1 US GAAP Illustrative financial statements: Investments funds
2 Technical guide The purpose of this publication is to assist you in preparing the financial statements of an investment fund in accordance with US GAAP. It illustrates one possible format of financial statements for fund-specific entities based on a fictitious tax-exempt open-ended master-feeder investment company structure adopter of US GAAP, which have been prepared in accordance with paragraph This publication reflects US GAAP in issue at June 1, 2014 that are required to be applied by an entity with an annual period beginning on January 1, 2014 ( currently effective requirements). Choice of accounting policies The accounting policies disclosed in these illustrative financial statements reflect the facts and circumstances of the fictitious tax-exempt open-ended investment company on which these financial statements are based. They should not be relied upon for a complete understanding of the requirements of US GAAP and should not be used as a substitute for referring to the standards and interpretations themselves. The accounting policy disclosures appropriate for an entity depend on the facts and circumstances of that entity and may differ from the disclosures presented in these illustrative financial statements. When preparing financial statements in accordance with US GAAP, an entity should have regard to its local legal and regulatory requirements. This publication does not consider any requirements of a particular jurisdiction (except for the illustrative example of disclosures relating Commodity Pool Operators in Appendix III). s The illustrative examples, together with the explanatory notes are not intended to be seen as a complete and exhaustive summary of all disclosure requirements that are applicable under US GAAP. For an overview of all disclosure requirements that are applicable under US GAAP, please refer to the AICPA Audit & Accounting Guide: Investment Companies. To the left of each item disclosed, a reference to the relevant currently effective standard is provided; generally the references relate only to disclosure requirements, except that Note 2 highlights key accounting requirements in relation to significant accounting policies. Under US GAAP paragraphs , through to it is ordinarily desirable that the financial statements are presented for one more preceding year, as well as for the current year with all information presented being comparable. However as this is not yet compulsory, these financial statements have only been prepared to reflect one financial period with no comparative figures.
3 Financial Statements of
4 Table of Contents Financial statements Statement of Assets, Liabilities and Partners Capital 1 Condensed Schedule of Investments 2-6 Statement of Operations 7 Statement of Changes in Partners Capital 8 Statement of Cash Flows 9 Notes to Financial Statements Appendix Guidance Notes Appendix I Additional Disclosures for Investments in Fund of Funds 35 Appendix II Additional Disclosures for Open Futures and Options Contracts 36 Appendix III Commodity Pools 37 Page
5 Statement of Assets, Liabilities and Partners Capital Assets Investments in securities, at fair value (cost: $133,032,234) $ 122,203,275 Investments in private company, at fair value (cost: $154,000) 200,000 Investments in other investment companies, at fair value (cost: $15,864,679) 19,024,165 Derivative contracts, at fair value (premiums paid: $6,008,243) 9,888, Cash and cash equivalents 38,145,660 Due from broker 30,328,490 Receivable from repurchase agreements 1,000,000 Dividends and interest receivable 64,575 Other assets 60, Total Assets $ 220,914,223 Liabilities Securities sold short, at fair value (proceeds: $20,807,000) $ 26,020,165 Derivative contracts, at fair value (premiums received: $160,000) 6,931,000 Payable under repurchase agreements 20,000,000 Dividend and interest payable 822, Withdrawals payable to Limited Partners 1,657,200 Withdrawals payable to General Partner 50,124 Accrued expenses and other liabilities 51, Total Liabilities $ 55,531, Partners Capital $ 165,382, Total Liabilities and Partners Capital $ 220,914,223 See accompanying notes to financial statements.
6 Condensed Schedule of Investments Description Shares Cost Fair Value % of Partners Capital Investments in securities Bank debt Europe Energy $ 1,000,000 $ 1,146, % Common stock T Asia Banks Malayan Bank Ltd. * 140,530 9,756, Basic materials 950, Consumer, cyclical 2,025, Consumer, non-cyclical 2,892, Energy 3,490, Healthcare 2,054, Industrial 4,479, Software NP Systems Technologies, Ltd.* 250,050 10,878, Transportation 1,530, Total Asia 42,486,008 38,059, Emerging Europe Basic materials 4,540, Consumer, cyclical 2,069, Consumer, non-cyclical 5,312, Energy 394, Financial 5,500, Industrial 6,700, Media 2,796, Telecommunications 1,928, Total Emerging Europe 28,187,336 29,242, Latin America Basic materials 2,182, Energy 1,182, Financial 1,294, Industrial 3,617, Total Latin America 14,176,322 8,277, Total common stock $ 84,849,666 $ 75,578, % See accompanying notes to financial statements. * $20,000,000 of these securities are held as collateral against the payable under repurchase agreement.
