Circular Letter CVM/SIN No. 6/2014: Recommended Procedures for Acquiring Private Credit Assets

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São Paulo Regional: Rua Cincinato Braga, 340/2nd, 3rd and 4th Floors – Bela Vista – São Paulo – SP – ZIP: 01333-010 – Brazil – Tel.: (11) 2146-2000 Brasília Regional: SCN Q.02 – Bl. A – Ed. Corporate Financial Center – S.404/4th Floor – Brasília – DF – ZIP: 70712-900 – Brazil – Tel.: (61) 3327-2030/2031

CIRCULAR LETTER/CVM/SIN/ No. 6/2014
Rio de Janeiro, December 5, 2014

To administrators and managers of investment funds that invest in private credit assets

Subject: Recommended procedures when acquiring private credit assets

Dear Sirs,

This Circular Letter aims to guide fiduciary administrators and investment fund managers regarding recommended procedures for the acquisition of financial assets representing debts or non-sovereign obligations (private credit). Note that the scope of this work covers both vehicles regulated by CVM Instruction No. 409 and structured funds, regarding which, despite regulation by specific rules, CVM Instruction No. 409 applies subsidiarily.

It is emphasized that there is no intention to replace determinations of specific regulations and that the application of the practices described herein must always be conditioned by the analysis of the factual situations related to each fund's investments.

In recent years, several factors have led to an expansion of the allocation of private titles in investment funds regulated by CVM Instruction No. 409/04, especially since the issuance of CVM Instruction No. 450/07. In addition, the assets of structured funds with private titles in the portfolio, such as FIDCs, have also been growing.

Given the risks inherent to private credit assets, this Superintendence understands that it is necessary to dedicate special attention to the supervision of practices adopted by participants involved in their acquisition, notably when it comes to acting in an emerging market, involving credits granted to smaller companies with a short track record.

The acquisition of private titles requires both specific knowledge on the part of managers and fiduciary administrators and the adoption of own procedures for managing the risks incurred. Only in this way could the duty of diligence established in item I of art. 65-A of CVM Instruction No. 409/04, also applicable to structured funds, by virtue of art. 119-A of the Instruction, be considered fulfilled.

In this regard, it is also appropriate, from the outset, to clarify that the guidelines to fiduciary administrators and investment fund managers in this Circular Letter must always be considered in light of the division of responsibilities and roles between these two service providers, which has been progressively clarified in CVM regulation, without prejudice to the necessary joint action in cases where regulation so determines.

It is important to note that, in the understanding of this Superintendence, the aforementioned duty of diligence implies, minimally, the adoption of consistent, objective, and verifiable practices, which are sufficient not only to understand and measure the risks associated with invested assets, but also to guarantee an acceptable standard of internal controls and risk management regarding operational, market, liquidity, and credit risks associated with the management of third-party resources. These practices must be coherent with the risks assumed in each of the markets in which one is operating.

In this sense, after analyzing the practices adopted by several fund managers who invest in private credit, this technical area gathered a set of procedures observed by a large part of managers and that exemplify, in our understanding, possible ways of complying with the norm when trading with this type of asset.

However, it is important to mention that the duty of diligence, by its very nature, could never be seen as a simple compliance with certain predetermined steps. It is an activity intrinsically characterized by its added value, a value that does not exist if reduced to a simple "box ticking" process. In addition, due diligence must always be seen as an iterative and dynamic process.

Thus, the analysis of compliance with the duty of diligence provided for in item I of art. 65-A of CVM Instruction No. 409/04 can only be done on a case-by-case basis. Some of the practices presented below are not applicable or need to be adapted in certain situations. The analysis of their relevance in light of the specific case is the responsibility of fiduciary administrators and managers, including taking into account the provisions of current regulation and self-regulation applicable to each type of fund. For example, if a manager chooses to invest in private credit assets with higher liquidity in the secondary market through capital market instruments and if such assets represent only a small part of the assets under management, some of these practices may be applicable only in a mitigated manner or even not applicable. Another example can be found in the case of funds that acquire fragmented credit rights or from certain assignors that have certain characteristics and meet specific conditions. In this type of situation, it may occur that the manager's activity is not based on the individualized assessment of the credit risk of each debtor, but rather on the assessment of the quality or behavior of portfolios or the fulfillment of certain requirements regarding the assigned credits. In summary, what is intended here is that the manager maintains an adequate and proportional structure to the type of private credit being analyzed.

