Michael Durante Western Reserve 4Q07 Letter

1. Fourth Quarter 2007 December 31, 2007
100 Crescent Court • Suite 400 • Dallas, Texas 75201
YTD
Oct-07 Nov-07 Dec-07 4Q07 2007
WRHE Gross 1.2% -8.9% -5.3% -12.7% -14.7% 25.4%
WRHE Class A, Net1
0.8% -7.2% -4.3% -10.4% -13.0% 14.8%
WRHE Class B, Net1
0.9% -7.5% -4.5% -10.8% -13.4% 15.3%
1
Class A shares are subject to a one year lockup and a 20% performance fee; Class B shares are subject to a three year lockup and a 17% performance fee.
Inception
to Date
“Flight to Simplicity”
-- Warren Buffett
Dear Partners:
Western Reserve Hedged Equity, LP (the “Fund”) posted a difficult year. We saw the excesses
in housing and mortgages and stayed well clear since mid 2005. And the Fund performed well in
2006. In 2007, the expected collapse in subprime mortgages unexpectedly reverberated across
all credit markets, causing irrational pricing of non mortgage financial assets, sectors and
services providers, setting the stage, we believe, for a bull market in financial related stocks not
seen in decades.
• Subprime has dragged down valuations for most financial assets well below intrinsic
value and there are incredible bargains in the carnage
• The best investing opportunity in financials in nearly twenty-years is developing
• New accounting rules and inefficient synthetic secondary market substitutes may be
overstating losses on some asset classes
• Risk discounting is over done. As one trader put it, “it’s been a truly terrifying
market for the financials…makes the Russian ruble crisis not look so bad.”
The year just past ranged from the sublime to the ridiculous. Iowa farmland became more
valuable than the Florida coastline and the world’s most prestigious banks became worth less
than a rock quarry in New Caledonia. The default insurance premium on many financial firms
now price higher than that of Pakistan. Selectively, some of this was deserved, but most of this
was irrational and financials under performed the broad stock market en mass and by the widest
margin (almost 30%) in the post WWII era, pressuring most service economy sectors. Some
patience may be required amid near term economic paralysis over this, but there’s marvelous
opportunity in the ubiquity of the purge just the same.
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

2. December 31, 2007
We remain committed to bottom-up, fundamental research and believe a market ignoring
intrinsic franchise values is an opportunity owing to the abject fear. Current valuations now echo
the lowest since the two prior post WWII lows of 1961 and 1990. For smaller capitalization
financials, they collapsed to the lowest valuations recorded (the average small cap financial fell
over 40% in 2007). While so-called “bottoms” are a process and not an event per se, it is well
underway and we are in position to take advantage with sufficient cash to put to work.
We suspect Buffett captured it best recently – “flight to simplicity”. The universal purging of
financial stocks didn’t make fundamental sense as much as it relieved a ‘brain ache’ to investors
not encouraged to figure out who was guilty or innocent in light of the subprime mortgage hot
potato being tossed around and these seemingly endless ‘mark-to-market’ accounting-based
write-downs by the large investment banking houses, the GSE’s and a few banks here and there.
Rating agency Moody’s recently captured the sentiment well - “this is not a credit crisis as much
as it is a loss of confidence”. Panic has caused tens of billions in perfectly performing loans
across many asset classes to be repriced to highly illiquid, recently invented synthetic secondary
market derivatives which represent a fraction of the credit outstanding in the financial system.
Most troubling is that these newly created synthetic derivatives were designed for single
direction investing – short. By early 2009, we expect write-ups by many a bank forced to
arbitrarily write-down performing loan pools caught in the present ‘mark-to-market’ accounting
madness.
Amid the securitization freeze, financials with well capitalized and solid balance sheets already
are putting loans on the books with ROE’s that may exceed 25% or more. The Street is pricing-
in a depression and is unwilling to consider the eventual recovery fueled by the powerful
combination of multi-decade low valuations, a steepening yield curve, wider credit spreads and
high ROE loan production. Many missed the great bank stock bull market of the nineties, when
fear and universal under investment in financials last reached this level of despair (1991).
M-E-I-T = M=Materials; E=Energy; I=Industrials; T=Cyclical Technology; ex- M-E-I-T = Services, Financials and Consumer
Source: Banc of America Securities
2005 2006 2007
92
96
100
104
108
112
Gold@
Indexed
S&P 1500 M-E-I-TSectors (639 Companies)
S&P 1500 ex- M-E-I-TSectors (861 Companies)
100 Crescent Court • Suite 400 • Dallas, Texas 75201
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

