DESIM is a Delaware limited liability company and an investment adviser registered with and regulated by the SEC under the Advisers Act. DESIM serves as an investment adviser to certain clients through separately managed accounts and as the managing member or manager of, and/or the investment adviser to, certain affiliated collective investment vehicles and other entities in the D. E. Shaw group (collectively, the “Funds”). With respect to certain Funds, the Adviser provides investment advice to such Funds in its capacity as their managing member or manager. (As used herein, the term “clients” refers both to the Adviser’s separately managed account clients and to the Funds, as applicable.) The investor base of the Funds comprises institutional investors and other highly sophisticated, high-net- worth participants. These investors must meet certain minimum financial requirements (e.g., an institution generally must own and invest on a discretionary basis at least $25 million of certain investments), among other requirements, to be eligible to participate in the Funds, which are structured as private investment companies that are exempt from registration as investment companies under U.S. law by virtue of Section 3(c)(7) of the Investment Company Act of 1940, as amended (the “Investment Company Act”). The D. E. Shaw group was founded in 1988. DESIM was formed in and has been a registered investment adviser since 2005. The D. E. Shaw group invests globally using a broad array of strategies in both public and private markets. Widely recognized as a pioneer in quantitative investing, the D. E. Shaw group also has considerable expertise in areas that involve fundamental analysis or portfolio manager discretion. D. E. Shaw & Co., L.P. (“DESCO LP”) is the managing member and sole owner of DESIM. DESCO LP’s principal owner is Dr. David Elliot Shaw. Other entities and individuals hold minority stakes in DESCO LP. DESIM bases its advice to clients on the investment objectives and restrictions (if any) set forth in such clients’ applicable investment management agreements, offering memoranda, organizational documents, and/or subscription agreements, as the case may be (each, a “Governing Document,” and collectively, the “Governing Documents”). DESIM managed approximately $20,528,900,000 in investment capital on a discretionary basis as of January 1, 2019. please register to get more info

DESIM acts as an investment adviser on a discretionary basis to managed accounts and to Funds. DESIM’s compensation for such services includes an asset-based fee (a “Management Fee”) and may also include a performance-based fee, charge, or allocation (each, a “Performance Charge”). The definitive terms of such compensation, including whether DESIM deducts or invoices for fees, are generally set forth in the applicable Governing Document. Management Fees generally are paid monthly or quarterly in arrears, unless set forth otherwise in the applicable Governing Document. The Management Fee schedule for managed accounts generally is based upon the client’s account size and expected risk level, although managed account clients may negotiate alternative fees. The following table sets forth the current standard Management Fee schedule for managed accounts that deploy DESIM’s “Active Equity Strategies” (as outlined in “Methods of Analysis and Investment Strategies” in Item 8 below). This table is subject to change (e.g., fees and/or investment strategies may be added, deleted, or modified).
Initial Next Over
Targeted Tracking Error (bps) $100 mn $100 mn $200 mn
Large Cap/Broad Market Core Strategies
Long-Only 100 30 bps 27 bps 24 bps 200 51 bps 46 bps 41 bps 300 63 bps 57 bps 51 bps 130/30 300 78 bps 78 bps 78 bps All Cap Core Strategies Long-Only 100 33 bps 30 bps 27 bps 200 54 bps 49 bps 44 bps 300 67 bps 60 bps 54 bps 130/30 300 82 bps 82 bps 82 bps International/World Strategies Long-Only 100 35 bps 32 bps 29 bps 250 70 bps 65 bps 60 bps 130/30 300 84 bps 84 bps 84 bps All Country Global Strategies Long-Only 100 38 bps 35 bps 32 bps 250 75 bps 70 bps 65 bps 130/30 300 89 bps 89 bps 89 bps Managed account fees shown in the preceding table are for investment management services only; third- party custodial fees and brokerage commissions and other fees are not included. Performance Charge arrangements may also be used in certain circumstances. DESIM may enter into Performance Charge arrangements with clients that fall within the definition of a “qualified client” pursuant to Rule 205-3 under the Advisers Act or as permitted under Section 205(b) of the Advisers Act. Performance Charges generally are paid in arrears but, where applicable, may be paid at the time of termination of the advisory agreement (with respect to a managed account) or at the time of a withdrawal or distribution of capital (with respect to a Fund), in each case unless otherwise set forth in the applicable Governing Document. The Management Fee and Performance Charge (if any) with respect to a Fund are set forth in the applicable Governing Document. Funds that deploy DESIM’s “Active Equity Strategies” (as outlined in “Methods of Analysis and Investment Strategies” in Item 8) generally have two series of regular member interests. One series is assessed a Management Fee that is generally comparable to the Management Fee applied to managed accounts utilizing the corresponding investment strategy. The other series is assessed a reduced Management Fee as well as a Performance Charge, typically equal to 20% of the Fund’s outperformance of the stated benchmark for the relevant investment strategy. Funds that deploy strategies on DESIM’s “Orienteer Platform” (as outlined in “Methods of Analysis and Investment Strategies” in Item 8 below) have only a single series of regular member interests; such series is assessed a Management Fee that ranges from 90 basis points annually to 135 basis points annually. In general, if a Management Fee has been paid in full in advance for a period in which either the advisory contract with the relevant client has been terminated, or, with respect to a Fund, for the period in which an investor has withdrawn its investment in such Fund, the applicable portion of such Management Fee paid relating to the portion of the period after such termination or withdrawal will be returned or credited to the client or to the withdrawing or redeeming Fund investor, subject to the terms of the applicable Governing Document; however, Governing Documents related to Funds typically do not permit such intraperiod terminations or withdrawals. A client may terminate an advisory contract before its expiration date by complying with the provisions regarding termination provided in the advisory contract, including without limitation by sending a notice of termination to the address designated under the advisory contract. The Adviser from time to time has entered into agreements with certain underlying investors in the Funds that provide for terms of investment that are more favorable than the terms set forth in the applicable Governing Document. Such terms may include, among other things, the waiver, reduction, or rebate of Management Fees, Fund expenses, and/or Performance Charges; the provision of additional information or reports; more favorable transfer and/or withdrawal rights; provisions regarding indemnification and/or the jurisdiction and choice of law for disputes regarding the investment; provisions regarding the investor’s and/or the Adviser’s confidentiality obligations; and “most-favored-nation” provisions covering one or more terms or rights. No such agreement necessarily entitles any other Fund investor to the same terms of investment as offered in such agreement. Clients advised by DESIM incur expenses in connection with custodial or brokerage services outlined in Item 12. In addition, each client incurs operating costs and expenses as are set forth in the applicable Governing Document. For certain Funds, these may include operating costs and expenses relating to services provided by Arcesium, as outlined below. The Adviser will make all determinations and computations regarding operating costs, including determining whether a particular item constitutes an operating cost and any adjustment to operating costs; and the allocation of operating costs (or elements of particular operating costs) between the Adviser’s clients and/or its affiliates. The allocation of operating costs (or their elements) between the Adviser’s clients and/or its affiliates, as well as between categories of client interests, will be determined by the Adviser and/or its affiliates using any objective criteria, any subjective criteria, or any combination of the foregoing selected by the Adviser and/or its affiliates (including estimates of value contribution, resource utilization, personnel utilization, capital utilization, investment strategy capacity utilization, space utilization, technology utilization, asset ownership, trading volume, revenue, headcount, and/or compensation). Determinations with respect to operating costs associated with services provided by the Adviser and its affiliates are subject to conflicts of interest, including those outlined in Item 10. Furthermore, the Adviser may be entitled under the Governing Document to be reimbursed for some or all expenses that it or its related persons incur on behalf of the relevant client, potentially including compensation and overhead costs attributable to certain personnel of the Adviser or its related persons who provide services to the relevant client. The Adviser or its related persons may waive such person’s right to reimbursement of any portion of operating costs and expenses it has incurred. The decision to waive (or not to waive) reimbursement rights with respect to any particular operating cost or expense shall not create or imply any right or obligation with respect to any other reimbursement rights, including with respect to operating costs and expenses of a similar nature to those for which reimbursement rights have been waived. Neither the Adviser nor its supervised persons receives compensation for the sale of securities or other investment products to clients or investors.
