advisor Funds are determined utilizing NAVs supplied by, or on behalf of, the Advisors of each Advisor Fund. Furthermore, NAVs received from the administrator of the Advisor Funds may be estimates and such values will be used to calculate the NAV of the Investees for purposes of determining amounts payable on redemptions and reported performance of the Investees. Such estimates provided by the administrators of the Advisor Funds may be subject to subsequent revisions which may not be reflected in the Investees’ final month-end NAV.
Credit risk
Credit risk is the risk that one party to a financial investment will cause a financial loss for the other party by failing to discharge an obligation.
The Managing Member has adopted procedures to reduce credit risk related to the Company’s dealings with counterparties and Advisor Funds. Before transacting with any counterparty or Advisor Fund, the Managing Member or its affiliates evaluate both creditworthiness and reputation by conducting a credit analysis of the party, their business and reputation. The credit risk of approved counterparties and Advisor Funds are then monitored on an ongoing basis, including periodic reviews of financial statements and interim financial reports as needed.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 5 -
Risk Management (continued)
Some of the Investees’ investments in Advisor Funds may have had credit exposure related to the bankruptcy of Lehman. See “Liquidity risk” for further information related to Lehman exposure.
Operational risk
Operational risk is the potential for loss caused by a deficiency in information, communications, transaction processing and settlement and accounting systems. The Company’s service providers maintain controls and procedures for the purpose of mitigating operational risk. Reviews of the service levels of service providers are performed on a regular basis. No assurance is given that these measures will be 100% effective. Operational risk also exists at the Investee and Advisor Fund level.
Liquidity risk
Liquidity risk is the risk that the Company will encounter difficulty in meeting obligations associated with financial liabilities. The Company provides for the subscription and redemption of units and it is therefore exposed to the liquidity risk of meeting member redemptions.
In order to meet its obligations associated with financial liabilities, the Company primarily redeems from the investments in the Investees. However, the Company’s investments in the Investees may only be redeemed on a limited basis. As detailed in “Note 3-Investments in affiliated Investees”, neither GFS Trust nor GRV provide investors with a voluntary redemption right, and HFPO’s current holdings consist solely of one illiquid investment in an Advisor Fund, which cannot be redeemed until the relevant Advisor liquidates such investment. As a result, the Company may not be able to liquidate quickly some of its investments in order to meet liquidity requirements.
Certain of the Advisor Funds held by the Investees may have liquidity exposure related to the Advisors’ estimates of the recovery value of these claims against Lehman Brothers Holdings, Inc. and for certain of its subsidiaries and affiliates (“Lehman”), including cash claims involving amounts owed to the Advisors by Lehman and/or proprietary claims involving the recovery of Advisor Funds’ assets held by Lehman at the time of its insolvency. These estimates are based on information received from the majority, but not all, of the Advisor Funds’, and the Company has no way of independently verifying or otherwise confirming the accuracy of the information provided. As a result, there can be no guarantee that such estimates are accurate. There is significant uncertainty with respect to the ultimate outcome of the Lehman insolvency proceedings, and therefore the amounts ultimately recovered in respect of the Advisors’ claims against Lehman could be materially different than such estimates. Based on the information received, the gross indirect exposure to Lehman did not materially affect the Company’s net assets.
Certain of the Advisor Funds held by the Investees are subject to various lock-up provisions. Additionally, an Advisor may, at its discretion, transfer a portion of an Investee’s investment in the Advisor Fund into share classes where liquidity terms are directed by the Advisor in accordance with the Advisor’s operating agreement, commonly referred to as side pocket share classes (“side pockets”). These side pockets may have restricted liquidity and prohibit the Investees from fully liquidating their investments without delay. The managing member of the Investees attempts to determine each Advisor’s strategy on side pockets through its due diligence process prior to making an allocation to the Advisor. However, no assurance can be given on whether or not the Advisor will implement side pockets during the investment period. The Advisors may also, at their discretion, suspend redemptions or implement other restrictions on liquidity which could impact the Investees’ ability to meet redemptions submitted by the Company. As of December 31, 2010 and December 31, 2009 approximately 2% and 2%, respectively, of the Company’s investments in the Investees were considered illiquid due to restrictions implemented by the Advisors of the investments held by Investees, excluding contractual restrictions imposed by the Advisors at the time of purchase, such as lock-ups. In addition, as of December 31, 2010 and December 31,
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 5 -
Risk Management (continued)
2009 approximately 4% and 7%, respectively of the Company’s members’ equity was considered illiquid due to restrictions implemented by the Investees, including the lack of a voluntary redemption right for GFS Trust and GRV.
