Michael Durante Western Reserve 3Q07 letter

Third Quarter 2007 October 16, 2007

100 Crescent Court • Suite 400 • Dallas, Texas 75201

YTDJul-07 Aug-07 Sep-07 3Q07 2007

WRHE Gross -3.2% 2.7% 4.1% 3.5% -2.3% 43.5%WRHE Class A, Net1 -2.6% 2.0% 3.1% 2.5% -2.8% 28.2%WRHE Class B, Net1 -2.7% 2.1% 3.3% 2.6% -2.9% 29.3%

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

The ‘Services Economy’ Issue That Other 80% of the Economy

Dear Partners: Western Reserve Hedged Equity, LP (the “Fund”) regained ground in a very difficult third quarter for services stocks (especially the battered financials) and has moved back to gains on the year through mid October. One of my early mentors warned that a client hires you to do just one thing – ‘beat an arbitrary benchmark not of your own choosing.’ On this front, we are not having a good 2007 (yet). Quite simply, our services-only focus is lagging the broader market due to our lack of exposure to cyclical and industrial stocks. Often, the market is this cut and dried (a “barbell”) in the propinquity of major inflection points. And we find ourselves “accidental contrarians” as this industrial stock bull market reaches its manic phase. Put simply, this is the best market for acquiring pure services-economy stocks in over a decade, as the pendulum is set to shift very quickly now. A strong contributor to our sentiment is that we currently see the best broad-based opportunity in financial services since 1991 due to the ongoing credit crisis. What market participants do not seem willing to explore is that tightening credit conditions are good for many financial firms (bad only for the abusers of the past cycle) and genuinely not so good for most capital intensive businesses such as industrials because the conditions quickly begin to cede pricing power back to the creditors. This credit shock is a reversal of fortunes and we spent the summer “upgrading” the portfolio by adding to financial babies drowned in the bathwater during the July and August credit panic. The material out performance of the fund in the third quarter relative to financials (small cap financials were down 15%-20% in the quarter and remain deep in the red for the year) is due to our avoiding truly troubled areas of finance and taking advantage of the market dislocation. The

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October 16, 2007

research team believes that we are sitting on the most profitable long book in Western Reserve’s history and, I believe, as compelling a “value” as I’ve seen at any time in the past fifteen years.

Quick Points

The credit crunch is positive for services stocks, even most financials, because their stable, recurring businesses are strengths re-discovered in deteriorating macro conditions. Valuations for services stocks discount much bad news and are compelling, while many cyclicals are expensive and discount economic perfection globally. The “global economy” is a revised version of the “new economy” and now will be tested by a synchronized slow-down. The China bubble watch is on… An inflection point is upon us. The Fed sees it. The bond market sees it. Equity traders do not yet. A reversion favoring higher quality investments could be of historic proportion.

The market for small and mid capitalization stocks has been one-sided this year with materials, industrials and cyclical stocks dramatically out performing services. Western Reserve continues to stay well ahead of our services end markets, and while our style discipline has positioned the Fund for tremendous out performance given valuations and fundamental trends, it also makes us contrarians amid the storm clouds forming over this formidable industrial stock bonanza of recent years. The risk has been wrung-out of services end markets stocks amid the beat-down in valuations and abandonment of the sectors. Value in small and mid cap growth and services stocks remains at historic troughs, and, in fact, we witnessed the best entry points for high quality growth stocks this summer seen a very long time. One would expect such valuation opportunity to be coincidental with an aggressive bull market elsewhere, so we see nothing new or unusual. In fact, it’s a patented barbell market at or near an inflection point. Most are piled in one way with the consensus. Merrill Lynch recently opined that “the ‘ultra contrarian’ trade is that the Fed is actually correct and economic growth is weakening considerably more than investors think. Declining earnings power across both industrial and consumer sector companies is the obvious evidence. So, whereas lower quality assets continue to rally in the short run, we continue to believe that stock market volatility will trend upward (a trend clearly in place) and that higher quality assets necessarily will emerge as the leadership of the next several years.”