Services Provided by Arcesium LLC
The Adviser has engaged Arcesium LLC (“Arcesium”) to provide certain middle- and back-office technology and services to the Adviser. Arcesium was formed in 2015 as a joint venture between a subsidiary of DESCO LP and a third-party minority investor when a substantial portion of the D. E. Shaw group’s back- and middle-office functions spun out into an independently managed entity. Arcesium provides certain technology and services with respect to the Adviser’s clients related to various middle- and back-office functions, including trade capture, asset servicing, margin and collateral monitoring, wires services, trade and position reconciliation, cash reconciliation, pricing, and support for accounting, tax, investor reporting, and compliance. In providing such technology and services, Arcesium is subject to the overall supervision of the Adviser. Certain Funds may incur certain operating costs and expenses associated with services provided by Arcesium to such Funds. For certain Funds, such operating costs and expenses may reflect estimates of the time personnel of Arcesium devote to providing such services and the compensation and overhead costs attributable to such personnel. Any fees that may be paid by a Fund to Arcesium do not reduce the Management Fee and/or any operating costs or expenses of such Fund. Arcesium has no portfolio management, investment advisory, or fiduciary responsibilities with respect to any of the Adviser’s clients. Arcesium does not manage, monitor, or oversee any trading decisions of any client, any client’s compliance with its investment objectives, or any other aspects of the portfolio management activity of any client. please register to get more info

When trading on behalf of multiple clients, the Adviser endeavors to allocate investment opportunities among such clients in a fair and equitable manner. The Adviser’s trade allocation among clients may vary based on, among other things, differences in investment objectives, capital constraints, and/or leverage preferences among clients, and any anticipated increase or decrease of any particular client’s assets under management. The Adviser does not alter its allocation policy with respect to a client, or allocate trades among multiple clients, without the approvals of the Adviser’s relevant senior management and compliance personnel. As outlined in further detail in this Item 6 and in Items 10 and 12, the Adviser and/or its related persons hold significant ownership interests in certain Fund clients. Furthermore, the Adviser and/or its related persons receive the benefit of more favorable terms (such as with respect to fees or the reimbursement of expenses) in connection with their management of certain Fund clients than in connection with their management of other clients. For purposes of this brochure, (a) “Significant Management Capital Fund” or “SMC Fund” refers to any Fund in which the Adviser or its related persons are the ultimate beneficial holders of significant ownership interests, potentially including a substantial majority or all of such ownership interests, and (b) “DESCO Favorable Fund” refers to any SMC Fund or to any Fund in which the Adviser and/or its related persons receive the benefit of more favorable terms (including higher Performance Charges or Management Fees or more generous expense reimbursement provisions) than those applicable to other Fund entities managed by (or other clients of) the Adviser. In the future, the Adviser and its related persons’ ultimate beneficial ownership of an SMC Fund may increase (or decrease) and/or the Adviser or its related persons may receive more favorable terms with respect to a DESCO Favorable Fund. Clients and prospective clients should note that SMC Funds and other DESCO Favorable Funds invest in asset classes in which other clients also invest. The Adviser and/or its related persons (a) hold investments in DESCO Favorable Funds that are larger (whether in percentage or absolute dollar terms) than any investments they hold in other Fund clients and/or (b) provide services to DESCO Favorable Funds that pay Management Fees, Performance Charges, or other amounts that are greater (whether in percentage or absolute dollar terms) than the corresponding amounts paid by other clients. As a result, the Adviser and/or its related persons have incentives to deploy more profitable investment strategies on behalf of, or to allocate more profitable investment opportunities to, such DESCO Favorable Funds instead of other clients, and have in fact done so on behalf of certain DESCO Favorable Funds. Any such deployment or allocation of such investment strategies or opportunities to a DESCO Favorable Fund would decrease the number and quality of investment strategies and opportunities available to such other clients. Further, the Adviser and its related persons have incentives to increase the capital each invests in SMC Funds, even if such increase would exacerbate the conflicts of interest described in this paragraph. Please see Item 10 for additional information regarding certain conflicts of interest arising from the Adviser’s allocation of investment opportunities and Item 12 for discussion of aggregated client orders. please register to get more info

DESIM’s clients include public and private pension plans, investment companies registered under the Investment Company Act, Undertakings for the Collective Investment in Transferable Securities (“UCITS”) governed by Directive 2009/65/EC, and certain other institutional investors. DESIM’s clients also include the Funds, which are structured as private investment companies that are exempt from registration under Section 3(c)(7) of the Investment Company Act. A minimum dollar value of assets and other conditions are typically imposed on clients. DESIM may advise clients, whether managed account clients or Funds, that are subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). DESIM qualifies as a “qualified professional asset manager” (“QPAM”) as defined by ERISA. As a result, client transactions directed by the Adviser may be exempt from certain prohibited transaction rules of ERISA. please register to get more info

Methods of Analysis and Investment Strategies
The Adviser primarily deploys two types of investment strategies—its “Active Equity Strategies” and strategies on its “Orienteer Platform.” With respect to its Active Equity Strategies, the Adviser applies the D. E. Shaw group’s quantitative and computational techniques, based on the D. E. Shaw group’s experience in managing alternative investment strategies, to construct benchmark-relative equity strategies for both separately managed accounts and Funds. The Adviser can customize its Active Equity Strategies by allowing a client to select a portfolio benchmark from a number of U.S., international, and global equity indices. The Adviser can manage its Active Equity Strategies on either a long-only basis or using a “130/30” or similar investment approach. The portfolios of Funds and managed accounts in which the Adviser deploys its Active Equity Strategies are generally expected to include common and preferred stock (including ETFs and other investment companies), swaps and other derivative instruments and contracts related to the foregoing, and money market instruments. In particular, such portfolios are expected to be focused on corporate equity securities publicly traded in U.S. and foreign markets (whether held directly or via swap) and ETFs. With respect to the strategies on its Orienteer Platform, the Adviser seeks to generate attractive long-term risk-adjusted returns across various asset classes through asset allocation and alpha generation. In deploying the strategies on its Orienteer Platform, the Adviser makes extensive use of subjective, qualitative evaluation in both the formulation and execution of many of its investment decisions. Such decisions also may be informed by, and/or made or executed algorithmically according to, quantitative models. Certain strategies on the Adviser’s Orienteer Platform may be managed in a manner that contemplates certain tax considerations applicable specifically to U.S. taxable investors or in a manner that is consistent with the requirements for registered funds under the Investment Company Act. The portfolios of Funds and managed accounts in which the Adviser deploys the strategies on its Orienteer Platform may include without limitation currencies; bonds, notes, debentures, bills, and other forms of indebtedness or liability issued or incurred by sovereign nations, governmental agencies and instrumentalities, corporations, municipalities, or other persons; futures, options on futures, and forward contracts; swaps (including credit default swaps) and other derivative instruments; common and preferred stock; mortgages, mortgage-backed securities, and other asset-backed securities, including securities backed by various forms of consumer and asset-based finance receivables; exchange-traded funds (and interests in other investment companies); commodities; energy-related products and instruments; weather-related instruments; emissions allowances and transmission rights; bank notes, term loans, debtor-in-possession loans, revolving loans, bank guarantees, letters of credit, and other forms of lender assets or obligations; options, rights, warrants, convertible securities, exchangeable securities, synthetic and/or structured convertible or exchangeable products, participation instruments, and investment contracts; insurance- and reinsurance-related products; instruments having a value or return that is explicitly tied to the occurrence (or non-occurrence) of economic, political, legal, natural, technological, bankruptcy, default, and/or other events; catastrophe bonds, industry loss warranties, and other catastrophe risk-linked instruments; royalty trusts; intellectual property; assets with specified tax attributes; cash and cash equivalents; money market instruments; limited partnership and other limited liability interests; general partnership and other unlimited liability interests; interests in portfolio funds; real estate and other forms of real property-related instruments; trade claims and other receivables; financial interests in settlements of legal disputes; and/or any other security, instrument, interest, or property selected by the Adviser (collectively, “Investments”). Investments held in connection with the strategies on the Adviser’s Orienteer Platform are expected to relate to markets and/or issuers both in the United States and outside the United States. Such Investments may be traded on exchanges, “over-the- counter,” or on any other markets, or may not be traded on any exchange or other market.