To mitigate some of the liquidity risks above, the Company has the ability to suspend redemptions prior to the effectiveness of redemption requests at the Managing Member’s sole discretion should conditions warrant.
Note 6 -
Related parties
The Management fee payable in the Balance Sheet represents management fees due to GS HFS at December 31, 2010 and December 31, 2009, respectively.
Included in the redemptions payable on the Balance Sheet at December 31, 2010 and December 31, 2009 were redemptions due to the Managing Member of $283,319 and $137,240, respectively.
For the year ended December 31, 2010, the Company earned dividends of $20,392 from an investment in one or more money market funds managed by Goldman Sachs Asset Management, L.P., an affiliate of GS HFS. For the year ended December 31, 2009, the Company earned dividends of $159,987 from an investment in one or more money market funds managed by Goldman Sachs Asset Management, L.P., an affiliate of GS HFS. At December 31, 2010 and December 31, 2009, the fair values of such money market investments was $29,919,410 and $35,440,838, respectively. The Company will bear its proportionate share of all fees, including investment advisory fees, paid by the money market funds.
The Advisor Funds may have executed investment transactions with various affiliates of the Managing Member.
Directors and executive officers of the Company and the Managing Member owned less than 1% of the Company’s equity at December 31, 2010, 2009 and 2008. Employees of GS & Co. owned approximately 2% of the Company’s equity at December 31, 2010, 2009 and 2008.
During the year ended December 31, 2009, members equity in Class A Series 66 through Class A Series 73 of $19,139,514 was transferred into the Company from an affiliated fund of the Company. The capital losses of these series were carried forward to the Company, which will be recovered before an incentive allocation is charged.
Note 7 -
Borrowing facility
The following table summarizes the Company’s credit facility (as amended from time to time, the “Credit Facility”) with Barclays Bank PLC (the “Facility Counterparty”) between January 1, 2009 and November 1, 2010:
(1)
The Credit Facility matured on November 1, 2010 and was not renewed.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 7 -
Borrowing facility (continued)
(2)
The Company also granted a security interest in the Company’s cash accounts and any other accounts that contain any other investment property of the Company.
(3)
London Interbank Offered Rate (“LIBOR”).
(4)
Effective September 1, 2010, the Credit Facility was extended to November 1, 2010 and converted to an uncommitted facility. Additionally, the commitment fee terminated, and the Company commenced paying a monthly facility fee to the Facility Counterparty at the rate of 1% per annum of the average Credit Facility.
The proceeds of the advances under the Credit Facility were used for liquidity management in connection with subscriptions to the Company and redemptions of the Company’s investments in the Investment Funds and for general purposes not prohibited by the Credit Facility or the investment guidelines therein. As of December 31, 2009, there were no borrowings outstanding. Interest related to borrowing and the commitment/facility fee is included in interest expense in the Statement of Operations. Effective November 1, 2010, the Credit Facility matured and was terminated.
Note 8 -
Members’ equity
At December 31, 2010, December 31, 2009 and December 31, 2008, the Company had Class A units outstanding. Each series of Class A units is identical in every regard except with respect to its individualized incentive allocation base. Effective January 1, 2010, Class A Series 55 through Class A Series 65 units and Class A Series 74 through Class A Series 76 units were converted into Class A Series 54 units. Effective January 1, 2008, Class A Series 33 through Class A Series 44 units were converted into Class A Series 1 units. The Managing Member does not own any units in the Company.