100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax

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October 16, 2007

So, is the table set into a slowing economy and Fed policy shift? The Fund is profitably traveling through one of the most out-of-favor periods for pure services end markets and with valuations seen at decade troughs. We don’t believe any economic outcome can support the current bifurcation in the market for very long. So far, investors have continued to push the market’s leadership groups higher by continuously lowering expectations and thus creating their own “upside” surprises. Weak jobs growth is now strong and beating lowered guidance is positive. The credit market disruption started this summer is not transitory in our view. It marks a major inflection point in growth prospects globally. The excess liquidity environment since 2003 and the durable “goods” consumption binge in place for a protracted period of time is finally coming to an end. The “juice” behind the global “hard asset” boom driving emerging markets and commodities is at its most heightened risk into a ‘speculative blow-off’ in the underlying end market stocks and commodities. The debate over this now has turned into denial in our view. The “goods” sectors of the US economy remain weak and are getting weaker. While the overall economy continues to grow (thanks to “services”), manufacturing grew a scant 0.6% in the first half of the year and transport fundamentals such as trucking indicate “goods” may already be in recession year over year in the second half. Investors now are betting the manic phase of the industrial stock bull market all on China to offset deterioration on the home front. So far, it’s working well and the Chinese continue their CapEx binge. But things are getting really outlandish and investors quite unbalanced. Shares of Chinese so-called blue chips like PetroChina (PTR) are now worth more than the likes General Electric (GE) and Citigroup (C) in market value distortions comparable to the Internet in 2000. Five of the world’s ten largest stocks by market cap are Chinese now. China Life (LFC), at 20x sales and 10x book value, now sports a market value that is 1.5x greater than AIG (AIG). And when one eliminates the earnings gains from Chinese public company cross ownership in the stock market boom there (IPOs), the Shanghai stock market trades at 88x “operating” earnings. Blue chip technology firms also sported heady gains from cross ownership in an IPO boom once too. Shanghai leads the world right now in new IPOs and the risk of a reverse “wealth effect” in China in the future is rising. With durable consumption weakening considerably in the G-7, the industrial/commodity trade now would appear totally dependent upon China holding-up, which they certainly have to date. Yet, China, last we checked, was still an upstream supplier to the slowing end market G7 led by the US (one strike) and has worrisome characteristics building that are undeniable (strikes two and three coming?)…

• China core consumer inflation has risen 4 fold in the past 18 months and Chinese central planners may have to get serious soon.

• China’s monetary base is growing almost 20% annually. The resulting liquidity is causing rampant CapEx spending into the end market slow-down in the West.

• China’s government subsidizes oil prices (and other inputs) for the state-owned industrial complex which suggests China’s competitive advantage (low costs) is over stated should they cede to growing calls for them to float their currency and eliminate subsidies.


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October 16, 2007

Why is China important to Western Reserve? It’s the sole cause for market capital to be flowing away from other, higher quality investment options in a manner eerily similar to the tech bubble when nothing but technology stocks worked at the end. We see capital flows redirecting in a shake-out. This will favor our under priced portfolio. Let’s get into the portfolio… Too little attention in our view is given to the magnitude of multiple expansion or contraction in stock groups as they “travel” in and out of “favor” with investors at any point in time. The accompanying table highlights that the past few years have showered small and mid cap industrial/cyclical stocks with heady multiple expansion. Conversely, small and mid cap services and growth end market stocks have been sold consistently to “pay” for the lavish multiple expansion in industrials, thus creating extraordinarily under valued earnings. The result is a very inefficient market today where quality and growth are severely under priced and cyclicals are priced for perfection. And we don’t hear much chatter about this out there…

Company/Stock

2yr EPS Growth

2yr Stock Return

Multiple Expansion

Sample of Western Reserve “Services” Longs Payment Processor E 34% 3% (30%) Auto Lender A 37% (14%) (51%) Advisory Firm L 59% 42% (17%) HNW Bank S 66% 42% (24%) Specialty Insurer P 83% 7% (76%) R/E Mgmt Company C 188% 73% (56%) Payment Processor G 45% 11% (34%) Transaction Processor N 81% 49% (32%) Asset Manager A 180% 15% (83%) Sample of Small-Mid Cap Industrial Stocks Industrial Distributor F 38% 57% 19% Trucking Firm A (30%) (1%) 29% Industrial Distributor I 30% 46% 16% Railroad B 34% 65% 31% Steel Maker N 19% 108% 89% Iron Oar Producer C 32% 135% 103% Comm. Procurement Firm F 23% 135% 112% Manufacturer E 27% 67% 30% Ind. Equipment Maker I 14% 58% 44% Market S&P 500 26% 29% 3% Nasdaq Composite 27% 31% 3% Russell 2000 20% 29% 9%