Potential Risk Factors
An investment in a managed account or Fund managed by the Adviser involves substantial risks that should be carefully considered by a prospective client or investor, respectively. Certain risk factors that may be applicable to such an investment are outlined below; the Funds’ Governing Documents outline additional risk factors. It should be noted, however, that there may be other risk factors applicable to such an investment that are not identified but that might still result in material losses to investors. Prospective investors should also consult their own legal, investment, tax, and other advisers, and the applicable Governing Document, as to whether such an investment is appropriate for them. It should be noted that many of the risks outlined under one caption or heading are applicable to one or more other captions and headings.
No Assurance of Investment Return
An investment in a managed account or Fund managed by the Adviser may involve a high degree of risk, including the risk that the entire amount invested will be lost. An investment in a managed account or Fund managed by the Adviser is not intended as a complete investment program. Such an investment should be regarded as speculative in nature and appropriate only for a sophisticated investor that can afford a loss of all of its investment with the Adviser and that is able to invest for an indefinite period. It should not be assumed that an investment in a managed account or in a Fund managed by the Adviser will be profitable. In addition to the risk of loss on such a managed account’s or Fund’s Investments, an investment in a managed account or Fund managed by the Adviser is subject to the direct and indirect fees and expenses (including Management Fees and any applicable operating costs) outlined elsewhere in this brochure or applicable Governing Document, which will reduce returns and require that the managed account or Fund make a certain level of profit from its investing activities in order for an investment simply to break even. Past performance of any of the Adviser’s strategies or the investment vehicles sponsored, advised, and/or managed by the Adviser, or of any investment strategies operated within any such investment vehicle, is not indicative of the results that will be achieved either by any such strategy or vehicle in the future or by any other strategy or vehicle. Further, such past performance provides no assurance of the success of any strategy or vehicle in achieving its investment objectives, including, for example, because investment strategies and/or personnel of one client may differ significantly from those of another client or may have operated in market conditions that were more favorable than current or future market conditions are or will be.
General Factors
The operating results, financial condition, activities, and prospects of an investment in a managed account or Fund managed by the Adviser could be materially adversely affected by changes or instability in market, economic, political, technological, regulatory, and social conditions, and by numerous other factors outside the control of the Adviser. Many of the Adviser’s investment strategies and/or Investments are likely to be exposed to risks relating to weaknesses in various global economies and risks relating to the economic cycle. Numerous factors affecting the performance of the Adviser’s investment strategies, such as market volatility (or lack thereof), interest rates, commodity prices, equity prices, currency prices, credit spreads, availability and terms of financing, demand from market participants, and deflationary and inflationary pressures, may be affected by the economic cycle and long-term economic trends. Predictions about financial market conditions and economic factors are highly uncertain, and the presence, duration, and impact of any market or economic conditions could have a material adverse effect on the Adviser’s investment strategies. Further, managed accounts and/or Funds managed by the Adviser may be unable to open or liquidate positions as a result of changes or instability in market conditions, trading halts due to regulatory limits (such as daily-price-fluctuation limits), emergency trading bans, counterparty actions, or other factors. Such inability to trade could have a material adverse effect on managed accounts and/or Funds managed by the Adviser. Disruptions in the global financial markets, whether similar or dissimilar to the global financial crisis that began in 2008, may exacerbate the risks to which Investments are exposed and may have a material adverse effect on the value, liquidity, and stability of the Adviser’s investment strategies and/or specific Investments. The duration, severity, and ultimate effect of any such disruptions cannot be forecast with confidence. The Adviser may choose not to attempt to, be unable to, or to cease to hedge the risk exposures outlined in this brochure, and there can be no assurance that any hedging attempted by the Adviser would reduce applicable risks. The risk models and risk management techniques expected to be deployed by the Adviser are based on the information and data available to it as well as on its assumptions, assessments, and estimates, all of which are subject to error. As a result, such models and techniques may not account for all relevant factors or may not account for any such factors correctly. More generally, there can be no assurance that such models and techniques would be effective.
Special Risks of Certain Markets
Certain markets may pose special risks due to, among other factors, the limited availability of useful information, the reliance on self-interested persons for price and other information, a limited number of market participants, and more or less regulation. For example, price information might be available only from brokers or dealers and might not be verifiable. Further, less regulation in certain markets might enable market intermediaries or other investors to engage in “frontrunning” (whether directly or through their customers or agents) of the Adviser’s trades, to misuse information about positions managed by the Adviser to reduce the value or liquidity of those positions, and to take other actions that materially adversely affect the Adviser’s investment strategies. The limited availability of price information or actions of market intermediaries or investors could exacerbate other risk factors outlined in this brochure, including short squeezes, and could have a material adverse effect on the Adviser’s investment strategies. In addition, brokers, dealers, or other market participants may withdraw or substantially reduce the scope of their activity with regard to certain markets or Investments without notice, resulting in disruptions to strategies, pricing, and/or the ability to liquidate or close out positions. Any of the foregoing could have a material adverse effect on the Adviser’s investment strategies.