3. December 31, 2007
While earnings fundamentals didn’t suffer across our largely non credit, financial processing
universe, the stocks did. Avoiding troubled areas wasn’t good enough and we experienced
material multiple contraction previously seen only a few times in the past sixty years. We
continue to hunt for asset classes and services providers unaffected by the housing malaise at
increasingly bargain bin pricing. We no longer are “accidental contrarians”. We have found
values that astonish us. Profitable firms with considerable dividends and excess capital trading
well below book value are not hard to find and willing sellers abound.
Current short interest across small cap financials is four times the normal as concerns that most
credit needs to be written down by material discounts to par value to match the derivatives
market proxy for a secondary market. If this were the case, then even these mostly performing
loans (>98% of all loans) require yields in excess of 25% to price at ‘fair value’. We think such
valuations are ridiculously dire. If the banks were forced to ‘mark-to-market’ all credit against
these illiquid derivative proxies, then regulators would have to close down the entire US banking
system for capital inadequacy. We’re not buying that as ‘fair market value’. We believe the
‘mark-to-market’ problem is overly influenced by new accounting standards and inefficient
derivatives markets, creating a problem multiples of the troubled loans that set-off the panic.
“The situation is exacerbated by changes in accounting rules. [Banks] have to mark their
portfolios to a market based upon psychological perceptions of the loan’s value. If banks had to
do this in prior cycles, none would have survived. And yet, they survived because they don’t lose
the money everyone thinks they will lose.” – Richard Pzena, Barron’s 12/31/07
Unexposed financials have been grossly and blindly sold. Patience is the hard part now as
emotion/fear has the edge presently. “Sound” financial firms and banks will benefit from the
increasingly more aggressive actions taken by the Federal Reserve we see in the coming months
and will be more competitive with the securitization market on a very slow heal. Hint: we have
added some very strong balance sheets in traditional banking of late long.
Subprime mortgage losses are expected to run between $150 and $300 billion. Goldman Sachs
seems to have the best feel for subprime on the Street these days and they peg ultimate losses at
roughly $240 billion. Citigroup, JP Morgan and Banc of America (neither of which the Fund has
been involved with (yet?)) have lost a combined $300 billion in market capitalization alone. We
estimate financial stock losses exceed $1.3 trillion or more than thrice the actual worst case
expectations for loan losses.
Some AAA mortgage bonds now trade around 80c to par, which implies losses will exceed 50%.
However, >80% of even subprime loans remain current. 50% loss expectations imply 100%
foreclosure and 50% severity (home price decline) or 50% foreclosure and 100% loss on the
house. These secondary market “marks” now are mathematically challenged against probable
outcome due to the crowded nature of the overwhelming short finance trade.
The only point we make is that current risk pricing may be more a function of panic and loss of
confidence on the one end and greed for heretofore easy short gains than potential reality at these
valuations on the other. Subprime is a mess to be sure, but we have priced in outcomes across
multiple asset classes outside subprime that have such low outcome probability that it cannot be
ignored by deep value hunters. Outside mortgage banking, the bargains are a plenty. And even
100 Crescent Court • Suite 400 • Dallas, Texas 75201
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

4. December 31, 2007
inside mortgage banking, things are getting interesting. A key catalyst will be getting the bond
insurance sector recapitalized and we suspect this will take place relatively quickly. Current
speculation is that Buffett’s Berkshire Hathaway is eyeing the group to privatize.
Among our top picks are prime mortgage REITs that benefit from Fed action and several
derivatives market makers and exchanges benefiting from the panic and heightened volatility.
We have a REIT asset manager trading hands at just 3x cash flow or half its peer group and
yielding over 7%. We also favor several financial processing firms both on-shore and off-shore.
But, it’s the small regional banks with clean balance sheets and loan capacity that are in pole
position to help fuel sound growth outside of housing and an absent securitization market for the
time being. We are long more traditional banks for the first time in years. And we our
monitoring closely the financial firms, such as financial guarantors, mortgage insurers, and other
firms squarely in the mortgage mess priced for depression. We suspect some incredible
opportunities will present themselves as they shore-up capital. This is not the end of Western
civilization.
Financial stock funds and distressed debt funds will find themselves like kids in a candy store as
we approach the spring-summer. Unwinding four-times the normal short interest in small cap
financials could send the sector into orbit, while those forced to actually sell loan pools at these
overly depressed secondary market prices will create fortunes for distressed credit players.
In 1990, many said it would take ten years to “fix’ the financial system. Such comments are
echoed today. What really matters is getting the bad loans circled, written-off and those
institutions that need capital infusions to get that done too. This process is well under way
already as we see sovereign funds, hedge funds and private equity funds investing in large US
financial institutions almost daily. This does parallel 1990 when the Saudis invested in then
beleaguered Citicorp.
Kuwaiti fund eyes US subprime bargains. Financial Times reports The Kuwait Investment Authority is
following its peers in the Middle East in the hope of finding bargain investments in the US in the wake of the
subprime mortgage crisis. The $213 bln sovereign wealth fund is particularly interested in opportunities in
financial services. "Perhaps we are at the eye of the storm now and are close to the peak of the problem,"
Bader Al-Sa'ad, head of the KIA, told the Financial Times. "We don't see prices dropping much more." Mr
Al-Sa'ad said he intended to speed up decision-making at the KIA to take advantage of the opportunities
thrown up by the crisis. "With Citi, the Abu Dhabi Investment Authority had good timing," he said, noting
that it took ADIA less than three weeks to seal its late November deal to invest $7.5 bln in convertible
securities in Citigroup. "I believe we need to move faster in some of our response time."
Peak-to-trough devastation in the financials lasted exactly twelve months (from September 1989
to October 1990). We are getting through the credit crunch/mark-to-market inefficiencies and a
100 Crescent Court • Suite 400 • Dallas, Texas 75201
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

