1 | P a g e

Fasanara Capital | Appendix

(last updated 1st March 2013)

Multi-Equilibria Markets

Longer-term, as our readers and investors know all too well, we remain skeptical on the

effectiveness of crisis resolution policies being implemented, wary of the sheer

magnitude of the level of over-leverage built in the system and its drag on the real

economy, conscious of the wild volatility which could be triggered by one too many

external or internal shocks in such crystal-fragile environment. As such, we design our

portfolio to sustain most of the states of the world we can see, and be protected

against new equilibria which deflect vastly from the baseline scenario currently

priced in by markets, and which are diametrically opposite from one another. The

baseline scenario remains one of a multi-year slow-deleverage Japan-style. But the

system has never been as vulnerable as it currently is to shocks which may flip the

equilibrium to a different set of variables than the status quo / mean reversion

would suggest.

To be sure, as Central Bankers keep flooding the system with liquidity, our base case

scenario is one of a stagnant economy and of a multi-year Japan-style deleverage.

Under such a scenario, a disorderly deleverage would be avoided and inflation would

not be triggered… at least in the short term, until such delicate equilibrium will

eventually break. In the coming years, we believe that 6 scenarios might play out (some

of which are mutually exclusive or may happen in succession): Inflation Scenario

(Currency Debasement, Debt Monetisation, Nominal Defaults), Default Scenario (Real

Defaults, sequential failures of corporates/banks/sovereigns across Europe), Renewed

Credit Crunch (similar to end-2008, end-2011 or mid-2012), EU Break-Up (either

coming from Germany rebelling to subsidies or peripheral Europe rebelling to

austerity), China Hard Landing, USD Devaluation.

We also believe that current market prices and compressed Risk Premia make it

worthwhile / relatively inexpensive to position for fat tail events, as they are currently

heavily mispriced by markets.

2 | P a g e

The Outlook

Our thinking is simple. The market is underestimating the potential impact of the

real economy not picking up despite unprecedented liquidity being thrown at it,

by extraordinarily expansive monetary policies, for too long a period of time. In doing it,

the market underestimates the impact that a fast increasing level of unemployment in

peripheral Europe can have on price dynamics in the second half of 2013 and beyond

(youth unemployment at approx 60% in Greece/Spain, and 36% in Italy/Portugal).

3 | P a g e

Here the market seems to be sedated to the flawed idea that the social compact and

welfare safety nets put in place by such democracies will suffice in keeping social

discontent at bay, and the army of unemployed in voting for yet another pro-European

pro-austerity government as soon as they are given another opportunity to do so over

time. As the readjustment needed to rebalance competitiveness across Europe is still

wide open (to closing the gap to German wages it would require Italian and

Spanish labor costs to fall by an additional 30% to 40%), we tend to challenge

market’s complacency about it. Falling real wages, perhaps falling nominal wages, in

Italy and Spain by up to 40% is the baseline scenario now, one of slow deleverage multi-

year Japan-style. If anything, Japan did have a choice ten years ago, to devalue the

currency in nominal terms, which they did not go for (they are taking a different view on

it only now), whereas Europe does not even have that option, as fixed-exchange

currency system impedes it, and allows only Internal Devaluation to happen. Until the

currency system itself implodes, as we expect down the line.

And more so now, as we enter a market environment of currency debasements one

country against another, where no mystery is held up any longer on one’s intention to

devalue and open wide the FX gates to its economy. More and more, evidence is in our

face of US and Japan intentions. South Korea, China, Latam, and the UK itself, might

follow, although the tempo of their reaction functions might vary greatly. Europe itself

will then face the choice of either catching up on the trend or split up, to allow individual

countries to opt for that route if they wish. Timing matters: the sequence of competitive

devaluations across countries might take years to materialize and be fully visible, and it

may be a stretch then to expect southern Europe to sustain multi-years of much

stronger EUR against pretty much anything else, and thus a more dramatic drop in

wages and increase in unemployment needed to make up for it. Look at Japan, where a

progressively stronger nominal Yen in the last ten years was associated with an even

larger Internal Devaluation and Price Deflation, so big that the Yen actually depreciated

in real terms by 35%/40% against EUR and USD over the past 15 years, counter-

intuitively, whilst appreciating in nominal terms by 75%.

