1. | 1
VOLSUNG MANAGEMENT
Q3 2013 Investor Letter Supplement
October 15, 2013
China: The Little Red (Short) Book
China has been a significant theme for the Volsung Global Total Return strategy almost since our
inception. This brief supplement to our quarterly letter offers a summary of our perspective on
China and provides an update on some recent developments in the year-to-date. In the following
sections, we will offer a summary of Chinese economic policy, highlight China’s capital allocation
problem, and discuss the implications of the mounting debt burden before briefly touching on the
prospects for reform. As of 10/15/13, the exposure of the long/short strategy to Chinese and
related assets was -48%, composed as follows:
Our Investment Thesis
The Chinese growth model is dependent on continued capital investment
The Chinese financial system was conceived so as to mobilize capital on a grand scale while still
allowing the Communist Party to retain tight control of the economy. The Chinese model has
several unique features, but generally applies a well-known policy framework which seeks to
minimize household consumption by implicitly and explicitly restraining wages. In doing so, it
maximizes the share of savings in the economy, which are then funneled into the state banking
system via a series of restrictive policies which provide a captive source of cheap capital.
While there is nothing inherently wrong with this approach, and indeed we believe it was highly
desirable when first adopted in China, its success ultimately depends on the returns achieved on
invested capital, even as it removes many of the traditional forces that discipline capital
Ticker Company Alloc.
1 FXI iShares FTSE/Xinhua China 25 Index ETF -13%
2 Var. Property Developers -12%
3 3323 China National Building Materal Co., Ltd. -6%
4 FMG Fortescue Metals Group -6%
5 JJC iPath Dow Jones UBS Copper TR ETN -5%
6 Var. Banks -3%
7 1157 Zoomlion Heavy Industry Scien. & Tech Co. -3%
Portfolio Allocation - 10/15/13
Global Total Return (Long/Short) - China Portfolio

2. | 2
allocators. Capital is frequently provided on cheap, flexible terms to politically favored entities to
stimulate investment in production capacity, real estate, and infrastructure, leading to a pervasive
underpricing of credit and investment risk. Despite some incremental professionalization of the
banking system and an increasingly large share of lending from non-bank conduits, the majority
of capital in China is still directed by state banks to state enterprises, both of which have a
demonstrably poor track record of capital allocation.
Capital allocation in China is inefficient & faces problematic incentives
We believe that China’s banking system, still more of a fiscal arm of the state than an
independent, profit-oriented commercial body, is an uncompetitive, conflicted system largely
incapable of efficiently allocating capital. Existing within an opaque political system with little
accountability and a rule of law that is ad-hoc at best, it is vulnerable to capture by politically
powerful businesses and individuals. Factional politics, corruption, and the need to achieve
economic policy goals mean that credit flows serve the policy goals of the Party and the personal
interests of its members rather than purely economic criteria. We believe these conflicts, in
combination with an institutional culture permissive of graft, have led to high levels of
unrecognized loan losses which are hidden by wide-spread accounting fraud and the
‘evergreening’ of bad loans.
Subsidized loans are but the largest of many implicit and explicit subsidies afforded to state-
backed businesses, however. Large portions of the economy are substantially over capacity,
inefficient, and serially unprofitable in spite of (or perhaps because of) their generous subsidies,
including the steel, cement, aluminum, and shipbuilding sectors. Subsidies, ranging from direct
cash grants to below-market utility contracts, have likely accounted for 100-200% of the profits of
the state-owned enterprises in the past decade, which likely still account for as much as ½ of
domestic production and investment. The poor operational results achieved by Chinese state-
owned enterprises are staggering given what one would imagine to be the rich pickings afforded
by such a rapidly growing economy. In our view, this is reflective of the problematic incentives
inherent in the Chinese capital allocation system, which frequently sustains uncompetitive and
unprofitable businesses.