Furthermore, it is natural that the degree of the manager's diligence takes into account other factors, such as the duties of other regulated service providers in the capital market, such as fiduciary agents, or the subjection, in the case of assets traded in organized markets, to market infrastructure rules and the necessary observance, with respect to such assets, of the rules and procedures established by the respective central depositories. Certainly, such factors do not eliminate the manager's diligence in these hypotheses, but the initial focus of this diligence in these hypotheses may take into account the reliability of the market structure and the service providers involved.

Furthermore, regarding practices concerning the evaluation of guarantees, it is understood that the degree of diligence in the process of evaluating the presented guarantees varies in proportion to whether they were decisive or not for the investment decision or asset acquisition, knowing that there are cases where they may even be irrelevant in the asset selection process.

Notwithstanding the difficulties of generalization reported above, the SIN understands it is important to mention the existence and adoption of these practices by a large part of the market to thus assist managers who acquire private credit, particularly those who are not yet specialized in this type of asset.

This text seeks to cover, as referred to above, both the situation where the fund acquires private credit originated by third parties and the situation where the manager structures operations to participate in the asset origination process of the credit asset to be acquired by the fund, since in both cases, the fund assumes credit risk and, therefore, must be able to adequately assess this risk.

A methodology widely disseminated in traditional literature on credit risk advocates the evaluation of the 6 Cs of credit: character, capacity, capital, collateral, conditions, and conglomerate 1. The analysis of "character" takes into account factors such as the debtor's punctuality in fulfilling its obligations and its experience in the field. "Capacity" refers to the efficiency of different sectors of a particular business and its ability to generate returns. "Capital" refers to financial indices such as profitability, indebtedness, and liquidity. "Collateral" relates to aspects of the presented guarantees. "Conditions" encompasses the analysis regarding, for example, the existence of competitors in the debtor's business. Finally, the analysis of the "conglomerate" seeks to verify the economic group to which the debtor belongs. Taking into account the characteristics of each operation, the acquisition of private credit assets by the manager should take these elements into consideration.

Furthermore, Resolutions 2,682 and 3,721 of the National Monetary Council determine the characteristics of the credit risk management structure and the minimum aspects that must be considered in the classification of credit risk of operations carried out by financial institutions and other institutions authorized to operate by the Central Bank of Brazil. Even when these rules are not directly applicable, they can be good guides for fund managers. In addition, in many cases, the structure existing in fund managers must have functionality comparable to that existing in financial institutions, as, by acquiring receivables originated by them, the funds managed by them assume the risk of the credit operations. Furthermore, the pricing of the assets themselves would be prejudiced if the manager were not able to adequately assess the risks, due to the informational asymmetry that would exist between the financial institution that originated the credits and the manager.

Another item we consider important is liquidity management, which, despite having a distinct dynamic from the credit risk management process, plays a fundamental role in the management of investment funds, in addition to what this letter provides, observing the current regulations in regulation and self-regulation.

For example: Securato, José Roberto et. al. Credit – Analysis and risk assessment. Ed. Saint Paul. São Paulo, 2012.

Finally, it is relevant to reinforce that the practices described in this Circular Letter do not intend to treat the subject exhaustively and that the primary requirement is that fund managers who invest in private credit assets have a credit risk management structure compatible with the nature and complexity of the operations in which the funds participate directly or indirectly.

LIQUIDITY MANAGEMENT

Take into account expected cash flows, redemption payment deadlines, and periods in which redemptions may be requested, and maintain sufficient cash for a defined period according to the characteristics of the investors and the fund's investments.
The possibility of using the secondary market to sell fund assets must also be a factor considered in liquidity management.
If necessary, define a minimum portfolio-to-cash conversion rate or a percentage of immediate liquidity for credit transactions.
In the case of funds with unitholders who may redeem a significant value at any time and investment in assets with an incipient or low-liquidity secondary market, evaluate the convenience of using exclusive or closed funds.

CREDIT RISK MANAGEMENT POLICY
5. There must be a clearly documented policy for credit risk management, which establishes the process for defining financial limits and their operational controls, with risk mitigation mechanisms and procedures intended to maintain credit risk exposure at levels considered acceptable by the manager and compatible with the investment policies of each managed fund. Limits must be established based on the risk profile of the funds.

The credit risk management policy must be reviewed periodically and whenever the conditions, environment, and assumptions on which it is based change significantly and relevantly.

