Sandler Associates Fund Returns 5% in 2011

January 20, 2012
Dear Partner,

We are pleased to provide this update on Sandler Associates (the “Fund”). Your individual capital account statement for year-end was delivered directly from the Fund’s administrator, Morgan Stanley Fund Services. Please let us know if you have not received it. Also, please be sure to review the end of this letter for several important announcements.

As shown below, the Fund was down approximately 0.7% net for the quarter, while the broad equity market indices posted double digit gains and the average long/short equity fund was up about 2%. The Fund finished the year up about 4.9% net. It was a disappointing quarter but capped a fairly successful year overall, especially relative to most equity indices and other long/short equity funds. Fourth quarter gains for equities were driven by a 20% intra month rally in October during which our short book performed poorly as the worst stocks rallied the most off the bottom. The rally was then followed by a choppy and challenging November and December.
1. Investment performance data is net of all fees, expenses, and incentive allocation and includes the reinvestment of all income, dividends and gains. Class A interests were charged a 1.0% management fee prior to April 2009 and after September 2011, and a 1.5% management fee in between. Class B interests were charged a 1.5% management fee since inception. Class A-U and B-U interests are eligible to participate in New Issues and Class A-R and B-R interests are ineligible. Unless otherwise indicated, Fund results reported in this letter are for Class A-U interests. Past performance is not necessarily indicative of future results. Fund results for 2011 are unaudited and subject to revision.
2. Market indices and benchmarks referred to in this letter are for illustration purposes only and have limitations when used for such purposes because they may have volatility or other material characteristics that are different from the Fund’s.

As shown below, during the fourth quarter, long positions added 5.0% to return while short positions detracted 5.3%, on a gross basis. On a standalone basis, the long portfolio was up 8.6% for the quarter while the short portfolio was down 14.8%, indicating significant negative alpha from stock selection during the period which was primarily driven by the run-up in the short portfolio during October.

Somewhat ironically, performance for the full year was driven by the short portfolio as we pressed our shorts at the right time, during the third quarter. For 2011, long positions added 0.2% to return and short positions added 8.5%, on a gross basis. On a standalone basis, the long portfolio was down 4.0% for the year while the short portfolio was up 3.6%, indicating flat stock picking results for the full year.

On a sector basis, positions in Industrials added most to performance during the fourth quarter (132 basis points), followed by positions in Tactical Market Indices (70 bps), Consumer Discretionary (57 bps), Consumer Staples (15 bps), and Utilities (5 bps). Positions in Materials detracted most from performance during the quarter (90 bps), followed by positions in Information Technology (77 bps), Energy (60 bps), Financials (40 bps), Healthcare (22 bps), and Telecommunications (13 bps). Currency hedging detracted from return for the quarter (14 bps).

For the year, the Fund exhibited a very favorable distribution of returns as the portfolio made money in every sector. Positions in Industrials added most to performance (229 basis points), followed by positions in Consumer Staples (165 bps), Energy (124 bps), Healthcare (93 bps), Materials (86 bps), Financials (61 bps), Tactical Market Indices (38 bps), Information Technology (32 bps), Utilities (29 bps), Telecommunication Services (18 bps), and Consumer Discretionary (17 bps). Currency hedging detracted from return for the year (45 bps). During the fourth quarter, the Fund’s delta-adjusted exposure averaged approximately 15% net long and 107% gross, while beta-adjusted exposure averaged approximately 21% net long and 119% gross. During 2011, the Fund’s delta-adjusted exposure averaged approximately 29% net long and 144% gross, while beta-adjusted exposure averaged approximately 35% net long and 158% gross.

As shown in the following chart, the Fund ended the year 18% net long on a delta-adjusted basis and 20% net long on a beta-adjusted basis. Gross exposure at year-end was 116% delta-adjusted and 135% beta-adjusted.

The following chart shows the Fund’s exposure by sector at year-end.

As shown above, our largest gross exposures by sector at year-end were 38% in Industrials, 28% in Consumer Discretionary, and 17% in Information Technology. The Fund ended the year with its largest net long exposures in Industrials (11%) and Consumer Discretionary (7%). The Fund had its largest net short exposure in Materials (4%) and had 3% or less net exposure in all other sectors.

The portfolio had positions in about 180 issuers at year-end and the largest single position was approximately 3.2% of assets.

Top Purchases/Sales
The three largest net purchases during the quarter, excluding ETFs, were of common stock in Rockwell Automation, Inc. (ROK), Spectris plc (London – SXS), and Clean Harbors, Inc. (CLH).

• Rockwell Automation is a global provider of industrial automation power, control and information solutions to manufacturing companies. We believe automation is being driven by several secular forces including the manufacturing of higher levels of goods in China, the need to combat higher labor costs in manufacturing-based emerging economies through increased productivity, consumer demand for higher quality products in the developing world, and low financing rates. We believe Rockwell is well positioned to capture this growth due to a superior product suite, favorable geographic exposures, and an increasing market share. In addition, we believe the company’s valuation is attractive vs. its peers and that it could be a strategic acquisition candidate for larger industrial conglomerates.

