Machine Translated by Google Financial Superintendence of Colombia The following is posted for public comment: TECHNICAL DOCUMENT PROJECT: Technical document of good practices for the analysis of investment in private equity funds. PURPOSE: To present the best international practices incorporated in the due diligence processes for investment in private equity funds, by institutional investors, so that they are implemented by the administrators of the Individual Savings Regime with Solidarity - RAIS. DEADLINE FOR COMMENTS: 5:00 pm on April 16, 2019. WE RECEIVE YOUR COMMENTS: VIA E-MAIL: lmsanta@superfinanciera.gov.co odcuellar@superfinanciera.gov.co dacastro@superfinanciera.gov.co IN WRITING TO: Laura Maria Santa Zuluaga Delegation for Pensions Financial Superintendence of Colombia Calle 7ª No. 4 - 49 Office 317 Zone B * Consult in this file the text of the Technical Document Machine Translated by Google Financial Superintendence of Colombia BEST PRACTICES IN DUE DILIGENCE FOR INVESTMENT IN PRIVATE CAPITAL FUNDS1 LaSuperintendenciaFinancieradeColombiadebevelarporlaproteccióndelosafiliadosdelsistemageneraldep The purpose of this document is to strengthen the supervision function of the Significant Activity of Investment Management, particularly in the Due Diligence processes carried out by the AFPs for the investment of the resources of their affiliates in Private Capital Funds. 1 Document prepared by: OscarDanielCuellarFernandez - AdvisorDelegaturaparaPensiones. odcuellar@superfinanciera.gov.co LauraMariaSantaZuluaga - Specialized ProfessionalDelegation for Pensions. lmsanta@superfinanciera.gov.co SoniaEsperanzaSantamaría Peña – Specialized ProfessionalSavings ManagementIndividualandPrimaMediaUno. sesantamaria@superfinanciera.gov.co DiegoAndresCastroBayona – ProfessionalSavingsDirectionIndividualandPrimaMediaUno. dacastro@superfinanciera.gov.co two Machine Translated by Google Financial Superintendence of Colombia Table of Contents Background and Introduction............................................... ........................................................... ................. 4 Abbreviations ........................................... ........................................................... ................................................. 5 Best International Due Diligence Practices ........................................................... ............ 6 1. Corporate Governance of the Pension Fund Administrator for the approval of the investment .................................... ........................................................... ................................ 6 2. Investment analysis.................................................... ........................................................... ................... 7 3. Risk-Return Analysis.................................................... ........................................................... .......... 9 4. Professional Manager ................................................ ........................................................... .......................... 9 5. Administrative Company.............................................. ........................................................... ..........10 6. Follow-up.............................................. ........................................................... .....................................eleven 7. Assessment ........................................... ........................................................... .........................................12 8. ESG - Environmental, Social and Governance Criteria ........................................... ............13 Bibliography................................................. ........................................................... ........................................................... 16 3 Machine Translated by Google Financial Superintendence of Colombia Background and Introduction TeniendoencuentaqueelprincipalobjetivodelSupervisoresprotegerlosinteresesdelosmiembrosybeneficiariosdelosf In order to unify the best practices of the due diligence processes in the pension industry related to the investment in Private Equity Funds, the Delegation for Pensions of the Financial Superintendence of Colombia SFC made requirements to the four AFPs with the objective of evaluating the investment process that they carry out in these vehicles2. In addition to this, the best international practices were identified in terms of due diligence for investments in Private Equity Funds, according to the standards of APRA – Australian Prudential Regulation Authority34, IOPS – International Organization of Pension Supervisors5, ILPA – Institutional Limited Partners Association6, and ColCapital7. ResultadodelanálisisdelainformaciónsuministradaporlasAFPydelasmejoresprácticasinternacionales,seelaboróelp 2 Requirements 2016040120, 2016040121, 2016040122, 2016040123 and 2018062486. 3 APRA.November2013.PrudentialPracticeGuide.SPG530– InvestmentGovernance. 4 APRA.November 2016.PrudentialPracticeGuide.SPG510– Governance. 5 IOPS. June 2010. Best Practices In Risk Management Of Alternative Investments Of Pension Funds. 6 ILPA developed a questionnaire for the Due Diligence process for investment in Private Equity Funds which can be consulted at the following link: https://ilpa.org/best-practices/due-diligence-questionnaire/ 7 ColCapital. November 2016. Guide to best practices in reporting and valuing the portfolio of Private Equity Funds. Second Version. 