All told, if the political gridlock over ECB OMT activities and other forms of heavy

QE is here to stay for long enough, we have one more reason to consider the risk

scenario of a EUR break-up a genuine one. Yet another one of the scenarios we seek

to be hedged (and over-hedged) against. We might as well have those hedges

implemented now, for it is still inexpensive to do so. If such tail events do not take place,

then great, as our Value portfolio will not be impaired, and we will enjoy the nominal

rally in the market. On the other end, if such events were to take place, we would be

amongst a few ones who bothered to spend that money on a hedge, before such hedge

became overly expensive or not available at all.

4 | P a g e

Bottom-line, over the next few years, if money printing failed to restart the

economy, we face the real chance of a multiple choice between a Default Scenario

(Real Defaults, Haircuts & Restructuring; potential Euro break-up, as either peripheral

Europe derails from the bottom, or Germany reconsiders it from the top) and an

Inflation Scenario (Nominal Default, Currency Debasement whilst engineering Debt

Monetization, as money printing continued unabated, until money multipliers/velocity

of money made a U-turn to fully drive it out of control). More on it in the attached.

Opportunity Set for 2013

As the strategy was unchanged over the last few months, let us quote freely from our

December Outlook (while updating some of the short dated investment positioning in

here described): ‘’In the following few lines we offer our observations on the main

themes underlying our portfolio construction, across its three main building blocks. Our

current Investment Outlook in implement into an actionable Investment Strategy along

the following three parts:

The Strategy

Value Investing

Over the course of 2012, our Value Investing portion of the portfolio was static

and entirely filled by Senior Secured bonds issued by strong companies from

northern Europe and the US (i.e. countries with their own domestic currencies –UK,

US – or on the right side of a foreign currency – Germany, Holland), export champs with

5 | P a g e

exposure to EM flows, high but affordable leverage, running yields of 5%-10% area,

target IRR at inception of 10%-15%. We thought the tail risks underneath markets this

year warranted to stay clear of peripheral Europe assets, clear of junior/mezzanine

paper, and clear of equity markets altogether. As we performed strongly into above 20%

returns, we still clearly lost the opportunity for even bigger gains: however, we

concluded that such opportunity was not appealing when adjusted for the large risks it

entailed. Risks did not materialize in the end, but in retrospect it is always easier to

read markets.

Now then, we are at a crossroad as High Yield valuations have reached bubble

levels. One thing is to say our senior bonds were good investments and deserved to

rally, another thing is to say they deserve to trade at 4% to 6% yields to worst. We do

not believe such sustained valuations are justified, especially as we do not discount the

tail risks out there at zero, and we believe it is only a matter of timing before the

valuations realigns to fundamentals somehow. True, liquidity is large in the system and

money printing (especially in the US) might target corporate paper directly and drive

valuations even further and yield even lower: however, the more time goes by the more

that equated to an Inflation Scenario (Debt Monetisation achieved via Currency

Debasement). An Inflation Scenario, where negative real rates and QE-type intervention

helps inflate one’s way out of nominal debt, is effectively just another form of Default

Scenario. Whether the debt is not paid back in full or whether its real value is eroded by

inflation does not make a huge difference to most investors. Inflation destroys the

value of fixed income claims as surely as default.

On the other end, should the money printing slow down or stop outright, should the

oxygen mask be removed from the debilitated patient, and the reversal of the trend

would be abnormally asymmetric, leading to important capital losses across the capital

structure. Playing for even lower yields on stretched corporate balance sheets (and even

more on government bonds) equates to pick up dimes in front of a steamroller. We

believe that the risk of rising interest rates is highly underestimated by the

market right now.