Source: Baseline, Western Reserve estimates


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October 16, 2007

Today, the Fund’s long portfolio trades at just 12x forward cash earnings or in step with the lowest multiples we have seen in a career and at roughly half the underlying, recurring-natured growth. By contrast, industrials trade at a premium to trailing growth while future growth is very hard to predict with all signs pointing to deceleration at best and earnings recession risk certainly possible. Such bifurcation usually is not recognized until the post mortem after an inflection point in the economy/monetary policy. Bellwether cyclicals like FedEx (FDX), Ryder Systems (R), Nucor (NUE), and Eaton (ETN) already have warned this earnings season of falling commercial demand and few retailers are signaling strength in consumer spending. Are we not potentially at risk to a major shift in money policy already? To this point, earnings growth has been strong across many industries, but deteriorating economics will stress the unanimity of this going forward. And the level of rotation out of small and mid cap industrial stocks into recurring services and growth will be the largest in thirty years and could take many years to fully unfold in our view. Some services companies we have liked such as the Chicago Mercantile Exchange (CME), which clears commodity trades, and other financial processors we research such as Nymex Holdings (NMX), which is a key trading bourse for natural resources, have seen their activity and volume growth explode like on-line brokers saw during the tech craze. Data we compile suggests that in the over-the-counter market (OTC) for commodity trading, for every guy trading commodity futures five years ago, we now have nineteen new guys trading levered commodity derivatives. All things being equal, this would indicate a lot of closet commodity experts either have come out of hiding or this is a very crowded space. CME is a monopoly and we still like it, but we have been taking profits of late. Things are too giddy in commodity transacting. Commodity broker GFI Group (GFIG) also is a favorite long in the Fund and we have been profit taking there as well on valuation. Given valuation and earnings, we remain bullish on domestic stock trading and still favor the Nasdaq Stock Market (NDAQ) among our capital markets transaction investments as well as OptionsExpress Holdings (OXPS), an on-line retail stock and option broker. NDAQ and OXPS continue to grow much faster than their current mid single digit P/Es. Conversely, we have been short NYSE Euronext (NYX) consistently because it is over valued and they are losing market share in equities due to poor technology. Part of our bull thesis on NDAQ is that the electronic trading changes afoot on the NYSE is creating more opportunity for the all electronic NDAQ to take market share. We are long “garden variety” regional banking for the first time since the Fund was launched in 2004. The credit panic leveled valuations indiscriminately and we swooped in. New long additions this summer included a few second stage thrift conversions such as Beneficial Mutual (BNCL), TFS Financial (TFSL) and Oritani Financial (ORIT). Each of these small regional savings banks is “squeaky clean”, trades for less than stockholder book value and remain grossly over capitalized, thus able to accelerate earnings and ROE’s through aggressive capital management. They also are taking advantage of the dislocation in mortgage securitizations (demise of non bank mortgage lenders) as “balance sheet” lenders. Even the slope of the yield curve now benefits their earnings growth going forward. They complement long positions in full conversion thrifts like Hudson City Bancorp (HCBK) and People’s United Financial (PBCT).


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October 16, 2007

In the financial technology and technology outsource services space, the summer financial stock bloodbath took many of them down over misplaced worry that their clients (banks) were all going out of business. Valuations went to silly. On-line Resources (ORCC), a provider of bill payment and other payment related services to small banks, Global Payments (GPN), a consumer payment processor, and FundTech (FNDT), a wholesale electronic funds processor, all were added to at attractive valuations. Of note, we did start to take profits in longstanding holding DealerTrak Holdings (TRAK), a processor of automobile purchases and financings, on valuation. In real estate, we are eying very attractive valuations in the brokers – namely Grubb & Ellis (GBE) and Jones Lang Lasalle (JLL), where transaction growth remains healthy, asset management (pure recurring revenue) is much larger than in the past and international exposure very high. GBE is trading at less than 5x cash flow when the merger with privately-held NNN Realty is factored in. That transaction should close by year end. The name of the game for us was “upgrade” the long book amid the carnage in July and August, while holding steady in our lower quality business shorts. We believe the short book, which was handy through the summer storm, will be very helpful as the earnings and economic picture gets cloudier from here. The ‘Services Economy’ Lost The services economy is not the “new economy” or the “old economy”, it is most of the economy. It’s the substance between the cyclical end points.

