Michael Durante Western Reserve 4Q05 letter

Fourth Quarter 2005 January 31, 2006

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

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FY04 Oct-05 Nov-05 Dec-05 4Q05 FY05WRHE Gross 27.1% -3.9% 0.9% 3.3% 0.1% -3.9% 22.2%WRHE Class A, Net1 20.5% -3.2% 0.6% 2.5% -0.2% -4.3% 14.8%WRHE Class B, Net1 21.2% -3.4% 0.6% 2.6% -0.2% -4.5% 15.4%S&P 500 9.0% -1.8% 3.5% -0.1% 1.6% 3.1% 12.3%NASDAQ Composite 8.7% -1.5% 5.3% -1.2% 2.5% 1.3% 10.1%

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.

Inception to Date

“Tread a woorme on the tayle and it must turne agayne”

- proverb circa 1546

Dear Partners: We entered 2005 optimistic about a year of strong earnings gains in the services sector and stable conditions within the credit markets. And as it turned out, we were correct on both fronts. Western Reserve’s average long generated strong double digit earnings growth, while the 10-year Treasury yield ended the year about where it began. Alas, neither earnings nor valuation mattered in the context of performance for the Western Reserve portfolio in 2005. It was a year of macro calls on sectors such as oil and commodities, euphoria over emerging markets, and momentum trading a la 1999 that created an unusually top-down and narrow market. On balance, the least defensible businesses, the simplest of commodities and entire geographies determined either success or head-scratching. Admittedly, the research team at Western Reserve scratched our heads throughout much of 2005. Against this backdrop, Western Reserve delivered what turned out to be a frustrating twelve months for returns. For the fourth quarter of 2005, the Fund was up 0.1% gross and down 0.2% net for both Class A shares and Class B shares. For the full year 2005, the Fund was down 3.9% gross, down 4.3% for Class A shares and down 4.5% for Class B shares. That said, it arguably was a terrific year for identifying and investing in undervalued and out-of-favor services stocks. While these opportunities did not manifest themselves in the form of recent performance, we are excited about their pent-up potential.

January 31, 2006


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The fund suffered no material (>1%) single position losses in 2005 despite the off returns, i.e. fundamental mistakes in 2005 were rare and of minimal consequence. Make no material mistakes and get beat? 2005 for us was like playing great tennis with few unforced errors and in the end looking across the net at a victorious Roger Federer holding a gold bar and an oil can instead of a tennis racket. Our goal is to achieve a return twice the market’s for half the risk, and through the first 24 months of operation, Western Reserve Hedged Equity has achieved that goal. It is important to note that we do not expect to achieve it each calendar year, but rather compounded over time. We recognize that some market environments will be more hostile to our consistent services focus and fundamental discipline than others. 2005 was an example and the first time for me since 1999. As we review the year, a few things stand out… First, the services sectors just didn’t perform. Being both obsessive and competitive, we have worried about the natural intra sector diworsification tendencies when out-of-favor (one part defensive and one part “everything’s so cheap”). So, we are in the middle of re-focusing and right sizing positions presently as the worm has started to turn. Put simply, our very best ideas need to be bigger (again) and some good, while slightly less compelling ideas must be used as a source of funds. Our heavy exposures in technology services and business services went nowhere in 2005, despite great earnings growth accumulation. Our top investment pick in this space, Alliance Data Systems, grew earnings 32% (versus analysts’ expectations of 20%) and its stock price declined 25%. What’s fascinating is that we expect ADS’ growth track to remain robust in 2006, in large part, based upon contracts and merchant portfolio additions closed in 2005. Accordingly, ADS is the partnership’s largest position as we enter 2006. It closed the year trading at less than 10x cash flow, has a historic compounded growth rate north of 30% and has never missed a quarter as a public company due to near 100% recurring revenue. Second, our specialty real estate positions were a weak link in 2005. We classify these companies as dividend growth (yield) investments and consider them among our most conservative. Throughout the year, yields remained attractive, dividend growth continued apace and the static debt market indicated attractive relative value. Nonetheless the group was adversely impacted by macro worries during the year, inclusive of Federal Reserve Chairman Greenspan’s declaration of war on housing formation and mortgages in August (the fund’s steepest decline of the year). Never before have we seen the Fed so purposefully target a specific industry with its rhetoric. The ensuing media pile-on caused panic selling in anything remotely housing related, eventually spilling into our more significant investments in commercial REITs. Note that these companies are not tied to housing formation and have minimal relationship with the shape of the yield curve. Believing trends would naturally moderate, the fund fortunately was not materially exposed to housing directly, but we clearly were less prepared for Greenspan’s open outcry and the fallout in anything specialty real

