Michael Durante Western Reserve 3Q07 letter

Third Quarter 2007 October 16, 2007
100 Crescent Court • Suite 400 • Dallas, Texas 75201
YTD
Jul-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
(214) 871-6720 Main • (214) 871-6713 Fax
info@western-reserve.net

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.”
(214) 871-6720 Main • (214) 871-6713 Fax

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.
(214) 871-6720 Main • (214) 871-6713 Fax

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
(214) 871-6720 Main • (214) 871-6713 Fax

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).
(214) 871-6720 Main • (214) 871-6713 Fax

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
(214) 871-6720 Main • (214) 871-6713 Fax

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 Employment
Manufacturing 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 Services
Manufacturing
Source: Federal Reserve
(214) 871-6720 Main • (214) 871-6713 Fax

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.
(214) 871-6720 Main • (214) 871-6713 Fax

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
(214) 871-6720 Main • (214) 871-6713 Fax

October 16, 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
2007
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 TTM
Inception
To Date
3
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 Net
5% 5% 10% 0% Long Short
9% 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 Returns
2
3.9% 69%
Trailing Twelve Months Comparative Returns
2
6.2% 172%
3.8% 69%
10.5% 121%
-4.6% 52%
73%
2.6% 73%
Performance Average Exposure
1
Trailing Twelve Months (TTM)
Summary for the Quarter Ended
September 30, 2007
Western Reserve Hedged Equity, LP
Top 10 Positions
-0.8% 125%
4.2% 53%
3.5% 178%
Financial Institutions
Quarter Ended
September 30, 2007
Percent of Directional Capital
Business Process Outsourcing
Performance Ending Exposure
1
Government Services
2.5%
Technology Services
Real Estate Services
Portfolio Composition (% of Capital)
Financial Services
Transaction and Payment
Cyclical and Industrial
Internet Services
Consumer Services Top 20 Positions
Healthcare 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
O
ct
D
ec
Feb
Apr
Jun
Aug
O
ct
Dec
Feb
Apr
Jun
Aug
O
ct
Dec
Feb
Apr
Jun
Aug
Western Reserve Gross
S&P 500
NASDAQ
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 RESERVE
CAPITAL MANAGEMENT, LP
(214) 871-6720 Main • (214) 871-6713 Fax

Michael Durante Western Reserve 3Q07 letter

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