7 3 Condensed Schedule of Investments (continued) Description Cost Fair Value % of Partners Capital Investments in securities (continued) Corporate bonds Asia Financial * $ 12,285,518 $ 13,042, % Emerging Europe Financial 373, , Latin America Telecommunications 6,033,191 5,018, North America Telecommunications 2,174,718 1,904, Total corporate bonds 20,866,777 20,447, Government bonds Emerging Europe Financial Russian Federation $9,000,000 5% step coupon bonds 3/31/ ,729,749 9,100, Mortgage-backed securities North America Financial Heller Financial Series $8,000,000, 2369 Class A 1.87%, 11/30/2015 8,000,000 8,802, Preferred stock Latin America Consumer, non-cyclical 1,683, Financial 2,370, Telecommunications 3,074, Total preferred stock 7,586,042 7,128, Total investments in securities 133,032, ,203, Investment in private company 154, , Investments in other investment companies (see Appendix I) North America Global macro 7,554,497 7,509, Multi-strategy 8,310,182 11,514, Total investments in other investment companies $ 15,864,679 $ 19,024, % See accompanying notes to financial statements. * $20,000,000 of these securities are held as collateral against the payable under repurchase agreement.
8 Condensed Schedule of Investments (continued) Description Premiums paid Fair Value Derivative contracts, at fair value 4 % of Partners Capital Credit default swaps Asia Basic materials $ 222, % Consumer, cyclical 143, Total Asia 365, Emerging Europe Basic materials 819, Energy 418, Total Emerging Europe 1,237, Total credit default swaps 1,603, Forward foreign currency exchange contracts 330, Futures contracts North America Equity indices 2,000, Metals 550, Total futures contracts 2,550, Interest rate swap 396, Options Call options purchased North America Technology 3,107, Indices 700, Total call options purchased $ 5,008,243 3,808, Warrants North America Financial 1,000,000 1,200, Total derivative contracts, at fair value $ 6,008,243 $ 9,888, % See accompanying notes to financial statements.
9 5 Condensed Schedule of Investments (continued) Description Proceeds/ Premiums received Fair Value % of Partners Capital Securities sold short Common stock Asia Basic materials $ 15,000,000 $ 21,224, % Government bonds Latin America 1,702,743 1,558, North America 610, , Total government bonds 2,312,909 2,068, U.S. agency bonds 3,494,091 2,727, Total securities sold short 20,807,000 26,020, Derivative contracts, at fair value Credit default swaps Asia Basic materials 50, , Options Call options written (see Appendix II) North America Basic materials 45, Financial 134, Total call options written 110, , Forward foreign currency exchange contracts 811, Futures contracts North America Financial 5,000, Total return swap North America Banks 50, Total derivative contracts, at fair value $ 160,000 $ 6,931, % See accompanying notes to financial statements.
10 6 Condensed Schedule of Investments (continued) Guidance Notes: (1) Investments in restricted securities, affiliated companies, securities subject to call options, and the like require special identification in the condensed schedule of investments and may require disclosure or specific identification in the notes to the financial statements. (2) Individual securities constituting more than 5% of partners capital (or net assets, where applicable) must be specifically identified. Securities of the same issuer aggregating more than 5% of net assets must be specifically identified. Total long and short positions in any one issuer must be considered separately. Follow look through rules for investments in other investment companies and master funds.
11 Statement of Operations For the year ended Investment income Dividends (net of withholding taxes of $1,484,378) $ 4,996,881 Interest 452,297 5,449,178 Expenses Interest expense 1,361,679 Professional fees 118,107 CFTC required Broker fees 89,347 Dividends expense 67,293 Other expenses 12,268 1,648, Net investment income 3,800, Net realized and unrealized gain/(loss) on investments, derivative contracts and foreign currencies: Net realized gain on investments, derivative contracts and foreign currencies 5,460,284 Net change in unrealized loss on investments, derivative contracts and foreign currencies (4,398,019) 1,062, Net increase in partners capital resulting from operations $ 4,862,749 See accompanying notes to financial statements.
12 Statement of Changes in Partners Capital For the year ended General Partner Limited Partners Total Partners capital at beginning of year $ 32,103, ,159, ,263,589 Net increase in partners capital resulting from operations 972,549 3,890,200 4,862, Capital contributions - 383, ,250 Capital withdrawals (200,000) (3,927,250) (4,127,250) Partners capital at end of year $ 32,876, ,505, ,382,338 See accompanying notes to financial statements.