January 31, 2006


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estate related that followed. The valuations are currently at historic troughs seen in past calamities and feared calamities that never materialized (e.g. Long-term Capital). We remain under invested in housing formation, although we believe an opportunity will present itself in the intermediate term. We believe investors have a hard time understanding growth areas of finance (which is why it is a specialty of ours), dismiss the stocks when under stress as just “too complex”, and thus handle the stocks inefficiently. These may be the most consistently inefficiently priced securities on the planet, which, while good for us long-term, negatively impacted our performance in 2005. We remain fully invested in this arena as 2006 rolls in. C-REITs, in particular, remain a significant bet, and the average yield in excess of 10% is actually higher than many third world junk bonds. Western Reserve’s real estate holdings returned -1.9% last year. Third, our reluctance to join the momentum party hurt our relative performance particularly hard in July and November as the beta grab ripped. Granted, we are as tired of complaining about momentum investing as you are of listening to us, and we simply must do a better job of recognizing when the market is more short-term oriented and momentum traded. The sloppiness of the momentum-driven market caused us to incur more small, but accumulative, entry point or timing mistakes short. Just as our longs didn’t trade fundamentally in 2005, neither did our shorts. And we simply weren’t reacting quickly enough to the narrow trading ranges relative our fundamentally driven price targets. Fourth, and lastly, the fund lacked a sub sector success in 2005. No services areas held favor amidst a commodity and cyclical led market. As is customary in periods of being on the outside looking in, the research team debated most days both our sanity and our devotion to qualitative investing. This too was similar to my experience in 1999, when I was a younger partner in a growth firm once referred to by a pension consultant as not jiggy with the “new economy.” Well, we’re not jiggy with the “new old economy” either. The margins still stink; the predictability a facade (it’s unlikely it’s “different this time”) and we’re just no good at it. And if we hire a commodity trader or an oil analyst and chuck the whole quality thing, we are sure to screw-up the party for everyone else. The year could be summed up by one potential investor, who inquired – “wouldn’t ‘oil services’ fit your fundamental discipline?” While there is absolutely nothing wrong with oil services sector investments, such investments do not conform to Western Reserve’s wide margin, non-commodity, recurring revenue investment discipline. In 2005, we were obviously wrong to be disciplined in this manner. And the last time I spent more time explaining why high quality, recurring revenue themes was an attractive investing strategy was in 1999. My performance certainly looked off the mark then. Yet the head scratching did come to an end for me and my former partners. It will end again! 2006 and ahead: can low quality keep beating high quality? We did not alter our strategy to chase the leaders in 2005. So as 2006 gets underway, I want to spend time talking about why we are correct to have stuck to our knitting. Fundamentals and