• Spectris develops and markets productivity-enhancing instrumentation and controls. This investment is also part of our testing and inspections theme as the company is involved in testing and calibration of complex equipment. We believe the company’s valuation is very attractive compared to its peers and that investors are underestimating the incremental margins the company can achieve as overall product complexity and levels of calibration and testing precision increase. The company should also benefit from exposure to strong end markets such as metals & mining, biotech, and aerospace while it has limited exposure to government and academic spend which could come under
austerity pressure. The company generates strong returns and free cash flow as its depreciation and amortization is in excess of its required maintenance cap-ex. We also believe Spectris is an attractive strategic acquisition target.

• We repurchased Clean Harbors, a provider of environmental, energy and industrial services, as the economy in the United States showed acceleration during the fourth quarter. The company continues to have strong pricing power in its incineration business and we believe its business in the Canadian Oil Sands is in the early innings of growth. In addition, we believe that the company’s balance sheet is well positioned for strategic acquisitions, something the company has done very effectively in the past.

The three largest net sales (selling of long positions) during the quarter, excluding ETFs, were common stock in eBay Inc. (EBAY), Oracle Corp. (ORCL), and General Mills, Inc. (GIS).

• Our investment in eBay was primarily based on our belief in the strong growth prospects for the company’s PayPal business as PayPal expands into new payment processing areas. In addition, both PayPal and eBay in general are beneficiaries of growth in ecommerce. We sold the position during the fourth quarter as we became concerned about the organic growth of the company’s marketplace division as it struggles to compete with Amazon. In addition, we were concerned about the company’s exposure to Europe. Lastly, the head of the company’s PayPal business left, causing us some alarm as we owned the stock primarily for this division.

We owned Oracle because we believed the company was well positioned for potentially contracting IT budgets, as customers with tighter budgets will likely skew purchasing towards larger vendors who can offer better pricing and value for multiple products versus single product vendors. In addition, the company has several new innovative products in data analytics software and high end analytics appliances and is a beneficiary of the growth in data processing and storage. Fortunately, we sold the position before the stock declined on the company’s earnings announcement. We had become wary of the company’s Sun Microsystems business and were concerned the stock was facing tough year over year comparisons going into earnings.

• We purchased General Mills as a dividend paying defensive stock as the company’s input costs were declining, its volumes were improving, and there was evidence the company was gaining shelf space over its rivals. We sold the stock as it reached our price target and we felt there was limited relative upside in an improving economy. In addition, the company showed disappointing volume growth in the cereal category.

Strategy and Outlook
During the fourth quarter, the economy in the United States showed better than expected results and fears of global catastrophe subsided. While catastrophe may well lie ahead at some point, we believe the risks have been significantly reduced for now, which should lead to lower daily volatility in equity markets. A more stable environment combined with continued growth, albeit slow, should provide ample investment opportunities for the Fund, both long and short.
We have increased both our net and gross exposures since the beginning of the year to about 35% and 130%, respectively, just above our historical averages. In addition, greater conviction and an improved backdrop have led us to build bulkier top positions in the portfolio as compared to most of 2011. Currently, the top five long positions represent combined exposure of 15%.

Some current themes on the long side of the portfolio include:

• Manufacturing cap-ex as businesses invest in plant sophistication and efficiency, as discussed above with Rockwell Automation. Several other positions in the book also touch on this theme.
• Testing and inspection, a longtime favorite, is also prevalent in the portfolio. However, we have been more selective in this space and have done some pair trading as some of these businesses are exposed to government spend and thus government austerity.
• Transportation services driven by either e-commerce growth, the manufacturing uptick in the United States, and/or pricing power in the case of the railroads.
• Energy cap-ex and services, specifically for oil related projects and those benefiting from increased shale drilling. Recently, we have trimmed some names and put on more hedges in this space as natural gas prices continue to nosedive.
• Selective themes in the consumer discretionary space including certain housing related investments and leisure plays with pricing power.
• Selective areas in technology including 4G equipment and software.

• In general, we are also favoring companies that we believe could be takeover candidates over the next several years.

On the short side, in addition to several hedges in the testing group and energy related space as mentioned above, themes include:

• Apparel names, as the area remains very promotional with no significant fashion trends.
• Retailers with declining market share and/or a weak e-commerce presence.
• Hardware companies in tech facing continued price erosion.
• Raw materials names with ever increasing challenges in production.

There are many factors to watch closely in 2012 from a top down perspective including the Euro situation, China growth, the presidential election in the United States, the 10-Year Treasury yield (which currently implies a very low level of growth ahead) along with several other credit metrics consumer discretionary spending growth which will likely depend on employment growth as the savings rate is currently at a low level, and most likely a couple factors we’ll learn about as the year progresses. We don’t know whether macro news and events will continue to drive the bus in 2012, but we will be paying close attention to them while we ride and will continue to be flexible in our positioning and approach if we see conditions change.

Asset Update
The asset size of the Fund at quarter-end was $361 million, and total strategy assets in our long/short equity products stood at approximately $1,093 million ($1,728 million with Sandler Plus strategy assets counted at 2 times).
Fund Re-open
As you know, we closed our long/short equity strategy to new investors last August. After evaluating portfolio liquidity at this asset level over the past several months, we have decided to open the strategy for a limited amount of additional capacity beginning February 1st. We are opening total capacity of
$500 million on a levered basis (investments in the Sandler Plus strategy will count as double towards this figure).

Yours sincerely,
Andrew Sandler
Managing Director