However, it is not solely state-owned enterprises which are guilty of overindulgence. Despite
including a greater share of ostensibly private enterprises, real estate is perhaps the most overbuilt
sector of all, with supply likely exceeding actual housing demand by 1.5x-2.0x. Beyond any
fundamental demand drivers, financial repression has created an artificial demand for housing as
an investment asset rather than for consumption as housing stock. Despite the central
government’s best efforts, real estate’s share of GDP and home prices, as measured by home
price/income ratios, continue to rise and are at levels that appear to be significant outliers when
charted against historical comparables. Local governments have become dependent on
revenues from land sales to developers, but are just one of many parties that are badly exposed
to a correction in real estate markets. The developers themselves have been responsible for some
of the most innovative financial practices in China, which will be discussed further below. We
believe the consensus still underestimates the degree to which real estate supply exceeds
demand and that the sector is long overdue for a significant correction.
Central authorities are aware of these problem areas, but struggle to impose discipline.
Unprofitable enterprises are frequently protected by lower level officials, whose primary incentive
is to maximize short-term growth for the benefit of their own career advancement, and who may
directly extract rents from these businesses. Local governments are not the only cadre which
enjoys substantial autonomy and limited oversight over their ‘empire building’ however; these

3. | 3
benefits also accrue to some of the most powerful state ministries and the explicitly political ‘policy
banks’, not to mention the friends and families of the most politically powerful individuals.
Leverage is higher than it appears, and “shadow banking” poses a systemic threat
We believe the state of the national balance sheet is significantly worse than most analysts
estimate and that its structure is highly sensitive to a correction in asset prices. Debt is likely already
at dangerously high levels given China’s relative level of economic and financial development
and still growing rapidly. While the debts of the central government appear relatively low at first
glance, it is the ultimate guarantor of the significant debts accumulated by local governments,
state ministries, and other state actors. Moreover, state guarantees would likely extend to much
of the banking and corporate sectors in any potential crisis scenario. Worse still, an increasing
share of overall lending is flowing through a rapidly expanding ‘shadow banking’ system largely
beyond the control of state regulators, which increases leverage in a complex, opaque, and
unpredictable fashion.
‘Shadow banking’ comprises a wide range of both legal and illegal financing activity, only some
of which is regulated: it ranges from off balance sheet vehicles such as Local Government
Financing Vehicles, Wealth Management Products, and ‘Entrusted’ loans, to loan guarantees
extended by third party Credit Guarantee companies, mutual intra-corporate debt guarantees,
and guarantees for credit extended to customers. Other, more exotic collateralized financing
schemes include loans on zero-down leased equipment and bogus trade financing schemes
involving industrial commodities, such as copper. By necessity, it is a dynamic and innovative
sector which must frequently stay one step ahead of regulators, but it is in all likelihood not a
system capable of sustaining itself in anything but an environment of continuous economic growth
and rising asset prices. In this regard, it meets the definition of what economist Hyman Minsky
once termed ‘Ponzi finance’.
The legal, more or less regulated portion of shadow banking now likely accounts for more than
20% of total banking assets, or more than 50% of GDP, up from what was a negligible share before
2009. We believe there is convincing evidence that ‘shadow banking’ is pervasive and that
shadow leverage is potentially large enough to pose a systemic threat to China’s financial system.
Shadow leverage represents an incremental and potentially critical contingent liability to the
banking system and, by extension, the state. Given the prominent role such practices played in
China’s financial crises of the ‘90s and the degree to which they represent a spontaneous,
uncontrolled deregulation of financial markets, we believe ‘shadow banking’ is an extremely
dangerous development typical of the late stages of a credit boom.
Reform demands painful, politically challenging changes
It is now increasingly apparent to even the most credulous observers that this system is likely at or
near its limits, and that ‘re-balancing’ is needed to sustain future growth, if not to avert an
imminent catastrophe. Many analysts believe China’s problems can readily be solved by central
government policy edicts, drawing conviction from the government’s previous success in hitting
the economic growth targets of its 5 Year Plans. We believe that rebalancing will be exceedingly
difficult, if not impossible to achieve within the current power structure of Communist China. It will
demand deep structural changes, which will profoundly change the distribution of political and
economic power in China, and will require that political insiders voluntarily relinquish their
privileged access to what has become one of the world’s largest financial systems. Furthermore,
while the Chinese system is authoritarian, it is not monolithic, as the recent deposition of former
Politburo Standing Committee member Bo Xilai demonstrates. It is a factional system of opaque

4. | 4
patronage politics, and even should central authorities unanimously agree on how best to address
the problems at hand, coordinating implementation will be no small task given the conflicting
interests of different factions.