International Investments
The Adviser is expected to cause one or more of its clients to purchase, sell, hold, trade, structure, restructure, and otherwise acquire or dispose of Investments relating to markets and/or issuers both in the United States and outside the United States, including in certain developing or emerging markets. International investing and trading involve special risks not typically associated with trading in Investments relating to markets and/or issuers solely in the United States. Depending on the particular countries and Investments involved and on the nature of the particular transactions executed outside of the United States, these special risks may include changes in exchange rates and exchange control regulations; downgrades in sovereign credit ratings; devaluations or non-convertibility of non-U.S. currencies; failures or disruptions in central banks, banking systems, markets, or financial exchanges; changes in monetary policies, interest rates, or interest-rate policies; political, social, and economic instability; adverse diplomatic developments; investment and repatriation restrictions; the nationalization and/or expropriation of assets; government intervention in the private sector; default by public and private issuers on their financial obligations (and limited recourse in connection with such defaults); the imposition of non-U.S. taxes; discrimination against foreign investors; and less liquid markets, less information, higher transaction costs, greater difficulty in enforcing contractual obligations, fewer or different rights for creditors generally, more uncertain procedures (if any) for bankruptcy or other reorganization or liquidation proceedings (“Reorganization Proceedings”), less information regarding legal and regulatory risks, less uniform accounting and auditing standards, greater price volatility, less reliable clearance and settlement procedures, more onerous regulatory requirements for private investment funds, and/or less government supervision of exchanges, brokers, market intermediaries, issuers, and other markets and market participants than is generally the case in the United States. Further, individual non-U.S. economies may differ favorably or unfavorably from the U.S. economy in various respects, such as pace of economic growth, rate of inflation, amount of capital reinvestment, degree of resource self-sufficiency, and balance of payments position. For example, inflation and rapid fluctuations in inflation rates have had and may continue to have very negative effects on the economies and securities markets (both public and private) of certain countries in which the Adviser may invest, and therefore may have a material adverse effect on the Adviser’s investment strategies. The Adviser’s clients may trade, directly or indirectly, Investments on exchanges, or use clearinghouses or clearing firms, located outside the United States. Some non-U.S. exchanges, in contrast to domestic exchanges, are “principals’ markets” in which performance is solely the responsibility of the individual member with whom the trader has entered into a contract and not that of an exchange or its clearinghouse. Clients thus may be subject to the risk of the inability of, or refusal by, a counterparty to perform with respect to any such contract. Moreover, as there may be less government supervision and regulation of non-U.S. exchanges, clearinghouses, and clearing firms than of those in the United States, clients may also be subject to greater risk of failures of the exchanges on which its positions trade and/or failures of such exchanges’ clearinghouses or clearing firms than it would be in the United States. The foregoing risks are likely to be more pronounced in connection with Investments in countries with developing or emerging markets. A client may be treated as a U.S. person for purposes of U.S. Commodities Futures Trading Commission (“CFTC”) regulations, which may limit such client’s ability to participate in certain non-U.S. futures. Alternatively, if a client is treated as a non-U.S. person under CFTC regulations, such client may be permitted to invest in non-U.S. futures, which are not subject to CFTC regulation or review. Any such client’s status as a U.S. person or non-U.S. person for these purposes will depend on, among other factors, the applicable Fund manager’s principal place of business and the level of investment in such Fund by U.S. investors and, accordingly, such status may change from time to time.
Availability of Investment Opportunities
There can be no assurance that the Adviser will be able to identify and/or successfully take advantage of suitable investment opportunities. For example, it is expected that the effectiveness of certain quantitative models developed in connection with the systematic trading strategies deployed by the Adviser will be particularly sensitive to changes in applicable policies, regulations, or laws; changes in the number, nature, or behavior of other market participants; and/or changes in economic or market conditions generally. The effectiveness of such models may therefore diminish, disappear, or become negative, any of which could occur quickly or over a more prolonged period. As a result, the performance of the applicable Fund will depend on the ability of the Adviser to develop suitable models and to respond to such changes. In addition, the Adviser decides which investment opportunities to pursue based on the information and data available to it and on its assumptions, assessments, and estimates, all of which are subject to error. Even if the Adviser makes investments (or fails to liquidate investments) with the intent of taking advantage of a perceived investment opportunity, there is a risk that any such decision will result in losses to the Adviser’s clients due to unanticipated circumstances, errors in judgment, errors in execution, or other causes. Further, the Adviser may elect to stop deploying any particular investment strategy on behalf of a particular Fund at any time, regardless of whether such strategy has been successful or whether other Funds (including DESCO Favorable Funds) continue (or begin) to deploy such strategy. If the Adviser is not able to identify and/or take advantage of suitable investment opportunities, it may alter its investment strategy and/or risk tolerances in order to deploy capital, which may have a material adverse effect on the Adviser’s investment strategies. Even if investment opportunities are identified, the Adviser is currently expected to cause one or more of its clients to hold significant cash positions for extended periods of time, which may materially reduce the returns of such client(s). Alternatively, the Adviser may elect to cause one or more of its clients to hold little or no cash for extended periods of time, which may materially increase the risk of loss associated with such client’s activities.
Correlation; Possible Concentration and Limited Diversification
It is expected that certain of the Adviser’s clients will experience returns that are closely correlated with one or more market indices or other strategies, including various equity, debt, commodities, or currency markets around the world. In addition, the Adviser is expected to cause its clients to maintain extensive unhedged exposure for an indefinite period to various sources of market and/or other risk, whether known or unknown (and thus not to be “market neutral”). Such sources of risk may include changes in the future levels and/or volatility of interest rates, currency prices, commodity prices, sovereign credit spreads, corporate credit spreads, and equity and other markets, as well as correlations between any such risks. Correlations between investment strategies deployed by the Adviser, and/or correlations between the returns of client portfolios managed by the Adviser and the returns of market indices and/or other investment vehicles, may change over time. In particular, such correlations may increase in times of market stress, such as those caused by widespread liquidation events, or other times of unusual market activity. There can be no assurance that an investment in a portfolio managed by the Adviser would improve the risk/return profile of any client’s or investor’s overall portfolio or otherwise improve the performance of such portfolio, and such an investment may in fact result in material losses. Although certain of the portfolios managed by the Adviser are expected generally to be relatively diversified in certain respects, in some circumstances they may be concentrated (either in absolute terms or relative to a particular market index) in particular issuers, issuances, companies, countries, industries, exchanges, counterparties, types of Investments, or other shared characteristics. Any such concentration would magnify risks associated with the Investments held in such portfolios, including the risk of significant losses. Portfolios managed by the Adviser may not have any diversification requirements. In general, less diversification will tend to expose the applicable client to greater volatility and/or risk than would be the case with a more broadly diversified portfolio. Even if a particular client’s portfolio were diversified, however, there can be no assurance that such diversification would reduce volatility and/or risk. In addition, certain Investments held in a client’s portfolio may represent, alone or together with Investments held in other clients’ portfolios, a significant percentage of the markets in which such Investments are traded, and there are no restrictions (other than limits imposed by applicable law) on the percentage of any market that such Investments may represent. Occupying a significant position in any given market may result in such Investments in such market being less liquid than would be the case with a smaller position, may subject a portfolio to additional regulatory scrutiny or restrictions, and/or may have other adverse effects.