Transactions in units for non-managing members for the years ended December 31, 2010, 2009 and 2008 are as follows:
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 8 -
Members’ equity (continued)
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 8 -
Members’ equity (continued)
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 8 -
Members’ equity (continued)
At December 31, 2010, 2009 and 2008, members’ equity consisted of the following:
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 8 -
Members’ equity (continued)
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 8 -
Members’ equity (continued)
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 9 -
Ownership in Investees
During the years ended December 31, 2010 and 2009, the Company’s ownership percentage of certain Investees exceeded 50%. This ownership percentage will fluctuate as a result of the Company’s investment strategy and investor subscriptions and redemptions at the Company and Investee levels. The Company does not consolidate the results of the Investees in its financial statements because the Company does not invest in such Investees for purposes of exercising control; ownership in excess of 50% may be temporary; and the consolidation of these balances would not enhance the usefulness or understandability of information to the members. The Company does not exercise control over majority owned Investees. The following tables summarize the Company’s ownership in the Investees at December 31, 2010 and December 31, 2009:
(1)
The Investees’ equity used in the calculation of the percentage owned by the Company is reduced for member redemptions from the Investees that are paid after the balance sheet date according to ASC 480, “Distinguishing Liabilities from Equity.”
Note 10 -
Indemnifications
The Company enters into contracts that contain a variety of indemnification arrangements. The indemnification arrangements the Company has entered into with service providers include provisions for the Company to indemnify and hold harmless such service providers for certain liabilities. These indemnification arrangements typically cover liabilities incurred by service providers in connection with the services provided under the contractual arrangements with the Company and are generally entered into as part of a negotiated contractual arrangement stipulating the furnishing of the delineated services. However, under the terms of such contractual arrangements, the Company will not be required to indemnify service providers in certain situations to the extent that the liabilities incurred by the service providers were caused by the gross negligence, willful misconduct, bad
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 10 -
Indemnifications (continued)
faith, reckless disregard of duties, or similar conduct on the part of the service provider. The Company’s maximum exposure under these arrangements is unknown. It is not possible to estimate the maximum potential exposure under these agreements, because the indemnification arrangements relate to unforeseeable liabilities suffered as a result of the conduct of the Company or other parties, which is presently unknown or unforeseeable. However, the Company has not had prior claims or losses pursuant to these indemnification arrangements and expects the risk of material loss to be remote.
Note 11 -
Financial Highlights
Financial highlights for the Company for the years ended December 31, 2010, 2009 and 2008 are as follows:
(1)
Net investment income/(loss) is calculated based on average units outstanding during the period.
(2)
Includes incentive allocation, if applicable.
(3)
The ratios of expenses and net investment income/(loss) to average members’ equity are calculated by dividing total expenses and net investment income/(loss), respectively, by the month end average members’ equity for the period. The ratios to average members’ equity calculated above do not include the Company’s proportionate share of the net investment income and expenses of the Investees. The ratios to average members’ equity for each member may vary based on individualized incentive allocation bases and the timing of capital transactions.
(4)
The components of total return are calculated by dividing the change in the per unit value of each component for the period by the NAV per unit at the beginning of the period. The total return for Class A Series 1 units is calculated taken as a whole. The total return for each member may vary based on individualized incentive allocation bases and the timing of capital transactions.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 11 -
Financial Highlights (continued)
The per unit operating performance, ratios to average net assets and total return are calculated and presented for the initial series.
Note 12 -
Significant Investees
The following is a summary of financial information for Investees that represented more than 20% of the Company’s total assets and/or income as of and/or for the years ended December 31, 2010, December 31, 2009 and December 31, 2008 (the “Significant Investees”):
Balance Sheet
The balance sheets as of December 31, 2010 and December 31, 2009, are summarized as follows:
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
Statement of Operations
For the years ended December 31, 2010, December 31, 2009 and December 31, 2008, the statements of operations are summarized as follows:
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
Statement of Cash Flows
For the years ended December 31, 2010, December 31, 2009 and December 31, 2008, the statements of cash flows are summarized as follows:
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
(1)
During the year ended December 31, 2009, GTT had an in-kind subscription of $71,930,617 and GFS had an in-kind redemption of $157,265,966.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
Condensed Schedule of Investments
The condensed schedules of investments as of December 31, 2010 and December 31, 2009, are as follows:
GELS - December 31, 2010
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
GFS - December 31, 2010
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
GTT - December 31, 2010
(1)
Advisor Fund is affiliated with the Significant Investee and the Company.