13 Statement of Cash Flows For the year ended Cash flow from operating activities Net increase in partners capital resulting from operations $ 4,862,749 Adjustments to reconcile net increase in partners capital resulting from operations to net cash used in operating activities: Net realized gain on investments, non-zero cost derivative contracts and foreign currencies (5,460,284) Net change in unrealized loss on investments, non-zero cost derivative contracts and foreign currencies 4,398,019 Payments on settlement of derivative contracts, net (460,284) Purchases of investments in securities (122,868,037) Proceeds from sale of investments in securities 122,866,978 Purchases to cover securities sold (17,893,219) Proceeds from securities sold short 19,435,803 Changes in operating assets and liabilities: Dividend and interest receivable (5,281) Other assets (10,000) Dividends and interest payable (35,130) Due from broker (18,507,880) Accrued expenses and other liabilities (15,283) Net cash used in operating activities (13,691,849) Financing activities Receivable from repurchase agreements (1,000,000) Payable under repurchase agreements 4,620,000 Capital contributions received 383,250 Capital withdrawals paid (13,620,618) Net cash used in financing activities (9,617,368) Net decrease in cash and cash equivalents (23,309,217) Cash and cash equivalents at beginning of year 61,454,877 Cash and cash equivalents at end of year $ 38,145, Supplementary information on cash flows from operating activities: Interest paid $ 1,059,559 See accompanying notes to financial statements.
14 10 Notes to Financial Statements 1. General information Global Master Fund, L.P. (the Master Fund ) is a Cayman Islands exempted limited partnership established under the laws of the Cayman Islands. The Master Fund was registered under the Cayman Islands Mutual Funds Law (as revised) on December 15, The Master Fund is governed by its Limited Partnership Agreement dated August 25, 2008 (the Agreement ) and commenced operations in a master/feeder structure on January 15, The objective of the Master Fund is to seek appreciation over the long-term, principally through long or short positions in equities and equity-related securities, commodities and other financial instruments. The Master Fund has two limited partners: Offshore Feeder Fund, Ltd. (the Fund ), a Cayman Island exempted company incorporated with limited liability, and Domestic Feeder Fund L.P. (the Partnership ), a Delaware limited liability partnership. The Partnership and the Fund are collectively referred to as the Feeder Funds. As at, the Partnership and Fund held 38% and 62%, respectively, of the Master Fund s limited partner capital balance. General Partner L.P. (the General Partner ), a Cayman Islands exempted limited partnership, has overall responsibility for the affairs of the Master Fund and Partnership. Investment Management, LLC (the Investment Manager ), a Delaware limited liability company, manages the Master Fund s investment portfolio and has full discretionary investment management authority. General Partner L.P. and Investment Management, LLC are controlled by the same principals. Prime Custodial Brokers, LLC (the Prime Broker ) is the prime broker and custodian. The administration of the Master Fund is delegated to Fund Admin Limited (the Administrator ). 2. Significant accounting policies The accompanying financial statements are prepared in conformity with U.S. generally accepted accounting principles ( US GAAP ). The Master Fund is considered an investment company under US GAAP and follows the accounting and reporting guidance applicable to investment companies in the Financial Accounting Standards Board ( FASB ) Accounting Standards Codification ( ASC ) 946, Financial Services Investment Companies ( ASC 946 ). The significant accounting policies adopted by the Master Fund are as follows: (a) Use of estimates The preparation of financial statements in accordance with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the year. Actual results could differ from those estimates. (b) Investment transactions and related investment income and expenses Investment transactions are accounted for on a trade date basis. Realized gains and losses and movements in unrealized gains and losses are recognized in the statement of operations and determined on a first-in-first-out ( FIFO ) basis. Movements in fair value are recorded in the statement of operations at each valuation date.
15 Significant accounting policies (continued) (b) Investment transactions and related investment income and expenses (continued) Dividend income is recognized on the ex-dividend date and is presented net of withholding taxes. Dividends declared on short positions held on the ex-dividend date are recorded as dividend expense. Interest income and expense are recognized on an accruals basis except for securities in default for which interest is recognized on a cash basis. Premiums and discounts on debt securities are amortized using the effective interest method. Withholding taxes on foreign dividends have been provided for in accordance with the Master Fund s understanding of the applicable country s tax rules and rates. (c) Receivables from and payables under repurchase agreements When the Master Fund purchases a financial asset and simultaneously enters into an agreement to resell the asset at a fixed price on a future date ( repurchase agreement ), the arrangement is accounted for as receivables ( receivables from repurchase agreements ), and the underlying asset is not recognized on the Master Fund s financial statements. When the Master Fund sells a financial asset and simultaneously enters into an agreement to repurchase the same asset at a fixed price on a future date, the agreement is accounted for as borrowings ( payables under repurchase agreements ), and the underlying asset is not recognized in the Master Fund s financial statements. Receivables and payables from repurchase agreements are initially measured at fair value less incremental direct transaction costs, and subsequently measured at amortised cost, using the effective interest method. (d) Fair value Definition and hierarchy Financial instruments are recorded at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the exit price ) in an orderly transaction between market participants at the measurement date. A fair value hierarchy of inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Master Fund. Unobservable inputs reflect the Master Fund s assumptions about the inputs market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows: Level 1-Unadjusted quoted prices in active markets for identical assets or liabilities that the Master Fund has the ability to access. Level 2-Observable inputs other than quoted prices included in Level 1 that are not observable for the asset or liability either directly or indirectly. These inputs may include quoted prices for the identical instrument on an inactive market, prices for similar instruments, interest rates, prepayment speeds, credit risk, yield curves, default rates, and similar data.