Many observers believe that China’s problems can be solved by incremental policy adjustments,
ignoring the structural nature of these imbalances. We believe successful reform will require at
least a partial restructuring and privatization of the state enterprise system, the gradual
abandonment of financial repression, the conclusion of currency intervention, and the end of the
countless implicit and explicit subsidies for favored interests. Given the fragility of the national
balance sheet, it remains to be seen whether it is possible to implement these changes without
prompting a major financial crisis, even in the best of political and economic circumstances. At
best, we believe China will face an extended period of significantly slower growth alongside rising
credit losses, corporate restructuring, and deleveraging, and that there is a very real risk of worse.
We do not believe that there have yet been any meaningful signs of a ‘rebalancing’, aside from
the vague policy pronouncements of party leaders, and that the potential for crisis grows the
longer unchecked investment growth continues. Despite increasing skepticism of China’s
economic health, we believe the consensus remains largely blind to the possibility of a Chinese
financial crisis and that current market prices do not reflect the magnitude of the prevailing
challenges. While the ultimate timing of future events is impossible to accurately forecast, we
believe our short positions will benefit from any meaningful rebalancing, much less a financial crisis,
which allows us to remain agnostic as to the ultimate timing of a correction.
Performance Review – Quarter & Year-to-Date
The China short portfolio is flat for the year to date after recording a loss of -12% in the third quarter.
A good start to the year was marked by rising skepticism over the status of banks’ balance sheets
and punctuated by a brief credit crunch in the Chinese financial system, which was likely
prompted by the clumsy attempts of the monetary authority to tame excessive credit growth. The
authorities’ subsequent retreat into large liquidity injections suggests the magnitude of the crunch
caught the central bank by surprise, and credit and investment growth has restarted anew. The
resurgent investment and credit economy has been optimistically interpreted by the market, and
most Chinese shares currently trade at or near annual highs.
We believe that this summer’s incident, rather than offering a demonstration of authorities’ vigilant
competence, illustrates the inherent fragility of China’s financial system and the limited
experience of its central bank at managing an increasingly large, opaque, and leveraged
financial sector. The panic caused by such a limited attempt to enforce market discipline on
lenders and the hasty retreat of the central bank does not bode well for future reform prospects,
nor does the subsequent return of ‘business as usual’.
While the performance of the Chinese short portfolio remains volatile, we believe that economic
fundamentals have been steadily deteriorating. Even as leverage has increased substantially, we
believe returns on capital continue to fall as more and more marginal investment projects are
undertaken. While we remain sensitive to potential reforms which could remove some of the
problematic incentives that challenge capital allocation, we believe there are substantial
obstacles inherent to the institutional structure of the Communist Party which are likely to impede
reform. Should these circumstances change, and should the new leadership regime show a
willingness and an ability to successfully challenge the status quo, we would likely curtail our
Chinese short exposure. In the absence of such evidence, we believe that shorting the most
vulnerable of Chinese assets continues to present a compelling risk/reward opportunity.

5. | 5
The information contained herein reflects the opinions and estimates of Volsung Management, LLC and its
affiliates (“Volsung Management”) as of the date of publication, which are subject to change without notice.
Volsung Management does not represent that any opinion or estimate will be realized. All information
provided herein is provided solely for information purposes and should not be construed as investment
advice or a recommendation to purchase or sell any specific security. While the information presented herein
is believed to be accurate, no representation or warranty is made with respect to the accuracy of any data
presented. This communication is confidential and may not be reproduced without prior written permission
from Volsung Management.
Performance is estimated and unaudited and reflects the performance of representative accounts. Past
performance is not indicative of future returns. Actual returns may differ from the returns presented. Returns
are presented net of a management fee of 1.50% and an incentive fee allocation of 20%. Exposure of the
Global Total Return Strategy includes put option contracts at unadjusted nominal value.