Volatility of Investment Returns
The performance of strategies the Adviser deploys on behalf of its clients may be highly volatile (both in absolute terms and relative to expected and/or realized returns), potentially resulting in increased risks, including the risk of substantial losses. Such strategies may, by design or otherwise, have high volatility, negative skewness (or “left tail” risk), negative kurtosis (or “flat” distribution risk), high correlation with certain macroeconomic risk factors, high position concentrations, and/or other significant risks, whether in absolute terms or relative to expected and/or realized returns, or relative to certain strategies that are deployed by the Adviser on behalf of other clients. As a result, the investment returns of a client may vary significantly over time, and there is a risk of substantial losses to such client. A prospective client or underlying investor should invest with the Adviser only if it has determined that such variance of returns is consistent with its investment objectives and risk tolerances. The risks outlined in this section may be intentional and/or may result, in part, from the election by the Adviser not to take risk-reducing actions that it might deploy elsewhere, including where it deploys similar strategies on behalf of other clients. In addition, the Adviser is expected to deploy certain strategies (or elements of certain strategies) for various clients. It is possible that such strategies may produce returns that are not closely correlated with, and from time to time may be inferior to, the returns associated with such strategies as they are deployed on behalf of other clients (including DESCO Favorable Funds).
Complexity of Quantitative Strategies
Many of the investment strategies that the Adviser deploys on behalf of clients, and many of the Adviser’s clients’ Investments, are highly complex. In many cases, the successful deployment of a particular investment strategy is expected to require or involve sophisticated mathematical calculations and complex computer programs. Although the Adviser intends to use good faith efforts to carry out such calculations and programs correctly and to use them effectively, there can be no assurance that it will successfully do so. Errors have occurred and are expected to continue to occur in designing, writing, testing, monitoring, and/or implementing such calculations and programs, including errors in the manner in which such calculations and programs function together. Any such error may be difficult to detect, may not be detected for a significant period of time, and could have a material adverse effect on the Adviser’s clients. This risk may be exacerbated by the fact that certain investment strategies deployed by the Adviser are expected to result in the execution of a significant number of trades over a relatively short period of time, which may result in many trades being affected by any such error before it can be detected and corrected. In addition, such calculations and programs are dependent upon accurate market and other data, and inaccuracies in or any corruption of such data (or errors in incorporating such data) may have a material adverse effect on the results of such calculations and programs. The Adviser may seek to apply existing calculations and programs to different components of the investment strategies deployed on behalf of its clients (including different markets, strategies, or Investments), but there can be no assurance that such application would prove effective in such different contexts. Moreover, the effectiveness of such calculations and programs is expected to diminish over time, including as a result of changes in the market and/or changes in the behavior of other market participants. The Adviser may respond to such diminishing effectiveness by making certain changes to the investment strategies and/or the manner in which they are implemented. Any such changes could increase the likelihood of the errors described above. The complexity of the components of the investment strategies that apply such calculations and programs, and the interactions among such components, may make it difficult or impossible to detect the source of any weakness or failure in such components and/or such calculations and programs before material losses are incurred. For example, it may be difficult or impossible to distinguish unexpected trading results caused by market activity from unexpected trading results caused by an error in the applicable calculations or programs. Any mathematical calculations and computer programs utilized by the Adviser are subject to inherent limitations and may be improved upon as experience is gained, strategies are refined, and markets change. However, there can be no assurances that the Adviser would be able to make, or would make, any such improvements, and its inability or failure to do so could have a material adverse effect on the Adviser’s clients. Further, the Adviser’s clients are exposed to risks arising from the systematic or algorithmic trading of other market participants. Market events such as the “flash crash” of May 6, 2010 illustrate how the behavior of one or a small number of market participants can cause dramatic movements in the prices of individual securities and/or the market as a whole. The systematic nature of certain investment strategies deployed by the Adviser may make the Adviser’s clients particularly susceptible to such movements, which could have unforeseen effects on one or more such investment strategies and/or on the interactions among such strategies. Any such market event could have a material adverse effect on a client of the Adviser.
Electronic Trading
The Adviser expects to trade on electronic trading and order routing systems. Transactions using an electronic system are subject to the rules, regulations, and policies of the exchanges or persons offering the system or listing the instrument. Characteristics of electronic trading and order routing systems vary widely with respect to order matching procedures, opening and closing procedures and prices, trade error policies, and trading limitations or requirements. Trading on such systems may also expose a client of the Adviser to the risk that the applicable exchanges may have discretion to cancel particular orders or trades under certain circumstances, including in the event of market disruptions. Any such cancellations could affect such client’s portfolio in unexpected and/or adverse ways. There are also differences regarding qualifications for access, grounds for termination of access, limitations on the types of orders that may be entered into the system, and other applicable terms. Each of these matters may present different risk factors with respect to trading on or using a particular system. Each system may also present risks related to system access, varying response times, the behavior of other market participants, security, service providers, and the receipt and monitoring of electronic mail. Trading through an electronic trading or order routing system is also subject to risks associated with system or component failure, whether such failure affects the hardware or software of the exchange or person offering the relevant system or of the Adviser. In the event of system or component failure, it is possible that, for a certain time period, it might not be possible to enter new orders, execute existing orders, or modify or cancel orders that were previously entered. System or component failure may also result in loss of orders or order priority. Trading venues offering an electronic trading or order routing system typically adopt rules to limit their liability, the liability of member brokers and software and communication system vendors, and the amount that may be collected for system failures and delays, which rules vary among the venues. In addition, changes in laws or regulations related to electronic trading and order routing systems are currently being considered in certain jurisdictions. Any such changes could have a material adverse effect on certain strategies deployed by the Adviser.
Reliance on Technology; Cybersecurity; Back-up Measures
The Adviser’s investment activities and investment strategies are dependent upon various computer and telecommunications technologies, many of which are provided by or are dependent upon third parties such as data feed, data center, telecommunications, or utility providers. The successful deployment, implementation, and/or operation of such activities and strategies, and various other critical activities of the Adviser on behalf of its clients, could be severely compromised by system or component failure, telecommunications failure, power loss, a software-related “system crash,” unauthorized system access or use (such as “hacking” or other cybersecurity breaches), computer viruses and similar programs, fire or water damage, human errors in using or accessing relevant systems, or various other events or circumstances. Such events or circumstances may affect the Adviser directly and/or may affect one or more third parties (including Arcesium and any third-party administrator to a Fund) that provide services to the Adviser and/or its clients. It is not possible to provide comprehensive and foolproof protection against all such events and circumstances, and no assurance can be given about the ability of the Adviser or any third party to continue providing applicable services. Any event or circumstance that affects the Adviser’s or one or more third party’s computer and/or telecommunications systems or operations (including systems or operations at co-location sites or other locations not controlled by the Adviser) could have a material adverse effect on the Adviser’s clients, including by preventing the Adviser from trading, modifying, liquidating, and/or monitoring its clients’ Investments. Moreover, any unauthorized access to the information systems of the Adviser or certain third parties could result in the loss, disclosure, or improper use of tangible or intangible property of the Adviser, its affiliates, or its clients, information relating to Investments, and/or personally identifiable information of the Adviser’s clients or underlying investors in the Funds; any such loss, disclosure, or use could have a material adverse effect on such clients or investors. The Adviser maintains back-up electronic books and records at their disaster recovery site, which is a fully operational data center facility. In the case of events that interrupt the Adviser’s computer and/or telecommunications systems or operations, the Adviser hopes to resume trading, modifying, liquidating, and/or monitoring its clients’ Investments relatively promptly, subject to any circumstances that are outside the control of the Adviser. In the case of severe business disruptions (e.g., regional power outage or loss of personnel), the Adviser may not resume such activities for one or more business days because (among other things) such resumption is dependent on other critical business constituents, such as brokers and exchanges, and on the nature of the disruption. Although the foregoing reflects the Adviser’s objectives, designs, and/or plans, no assurance can be given that these objectives, designs, and/or plans will be realized, or that, in particular, the Adviser would be able to resume operations following a business disruption, and any such disruption could have a material adverse effect on the Adviser’s clients.
