Michael Durante Western Reserve WRHE 2Q04 letter

First Half 2004 August 16, 2004

Jan Feb Mar 1Q04 Apr May June 2Q04 YTD

Long 2.1% 2.8% 2.1% 7.0% -4.3% 1.3% 1.8% -1.3% 5.7%Short -0.1% -0.7% -1.0% -1.8% 1.2% -0.9% -0.5% -0.2% -2.0%Total 2.0% 2.2% 1.0% 5.1% -3.0% 0.3% 1.3% -1.5% 3.6%

S&P 500 1.7% 1.2% -1.6% 1.3% -1.7% 1.2% 1.8% 1.3% 2.6%NASDAQ Composite 3.1% -1.8% -1.8% -0.5% -3.7% 3.5% 3.0% 2.6% 2.2%Russell 2000 4.3% 0.8% 0.8% 5.9% -5.2% 1.5% 4.0% 0.2% 6.2%Dow 0.3% 0.9% -2.1% -0.9% -1.3% -0.4% 2.4% 0.7% -0.2%

* Estimated returns are gross of all fees and expenses.

“The price of ability does not depend on merit, but on supply and demand.”

- George Bernard Shaw Dear Partners: Western Reserve Hedged Equity, LP (“WRHE”) declined 1.5% in the second quarter and is up approximately 3.6% for the first half of the year. The quarter was dominated by extreme volatility in the broader market and very poor performance in financial-related stocks ahead of the first Fed rate hike in nearly five years. April witnessed a sharp sell-off in Western Reserve’s real estate and financial services holdings, WRHE’s highest recurring revenue investments, as the broad market focused on interest rates. Job growth picked up significant steam in March after lagging (and frightfully so) for much of the expansion. The sudden timetable shift forward for action by the Federal Reserve in early April caused investors to rotate (we suspect over-rotate) out of high recurring revenue financial-related investments into more counter cyclical, large cap and staple investments (food e.g.). This is a normal knee-jerk reaction by the investing public and many terrific companies (e.g. Citigroup in which the fund has never held a position) were down over 10% during the second quarter. REITs were down 18% at their trough by mid May. Investors are struggling in 2004 to assess risk amid a very turbulent period for macroeconomic factors including concerns over inflation, interest rates, the economy, Iraq, the fall election, record nominal oil prices and terrorism (did we get all of them?). Regardless, we continue to stick with our investment discipline and the inefficient marketplace has afforded us highly attractive entry points in many stocks. Additionally, some uniquely compelling late stage private equity opportunities have surfaced due to hostile public market conditions.

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

August 16, 2004

The partnership’s longs continued to see terrific fundamentals during April’s earnings reporting season in the face of a steep decline in prices and this was repeated during the July reporting season as well. Investor reaction to strong fundamentals can at best be described as disappointing so far in 2004. Perhaps an example of how distorted the risk premium in public market pricing has become can readily be seen in some of the partnership’s larger long holdings. As of June 30, 2004:

2005E Price/Cash Earnings

Cash Earnings Growth Rate

PEG

Implied Cash Earnings Yield

Dividend Yield

ACF 9x 20% 45% 12% N/A AHM* 7x 15% 50% 13% 12% COF 10x 18% 55% 10% N/A CKFR 8x 20% 40% 17% N/A NCEN* 5x 17% 30% 18% 15% NDE 7x 18% 40% 13% 4% Private A* 5x 20% 25% 16% 16% S&P 500 20x 8% 250% 6% 2% *pro forma for REIT conversion.

At the end of the second quarter, the fund’s long position P/E stood at an average of 10.7x our estimate for next twelve month’s earnings or operating cash flow equivalent and an average cash earnings yield that exceeds 11% (almost double the broader market). Conversely, we forecast long position growth of earnings or cash flow equivalent to exceed 18% in the coming twelve months. That’s about as compelling a discount (valuation and implied earnings yield) relative to growth as we have seen in other tough periods, including crisis periods such as Long-Term Capital in 1998 and after 9/11. Conversely, the partnership’s short positions carry a much higher 21x average P/E and averages a far less compelling cash earnings yield of under 6%. Thus, any differentiation by the market should be well rewarded down the road as more efficient conditions resume. We have high conviction in our growth rate assumptions for the partnership’s longs due to our intense focus on high recurring revenue business models. For example, we did not suffer a single estimate miss during the second quarter earnings period nor did a single one of our longs call down future earnings or growth estimates while many increased their forecast. Amid the malaise for most stocks, we are finding terrific bargains as a result. While the rewards are not immediate given current market conditions, we are very compelled by the growing number of opportunities we are seeing through our fundamental research.