RISK MANAGEMENT STRUCTURE
7. The manager's organizational structure must be compatible with the nature and complexity of the credit operations intended to be acquired for the portfolios of the managed funds. The manager must have a team of professionals specialized in relevant areas for the activities conducted, such as legal and credit analysis, as well as compliance and risk management areas for private credit operations, which allow for prior assessment of acquisitions and periodic monitoring of the quality of acquired titles, receivables, or credits.
7.1. In the event of hiring service providers or outsourced professionals, there must be prior and careful analysis and selection of the contracted parties.
7.2. The fiduciary administrator is responsible for ensuring the existence of the manager's organizational structure. This responsibility does not limit itself to the moment of hiring the manager; there must be periodic reassessment based on aspects that may change over time and changes in the funds' investment policies.
8. The need for specialization may make it advisable to have separate managers for different markets.
9. The manager's credit analysis area must be independent of the area that performs ex post risk monitoring or that establishes asset pricing methodologies, including the definition of the credit spread.
9.1. There must be a structure for systematic and periodic reporting to the investment committee or equivalent authority defined in terms of internal governance, especially regarding asset monitoring.

9.2. The existence of a credit committee responsible for approving the acquisition policy for credit operations is recommended, observing the approval authorities defined in the credit risk management policy. Deliberation through committees is a way to reduce possible subjective biases in credit analysis.
9.3. It is recommended that a member of the area that performs ex post credit monitoring participate in the Credit Committee.
9.4. In cases where the credit structure provides for the existence of a credit committee, it is desirable that periodic meetings of this committee be provided for the reassessment of the main risks incurred, with decisions recorded in minutes or similar documents. In these cases, if it is not possible for senior members to participate in all meetings, a minimum periodicity for their participation must be defined, ensuring that professionals with greater expertise actively participate in the risk level reassessment process. Alternatively, the credit committee's approval authorities by financial volume and risk degree must provide progressively more qualified quorums of senior members.
10. It is good practice for the manager to prepare and make available to unitholders a description of the main aspects of the risk management structure used.

TECHNOLOGICAL STRUCTURE AND CONTROL PROCESSES
11. Information technology systems and processes used must be capable, at least, of registering the different assets that can be traded by funds, making it possible to store characteristics of these assets such as: credit modality, installment dates and values, contract and maturity dates, interest rates, guarantees, date and value of acquisition by the fund, information about the operation's rating on the contract date, and, when applicable, data of the assignor and data of the debtor (in operations where the assignor does not hold substantial risks and benefits on the asset).

The systems and controls used must also be capable of pricing based on the type of asset and other risk factors. They must also preserve calculation memory, including the formulas and variables used in the model.
The systems and controls used must allow the issuance of management reports for monitoring acquired operations. They must also be capable of measuring, both at the individual level and at the aggregated level of operations with similar characteristics, credit risk exposure under normal conditions and in stressed scenarios.
As applicable to each type of invested asset, the controls used must be capable of projecting non-standardized cash flows, representing credit curves, and calculating the present value of operations.
When relevant, care must be taken to ensure compatibility between the systems used by the manager and the systems of participants in the credit origination process.

PRE-ACQUISITION OR CREDIT OPERATION STRUCTURING ANALYSIS
16. It is always necessary to previously verify the compatibility of the credit operation intended to be structured or acquired with the fund's investment policy and regulatory restrictions. Such verifications must be consistent and verifiable, duly documented, and made available to external auditors and regulators.
17. The mere verification of the existence of a risk classification (rating) made by a specialized agency does not fulfill the manager's duty of diligence regarding the analysis of credit assets, and thus, the investment decision cannot be based exclusively on the rating. In addition, it must be guaranteed that internal risk classification models do not assign predominant weight to agency ratings.
18. In operations involving controlling, controlled, affiliated, and/or commonly controlled companies of the manager and/or the fund administrator, in addition to the applicable issuer concentration limits, the same criteria used in operations with unrelated parties must be observed, in order to prove that operations are carried out on an arm's length basis. Operations originated or assigned to funds by these companies must be treated with special diligence regarding the distribution of gains between issuers and funds, both in primary offerings and in secondary market operations.