Source: Peer Insight Throughout most of our early history, the US economy produced more “goods” than “services”. An inflection point took place in the mid eighties (graph courtesy of Peer Insight). In 1987, the economy produced goods and services in equal amounts for the first time and in less than twenty


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October 16, 2007

years since, the balance has shifted enormously in favor of “services” as we have efficiently pawned off low margin manufacturing to lower cost producers in the most accretive economic shift in world history. And wealth has skyrocketed in the US as a result. The service sectors of our economy produce roughly 80% of our output and employment now and have produced the entire net gain in non farm payrolls since the seventies. This, in large part perhaps, is why the commodity surges of this decade have failed to produce much inflation domestically. It’s not a government cover up. Our output is materially less levered to natural resources. Put simply, we’ve become much more efficient and able to displace periodic input (commodities) price swings better than in times past.

40

60

80

100

120

140

160

180

'79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03

Services EmploymentManufacturing Employment

Share of U.S. Profits

5.0%

15.0%

25.0%

35.0%

45.0%

55.0%

'50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00

Financial ServicesManufacturing

Source: Federal Reserve


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October 16, 2007

There are two secular forces that have created steady long-term organic growth opportunities for smaller services companies. First, in an aging but dominant economy, large American companies have been forced to get more efficient. For Fortune 1000 companies, they must manage profit growth expectations amid increased top line growth strain. They do this mostly through improving their operating efficiency via both in-sourcing information technologies as well as out-sourcing non core operations. Western Reserve’s research team researches for fast growing services firms that do both. Second, capitalism has crept throughout the world since the fall of the Berlin Wall. America is the center for financial innovation and intermediation and we are out-sourcing this knowledge base to the rest of the world. This is a silent take-over and rarely is mentioned by investors. Even if the sub prime black eye slows this a bit, it will be very temporary. The export of our financial system and ‘know-how’ is the greatest story never invested in. It’s important to note that the official trade deficit figures don’t factor-in most services. If Goldman Sachs (GS) advises Beijing, the revenue related to the work doesn’t run through the official trade numbers, just like investments in stocks and real estate etc. by individuals mysteriously don’t count as “savings” in our accepted government statistics. Goldman partners (and shareholders like us) are pretty sure it is real however. It indeed is a global economy and has been for a long time. America actually is not losing the trade war. We, in fact, are winning it. We import manufactured goods from low cost providers and sell them high margin information, intelligence and advice (“services”). This, for a lack of a more politically correct answer, is called “accretion” and is why Americans, now worth almost $70 trillion net, are wealthier than the rest of the G-7 combined. Among my favorite service economy deals of late is the government of Dubai paying former President Clinton a $10 million retainer for his smarts. I doubt that was deducted from the “official” trade deficit figures and the margin on that business is lights out. Equity investors wish to favor US Steel (X) over Goldman Sachs? Clinton’s margins make the partners at Goldman blush, and they still produce 30% ROE’s and cash margins of 25% despite pretty lavish salary expense. Services are a “good” business. We like the venerable investment bank Lazard (LAZ) the most in the “advice” space, by the way. Very attractive opportunities within our largest export business – Financial Services – abound amid the universal dislike for financial stocks today. American financial firms process for ATM’s and credit cards the globe over and provide investment banking advice on every continent. Western Reserve’s research focus in financial services is based on recurring ”transacting” services both within the world’s most transacted economy (ours) and the rest of the globe desiring to get where we are. Credit worries affect only a small slice of the financial world, yet most financials are on fire sale these days. The opportunity set is extraordinary.


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October 16, 2007

While we see great advantage to our positioning, we do recognize the impatience such a barbell market can create among investors. The tech bubble trained us well for these moments, and we recognize that the alternatives to services in industrials and commodities have been overwhelmingly appealing. However, the bubble watch is now on across the Pacific and if history proves to not be “different this time”, a plunge in Chinese stock speculation will take the entire “global economy” trade in multi-nationals, commodities and emerging markets with it as all are fully linked. When the US went into recession in 1990, the then high flying Taiwanese stock market was said to be “immune” right before it declined almost 80% in six months time. The “global economy” is a revision to the “new economy” and is based on de-coupling theory. Internet technologies were supposed to be de-linked from the real economy and thus immune just like the growth in Asia today is believed to be de-linked today from the G-7, which is in a synchronized slow-down. Western Reserve is looking for investors actively seeking to diversify away from cyclical-end markets right now into a pure services strategy. It’s been one hell of an industrial boom, but nothing lasts forever. The beginning of the end to a great consumption binge has started with US (and UK) housing and is spreading. The inflection building benefits higher quality services economy investments and Western Reserve is sitting on one of the most profitable portfolios we have been able to construct.