August 16, 2004

In the first quarter 2004 letter, we discussed a few of WRHE’s winners. As we reflect upon the second quarter, it’s a good time to recap our core investment philosophy and strategy given that the market is currently not focusing on fundamentals. Western Reserve espouses a purely bottom-up fundamental and valuation discipline to stock selection. We use strict sell/cover disciplines to avert material harm driven by events outside our research scope and capabilities. Predicting oil prices, interest rates and terrorism are among our more decidedly absent skill sets. If these issues were to become a serious threat to portfolio positions, our disciplines would reduce these threats stock by stock on volume, volatility and price movement measures we have employed for some time. The important point is that we invest in firms where their fundamentals are not dictated by a commodity. The more a highly skilled management team and a superior business strategy dictates fundamental outcome, the more interested we become as investors. However, that does not preclude their stocks from trading like a commodity during inefficient markets driven by sudden shifts in macro expectations and fear on the part of the investing public. We strongly believe the market will revert to trading on fundamentals. It always does. Expectations, both local and global, will affect stocks in the short term, but only earnings affect stock prices over time. Our highly disciplined valuation focus, which encompasses both public and private market valuation metrics, is used to measure our entry and exit points. Put succinctly, our earnings forecasts dictate our interest long and short and valuation drives timing. Thus, we see the investment landscape in a very simplified way: (i) get the earnings right through intensive fundamental research and by focusing on superior business models; (ii) hold for valuation by being disciplined not to over pay; and (iii) use strict sell/cover disciplines to mitigate mistakes made in (i) or (ii). Our short discipline is to identify companies that have fundamental business flaws which prevent them from generating consistent earnings (and thus economic value), and whose valuations are intrinsically high as a result. If we remain focused upon our research and get the earnings right, the enormous disparity between growth and valuation should take care of itself here in time. So far, 2004 is a slugfest for stocks driven by macro forces. As such, we remain disenfranchised (albeit not surprised) but not disengaged by the sheer top down nature of the market so far. As Fed policy now has become a focus as more economic data is digested and the election uncertainty gets discounted, investors again will turn to fundamentals. What is important to our style of investing is not predicting macro shifts, but rather staying on point by getting the fundamentals right while waiting for investors to discount macro shifts and return to fundamental investing.


August 16, 2004

Occasionally and despite our protest, we are reminded of something the great satirist and Noble Laureate George Bernard Shaw said about merit when we apply it to the oft delicate balance between supply and demand for stocks during controversial times - “The price of ability does not depend on merit, but on supply and demand.” Stay the course. Inefficiency, while frustrating at times, is more our friend than our foe. Regards,

Michael P. Durante Managing Partner


August 16, 2004

Summary for the Six Months Ended June 30, 2004

Western Reserve Hedged Equity, LP

Positions Perf. Ending Exposure

Average Exposure

Long 53 5.7% 88% 72%Short 40 -2.0% 46% 38%Total (Gross) 93 3.6% 134% 110%Total (Net) (1) 2.3% 42% 31%

(1) Estimated performance net of expenses, management fee and prospective incentive allocation.

Composition by Sector (% of Capital)

Sector Long Short Gross NetBusiness Services 8% -3% 11% 5%Consumer 10% -8% 18% 2%Financial Institutions 16% -15% 31% 1%Financial Services 22% -9% 31% 13%Healthcare 1% 0% 1% 1%Industrial 0% 0% 0% 0%Technology 3% 0% 3% 3%Technology Services 16% -2% 18% 14%Yield/Real Estate 12% -9% 21% 3%

88% -46% 134% 42%

Percent of Total Capital

Top 3 Winners Overall YTDLong Short Long Short

Top 5 17% 10% Metris Companies CarMaxTop 10 31% 19% Alliance Data Services Bearing Point

Doral Financial Krispy Kreme

Attribution Analysis - Contribution to Total Return (gross)

Jan Feb Mar 1Q04 Apr May June 2Q04 YTDLong 2.1% 2.8% 2.1% 7.0% -4.3% 1.3% 1.8% -1.3% 5.7%Short -0.1% -0.7% -1.0% -1.8% 1.2% -0.9% -0.5% -0.2% -2.0%Total 2.0% 2.2% 1.0% 5.1% -3.0% 0.3% 1.3% -1.5% 3.6%

S&P 500 1.7% 1.2% -1.6% 1.3% -1.7% 1.2% 1.8% 1.3% 2.6%NASDAQ Composite 3.1% -1.8% -1.8% -0.5% -3.7% 3.5% 3.0% 2.6% 2.2%Russell 2000 4.3% 0.8% 0.8% 5.9% -5.2% 1.5% 4.0% 0.2% 6.2%Dow 0.3% 0.9% -2.1% -0.9% -1.3% -0.4% 2.4% 0.7% -0.2%

Six Months