January 31, 2006


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valuations in the services economy have rarely looked better. Change is on the horizon, not in small part, because the Fed appears closer to concluding a protracted mid cycle tightening campaign. We very much doubt that the strategy of investing in ‘good businesses’ is dead. Instead, we believe the consensus is simply distracted by commodity fever; one part truth and two parts mania. It should come as no surprise to those familiar with Western Reserve’s strategy that we are unusual folks, especially within the context of today’s popular investment themes. We only invest in the more dominant services economy and we endeavor to take minimal exposure to commodities. Although we do not dispute the potential to make money in commodities or in low quality businesses, the lack of consistency and repeatability of the investment process makes such a strategy limiting. Conversely, the stock of an attractively priced ‘good business’ cannot be held back for too long. A commodity can go into hibernation or experience multi-decade bear markets without notice and without explanation. Commodities can fall as suddenly as they rise. And while Western Reserve’s lack of exposure to such investments left us on the outside looking in last year, the “new old economy” looks and feels a bit like its predecessor – the “new economy”, a bit too easy and too good to be true perhaps. With commodities driving global markets, especially equity markets, the lower the quality and more commoditized the business (low margin), the better the stock has performed. The end result is a 30 year low in the spread between high quality (high margin) stocks and the lowest quality, based upon free cash flow yield. We increasingly believe the current qualitative performance inversion in the stock market is unsustainable at the very least and perhaps tantamount to mania at worst. It’s paradoxical to suggest that low quality stocks can out perform high quality ad infinitum. The market and the financial press are obsessed with narrow leadership investment strategies and asset reallocation therein. Commodity trading volumes have exploded and the stocks of commodity exchanges are trading at 3-4x the market multiple. Investment firms are hiring commodity traders as fast as they can get them. The fastest growing on-line retail broker specializes in commodities and futures. And countries with historically unproven economic structures and opaque governance such as China and Brazil are deemed invincible by the media. And who doesn’t know what the “BRICK” is at this point – Brazil, Russia, India, China and Korea. Retail mutual fund flows also are worth noting. Foreign stock and commodity funds are overwhelmingly popular. Last fall, the mutual fund industry consortia reported that for every dollar newly invested in a domestic stock fund, as many as fifteen dollars were being pumped into foreign stock funds. The United States is home to so many innovative and fast growing firms. We have the world’s largest, most diversified and safest economy, where both innovation and corporate profitability are the strongest and most enduring. And despite our whining from time to time about abuses of

January 31, 2006


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and loopholes within Generally Accepted Accounting Principles (GAAP), we have far greater confidence in the accounting here than in overseas markets. Thus far in 2006 the market has witnessed an old fashioned beta grab, aided in part by the sudden emergence of more dovish comments by the Fed. The overnight doves are likely late as usual. In our opinion, economic indicators began to show signs of instability as early as late last summer. Inflation measures are muted, retail sales have been weaker than expected, and business spending stubbornly remains in hibernation. The favored cyclicals have been saddled with softer manufacturing indications as well. And in fact, the fourth quarter earnings season has done little to support the cyclical bull thesis (so overwhelmingly bet by fund managers), as the first set of disappointing earnings reports hail mostly from cyclical sectors like aluminum, steel and semiconductors. We strongly suspect that the yield curve may not be the conundrum some hope for and that fourteen straight rate hikes may finally weigh on the value stock bubble we first mentioned last year (and clearly were early). Advocates of the neo-industrial revolution or ‘new old economy’ will argue that the Fed doesn’t matter and it’s different this time. We would tend to disagree. We are periodically criticized for being too committed to our knitting and are accustomed to the debate about diversifying our strategy into other areas. But, sticking to our knitting is what we do in times of market dislocation. Volatility, despite its often negative connotation among fund managers, is integral to fundamental stock picking firms’ pursuit of long-term value creation. Operational Update Two important business issues bear mention. First and most significantly, Ted Brynn, Rod Hinze and James Davis have been elevated to equity partner at Western Reserve Capital Management, LP. These are the people that add the most value to the limited partnership, and our high inside ownership structure provided capacity to anchor the core team. To refresh your memory, Ted is our senior technology services and business services analyst, Rod is our senior real estate and financial services analyst, and James runs the business as our COO. I would have preferred to have done this in a year of stronger performance because it is a cause for great celebration. But, it actually says more about them and more about our collective commitment to our discipline at a time of heightened adversity. The future of our firm will be built around these core partners. Secondly, our registration with the U.S. Securities and Exchange Commission was declared effective on January 24, 2006. We look forward to working under the oversight of the SEC as we move forward and hope that our registration gives current and prospective investors even greater confidence in our compliance and operational procedures. I have often expressed in these letters my gratitude for the continued support of our partners, and your support and confidence was especially notable during this difficult year for our fundamental investing strategy. Despite suffering through one of the least fundamentally driven markets and

