Michael Durante Western Reserve 3Q05 letter

Third Quarter 2005 October 25, 2005

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

FY04 Jul-05 Aug-05 Sep-05 3Q05

YTD05 WRHE Gross 27.1% 2.7% -5.1% -1.9% -4.3% -3.9%WRHE Class A, Net1 20.5% 2.1% -4.2% -1.6% -3.8% -4.1%WRHE Class B, Net1 21.2% 2.1% -4.3% -1.7% -3.9% -4.2%S&P 500 9.0% 3.6% -1.1% 0.7% 3.1% 1.4%NASDAQ Composite 8.7% 6.2% -1.5% 0.0% 4.6% -1.1% 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.

“You have shown me the manure.…Now show me the pony” - Ronald Reagan

Dear Partners: Withholding no punches, Western Reserve Hedged Equity (WRHE) had a lousy third quarter, declining 3.8% net in value. After six consecutive quarters of outperforming the market since launch, the fund ran into three hurricanes in the late summer – Katrina, Rita and Alan. All three added spark to an already heady price momentum rally in deep cyclicals, a trend which has dominated the stock market in 2005. Investors have been plowing capital into an ever narrower leadership group consisting of oil and hurricane stocks, or have left the country to buy better performing foreign markets. If it digs it, trucks it, distributes it, or has hurricane leverage, then it has played well thus far in 2005. And what has become of the more dominant and “flexible” services economy Chairman Greenspan brags so much about? There seems to be but a fading glimmer of evidence of its existence as far as investors are concerned. The sudden hurricane economy and relentless string of speeches from Fed officials is all that counts. Such transitory macros have created a cold front for services economy stocks this fall, and extremely low valuations have been reached courtesy of the selling pressure. We normally aren’t top down in our commentary, but as it stands, the market is anything but bottom-up or fundamental at the moment. We believe conditions are currently at extreme levels. As is often the case with extremes, change is likely in the offing. Several layers of fear (and outright panic) have been baking into services stocks this fall, including, but not limited to, much higher risk of insipient inflation due to the hurricanes, a now forgone housing collapse (there isn’t even an argument against a collapse offered by anyone), a likely inverted yield curve, a consumer under extreme duress over energy costs, and a potential bird flu pandemic.

October 25, 2005

Nevertheless, not all is bad. Credit markets (including inflation adjusted bonds) remain stable and continue to discount low inflation risk. The yield on the 10-year Treasury has been range bound for almost four years. Employment remains strong and both companies and consumers remain very liquid relative to history. Further, the Fed has raised 11 straight times, resulting in core inflation deceleration over the past six months. By the sheer data, it would appear that things are moving along on schedule and in the right direction. Our “flexible” services economy is absorbing higher energy costs better than anyone could have imagined in years past, and the Fed is getting the job done by not leaving much stimulus around to monetize the impact of higher international commodity prices. But then there are the hurricanes… the two dominant drivers in the market right now, the Fed and oil, have proven particularly stifling to services stocks. A set of natural disasters in the gulf has compounded the issue. In this quarterly installment, we make our case that services stocks are ripe for the picking as valuations are discounted, in some cases, to calamitous lows; and what our risk and volatility tolerance is during this suddenly sloppy transition (due to Katrina and Rita) from a maturing cyclical recovery into a more stable environment post a major monetary tightening. The “Flexible” U.S. Economy is led by Finance and Technology Chairman Greenspan delivered his career victory speech on September 27 and it was nothing short of a byline in support of Western Reserve’s sole purpose for being – to invest in America’s key economic drivers: i) Information technology that drives the economy’s increasing efficiency, and ii) financial intermediation and innovation that drives its growth. By his words – “Innovative technologies, especially information technologies, have contributed critically to enhanced flexibility.” and “…Financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago. Although the business cycle has not disappeared, flexibility has made the economy more resilient to shocks and more stable overall during the past couple of decades. To be sure, the stability has created some new challenges for policymakers. But more fundamentally, an environment of greater economic stability has been key to impressive growth in the standards of living and economic welfare so evident in the United States.” As a specialized investment firm, the Western Reserve team cheered the remarkable speech, though we have been equally frustrated by the fact that the message is being clouded by the necessary, but transitory, effects of the storms on the economy and perhaps Fed policy. The highly flexible nature of our services-led economy is and will continue to manage through the after effects of the natural disasters in the gulf region. Low services stock valuations underpin palpable fear on the part of investors towards the impact on consumption spending, which is two-thirds of GDP. So, much is discounted. Western Reserve’s long portfolio (which has been the weak link this fall) is trading at only 11x forward earnings and under 10x cash flow, versus double digit growth expectations. And, interestingly, oil prices peaked the day after Katrina and have been drifting lower since, arguably unable to move higher on damage from Rita. Minutes