Currencies
Client accounts generally will be denominated in U.S. dollars. Therefore, investments in such accounts generally will be subject to fluctuations in the value of a client’s own domestic currency relative to the U.S. dollar. With respect to certain of its clients’ portfolios, the Adviser expects to recommend Investments that are denominated in currencies other than U.S. dollars, and there generally would be no limit on the portion of Investments that may comprise such Investments. In addition, the Adviser may cause such portfolios to make investments in, or otherwise hold, non-U.S. currencies themselves. As a result, a client may be exposed to currency risks, including the risk of fluctuations in the value of the applicable currency relative to the U.S. dollar. The occurrence of any such currency risks could have a material adverse effect on such client. The Adviser may or may not seek to hedge such exposures, and there can be no assurance that any such hedging would be feasible or, if undertaken, would reduce applicable risks. A client may also incur costs in connection with hedging against currency exposures and conversions between various currencies.
Leverage; Financing
Certain of the strategies deployed by the Adviser may be highly dependent on the use of leverage for their success, and certain clients are expected to employ financial leverage (which may be substantial) in connection with their investment and other activities. Further, with respect to certain of its strategies, the Adviser intends to use instruments (including futures, swaps, options, and other derivative instruments) that, if such instruments were to decrease in value, could result in losses exceeding the capital allocated to them. In addition, the Adviser may cause certain clients to buy certain Investments on margin and/or to enter into swaps or other derivative instruments to enhance leverage or for any other reason. The amount of leverage employed by clients is determined by the Adviser. The Adviser may cause a client to employ leverage up to the maximum amount permitted by the terms of the applicable Governing Document, by applicable law and regulation, and by the persons extending credit or otherwise providing leverage to the client. Only a limited amount of the leverage employed by a client may be apparent from the balance sheet or other financial statements of the client, and it is possible that a large portion (and possibly a significant majority or more) of the leverage employed would be effected through off-balance sheet transactions or methods, such as total return swaps (which can offer leveraged exposure to the reference instrument). A client may incur potentially significant expenses, including interest charges and commitment fees, in connection with any leverage that it uses, and the client’s returns will be reduced by such expenses. In addition, the rights of any lenders to a client (including a client’s prime brokers) to receive payments of interest, additional margin, or repayments of principal generally will be senior to the rights of the client’s underlying investors, and the terms of any such borrowings or arrangements may restrict certain activities of a client, including the client’s ability to make distributions. Leverage will increase the volatility of the performance of the client investments and, as a result, will increase the volatility of returns. Although the use of leverage may have the effect of increasing returns to a client (or in the case of Funds, to underlying investors) in the event of favorable investment results (to the extent the effect of such leverage is larger than the related costs incurred), and investment losses and other losses will be exacerbated by leverage and may be substantial losses, possibly including losses exceeding the total value of the assets of a client). Notwithstanding the foregoing, there can be no assurance that clients will be able to borrow money, use margin, or engage in any financing transaction in order to obtain and/or employ leverage. Events in the global financial markets in recent years have decreased the availability, and increased the cost, of certain forms of financing. Further, a client may not be able to obtain leverage and/or other financing, whether at a reasonable cost or at all, in the event that the Investments held by the client are not sufficiently diversified. Any inability of a client to obtain, employ, and/or maintain leverage or other forms of financing, whether at a reasonable cost or at all, would be expected to result in (possibly materially) lower returns to the client than had the client been able to obtain, employ, and/or maintain such leverage or other financing at a reasonable cost. Conversely, the Adviser may determine to obtain financing for clients despite the substantial costs or other onerous terms of that financing. By way of example, should a client require capital on an emergency basis, such as when that client is suffering substantial losses, the Adviser may agree to “rescue financing” on terms that are significantly favorable to the lender. Any such arrangement could have a material adverse effect on a client.
Derivative Instruments
In certain circumstances, the Adviser may cause its clients to trade derivative instruments. Derivative instruments are financial instruments that derive their performance, at least in part, from the performance of an underlying asset, index, interest rate, or other reference instrument. Examples of derivative instruments include swaps, futures, forwards, options, warrants, options on futures, and swaptions. To the extent such Investments are consistent with the applicable client’s investment objectives, the Adviser will have authority to trade all types of derivative instruments on behalf of such client without limitation other than any limitations imposed by applicable regulations and/or by the client’s counterparties and clearing brokers. Investments and trading in derivative instruments are generally highly speculative and involve various risks that are different in certain respects from, and are possibly greater than, the risks associated with investing directly in the applicable underlying assets or reference instruments. Examples of various risks associated with derivative instruments include market risk, complexity, a high degree of leverage, illiquidity, the absence of reliable price quotes and/or a reliable trading market, unstable correlation between a derivative instrument and the underlying asset or reference instrument, volatility, tax risk, government intervention to influence prices, legal or regulatory uncertainty, insider trading by other market participants, and non-performance of counterparties (including direct or central counterparties). A decrease in the value of the derivative instruments held by a client of the Adviser could result in losses exceeding the capital allocated to them. Further, because trading such derivative instruments often requires amounts of capital that are small relative to the instruments’ notional value, such trading may result in leveraging effects for such client’s overall portfolio. In addition, agreements that govern the Adviser’s investments in derivative instruments typically impose obligations on the Adviser or the applicable client. Under such agreements, a failure to observe such obligations (e.g., a failure to meet a required margin call) may result in the declaration of an event of default, which could permit the counterparty to exercise a range of remedies, possibly including the ability to unilaterally terminate Investments governed by such agreements and to require the Adviser’s client to pay such counterparty the replacement cost of the terminated Investments based on prices determined by such counterparty, which may be materially different than market prices. Such agreements also typically include payment or valuation provisions that require determinations by a calculation agent or a valuation agent (typically the dealer). If the Adviser is unable to negotiate favorable terms for such provisions or rights to dispute such determinations, the counterparty may have rights to make determinations that materially adversely affect the applicable Investments. Trading derivative instruments might deprive a client of certain tax benefits obtained from trading the underlying assets or reference instruments and/or, with respect to over-the-counter derivative instruments, from trading otherwise similar exchange-traded instruments. Trading in options or warrants involves a risk of loss related to the premium for the option or warrant as well as a risk of loss related to the value of the underlying security or instrument, which loss in either case could be substantial. The writing of an uncovered option by a client may result in an unlimited loss of a client’s capital within a relatively short period of time. Trading in futures contracts and options on such contracts may be subject to limitations imposed by regulatory authorities and relevant exchanges that may prevent a client from liquidating positions and could subject such client to substantial losses. Many derivative instruments, including forward contracts and options on forward contracts, are not traded on exchanges and are generally not regulated. The regulation of derivative instruments is evolving, and changes in such regulation may materially adversely affect Investments in client portfolios. For example, several U.S. and non-U.S. regulatory authorities have adopted, and other regulators have proposed or considered, rules for oversight and/or regulation of the previously largely unregulated market in over-the-counter derivatives.