8 Environmental, Social and Governance (ESG) factors. 4 Machine Translated by Google Financial Superintendence of Colombia abbreviations Abbreviation Concept SAA Strategic Asset Allocation AFP Administrators of Pension and Unemployment Funds APRA AustralianPrudentialRegulationAuthority CAPM CapitalAssetPricingModel IS G Environmental, Social and Governance Final Cut Pro Private Equity Fund(s) IOPS International Organization of Pension Supervisors ILPA Institutional Limited Partners Association SA Administrative Company GSP General Pension System 5 Machine Translated by Google Financial Superintendence of Colombia International Due Diligence Best Practices 1. Corporate Governance of the Pension Fund Administrator 9 for the approval of the investment One of the most important elements towards adequate investment management consists of the robustness of the Corporate Governance for the investment process, which must adhere to the principles of responsibility, independence, experience, diligence, prudence, transparency and vigilance, and consider the amount of time, resources and experience required to make the best informed investment decisions, in the best interest of the beneficiaries, in the best interest of the beneficiaries, will then be presented. 1.1.The investment process carried out by the AFPs must ensure sufficient understanding and knowledge of each selected investment. Esimportantedefinirelprocesoyloscriteriosparalaseleccióndecadainversión;estoscriteriosdeberánversereflejadose 1.2. The existence of a robust Corporate Governance in the due diligence process is an essential element for managing the risks inherent in this type of investment vehicle. Lacomplejidadinherentealosfondosdecapitalprivado10, asícomolaheterogeneidaddelosactivosenlosqueinviertenyelmayorhorizontedeinversiónrespectoaotrosactivos,gen 1.3. Depth in the investment analysis process requires specific professional experience of the human resource involved in the due diligence process, both in the capital market and in private equity funds. It is important to have investment and risk teams with specific experience in managing them (or in similar investment vehicles); likewise, it is ideal to guarantee the existence of continuous training plans for the human resources of these teams. 1.4. Establish a clear definition and scope of the instances of analysis, validation, and approval and monitoring of investments in FCP. Lainstanciadeanálisissueleestarconformadaporlasáreasdeinversiones,deriesgosyjurídica,lascuales,desdesuexpe 9 Hereafter: AFP. 10 Onwards: FCP. 6 Machine Translated by Google Financial Superintendence of Colombia It may also be part of the approval instance, in accordance with the powers defined in said policies. 1.5. The analysis and approval process involves the risk and investment committees. EsresponsabilidaddelComitédeInversionesrealizarunanálisissobrelapertinenciadelaestrategiadeinversiónenelFCPfrentealaestrategiadeinve 1.6. The role of the Risk Committee should not be limited to regulatory compliance and policy compliance. The role of the Risk Committee consists of validating that the investment conforms to the risk profile of the AFP and of the funds it manages. In turn, it evaluates the risks identified in the analysis instance, as well as the controls suggested by the Professional Manager and by the Management Company, so that the exposure to residual risk of the investment is clear. 1.7. Technical monitoring differs from corporate governance monitoring, for which each requires suitable equipment. In the monitoring of FCPs and vehicles with similar structures, two main lines of focus are evident. The first refers to the monitoring of technical or financial risks in which the teams and/or risk and investment committees are involved; and the second refers to monitoring the management of the vehicle and the administration of conflicts of interest, for which a team with experience in corporate governance is required. Section 6 of this document presents the reporting standards and information for monitoring alternative investments. 2. Investment analysis The analysis of the investment in Private Equity Funds must be carried out with the greatest diligence, since it allows the understanding of the investment vehicle and strategy, as well as its underlying assets, so the AFP must be able to explain the way in which said investment is consistent with the AEA, as well as the expected impact on achieving the investment objectives. For the above, the following practices can be adopted: 2.1. It is necessary for the investment strategy in private capital funds to be consistent with the investment objective set out within the AEA defined for the management of the funds administered by the AFP. EstoimplicaquelaAFPrealiceunanálisis,nosólodelaestructurayviabilidaddelvehículo,sinotambiéndelaconsistenciade laestrategiadeinversión delFCPconlaestrategiadeinversiónyapetitoderiesgodelFondodePensiones;esimportante,ala vez,asegurarque lainversiónenelFCPseaconsistenteconlaAEA,encuantoalobjetivo,horizonte,rentabilidad, yriesgodedichasinversiones.Teniendoencuentaelplazodeinversióndeestasinversioneses necesarioqueseinvolucrenevaluacionesdeimpactosmedioambientales,socialesydegobiernocorporativopueséstosseránfactoresdeterminante 7 Machine Translated by Google Financial Superintendence of Colombia In this sense, although the analysis teams may base the evaluation on the reports provided by the Professional Manager, the critical analysis carried out by the AFP as an investor is vital to complement the analysis of the investment. 