The type and industry for each Advisor Fund is categorized as hedge fund investment.
The Advisor Funds are primarily domiciled in the United States of America.
Information about the underlying investments of Advisor Funds other than affiliated Advisor Funds is generally not available at December 31, 2010.
For all the investments in Advisor Funds that represent more than 5% of the Significant Investees net assets at December 31, 2010, the redemption periods ranged from monthly to annually and there are no restrictions such as lock-ups or suspended redemptions in place with the exception of one Advisor fund with a three year lock-up. Additionally, certain Advisor Funds had notified the Significant Investees of certain restrictions on liquidity such as side pocket investments.
See “Note 3 - Investments in affiliated Investees” for investment objectives of the Significant Investees.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
GELS - December 31, 2009
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
GFS - December 31, 2009
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
GTT - December 31, 2009
(1)
Advisor Fund is affiliated with the Significant Investee and the Company.
The type and industry for each Advisor Fund is categorized as hedge fund investment.
The Advisor Funds are primarily domiciled in the United States of America.
Information about the underlying investments of Advisor Funds other than affiliated Advisor Funds is generally not available at December 31, 2009.
For all the investments in Advisor Funds that represent more than 5% of the Significant Investees net assets at December 31, 2009, the redemption periods ranged from monthly to annually and there are no restrictions such as lock-ups or suspended redemptions in place with the exception of one Advisor fund with a three year lock-up. Additionally, certain Advisor Funds had notified the Significant Investees of certain restrictions on liquidity such as side pocket investments.
See “Note 3 - Investments in affiliated Investees” for investment objectives of the Significant Investees.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
Fair Value Hierarchy
The following tables summarize by level within the fair value hierarchy each Significant Investee’s investments at fair value as of December 31, 2010 and December 31, 2009:
See “Note 2 - Significant accounting policies” for disclosures regarding the fair value hierarchy.
Liquidity
As of December 31, 2010 and December 31, 2009, certain of the Advisor Funds of the Significant Investees’ were considered illiquid due to restrictions such as side pocket investments or suspended redemptions implemented by the Advisors of such Advisor Funds. The Significant Investees have not imposed any liquidity restrictions on the Company. The following represents the percentage of the net assets of the Significant Investees that were considered illiquid.
See “Note 5 - Risk management - Liquidity Risk” for disclosures regarding illiquidity related to the Significant Investees.
Each of the Significant Investees maintains a borrowing facility with a financial institution in order to meet liquidity needs. At December 31, 2010 and December 31, 2009, GELS had borrowings outstanding of $3,100,000 and $0, respectively, and GFS and GTT had no borrowings outstanding.
Risk Management
See “Note 5 - Risk Management” for information on risk information associated with the Significant Investees.
Advisor Funds’ Management Fees and Incentive Allocations/Fees
See “Note 3 - Investments in affiliated Investees” for information on the contractual weighted average Advisor Funds’ management fee and incentive allocation/fee rates at the Significant Investee level.
GOLDMAN SACHS HEDGE FUND PARTNERS, LLC
NOTES TO FINANCIAL STATEMENTS (continued)
December 31,
Note 12 -
Significant Investees (continued)
Financial Highlights
The financial highlights for the Significant Investees for the years ended December 31, 2010, December 31, 2009 and December 31, 2008 are summarized as follows:
(1)
The ratios to average net assets are based on expenses and net investment income/(loss) of Class C Series 1 units for GELS, GFS and GTT. The ratios to average net assets calculated above do not include each Significant Investees’ proportionate share of the net investment income/(loss) and expenses of their investments.
(2)
The total returns are based on the performance of Class C Series 1 units for GELS, GFS, and GTT. The returns include administration fees. No management fee or incentive allocation was charged by the managing member of the Significant Investees with respect to the Company’s investment in any of the Significant Investees.
Note 13 -
Subsequent Events
Effective January 1, 2011, Class A Series 48, Class A Series 53 through 54, Class A Series 77 through 81 and Class A Series 84 through 90 units were converted to Class A Series 46 units.