16 12 2. Significant accounting policies (continued) (d) Fair value (continued) Definition and hierarchy (continued) Level 3-Unobservable inputs for the asset or liability to the extent that relevant observable inputs are not available, representing the Master Fund s own assumptions about the assumptions that a market participant would use in valuing the asset or liability, and that would be based on the best information available. In determining fair value, the Master Fund uses various valuation approaches. Inputs that are used in determining fair value of an instrument may include price information; quotations received from market makers, brokers, dealers and/or counterparties (when available and considered reliable); credit data; volatility statistics and other factors. Inputs, including price information, may be provided by independent pricing services or derived from market data. Inputs can be either observable or unobservable. The availability of observable inputs can vary from security to security and is affected by a wide variety of factors, including, for example, the type of security, whether the security is new and not yet established in the marketplace, the liquidity of markets, and other characteristics particular to the security. To the extent that valuation is based on models or inputs that are less observable in the market, the determination of fair value requires more judgement. Accordingly, the degree of judgement exercised in determining fair value is greatest for instruments categorized in Level 3. The inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement falls in its entirety is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Valuation Equity securities and equity securities sold short The Master Fund values investments in equity securities and equity securities sold short that are freely tradable and are listed on a national securities exchange at their last sales price as of the valuation date. These investments are classified as Level 1 in the fair value hierarchy and include common stocks, and preferred stock. The Master Fund s policy for securities traded for which no sale was reported on that date are valued at their last reported bid price if held long, and last reported ask" price if sold short. If no price is available, the security is valued at its fair value determined in good faith by the Investment Manager. Such circumstances would generally result in the security being classified as level 2 or 3 in the fair value hierarchy. Many investment transactions have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that the marketplace participants are willing to pay for an asset. Ask prices represent the lowest price that the marketplace participants are willing to accept for an asset. For securities whose inputs are based on bid-ask prices, the Master Fund s valuation policies do not require that fair value always be a predetermined point in the bid-ask range.
17 13 2. Significant accounting policies (continued) (d) Fair value measurements (continued) Valuation (continued) Fixed income investments Fixed income investments include bank debt, corporate bonds, convertible bonds, government bonds and mortgage-backed securities ( MBS ). These investments are stated at fair value based on quoted market prices whenever available. For the securities for which no quoted market prices are available, fair value is determined based on bid/ask quotes received by brokers specializing in specific investments and multiple broker quotes are used where possible to determine the end market value. The broker s pricing methodology is assessed when determining the fair value hierarchy. The fair value level for broker quotes is Level 2 only if the prices are derived from market observable inputs, otherwise the Level 3 fair value category is applied. The fair value of bank debt is generally valued using recently executed transactions, market price quotations (where observable) and market observable credit default swap levels. When quotations are unobservable, proprietary valuation models and default recovery analysis methods are employed, utilizing default rates within a range of 1.25% to 5.25%, recovery rates within a range of 2.50% to 6.50%, and loss rates within a range of 2.50% to 6.50%. Depending on the frequency of executed transactions and availability of market quotations, bank debt is generally categorized in Level 2 or 3 of the fair value hierarchy. Daily market quotations for MBS securities in which the Master Fund invests are not always readily available. In such cases, the fair value of the Master Fund s MBS investments is determined on a mark-to-model basis which incorporates both observable and unobservable inputs. As a result, the unrealized gains and losses for MBS securities may include changes in fair value attributable to both observable and unobservable inputs. Using observable historical inputs (prepayments, delinquencies, etc.) as well as unobservable inputs (market yields, etc.), the Master Fund s management values its MBS investments by estimating each investment s future cash flow. Individual investments are reviewed based upon historical collateral performance of the issuer, the structure of the security and the certainty and timing of cash flows. When valuing its investments, the Master Fund s management will take into consideration changes in prepayment trends and assumptions, changes in default trends and assumptions, changes in delinquency, and changes in interest rates, structural triggers, collateral seasoning, deal seasoning, and other factors. Deal specific scenarios will be derived from historical performance information and loan level details. These scenarios will be used to test the timing of cash flows, step down probabilities, certainty of triggers tripping/passing, and other structural components specific to each individual security. MBS are categorized in Level 2 of the fair value hierarchy when external pricing data is observable and in Level 3 when external pricing data is unobservable.