2.2. The diversifying effect of the private equity fund is assessed both at the level of the total portfolio of the fund managed by the AFP, and at the level of the portfolio of alternative assets. Aniveldeltipodefondo,laevaluacióndelefectodiversificadorinvolucralasestrategiasdeinversión,losactivossubyacentes,lo 23. The evaluation of exit mechanisms is a fundamental element in the due diligence process of private equity funds and other investments with similar structures. TeniendoencuentaquelosFCPsonvehículosdeinversióncerrados,sehacenecesarioqueelprocesodedebidadiligenciarea 2.4. It is necessary to evaluate the investment both at the level of the Professional Manager and at the level of the Management Company, through the development of models for assigning quotas by the AFPs (either to the Professional Managers, the Management Company or directly to the FCPs) that evaluate quantitative and qualitative criteria without being limited to the restrictions of the investment regime, defining the investment analysis and risk agreement. Finally, other important aspects to take into account in the analysis of the investment are: • Incorporate the underlying. • The fundraising schedule and the rate of investment. • The target size of the fund and the investment capacity of the FCP. • Holding periods. • The geographic and industry focus. • The risk factors of the investment strategy and their mitigating factors. • The methods used by the manager to add value to its portfolios, its ability to search for offers. • The process and governance used by the manager to identify, evaluate and approve attractive investment opportunities. 8 Machine Translated by Google Financial Superintendence of Colombia 3. Risk-Return Analysis Having a risk budget associated with the investment strategy makes it easier for the AFP to understand and determine their exposure to risk. 3.1. Choosing an appropriate benchmark implies choosing private equity funds with similar investment strategies and underlying assets. SibienelanálisisdebenchmarkingutilizandoFCPconestrategiasdeinversiónyactivossubyacentesdiferentesalevalu 3.2. The effectiveness of risk-return analyzes depends on the inclusion of both legal stress scenarios and underlying asset performance models. For a complete analysis of the risks of the investment versus the returns that it may generate in the future, it is also necessary to carry out the respective sensitivity analyzes of the expected return (stress analysis), as well as scenarios for the materialization of legal risks, trying to anticipate real situations that may arise in the FCP, impacting its viability or profitability. 4. Professional Manager Taking into account that the Professional Manager depends to a greater extent on the performance results of the FCP, it is necessary for the AFP to ensure that it carries out a deep and robust due diligence that allows knowing the strategy and performance of the Manager in previous Funds, as well as the incentive structure of its team. To achieve this, it is suggested to evaluate the aspects developed below. 4.1. The suitability and experience of the Professional Manager are fundamental elements in the analysis of the assets. Just as institutional investors have a team of suitable people for the management of resources such as pensions, it is also very important that the underlying assets of the FCP be managed by a Professional Manager that has sufficient experience in the asset(s) that are part of the FCP, whose track record is broad enough to carry out the proposed investment plan in the FCP, and that it has a solid legal background that allows it to be reputable 11 CapitalAssetPricingModel. 12 Analysis of ratios between the value of a company and the company's financial indicators (historical or projected). The comparable multiples usually used: 1). Company value over EBITDA “EV/EBITDA”; 2). Company value over EBIT “EV/EBIT”; 3). Price over earnings per share “P/E”. 13 Percentage decline in the valuation of an investment or fund for a specified period, calculated from the last valuation peak. 9 Machine Translated by Google Financial Superintendence of Colombia perform their functions without restrictions. In line with the foregoing, the AFPs must evaluate the consistency of the investment strategy of the professional manager in previous funds, their experience generating value from said strategy, and their experience promoting an upside in the asset when the investment hypothesis is put at risk. 4.2. It is necessary to evaluate the organizational structure of the Professional Manager and the protocols for the substitution of key persons. Esidealqueelgestorprofesionaltengaunaestructurasuficientementeestableycohesionadaparaquesudesempeñofuturo 4.3.The remuneration of the Professional Manager and the KeyPersons must be evaluated. Also, it is necessary for the FCP to maintain an incentive policy for both the professional manager and the Key Persons that limits the risk of the absence of one of them, and that aligns their interests with those of the FCP 's participants. 