October 25, 2005

from the last Federal Open Market Committee meeting signaled that their language is under discussion for a change as well. Wall Street strategists, economists and erstwhile market sages alike are unanimous at the moment (this normally should cause folks to question current momentum). The “flexible” services-led US economy is dead by their observation. The message is loud and clear: “Don’t invest here please. The US is finished!” So, they have busily instructed folks to invest much of their capital outside of America. Obligingly, the stampede of money flows out of the US and into emerging markets has been significant and, in large part, explains why even high quality US stocks have been under selling pressure despite solid fundamentals and increasingly compelling valuations. In fact, the US stock market is among the few markets that aren’t up in 2005. For all of the finger pointing going on over New Orleans, the worst natural disaster in our history has cost us less than 1,000 lives. Interestingly, as many as 50,000 were killed in Pakistan recently and their stock market is up 40% this year. Outside the US, almost every emerging market has been on a rampage, fueled by enthusiastic US investors plowing into their thinly capitalized bourses. In September alone, mutual fund investors invested $15 in foreign stock funds for every $1 invested in domestic funds. So, much of the world’s known stock markets are up in 2005 except the world’s most significant, safest and most productive...ours. Back to Fundamentals (in this Lifetime?) Stock prices, naturally, are determined by earnings. If one were to observe the relationship between long term earnings accumulation and stock price progression of tech stocks after the bubble burst a few years ago, one could understand what happened. Western Reserve’s devotion to earnings-driven stock picking and valuation risk management is not an accident. A quick glance at the accompanying chart of Cisco Systems, a widely owned technology name, serves as a good example here. The peak in the stock in early 2000 was tough to predict because of irrational momentum driving the stock price well above economic accumulation (earnings). But, the range for the decline was quantifiable to the extent one could predict earnings within reason. The types of companies Western Reserve holds long are never much above their earnings accumulation and most are well behind, meaning the market is underestimating the sustainability of earnings we have modeled (i.e. they’re likely very cheap). We gain additional confidence via our focus on high recurring, services businesses to help us make fewer mistakes on earnings and cash flows in our models. Within the context of current market conditions, this type of discounting is not working, and we have underperformed as a result.


October 25, 2005

Source: Baseline Our universe of services economy stocks has underperfotwo years. Inflections often coincide with major mid-cyccredit markets continuing to signal low long term inflatioreassert market leadership in due time and will “catch-up The risk with a fundamentally driven stock picking teamThe WRHE team is a bit like a ‘fundamental majority’ ware focused on high quality small cap services stocks andmodel metrics as high recurring revenue and wide margibut look for extended valuations, lower quality businessethis qualitative approach works out quite well for us. Whquality stocks are outperforming high quality stocks. In sustainable margins and the long term recurring attractivaside by market participants in lieu of shorter term trend occasional ‘January effect’ and 2003 posed a risk to quallike ours, and we expect to experience higher volatility fosimilar: a low quality and momentum driven market clouquite manageable until the hurricanes, which have exaceimbalance in stock price performances. So, our very disc We have continued to focus on upgrading the long-side porder to prepare for a better market for us. This has comperformance. More recently, we have taken additional stpotentially at risk to further discounting based upon histo

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6720 • (214)871-6713 Fax

October 25, 2005

As noted often, Western Reserve’s investment strategy does not stray. Smaller capitalization services stocks are what we are good at, and I have long since come to believe what Chairman Greenspan now has outlined in his victory speech – the US economy is both great and “flexible.” The drivers of our recent past and long-term future lie in two broad services areas – financial intermediation and information technology. The current rush to invest in commodities and foreign stocks is not risk averse in my view. It’s the same old momentum game we have seen time and again. The rotation out of services has been costly to Western Reserve’s recent performance. We have been both frustrated and humbled by our performance this Fall, and we will redouble our efforts to generate superior returns once again through our fundamental research process. From time to time (especially when things aren’t so rosy short term), I am criticized for being too committed to our strategy. But, sticking to our knitting is what we do in such times of market dislocations as the present. Volatility, despite its negative perception by some fund managers, is inherent to the process of fundamental long-term value creation. We view the investing landscape more consistently – apply what we have learned that works cycle in a cycle out. We also know that few are standing where Western Reserve is standing right now – in the services arena - and we have had to risk manage from the top down more than usual in order to deal with the current non-fundamental reality. I believe it will prove temporary, and while it’s incredibly poor form for a money manager to ring the dinner bell when he’s riding through a rough patch, I’m doing just that. Services economy stocks have for too long now underperformed their own economic value creation (earnings). A reversion generally follows… The headlines in the financial press are all tortuously negative these days, and as the late President Reagan told his staff during periods of seemingly endless bad news: “You have shown me the manure… Now show me the pony.”