18 14 2. Significant accounting policies (continued) (d) Fair value measurements (continued) Valuation (continued) Fixed income investments (continued) U.S. agency bonds are comprised of two main categories consisting of agency issued debt and mortgage pass-throughs. Agency issued debt securities are generally valued based on a valuation model that includes interest rate yield curves and cross curve index spreads and sovereign credit spreads similar to the bond in terms of the issuer, maturity and seniority. Mortgage pass-throughs include to-be-announced (TBA) securities and mortgage pass-through certificates. TBA securities and mortgage pass-throughs are generally valued using dealer quotations. Depending on market activity levels and whether quotations or other data are used, these securities are typically categorized in Level 1 or Level 2 of the fair value hierarchy. Private company Investment in private company consists of a direct ownership of common and/or preferred stock of a privately held company. The transaction price, excluding transaction costs, is typically the Master Fund s best estimate of fair value at inception. When evidence supports a change to the carrying value from the transaction price, adjustments are made to reflect expected exit values in the investment s principal market under current market conditions. The Master Fund performs ongoing reviews based on an assessment of trends in the performance of each underlying investment from the inception date through the most recent valuation date. These assessments typically incorporate the original transaction price, recent transactions in the same or similar instruments, completed or pending third-party transactions in the underlying investment or comparable issuers, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt capital markets and changes in financial ratios or cash flows. As at, the fair value of the Master Fund s investment in private company was $200,000, determined by industry standard valuation models based on a market approach. The significant inputs into the valuation models comprised a comparable market transaction, earnings before interest, depreciation and amortization of the underlying company and enterprise value multiples (based on comparable public company information, ranging from 8.0x to 10.0x). The investment in private company is included in Level 3 of the fair value hierarchy.
19 15 2. Significant accounting policies (continued) (d) Fair value measurements (continued) Valuation (continued) Other investment companies Investments in other investment companies ( Investee Funds ) are valued, as a practical expedient, utilizing the net asset valuations provided by the Investee Funds, without adjustment, when the net asset valuations of the investments are calculated in a manner consistent with US GAAP for investment companies. The Master Fund applies the practical expedient to its investments in the Investee Funds on an investment-by-investment basis, and consistently with the Master Fund s entire position in a particular investment, unless it is probable that the Master Fund will sell a portion of an investment at an amount different from the net asset valuation. If it is probable that the Master Fund will sell an investment at an amount different from the net asset valuation or in other situations where the practical expedient is not available, the Master Fund considers other factors in addition to the net asset valuation, such as features of the investment, including subscription and redemption rights, expected discounted cash flows, transactions in the secondary market, bids received from potential buyers, and overall market conditions in its determination of fair value. Investments in the Investee Funds are categorized in Level 2 or 3 of the fair value hierarchy. In determining the level, the Master Fund considers the length of time until the investment is redeemable, including notice and lock-up periods or any other restriction on the disposition of the investment. The Master Fund also considers the nature of the portfolios of the Investee Funds and their ability to liquidate their underlying investments. If the Master Fund has the ability to redeem its investment at the reported net asset valuation as of the measurement date, the investment is generally categorized in Level 2 of the fair value hierarchy. If the Master Fund does not know when it will have the ability to redeem the investment or it does not have the ability to redeem its investment in the near term, the investment is categorized in Level 3 of the fair value hierarchy. Derivative contracts - exchange-traded As part of the Master Fund s investment strategy, the Master Fund enters into exchange-traded derivative contracts which include futures contracts, options and warrants. Exchange traded derivative contracts are generally categorized in Level 1 of the fair value hierarchy. Futures contracts are marked to market daily on the fluctuations between the contract price and the market value of the underlying, as reported on a recognized exchange. Options are recorded at fair value based on quoted market prices in active markets, including recent market transactions or observable inputs based on quoted market prices. Warrants are valued at the last traded price on their principal markets.
20 16 2. Significant accounting policies (continued) (d) Fair value measurements (continued) Valuation (continued) Derivative contracts - over-the-counter As part of the Master Fund s investment strategy, the Master Fund enters into over-the-counter ( OTC ) derivative contracts which include forward foreign currency exchange contracts, interest rate swaps, total return swaps and credit default swaps. OTC derivative contracts are generally categorized in Levels 2 or 3 of the fair value hierarchy. Forward foreign currency exchange contracts ( forward contracts ) are valued at the prevailing forward exchange rate of the underlying currencies on the reporting date and unrealized gains or losses are recorded daily. Forward contracts are generally categorized in Level 2 of the fair value hierarchy. Interest rate swaps are traded on the OTC market. The fair value for interest rate swap contracts is derived using a pricing model that is widely accepted by marketplace participants. The pricing model takes into account the contract terms (including maturity) as well as interest rates. Some inputs into the model do not require material subjectivity as they are observable in the marketplace. Interest rate swaps are generally categorized in Level 2 of the fair value hierarchy. Total return swaps are traded on the OTC market. The fair value of total return swaps is recorded at the swap contract s net equity value. Net equity is calculated by determining the notional fair value of the assets or liabilities underlying the swap contracts, which are typically equity securities, and is consistent with the valuation procedures discussed below. Total return swaps are classified in Levels 2 or 3 of the fair value hierarchy. Credit default swaps are traded on the OTC market. The fair value for a credit default swap contract is derived using a pricing model that is widely accepted by marketplace participants. The pricing model takes into account multiple inputs including specific contract terms, interest rate yield curves, interest rates, credit curves, recovery rates, and current credit spreads obtained from swap counterparties and other market participants. Many inputs into the model do not require material subjectivity as they are observable in the marketplace or set per the contract. Other than the contract terms, valuation is heavily determined by the difference between the contract spread and the current market spread. The contract spread (or rate) is generally fixed and the market spread is determined by the credit risk of the underlying debt or reference entity. If the underlying debt is liquid and the OTC market for the current spread is active, credit default swaps are categorized in Level 2 of the fair value hierarchy. If the underlying debt is illiquid and the OTC market for the current spread is not active, credit default swaps are categorized in Level 3 of the fair value hierarchy.