5. December 31, 2007
back-up the truck opportunity in the financials seen every few decades is prepping itself. The
demolition in the financials this time around began in February 2007 with the demise of New
Century Financial. As a percentage of GDP, this crisis is half the size of the eighties’ credit
debacle, barring a major mistake from the Federal Reserve. Certain mortgages ain’t pretty, but
97.5% are still current.
Small cap financials are on ‘fire sale’ right now with valuations ranging 15% to 80% of book
value and financial technology and processing stocks at 3x to 6x cash flow. The survivors,
which will be most of them, will double in value to get back to “cheap”. And large cap
financials like JP Morgan and Bank of America et al will rise 50% just to get back to
“undervalued” as credit markets mend. We think a steeply sloped yield curve and eventual
cessation of write-offs and reserve builds by 2H08 could add even more earnings power than the
increasingly pessimistic cuts by Street analysts presently. A recent poll of multiple Street
analysts by us suggests the towel has been thrown-in. This is good news.
Small caps in general went through a very rough relative bear market in the late nineties. When
asked by Barron’s if small caps would ever out perform again, a former mentor of mine replied
simply – “yes”. The Barron’s reporter, astonished at the simplicity of his answer inquired
“why?” “Greed” was his reply. I’m with Buffett on this one – simplicity. Markets are
irrationally despondent and financials are the best value around. ‘Greed’ is the other simple
emotion we can think of, while much of the ground on that other emotion has been well covered
now…
Western Reserve Hedged Equity, LP
Cumulative Performance Since Inception (Gross)
-20%
-16%
-12%
-8%
-4%
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
48%
52%
56%
60%
Western Reserve Gross
Western Reserve Net (Class A)
SMID Cap Services Composite
As for Iowa replacing California and Florida as the most migrated to and valuable state? We’ll
just have to see. As one can see above, it’s been a very negative environment for a fund strategy
focused just on the services economy. Our comparative services index is down nearly 20% since
we launched the Fund. While our returns have been disappointing relative to our longer history
in the services space, this is an unprecedented opportunity in an exceptionally out-of-favor space.
Interestingly, petrodollars aren’t buying farmland, but they are investing in America’s top
100 Crescent Court • Suite 400 • Dallas, Texas 75201
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

6. December 31, 2007
financial firms. They will lead us out of this downturn and become the next great investment
opportunity globally.
Regards,
Michael P. Durante
Managing Partner
100 Crescent Court • Suite 400 • Dallas, Texas 75201
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