Debt Investments
The Adviser is expected to cause certain clients to hold, structure, restructure, and otherwise acquire or dispose of bonds, loans, and other forms of indebtedness. The discussion in this section is based in part upon principles of U.S. federal and state laws. However, it is possible that a significant portion of a particular client’s portfolio will be invested in non-U.S. jurisdictions, and there may be no limit on the portion of such portfolio that can be invested in such Investments. With respect to Investments relating to non-U.S. borrowers, there can be no assurance that the laws of certain non-U.S. jurisdictions (and/or the consequences of such laws) would not result in different or additional risks.
General Risks; Default
In general, any Investments by a client of the Adviser in bonds, loans, or other forms of indebtedness will entail various market risks (i.e., the risk that certain market factors, including interest rates, credit spreads, and supply and demand imbalances caused by the activities of other market participants will cause the value of the applicable Investment to decline) and issuer-specific risks (e.g., the risk of non- payment of interest and principal; the risk that changes in an issuer’s credit quality causes the value of the applicable Investment to decline). Further, the Adviser may cause a client to invest in debt instruments that are currently in default or that may later experience events of default. Any default in payment under any debt instrument owned by a client of the Adviser may result in material losses to such client. Certain of the Adviser’s clients may also invest in pools of loans, which may be subject to additional risks, such as high correlation of the performance of the loans in any such pool.
Debt Market Conditions
Disruptions in debt markets have occurred in the past, including during the global financial crisis that began in 2008, and may occur in the future, possibly with greater severity and/or frequency. Any such disruptions may negatively affect a wide range of issuers and may increase the likelihood that such issuers will be unable to make principal and interest payments on, or refinance, outstanding debt when due. Moreover, the risk that such disruptions will affect an issuer’s ability to pay its debts and obligations when due is enhanced if such issuer in turn provides credit to third parties or otherwise participates in the credit markets. In the event of a default by an issuer, the Adviser’s clients could lose both capital invested in, and anticipated profits from, any affected Investment. The reoccurrence of the events described in this paragraph, or other similar or dissimilar events, could have an adverse impact on the availability of credit to businesses generally and may lead to an overall weakening of the U.S. and other economies around the world. In addition, any disruptions of this kind may affect a client’s ability to procure its own financing arrangements and/or the terms of any such arrangements.
Secured Loans; Unsecured or Subordinated Loans
Certain clients of the Adviser may invest in loans secured by property of the borrower. Investments in such loans are subject to the risk that some or all of the underlying collateral will decrease in value to an extent that the value of such collateral is insufficient to satisfy the borrowers’ payment obligations under such loans in the event of a default. Measures taken by the Adviser to protect clients’ interests in loans in which they may invest, including the validity or enforceability of such loans and the creation and maintenance of the anticipated priority and perfection of applicable security interests, may prove to be inadequate. There can be no assurance that any collateral would be sufficient to cover the obligations being collateralized or the amount of a client’s investment. Any collateral may decline in value; may be subject to competing claims of creditors; may be difficult to recover or sell due to legal, regulatory, or other reasons; or otherwise may be inadequate to allow a client to recoup its investment. The Adviser may cause certain clients to invest in loans that are secured with a junior priority interest or lien on collateral that is subordinated to senior secured obligations. Such loans are subject to a risk that the cash flow of the related borrower and the collateral securing such a loan may be insufficient to make scheduled payments after giving effect to any obligations in respect of the senior secured loans of the borrower. As a result, in certain situations little or no recovery may be available following a default with respect to such a loan. Such loans are also expected to be less liquid than senior secured loans. Such loans are intended to be senior in right of payment and priority to any unsecured obligations, but the priority of such loans could be challenged, whether in bankruptcy court or otherwise. Any successful challenge could have a material adverse effect on the value of the applicable Investment. Finally, the Adviser may cause a client to invest in various types of unsecured indebtedness (such as senior unsecured, subordinated, or general indebtedness) that would be junior in priority to the claims of secured creditors. The claims of secured or senior creditors may exhaust some or all of the assets of a borrower before unsecured, subordinated, or general creditors may participate in such assets, thus materially adversely affecting the value of the applicable Investment.
Lender Liability; Equitable Subordination; Fraudulent Conveyance
Investments structured as loans or other forms of indebtedness may subject clients to claims of lender liability and/or may be subject to claims of equitable subordination or recharacterization. The risk of such claims may be exacerbated if a client holds a significant equity position and/or certain management positions (including representation on the board of directors) with respect to the applicable borrower. It is also possible that such claims could arise without the direct involvement of a client or the Adviser with the applicable borrower. Any successful claims of lender liability against a client or any equitable subordination or recharacterization of any Investment (which may result in the claims of a client being subordinated to the claims of certain or all other creditors) could have a material adverse effect on such Investment held by a client (possibly resulting in losses that exceed the value of such Investment) and thus on the client itself. Investments structured as loans or other forms of indebtedness may also be subject to claims of fraudulent conveyance if the borrower was insolvent or rendered insolvent. Any successful claims of fraudulent conveyance or preferential payment with respect to an Investment could have a material adverse effect on such Investment and, possibly, on a client, and the client and/or one or more of its underlying investors may be required to return related payments and could experience losses that exceed the value of such Investments.
Certain Additional Risks
Certain loans in which the Adviser may cause a client to invest may be subject to additional obligations, including intercreditor agreements (pursuant to which certain creditors agree to restrictions on their rights) or future extensions of credit to the borrower. Such obligations may materially adversely affect the value of such loans, such as by limiting the ability of the applicable client to exercise its rights under a loan agreement or by increasing such client’s exposure to the borrower.
Asset-Backed Securities
The Adviser may cause certain clients to invest directly or indirectly in asset-backed securities, which are structured securities collateralized or backed by another asset or assets, such as residential or commercial mortgages, home equity loans, auto loans, student loans, installment sale contracts, credit card receivables, business loans, investment-grade or high yield debt, or a mix of such assets. Asset-backed securities may include instruments such as commercial mortgage-backed securities, residential mortgage- backed securities, collateralized mortgage obligations, collateralized bond obligations, collateralized debt obligations, and collateralized loan obligations, and may include synthetic structures that are backed by derivative instruments instead of by the relevant loans, bonds, or other assets themselves. Other types of asset-backed securities, including interest-only, inverse interest-only, and principal-only securities, may participate in only certain types of income streams generated by the underlying assets. Asset-backed securities are often extremely complex, and their values and returns may be subject to significant fluctuations as a result of relatively small changes in interest rates; the rates of prepayments, defaults, or late payments with respect to the relevant underlying assets; or other factors. The value of an asset-backed security is highly dependent upon the performance of its underlying assets and upon the expected quality of the underlying assets. Substantial leverage may be inherent in the structure of some asset-backed securities. Consequently, asset-backed securities may present a greater degree of risk than other types of fixed income securities and may be more volatile, less liquid, and more difficult to price accurately than less complex securities. The Adviser may recommend hedging transactions in certain circumstances to protect against interest rate movements, prepayment risk, defaults, or other factors, but there can be no assurance that such hedging transactions, if any are undertaken, would fully protect a client against such risks. Asset-backed securities are typically separated into tranches representing different degrees of credit quality, with lower-rated tranches being subordinate to senior tranches. It is expected that the returns on the junior tranches of such securities would be especially sensitive to the rate of defaults in the collateral pool and would be subject to a substantially greater risk of non-payment than would senior tranches of such securities. There are no restrictions on the tranches in which clients of the Adviser may invest. Because mortgage-backed securities comprise pools of underlying loans, such securities are subject to risks similar to those applicable to investments in particular mortgage loans. In addition, certain types of mortgage-backed securities contain highly complex interest-rate and cash-flow provisions and may be highly volatile with respect to yield, total return to maturity, and market value For example, a mortgage- backed securities position may experience losses due to defaults in one or more underlying mortgage loans, but it may be difficult to assess the extent of such losses because the resolution of such defaults may occur only after extended settlement negotiations, or after the foreclosure and subsequent liquidation of the underlying properties, which could take a significant period of time. Asset backed securities backed by other types of loans may be subject to similar risks. Even though assets typically support the underlying loans, full recovery of a loan in the event of default may not be possible due to litigation costs or delays, legal uncertainties, limited marketability or reduced valuations of the asset, and other similar or dissimilar factors. Accordingly, any defaults may materially adversely affect an Investment in asset-backed securities. In addition, the quality of certain asset-backed securities in which clients of the Adviser may invest is subject to the accuracy and completeness of representations made by the borrowers under the underlying loans. Accordingly, clients of the Adviser that invest in asset-backed securities are subject to the risk that originators of certain such securities fail to adequately verify such representations, whether because of defects in the verification systems used by such originators or otherwise.