21 17 2. Significant accounting policies (continued) (d) Fair value measurements (continued) Valuation (continued) Valuation process The Master Fund establishes valuation processes and procedures to ensure that the valuation techniques for investments that are categorized within Level 3 of the fair value hierarchy are fair, consistent, and verifiable. The Master Fund designates a Valuation Committee (the Committee ) to oversee the entire valuation process of the Master Fund s Level 3 investments. The Committee is comprised of various personnel of the Investment Manager who are separate from the Investment Manager s portfolio management and trading functions, and reports to the General Partner s Board of Directors. The Committee is responsible for developing the Master Fund s written valuation processes and procedures, conducting periodic reviews of the valuation policies, and evaluating the overall fairness and consistent application of the valuation policies. The Committee meets on a monthly basis, or more frequently as needed, to determine the valuations of the Master Fund s Level 3 investments. Valuations determined by the Committee are required to be supported by market data, third-party pricing sources, industry accepted pricing models, counterparty prices, or other methods the Committee deems to be appropriate, including the use of internal proprietary pricing models. The Master Fund periodically tests its valuations of Level 3 investments through performing back testing of the sales of such investments by comparing the amounts realized against the most recent fair values reported, and if necessary, uses the findings to recalibrate its valuation procedures. On an annual basis, the Master Fund engages the services of a nationally recognized third-party valuation firm to perform an independent review of the valuation of the Master Fund s Level 3 investments, and may adjust its valuations based on the recommendations from the valuation firm. (e) Foreign currency translation Assets and liabilities denominated in a currency other than the U.S. dollar are translated into U.S. dollars at the exchange rate as at the reporting date. Purchases and sales of investments and income and expenses denominated in currencies other than U.S. dollars are translated at the exchange rate on the respective dates of such transactions. The Master Fund does not isolate that portion of the results of operations resulting from foreign exchange gains or losses arising from holding or selling foreign currencies, currency gains or losses realized between the trade and settlement dates on securities transactions, and the difference between the amounts of foreign dividends, interest, and withholding taxes recorded on the Master Fund s books and the U.S. dollar equivalent of the amounts actually received or paid. Nor does the Master Fund isolate unrealized or realized foreign exchange gains and losses arising from changes in the fair values of assets and liabilities including investments. All such foreign exchange gains and losses are included in the net realized and net change in unrealized gain/(loss) on investments, derivate contracts and foreign currencies in the statement of operations.
22 18 2. Significant accounting policies (continued) (f) Cash and cash equivalents Cash and cash equivalents includes highly liquid investments, such as money market funds, that are readily convertible to known amounts of cash within 90 days from the date of purchase. All cash balances are held at major banking and broker institutions. (g) Allocation of income and expenses The Master Fund s increase or decrease in partners capital resulting from operations is allocated among the capital accounts of the Partners in proportion to their respective ownership percentage for the month as of the last day of each month. (h) Withdrawals payable Withdrawals are recognized as liabilities when the amount requested in the withdrawal notice become fixed. This generally may occur either at the time of the receipt of the notice, or on the last day of a fiscal period, depending on the nature of the request. Withdrawal notices received for which the dollar amount is not fixed remain in equity until the amount is determined. Withdrawals payable are treated as equity for purposes of allocation of income pursuant to the Feeder Funds governing documents. (i) Taxation There are no taxes on income or gains in the Cayman Islands and the Master Fund has received an undertaking from the Governor in Cabinet of the Cayman Islands exempting it from all local taxation on future profits, income or gains until September 16, The only taxes payable by the Master Fund are withholding taxes of other countries applicable to certain investment income. As a result, no tax liability or expense has been recorded in the financial statements. The Master Fund recognizes the tax benefits of uncertain tax positions only where the position is more-likely-than-not (i.e. greater than 50 percent) to be sustained assuming examination by a tax authority based on the technical merits of the position. In evaluating whether a tax position has met the recognition threshold, the Master Fund must presume that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the Master Fund s financial statements. Income tax and related interest and penalties would be recognized by the Master Fund as tax expense in the statement of operations if the tax positions were deemed to meet the more-likely-than-not threshold. The General Partner, in consultation with the Investment Manager (together, Management ), have analyzed the Master Fund s tax positions and has concluded that no liability for unrecognized tax benefits should be recorded related to uncertain tax positions. Further, Management is not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly change in the next twelve months.