Regards,

Michael P. Durante Managing Partner


October 25, 2005

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-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 Jul-05 Aug-05 Sep-05 YTDWRHE Gross 0.4% -1.9% -2.3% -0.9% 1.3% 4.0% 2.7% -5.1% -1.9% -3.9%WRHE Class A Net 0.2% -1.6% -2.0% -0.8% 0.9% 3.1% 2.1% -4.2% -1.6% -4.1%WRHE Class B Net 0.3% -1.7% -2.1% -0.8% 1.0% 3.2% 2.1% -4.3% -1.7% -4.2%S&P 500 -2.5% 1.9% -1.9% -2.0% 3.0% 0.0% 3.6% -1.1% 0.7% 1.4%NASDAQ -5.2% -0.5% -2.6% -3.9% 7.6% -0.5% 6.2% -1.5% 0.0% -1.1%

Sep-05 Aug-05 Jul-05 Jun-05 May-05 Apr-05 Mar-05 Feb-05 Jan-05 Dec-04 Nov-04 Oct-04 TTMInception To Date3

WRHE Gross -1.9% -5.1% 2.7% 4.0% 1.3% -0.9% -2.3% -1.9% 0.4% 7.8% 7.7% 2.7% 14.4% 22.1%WRHE Class A Net -1.6% -4.2% 2.1% 3.1% 0.9% -0.8% -2.0% -1.6% 0.2% 6.1% 6.0% 2.0% 10.3% 15.1%WRHE Class B Net -1.7% -4.3% 2.1% 3.2% 1.0% -0.8% -2.1% -1.7% 0.3% 6.3% 6.3% 2.1% 10.7% 15.7%S&P 500 0.7% -1.1% 3.6% 0.0% 3.0% -2.0% -1.9% 1.9% -2.5% 3.3% 3.9% 1.4% 10.4% 10.6%NASDAQ 0.0% -1.5% 6.2% -0.5% 7.6% -3.9% -2.6% -0.5% -5.2% 3.8% 6.2% 4.1% 13.5% 7.5%

Sector Long Short Gross NetBusiness Services 12% 4% 17% 8% Alliance Data LongConsumer 7% 8% 14% -1% Capital One FinancialFinancial Institutions 21% 5% 26% 16% Euronet WorldwideFinancial Services 18% 5% 23% 13% SLM CorporationHealthcare 0% 0% 0% 0% Affiliated Computer ServicesIndustrial 2% 6% 8% -3%Technology 10% 3% 13% 7%Technology Services 22% 6% 28% 15% Long ShortReal Estate 16% 5% 21% 11% Top 5 21% 9%

108% 42% 150% 65% 36% 16%

Summary for the Quarter EndedSeptember 30, 2005

Western Reserve Hedged Equity, LP

Quarter EndedSeptember 30, 2005

Positions1 Performance Ending Exposure1

58 -1.2% 108%37 -3.3% 42%95 -4.3% 150%

-3.8% 65%-3.9% 65%

Trailing Twelve Months (TTM)

Performance Average Exposure1

21.8% 100%-6.8% 46%14.4% 146%10.3% 55%10.7% 55%

Year to Date Comparative Returns2

Trailing Twelve Months Comparative Returns2

Composition by Sector (% of Capital) Key Positions

Euronet Worldwide Superior Industries

Top 5 Winners YTD Short

Compucredit H&R Block, Inc.

Percent of Capital

Largest Long Positions

Top 10 Positions

SI International Ocwen FinancialPortfolio Recovery Patterson Cos.

MBNA Corporation eSpeed, Inc.

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

-9%

-5%

-1%

4%

8%

12%

16%

20%

24%

28%

32%

Dec Jan

Feb

Mar

Apr

May Jun

Jul

Aug

Sep Oct

Nov

Dec Jan

Feb

Mar

Apr

May Jun

Jul

Aug

Western ReserveS&P 500NASDAQ

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.

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.