January 31, 2006


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among the more frustrating years of my career, Western Reserve Master Fund’s withdrawals at year-end were immaterial. We thank you again for the trust you have placed in us. Now, about adding while the valuations are compelling…

Regards,

Michael P. Durante Managing Partner

January 31, 2006

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 Oct-05 Nov-05 Dec-05 YTDWRHE Gross 0.4% -1.9% -2.3% -0.9% 1.3% 4.0% 2.7% -5.1% -1.9% -3.9% 0.9% 3.3% -3.9%WRHE Class A Net 0.2% -1.6% -2.0% -0.8% 0.9% 3.1% 2.1% -4.2% -1.6% -3.2% 0.6% 2.5% -4.3%WRHE Class B Net 0.3% -1.7% -2.1% -0.8% 1.0% 3.2% 2.1% -4.3% -1.7% -3.4% 0.6% 2.6% -4.5%S&P 500 -2.5% 1.9% -1.9% -2.0% 3.0% 0.0% 3.6% -1.1% 0.7% -1.8% 3.5% -0.1% 3.1%NASDAQ -5.2% -0.5% -2.6% -3.9% 7.6% -0.5% 6.2% -1.5% 0.0% -1.5% 5.3% -1.2% 1.3%

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

WRHE Gross 3.3% 0.9% -3.9% -1.9% -5.1% 2.7% 4.0% 1.3% -0.9% -2.3% -1.9% 0.4% -3.9% 22.2%WRHE Class A Net 2.5% 0.6% -3.2% -1.6% -4.2% 2.1% 3.1% 0.9% -0.8% -2.0% -1.6% 0.2% -4.3% 14.8%WRHE Class B Net 2.6% 0.6% -3.4% -1.7% -4.3% 2.1% 3.2% 1.0% -0.8% -2.1% -1.7% 0.3% -4.5% 15.4%S&P 500 -0.1% 3.5% -1.8% 0.7% -1.1% 3.6% 0.0% 3.0% -2.0% -1.9% 1.9% -2.5% 3.1% 12.3%NASDAQ -1.2% 5.3% -1.5% 0.0% -1.5% 6.2% -0.5% 7.6% -3.9% -2.6% -0.5% -5.2% 1.3% 10.1%

Sector Long Short Gross NetBusiness Services 8% 5% 13% 3% Alliance Data Systems LongConsumer 3% 3% 6% -1% Aspen Insurance HoldingsFinancial Institutions 20% 7% 26% 13% Capital One FinancialFinancial Services 24% 4% 27% 20% CompuCredit CorporationHealthcare 0% 0% 0% 0% Hilton HotelsIndustrial 2% 7% 9% -5%Technology 4% 1% 5% 3%Technology Services 19% 3% 22% 16% Long ShortReal Estate 24% 7% 30% 17% Top 5 16% 8%

103% 36% 139% 67% 28% 14%

Summary for the Quarter EndedDecember 31, 2005

Western Reserve Hedged Equity, LP

Quarter EndedDecember 31, 2005

Positions1 Performance Ending Exposure1

69 1.8% 103%31 -1.7% 36%100 0.1% 139%

-0.2% 67%-0.2% 67%

Trailing Twelve Months (TTM)

Performance Average Exposure1

-0.3% 96%-4.0% 43%-3.9% 139%-4.3% 53%-4.5% 53%

Year to Date Comparative Returns2

Trailing Twelve Months Comparative Returns2

Composition by Sector (% of Capital) Key Positions

Monster Worldwide Espeed Inc.

Top 5 Winners YTD Short

Compucredit H&R Block, Inc.

Percent of Capital

Largest Long Positions

Top 10 Positions

SI International Superior IndustriesWest Corporation Jack in the Box

MBNA Corporation Pier 1 Imports

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

-9%

-5%

-1%

4%

8%

12%

16%

20%

24%

28%

32%

Dec Feb Apr Jun

Aug OctDec Feb Apr Ju

nAug Oct

Dec

Western Reserve S&P 500

NASDAQ

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.


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