23 19 2. Significant accounting policies (continued) (j) Organization costs Organization costs are stated net of accumulated amortization. Management has elected to capitalize organization costs of approximately $65,000 and amortize them on a straight-line method of over sixty months. Management believes this method to be more equitable to the limited partners than the method prescribed under US GAAP, which requires organization costs to be expensed as incurred, resulting in the original partners bearing all such costs. (k) Comprehensive Income The Master Fund has no comprehensive income other than the net income disclosed in the statement of operations. Therefore, a statement of comprehensive income has not been prepared. (l) Recent accounting pronouncements In June 2014, the FASB issued ASU No , Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures ( ASU ). ASU aligns the accounting for repurchase-to-maturity transactions and repurchase financing arrangements with the accounting for other typical repurchase agreements, i.e., these transactions will be accounted for as secured borrowings. The ASU also requires additional disclosures about repurchase agreements and similar transactions. The requirements of ASU are effective for fiscal years that begin after December 15, The Investment Manager is currently evaluating the impact, if any, that these updates will have on its financial condition or results of operations.
24 20 3. Fair value measurements The Master Fund s assets and liabilities recorded at fair value have been categorized based upon a fair value hierarchy. See Note 2 for a discussion on the Master Fund s valuation policies. The following table presents information about the Master Fund s assets and liabilities measured at fair value as of : Level 1 Level 2 Level 3 Total Assets (at fair value) Cash equivalents $ 1,000,000 $ - $ - $ 1,000,000 Investments in securities Bank debt - 1,146,416-1,146,416 Common stock 75,578, ,578,735 Corporate bonds 1,239,000 19,208,040-20,447,040 Government bonds - 9,100,220-9,100,220 Mortgage-backed securities - 8,802,224-8,802,224 Preferred stock 7,128, ,128,640 Total investments in securities 83,946,375 38,256, ,203,275 Private company , ,000 Other investment companies ,024,165 19,024,165 Derivative contracts Credit default swaps - 1,603,427-1,603,427 Forward foreign currency exchange contracts - 330, ,000 Futures contracts 2,550, ,550,000 Interest rate swap - 396, ,573 Call options purchased 3,808, ,808,058 Warrants 1,200, ,200,000 Total derivative contracts $ 7,558,058 $ 2,330,000 $ - $ 9,888,058 Liabilities (at fair value) Securities sold short Common stock $ 21,224,165 $ - $ - $ 21,224,165 Government bonds - 2,068,940-2,068,940 U.S. agency bonds - 2,727,060-2,727,060 Total securities sold short 21,224,165 4,796,000-26,020,165 Derivative contracts Credit default swaps - 890, ,000 Call options written 180, ,000 Forward foreign currency exchange contracts - 811, ,000 Futures contracts 5,000, ,000,000 Total return swap - 50,000-50,000 Total derivative contracts $ 5,180,000 $ 1,751,000 $ - $ 6,931,000
25 Fair value measurements (continued) The following is a reconciliation of assets for which Level 3 inputs were used in determining fair value: Other Investment Companies Mortgage- Backed Securities Private Company Total Balance at January 1, 2014 $ 3,700,000 18,624,165 3,219,737 25,543,902 Total realized gains 334, ,755 Change in unrealized gain 415, , ,737 1,204,982 Cost of purchases , ,000 Proceeds from sales (4,250,000) - (3,809,474) (8,059,474) Transfers into Level 3* Transfers out of Level 3* - - (300,000) (300,000) Balance at $ 200,000 19,024,165-19,224,165 Change in unrealized loss on investments, derivative contracts and foreign currencies included in the statement of operations attributable to Level 3 investments held at $ 67, , ,543 The Master Fund s policy is to recognize transfers into and out of the various levels as of the actual date of the event or change in circumstances that caused the transfer. * Transfers into and out of Level 3 generally relate to whether significant relevant observable inputs are available for the fair value measurement in their entirety. See Note 2 for additional information related to their fair value hierarchy and valuation techniques and inputs.