The bubble in the credit markets is unmistakable, starting with government bonds to

slide down the credit curve into High Yield markets. Valuations are so high that any

room for further appreciation is close to exhaustion. 2013 might be the first year

earmarked with a negative return (of some dimension) for government bonds

ever since 1994. To continue slowly or quickly, in the following year, until it changes

gear. Cracks are well visible in the High Yield and Loan markets too, as issuance

volumes reached approx. $600bn, which is 2007 record levels (another credit

bubble market back then, which was going to pop a year later). More importantly, the

share of covenant-lite issuance has reached a staggering 30% of the total (in 2005

6 | P a g e

it was 5%): which means less maintainance covenants in exchange for pure incurrence

covenants, which means lower protection for investors. Market players now argue that

this is a positive development as a potential catalyst to a credit event / down

performance is outright removed, forgetting it also damages recovery values. It sounds

like typical complacent bubble market commentary, ready to justify overvaluations in

retrospect as the new normal and make the case for further future appreciation. To us, it

may be wishful thinking, and it is only a matter of time for the market to catch up

with reality.

For all these reasons, in 2013 we intend to keep migrating slowly and safely from

High Yield territory into Equity, hedged, with similar characteristics to senior

debt. As Equity most obviously presents different characteristics of expected volatility,

we apply three layers of risk management: 1) security-specific hedges (typically through

long/shorts, but also via capital structure arbitrage), 2) macro overlay strategies and 3)

Fat Tail Risk hedging programs.

Fat Tail Risk Hedging Programs

The leit-motiv of our Investment Strategy remains to take advantage of current

market manipulation and compressed Risk Premia to amass large quantities of

(therefore cheap) hedges and Contingency Arrangements against the risk of

hitting Fat Tail events in the years to come. If we do not hit them, then great, it will be

the easiest catalyst to us hitting the target IRR on the value investment portion of our

portfolio (what we call Safe Haven, or Carry Generator). If we do hit one of those pre-

identified low-probability high-impact scenarios, then cheap hedges will kick in for

heavily asymmetric profiles (we typically targets long only/long expiry positions with

10X to 100X multipliers). Such multipliers are courtesy of market manipulation and

‘interest rate rigging’ by Central Banks. We believe they represent the only truly

7 | P a g e

Distressed Opportunity in Europe. Timing-wise, the next months may offer an

interesting window of opportunity.

Currently, thanks to Central Banks’ liquidity and asset value manipulation, three

strategic scenarios (out of the six strategic scenarios we have in mind) can first be

hedged at rock-bottom valuations. Such scenario include: Inflation, Renewed Credit

Crunch & Euro Break-Up. Hedging against such scenarios is currently very cheap

and as a result Fasanara aims to increment hedging on such opportunities first in

Q1 2013.

Tactical Short-Term Plays / Yield Enhancement

We will not expand on this section too much, as it is less relevant in our portfolio

construction, which tends to be quite static and ‘buy and hold’. Short term tactical

positioning / yield extraction strategies. Such positioning is typically tactical and

short term, for we remain prepared to adjust as information comes in.

Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001 E-Mail: francesco.filia@fasanara.com 16 Berkeley Street, London, W1J 8DZ, London Authorised and Regulated by the Financial Services Authority

8 | P a g e

“This document has been issued by Fasanara Capital Limited, which is authorised and regulated by the Financial Services Authority. The information in this document does not constitute, or form part of, any offer to sell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or the fact of its distribution form the basis of or be relied on in connection with any contract. Interests in any investment funds managed by New Co will be offered and sold only pursuant to the prospectus [offering memorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carries a high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and no assurance can be given that the stated investment objectives will be achieved. Fasanara Capital Limited may, to the extent permitted by law, act upon or use the information or opinions presented herein, or the research or analysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnel may have, or have had, investments in these securities. The law may restrict distribution of this document in certain jurisdictions, therefore, persons into whose possession this document comes should inform themselves about and observe any such restrictions.