Regards,

Michael P. Durante Managing Partner


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October 16, 2007

LongShortTotal (Gross) Total Class A (Net)2

Total Class B (Net)2

LongShortTotal (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-072007 YTD

WRHE Gross 3.1% -3.8% -1.8% 1.9% 1.5% -6.2% -3.2% 2.7% 4.1% -2.3%WRHE Class A Net 2.3% -3.2% -1.5% 1.4% 1.1% -5.1% -2.6% 2.0% 3.1% -2.8%WRHE Class B Net 2.4% -3.3% -1.6% 1.5% 1.1% -5.3% -2.7% 2.1% 3.3% -2.9%S&P 500 1.4% -2.2% 1.0% 4.3% 3.3% -1.8% -3.2% 1.3% 3.6% 7.6%NASDAQ 2.0% -1.9% 0.2% 4.3% 3.1% -0.1% -2.2% 2.0% 4.1% 11.9%

Sep-07 Aug-07 Jul-07 Jun-07 May-07 Apr-07 Mar-07 Feb-07 Jan-07 Dec-06 Nov-06 Oct-06 TTMInception To Date3

WRHE Gross 4.1% 2.7% -3.2% -6.2% 1.5% 1.9% -1.8% -3.8% 3.1% 2.3% 2.0% 4.2% 6.2% 43.5%WRHE Class A Net 3.1% 2.0% -2.6% -5.1% 1.1% 1.4% -1.5% -3.2% 2.3% 1.7% 1.5% 3.3% 3.8% 28.2%WRHE Class B Net 3.3% 2.1% -2.7% -5.3% 1.1% 1.5% -1.6% -3.3% 2.4% 1.8% 1.6% 3.4% 3.9% 29.3%S&P 500 3.6% 1.3% -3.2% -1.8% 3.3% 4.3% 1.0% -2.2% 1.4% 1.3% 1.6% 3.2% 14.3% 37.4%NASDAQ 4.1% 2.0% -2.2% -0.1% 3.1% 4.3% 0.2% -1.9% 2.0% -0.7% 2.7% 4.8% 19.6% 34.9%

Sector Long Short Gross Net5% 5% 10% 0% Long Short9% 1% 10% 9% 33% 37%6% 11% 17% -5% 55% 58%5% 0% 5% 5%12% 4% 16% 8%18% 4% 22% 15%18% 5% 23% 13%0% 14% 14% -14%15% 2% 16% 13%16% 3% 19% 13%22% 5% 27% 16%

125% 53% 178% 73%

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.

2007 Year to Date Comparative Returns2

3.9% 69%

Trailing Twelve Months Comparative Returns2

6.2% 172%3.8% 69%

10.5% 121%-4.6% 52%

73%2.6% 73%

Performance Average Exposure1

Trailing Twelve Months (TTM)

Summary for the Quarter EndedSeptember 30, 2007

Western Reserve Hedged Equity, LP

Top 10 Positions

-0.8% 125%4.2% 53%3.5% 178%

Financial Institutions

Quarter EndedSeptember 30, 2007

Percent of Directional CapitalBusiness Process Outsourcing

Performance Ending Exposure1

Government Services

2.5%

Technology ServicesReal Estate Services

Portfolio Composition (% of Capital)

Financial ServicesTransaction and Payment Cyclical and IndustrialInternet Services

Consumer Services Top 20 PositionsHealthcare Services

Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross)

-9%-5%-1%4%8%

12%16%20%24%28%32%36%40%44%48%52%56%60%

Dec Feb Apr Jun

Aug OctDec Feb Apr Ju

nAug Oct

Dec Feb Apr Jun

Aug OctDec Feb Apr Ju

nAug

Western Reserve GrossS&P 500NASDAQ

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

Long Short Net

WESTERN RESERVECAPITAL MANAGEMENT, LP


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