26 22 ASU Fair value measurements (continued) The following table summarizes the valuation techniques and significant unobservable inputs used for the Master Fund s investments that are categorized within Level 3 of the fair value hierarchy as of December 31, 2014: Quantitative Information about Level 3 Fair Value Measurements Balance at December 31, Valuation Unobservable Range 2014 Methodology Inputs (Weighted Average) Investments in securities Private investment companies $ 200,000 Industry accepted model EBITDA multiple Revenue multiple (1) 10X 15X (12.5X) (1.7) Other investment companies $ 19,024,165 Audited Net Asset Value of underlying investment company Current price of underlying instrument is illiquid N/A (1) Represents amounts used when the reporting entity has determined that market participants would use such multiples when pricing the investments Cash and cash equivalents Cash and cash equivalents at consist of the following: Cash $ 37,145,660 Money market funds 1,000,000 $ 38,145,660 Securities with a fair value of $500,000 were pledged to the Master Fund as collateral for amounts receivable under repurchase agreements. As at, cash in the amount of $13,694,362 was deposited with counterparties as collateral for positions held in derivative financial instruments. Included in the cash and cash equivalents balances at is cash in foreign currencies with a fair value of $145,000 (cost $130,300). 5. Due from broker All trades are settled through the Prime Broker. At, $30,328,490 was due from the Prime Broker for unsettled sales of securities. 6. Administration fees The Administrator is entitled to a fee based on a percentage of the Master Fund s capital value, subject to $12,000 minimum per month. Administration fees are accrued monthly and are payable monthly in arrears. The Administrator is also entitled to reimbursement of all out-of-pocket expenses incurred on behalf of the Master Fund.
27 Related party transactions As of, the Master Fund held investments in four related investment companies, which had an aggregate fair value of $2,093,813 (1.3% of partners capital). These related entities have the same Investment Manager as the Master Fund. 8. Financial instruments and associated risks Securities sold short The Master Fund sells securities that it does not own, and it will therefore be obligated to purchase such securities at a future date. The value of the open short position is recorded as a liability, and the Master Fund records an unrealized gain or loss to the extent of the difference between the proceeds received and the value of the open short position. The Master Fund records a realized gain or loss when a short position is closed out. By entering into short sales, the Master Fund bears the market risk of increases in the value of the security sold short in excess of the proceeds received. Possible losses from short sales differ from losses that could be incurred from purchases of securities because losses from short sales may be unlimited whereas losses from purchases cannot exceed the total amount invested. Market risk The General Partner seeks to manage the Master Fund s market risk on a continuous basis within a rigorous risk management framework by shorting securities to offset long positions, by investing in markets that have traditionally not been highly correlated to each other, by limiting the Master Fund s exposure to each country and issuer, and by utilizing other hedging strategies. Details of the Master Fund s investment portfolio at are disclosed in the condensed schedule of investments. Each separate investment exceeding 5% of net assets is disclosed separately. Counterparty credit risk Counterparty credit risk is generally the risk of counterparty default. Counterparty credit risk is generally higher when a non-exchange-traded financial instrument, such as an OTC derivative, is involved because the counterparties for non-exchange-traded financial instruments are not backed by an exchange clearing house. However, counterparty credit risk exists whenever another entity has possession and/or use of assets belonging to the Master Fund. The amount of exposure to credit risk is represented by the carrying amount of the assets on the statement of assets, liabilities and partners capital and the possible inability to replicate these contracts at market price. Substantially all financial instruments are cleared through or held in custody by the Prime Broker.
28 24 8. Financial instruments and associated risks (continued) Counterparty credit risk (continued) When the Master Fund uses non-exchange-traded derivative instruments, the Master Fund is exposed to the counterparty's credit risk: the risk that derivative counterparties may not perform in accordance with the contractual provisions. This risk is offset by the value of collateral received from the counterparty, if any. The Master Fund s exposure to credit risk associated with counterparty non-performance at any point in time is generally limited to the unrealized gains inherent in such transactions at such time that are recognized in the statement of assets, liabilities and partners capital, plus the amount of any collateral pledged by the Master Fund to the counterparty to support these transactions. The Master Fund seeks to minimize its credit and counterparty risk through continuous monitoring of the credit rating of the different issues. The Master Fund will seek to minimize downside risk and protect principal by maintaining a diversified portfolio with respect to industry and the size of individual holdings and actively monitoring the risk of each of the investments and risk of portfolio correlation among assets. For the risk associated with the repurchase agreements, see Note 9. Leverage The Master Fund may borrow funds in order to increase the amount of capital available for investment. The use of leverage can substantially improve the return on invested capital; however, such use may also increase the adverse impact to which the portfolio of the Master Fund may be subject. Borrowings will usually be from securities brokers and dealers and will typically be secured by the Master Fund s securities and other assets. Under certain circumstances, such a broker-dealer may demand an increase in the collateral that secures the Master Fund s obligations and if the Master Fund were unable to provide additional collateral, the broker-dealer could liquidate assets held in the account to satisfy the Master Fund s obligations to the broker-dealer. Liquidation in this manner could have extremely adverse consequences. In addition, the amount of the Master Fund s borrowings and the interest rates on those borrowings, which will fluctuate, could have a significant effect on the Master Fund s profitability.
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