The same level of diligence must be adopted both for the case of structuring a credit operation that involved the participation of the manager or a related company and for the case of investing in an operation structured by unrelated parties.
It is necessary to determine limits for carrying out operations subject to credit risk, both at the individual level and at the aggregated group level with common economic interest and, when applicable, borrowers or counterparties with similar characteristics. The assigned credit limits must have a predetermined validity and allow for early review based on the borrower's behavior or other events that may impact the initial investment decision. For the definition of limits, not only normal conditions of the issuer and the market must be considered, but also stressed conditions based on probability scenarios and historical experiences. In addition, the authorization of a certain operation by the committee should not be seen as automatic authorization for subsequent operations from the same issuer/debtor.
Prior to the acquisition of operations, the manager must ensure full access to the information deemed necessary for the credit analysis for purchase and for monitoring the asset, including, if applicable, access to the documents comprising the operation or accessory to it.
It is important that the manager considers, on a case-by-case basis, the importance of combining quantitative and qualitative analyses. In certain cases, the use of statistical calculations based on the debtor's financial indices must be accompanied by an analysis, also duly documented, that takes into account aspects such as the issuer's reputation

Headquarters: Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP: 20050-901 – Brazil – Tel.: (21) 3554-8686 – http://www.cvm.gov.br.
Regional Office of São Paulo: Rua Cincinato Braga, 340/2nd, 3rd and 4th Floors – Bela Vista – São Paulo – SP – ZIP: 01333-010 – Brazil – Tel.: (11) 2146-2000 Regional Office of Brasília: SCN Q.02 – Bl. A – Ed. Corporate Financial Center – S.404/4th Floor – Brasília – DF – ZIP: 70712-900 – Brazil – Tel.: (61) 3327-2030/2031 e) analysis of variables such as yield, interest rate, duration, convexity, volatility, among others that may be considered relevant; f) global amount, maturities and delays, in the case of acquisition of portions of operation.
24. When applicable, diligence must be exerted to ensure the perfect and complete assignment of rights
of credit acquired by the funds' portfolios, in order to guarantee total legal segregation between the risks of the originator of these rights and the assets represented by them in the issuer (true sale of credit rights).
25. When applicable, credit contracts must provide for restrictive clauses (covenants) such as
developer leverage level, interest coverage ratio, existence of protests and negative registrations in credit protection agencies above a certain threshold, occurrence of changes in corporate structure and minimum guarantee ratio.
26. The analysis of operations of legal entities must take into account not only the information
of the company, but also that of its controllers. The analysis must also take into account issues related to the economic group of which the debtor company is part, such as the managerial capacity of the controller, the existing governance structure, the market perception regarding the group, the asset and financial situation, the liquidity and term of the main obligations, as well as possible risks of contagion of damage to the image and conflicts of interest in assemblies. The initial analysis and permanent monitoring of these situations, and their consequences on risk classifications, must be properly documented.
27. Investment decisions must be documented in a consistent and verifiable manner, for example through minutes of credit committee meetings signed by the
participants. In addition to the final deliberation, the minutes must include documentary record of the factors that underpinned the decisions taken, such as, for example, the information and materials presented to the credit committee.

Headquarters: Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP: 20050-901 – Brazil – Tel.: (21) 3554-8686 – http://www.cvm.gov.br.
Regional Office of São Paulo: Rua Cincinato Braga, 340/2nd, 3rd and 4th Floors – Bela Vista – São Paulo – SP – ZIP: 01333-010 – Brazil – Tel.: (11) 2146-2000 Regional Office of Brasília: SCN Q.02 – Bl. A – Ed. Corporate Financial Center – S.404/4th Floor – Brasília – DF – ZIP: 70712-900 – Brazil – Tel.: (61) 3327-2030/2031
28. In addition to verifying the documentation considered pertinent for the adequate analysis of
credit, it is necessary to formalize this verification. The documentation must be kept in a place easily accessible to the investment committee and the risk and compliance areas.
29. The use of an internal risk classification system based on levels is a good practice. The
manager must carefully evaluate the scale it intends to use and ensure that there is comparability and consistency between the different invested assets, including in the case of issuers/debtors from different sectors.
30. Given the important legal issues involved in credit operations, the manager
must always evaluate the need for verification by its legal department, or by a third party hired, of the contracts that formalize the credits. In complex cases or when it is perceived that the manager may lack the necessary expertise, the legal analysis must be conducted by a specialized law firm in the sector, industry or type of guarantee of the transaction. The report or legal opinion must be properly documented and submitted for review by the decision-making authority, which will attest to its knowledge in the minutes.
31. In cases of acquisition of receivables portfolios, the determination of the credit risk level
must involve the analysis of the composition of the debtor base, the values of the operations and the terms and the periodic review of these factors. In addition, the risk of fungibility (commingling) must be considered, that is, whether the receivables, while passing through the debtor's account, before their transfer to the fund's assets, may suffer any type of reduction or judicial constriction.
32. Ensure that the risk management processes used are capable of monitoring,
according to consistent criteria, potential losses associated with credit risk.
33. The monitoring of the risk of receivables portfolios must provide for stress tests for the
main risk factors.