Sovereign Debt
Certain clients of the Adviser may make Investments in sovereign debt instruments. Certain sovereign issuers have in the past experienced substantial difficulties in servicing their external debt obligations, which has led to defaults on certain obligations and the restructuring of certain indebtedness. Countries in which clients of the Adviser may invest may experience high rates of inflation, high interest rates, exchange rate fluctuations and currency devaluation, large amounts of external debt, balance of payments and trade difficulties, political and/or social uncertainty and instability, and/or poor economic performance or conditions. Any of these factors, as well as other factors, could materially increase the risk of a total or partial default by such sovereign issuers and/or the risk of the restructuring of all or certain indebtedness of such sovereign issuers, either of which may result in substantial losses for the Adviser’s clients.
Distressed Debt and Other Investments
The Adviser may cause certain clients to make investments in instruments issued by or otherwise related to companies that at the time of the applicable investment are experiencing, or subsequent to the applicable investment do experience, various forms of financial, business, operational, legal, and/or other distress or impairment, including companies involved in bankruptcy or other reorganization or liquidation proceedings (collectively, “Reorganization Proceedings”), as well as those emerging from Reorganization Proceedings and those seeking financial restructurings or reorganizations outside such proceedings. These Investments involve a high degree of risk that the total value of the applicable Investment may be lost. The Adviser also may cause clients to purchase from banks, other financial institutions, or other investors bank loans (whether through assignment or participation transactions) and other forms of direct or indirect indebtedness (including revolving loans and letters of credit) of distressed companies. Investments in loan participations would expose a client to risks related to the creditworthiness of the banks or other financial institutions issuing such participations. As a holder of participation interests or as a member of a loan syndicate, such client may not be able to assert any rights against the borrowers of the underlying indebtedness and may need to rely on the financial institutions issuing the participations or the lead or agent bank to assert such rights. These financial institutions and banks may have reasons not to assert their rights, whether due to a limited financial interest in the outcome, other relationships with the borrowers, the threat of potential counterclaims, or other reasons. The Adviser also may cause clients to purchase bankruptcy claims (including trade claims), which are amounts owed to creditors of a distressed company. Investments in bankruptcy claims are difficult to value. Moreover, bankruptcy claims generally are illiquid and non-interest-bearing, and there can be no assurance that a company will be able to satisfy its obligations under a claim. Sophisticated financial and legal analysis is required to invest successfully in distressed companies, and there can be no assurance that the Adviser will adequately perform such analysis. Among other things, the Adviser may not correctly determine the value of the collateral (if any) supporting the Investments held by a client or the prospects for a successful reorganization or similar action. Such Investments may be subject to additional risks, such as significant volatility in the value of the Investment; the involuntary exchange of such Investments for cash, financial instruments, or other property (including illiquid Investments) having substantially less value than the original Investment; and/or delayed or extended payment for such Investments. In addition, Reorganization Proceedings, as well as other financial restructurings or reorganizations, are subject to a number of risks. For example, such proceedings may be of uncertain duration; may be subject to unanticipated and possibly lengthy delays; may involve substantial legal, professional, and administrative costs to the reorganizing company and its investors; may involve other factors that are beyond the control of the reorganizing company and its investors; and/or may result in the liquidation of the reorganizing company. Further, the Adviser, on behalf of a client, may decide to become involved in the restructuring of a particular distressed company, including through representation on creditors’ or equityholders’ committees or other groups (whether formal or informal) and participation in litigation or direct negotiations with the company’s management, each of which may involve special risks and/or conflicts of interest for a client. The occurrence of any of these risks could have a material adverse effect on the value of the applicable Investment or on the Adviser’s ability to dispose of or to act to protect the value of such Investment. Administrative costs related to Reorganization Proceedings may be substantial and generally are paid from the reorganizing company’s assets prior to any payments to creditors or equityholders. Certain other claims, including claims for taxes, have priority by law over claims of creditors and equityholders. Such administrative costs and other claims could materially reduce the return to the Adviser’s clients on a particular Investment.
Low Creditworthiness Investments
A (possibly substantial) portion of the Investments held in connection with certain of the Adviser’s investment strategies may, whether at the time of investment or at a later time, be unrated; rated below “investment grade” by recognized rating agencies; and/or defaulted. Unrated, sub-investment-grade, and defaulted Investments generally involve greater risk of loss in either a short or a long position than do investment-grade Investments. For example, the market values and yields of unrated, sub-investment- grade, and defaulted Investments generally react more dramatically to changes in general economic conditions, in the levels of interest rates, and in the financial condition and prospects of their issuers than do those of more highly rated Investments. During periods of economic downturn (and potentially during other periods), issuers of unrated, sub-investment-grade, and defaulted Investments may experience, to a greater degree than issuers of more highly rated Investments, certain forms of financial stress that could materially adversely affect such Investments. Adverse publicity and investor perceptions, whether based on fundamental analysis, market rumors, distress of related issuers, or other sources, may materially adversely affect such low creditworthiness Investments. Adverse effects on long positions in these Investments include the increased probability of default, the decreased value of any recovery in connection with a reorganization proceeding, decreased secondary market prices (if any) for these Investments, and general decreases in the liquidity of these Investments. The secondary market for these Investments is concentrated among relatively few market- makers or investors and may be expected to be less liquid than the secondary market for Investments that have higher ratings or are issued by non-distressed issuers. In addition, the lower liquidity of unrated, sub-investment-grade, and defaulted Investments, as well as other factors outlined above, could exacerbate the risks of short positions in these Investments.
Credit Ratings
Certain of the bonds, loans, or other forms of indebtedness in which a client of the Adviser may invest may receive ratings from Moody’s, Standard & Poor’s, Fitch, or another credit rating agency. No assurance can be given that ratings assigned by a credit rating agency will not be withdrawn or revised downward if, in the view of such credit rating agency, circumstances so warrant. Any such withdrawal or downward revision with respect to an Investment could have a material adverse effect on such Investment. Such ratings reflect only the views of those credit rating agencies, which views may prove inaccurate, and the Adviser is not obligated to obtain such ratings or to provide any such ratings to its clients (or, in the case of Funds, to underlying investors).
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