7. December 31, 2007
Long
Short
Total (Gross)
Total Class A (Net)
2
Total Class B (Net)
2
Long
Short
Total (Gross)
Total Class A (Net)
2
Total Class B (Net)2
Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
2007
YTD
Inception
To Date
3
WRHE Gross 3.1% -3.8% -1.8% 1.9% 1.5% -6.2% -3.2% 2.7% 4.1% 1.2% -8.9% -5.3% -14.7% 25.4%
WRHE Class A Net 2.3% -3.2% -1.5% 1.4% 1.1% -5.1% -2.6% 2.0% 3.1% 0.8% -7.2% -4.3% -13.0% 14.8%
WRHE Class B Net 2.4% -3.3% -1.6% 1.5% 1.1% -5.3% -2.7% 2.1% 3.3% 0.9% -7.5% -4.5% -13.4% 15.3%
SMID Cap Services 1.0% -2.0% -1.4% 1.9% 3.3% -1.2% -6.5% 0.9% 2.1% 0.9% -6.2% -10.3% -17.0% -14.6%
Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06
2006
YTD
WRHE Gross 4.7% 2.7% 1.3% 0.7% -2.3% -0.2% -2.6% -0.1% 6.3% 4.2% 2.0% 2.3% 20.3%
WRHE Class A Net 3.6% 2.1% 1.0% 0.4% -1.9% -0.3% -2.2% -0.2% 5.0% 3.3% 1.5% 1.7% 15.0%
WRHE Class B Net 3.8% 2.1% 1.0% 0.4% -2.0% -0.3% -2.3% -0.2% 5.2% 3.4% 1.6% 1.8% 15.6%
SMID Cap Services 4.3% -0.2% 3.1% 1.0% -4.2% -0.8% -3.4% 1.4% 3.5% 3.5% 1.8% -6.1% 3.3%
Sector Long Short Gross Net
4% 4% 8% -1% Long Short
0% 0% 0% 0% 38% 27%
1% 7% 8% -5% 59% 46%
0% 0% 0% 0%
13% 3% 17% 10%
13% 6% 19% 8%
7% 1% 8% 6%
0% 4% 4% -4%
1% 1% 2% 0%
1% 0% 1% 1%
12% 5% 17% 7%
53% 31% 84% 22%
1
Freely tradable securities. Immaterial position sizes omitted.
2
Class A shares are subject to a one year lock-up and a 20% performance fee; Class B shares are subject to a three year lock-up and a 17% performance fee.
3
Western Reserve Hedged Equity, LP's inception date is January 1, 2004.
Full-Year 2006 Comparative Returns
2
Top 20 Positions
Healthcare Services
Transaction Processing
Cyclical and Industrial
Internet Services
Consumer Services
Quarter Ended
December 31, 2007
Performance Average Exposure
1
Trailing Twelve Months (TTM)
-15.7% 112%
0.2%
Percent of Directional Capital
Business Process Outsourcing
Performance Ending Exposure
1
-10.4%
Portfolio Composition (% of Capital)
31%
-10.8% 31%
Summary for the Quarter Ended
December 31, 2007
Western Reserve Hedged Equity, LP
Top 10 Positions
-13.7% -10%
0.6% 53%
-12.7% 22%
50%
-14.7% 162%
-13.0% 61%
Full Year 2007 Comparative Returns
2
-13.4% 61%
Financial Institutions
Government Services
Technology Services
Real Estate Services
Financial Services
Western Reserve Hedged Equity, LP
Cumulative Performance Since Inception (Gross)
-20%
-16%
-12%
-8%
-4%
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
48%
52%
56%
60%
D
ec
Feb
Apr
Jun
Aug
O
ct
D
ec
Feb
Apr
Jun
Aug
O
ct
D
ec
Feb
Apr
Jun
Aug
O
ct
D
ec
Feb
Apr
Jun
Aug
O
ct
D
ec
Western Reserve Gross
Western Reserve Net (Class A)
SMID Cap Services Composite
Please be advised that the past performance of Western Reserve Hedged Equity, LP (the “Fund) is not necessarily indicative of future results. Depending on the timing of a person’s investment in one of the Funds,
actual investment returns in the Fund may vary from the returns stated herein. Performance results are estimated, based on both audited and unaudited results, net of management and performance fees and
operating expenses. Such performance results assume that a partner invested in the Fund at the inception of the Fund and has not made additional contributions or withdrawals. There is no assurance that at any
time the securities held by the Fund will be securities which comprise any of the indices listed above, and the Fund may have substantial cash balances and investments in relatively illiquid securities at any time
when compared to the securities comprising a listed index. This report is provided for informational purposes only and is not authorized for use as an offer of sale or a solicitation of an offer to purchase investments in
the Fund or any affiliated entity. This report is qualified in its entirety by the more complete information contained in the Fund’s Confidential Private Placement Memorandum and related subscription materials. This
report is confidential and may not be reproduced for any purpose. Western Reserve Capital Management, LP serves as the Fund’s investment manager. Its Form ADV Part II and Privacy Policy are available to
investors upon request.
Historical Monthly Long/Short Exposure
0%
50%
100%
150%
Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07
Long Short Net
WESTERN RESERVE
CAPITAL MANAGEMENT, LP
100 Crescent Court • Suite 400 • Dallas, Texas 75201
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net