Headquarters: Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP: 20050-901 – Brazil – Tel.: (21) 3554-8686 – http://www.cvm.gov.br.
Regional Office of São Paulo: Rua Cincinato Braga, 340/2nd, 3rd and 4th Floors – Bela Vista – São Paulo – SP – ZIP: 01333-010 – Brazil – Tel.: (11) 2146-2000 Regional Office of Brasília: SCN Q.02 – Bl. A – Ed. Corporate Financial Center – S.404/4th Floor – Brasília – DF – ZIP: 70712-900 – Brazil – Tel.: (61) 3327-2030/2031
34. Within the reality of the manager's operation, it is considered a good practice that, instead of seeking
information about a specific debtor/issuer only at the moment the transaction opportunity arises, a prior monitoring of promising participants in their sectors should be done, maintaining, for example, a watch list of news and events related to these issuers. This practice helps to identify more adequately the risk of a new operation.
35. Formalize the procedures for credit recovery, detailing the measures to be
taken and, as far as possible, the deadlines to be observed regarding each measure. The persons responsible for the execution of the procedures must be identified in advance.
ON THE EVALUATION, ACCEPTANCE AND FORMALIZATION OF GUARANTEES
36. Take into account that in some situations guarantees represent quality enhancements of
operations and their analysis should not replace the assessment of the issuer's payment capacity.
37. When applicable, pay attention to the mechanism of guarantee formalization, since different
mechanisms imply different risks. It is also necessary to ensure that the documents related to the guarantees (for example, encumbrance certificate) are up to date and valid at the moment of the acquisition of the credits. It is also important that there is a monitoring structure and internal controls compatible with the amount and complexity of the credit risk exposures.
38. Evaluate the possibility of executing the guarantees, defining specific criteria for this
evaluation. In addition, take into account the variability of the liquidation value, including considering the probable forced sale values, and define the percentages of guarantee reinforcement (overcollateral) based on a conservative forced liquidation value.

Headquarters: Rua Sete de Setembro, 111/2-5th and 23-34th Floors – Center – Rio de Janeiro - RJ – ZIP: 20050-901 – Brazil – Tel.: (21) 3554-8686 – http://www.cvm.gov.br.
Regional Office of São Paulo: Rua Cincinato Braga, 340/2nd, 3rd and 4th Floors – Bela Vista – São Paulo – SP – ZIP: 01333-010 – Brazil – Tel.: (11) 2146-2000 Regional Office of Brasília: SCN Q.02 – Bl. A – Ed. Corporate Financial Center – S.404/4th Floor – Brasília – DF – ZIP: 70712-900 – Brazil – Tel.: (61) 3327-2030/2031
39. When there is sharing of guarantees, ensure that this is adequate to the
operation and that the part of the guarantee belonging to it is free, as well as verify under what conditions it can be executed.
40. Provide, whenever applicable, the inadmissibility of receiving as guarantee assets whose
execution may become unfeasible, such as assets essential to the continuity of the debtor's operation, family assets, large rural areas in remote locations and real estate with relevant social function.
Also consider the possibility of favoring assets that have an explicit second use (e.g. industrial land that can be converted to residential), taking into account the economic potential of the asset not only for the current user but also regarding other potential users. ON THE POST-CONTRACTING/ACQUISITION PERIOD AND CREDIT MONITORING.
41. The credit quality of the main debtors/issuers must be periodically reassessed. The
periodicity of the review must be proportional to the credit quality - the worse the quality, the shorter the interval between reassessments should be – and/or to the relevance of the credit to the portfolio. The reassessments must be properly documented and reviewed by the decision-making authorities, whose considerations must be documented.
42. Periodically monitor available market indicators, as a proxy for the credit quality of
developers. For example: performance of stocks and debt securities, public ratings and spread practiced in the last fundraising done in the market. Monitor sectoral indices for which it is perceived that there is a high correlation with the performance of companies
43. Whenever there are restrictive clauses (covenants), monitor them with the same periodicity as their
calculations so that it is possible to take the measures permitted contractually in case of disagreement with what was established. When the calculation of covenants is the responsibility of third parties, diligence must be exerted to ensure effective calculation and disclosure, for example by determining that a report be provided with the rationale for the calculation of the covenants, the index obtained and the minimum

Circular Letter CVM/SIN No. 6/2014: Recommended Procedures for Acquiring Private Credit Assets

Lineage: In force