4.4.It is important to carry out an analysis of the financial capacity of the Professional Manager. This analysis should focus especially on the financial indicators of the Professional Manager, seeking to identify its ability to meet the investment commitments in the FCP (if it has one), as well as the possible risks of appropriation of resources by the same, seeking to address its own situations of insolvency; the foregoing in order to establish the alignment of interests between the Professional Manager and the participants of the FCP. 4.5.The due diligence also includes the analysis of conflicts of interest of the Professional Manager. It is necessary for the AFP to evaluate the policies of identification, disclosure, and management of conflicts of interest of the Professional Manager, as well as the potential conflicts of interest with respect to the underlying assets, the administrator of the FCP, and the other investors. In addition, the disclosure of information by the manager is expected about whether he, his related entities, members of his team have been the subject of legal investigations or if they have had requirements from any control body; all of the above complements the analysis of the investment by the AFP. 4.6. The AFPs must evaluate the risk management policies of the Professional Manager, in order to understand what risks are monitored by it and how they are managed, with an operational focus and on the underlying assets. Likewise, the Manager's compliance policies must be evaluated to prevent the FCP from being used for money laundering, terrorist financing, or personal gain. 5. Administrative Company15 At the international level, the Professional Manager of a FCP usually acts both as a Manager and as an Administrator, in Colombia the FCPs can only be managed 14 For example, it should be assessed whether the carried interest established for investment outflows could generate incentives to exit an asset early. 15 Onwards:SA 10 Machine Translated by Google Financial Superintendence of Colombia porSociedadesFiduciarias,SociedadesComisionistasde BolsaoSociedadesdeInversión,lascualespodríanactuarasuvezencalidaddeGestoresProfesionalescuandocumplenlos 5.1.Incorporate a thorough analysis of the corporate governance of the managing company and its policies on conflicts of interest into the due diligence process. Desdeelpuntodevista delasolidezdesugobiernocorporativo,esimportanteidentificarcómolaSAsupervisa,monitoreayapruebasuspolíticas,eva 5.2. Evaluate the operating performance of the Management Company in the management of previous private equity funds. It is important to carry out an analysis of the track record of this management, seeking to identify situations of failures in the technological platforms that support the operation, errors in the processes for calculating the value of the unit for the FCPs, segregation of FCP accounts from its own position and other business compartments, business continuity policies, information security, and the strength of the internal control environment. Likewise, as part of the operational management carried out by the SA, it is important to evaluate and negotiate the conditions of periodicity and detail of the information report to investors, in accordance with the needs of the AFP. 5.3. An adequate due diligence process of the AFPs would inquire of the Management Company about its risk management policies, with the purpose of understanding which risks are monitored by it and how they are managed; in this sense, it is a good practice to place special emphasis on the management of operational and compliance risks , the latter to prevent the FCP from being used for money laundering, terrorist financing, or personal gain. 6. Tracking The investment horizon of Private Equity Funds is long-term, so the monitoring of this type of investment must be done regularly and by qualified personnel, both in its financial component, and in risk control and conflicts of interest, generating periodic reports to the corresponding Government instances, as explained below: 6.1.With regard to the Professional Manager, ColCapital16 recommends submitting quarterly and annual reports, as well as notifying calls for capital and/or distributions. This information must be sent between 45 and 60 calendar days after the quarterly close and up to 90 days for the annual close. In the quarterly report, the Professional Manager is expected to present to its investors a report containing the 16 ColCapital. November 2016. Guides to best practices in reporting and valuing the portfolio of private equity funds. eleven Machine Translated by Google Financial Superintendence of Colombia performance of the FCP, the investment strategy and its underlying assets. In the annual report, it is considered appropriate to present an executive summary, in order to inform investors of the most significant events that occurred during the year with respect to: the investments (including their valuation), the value of the FCP, the Professional Manager, and the conditions of the FCP in general. 6.2.In order to ensure proper monitoring, ILPA suggests knowing the accounting and valuation policies with which the professional manager and the SA will operate the FCP, as well as evaluating the appropriateness of appointing an Internal Audit, Statutory Auditor, or independent evaluation for the FCP17. For its part, through the information requirements made to the AFPs marked within their powers from supervision18, the Superintendency's Delegation for Pensions Financiera de Colombia has identified the following additional good practices that it considers relevant to be adopted by the AFPs in their due diligence processes: 6.3.It is recommended that the risk areas of the AFPs participate actively in the Surveillance Committee, accompanied by a team specialized in managing conflicts of interest and corporate governance, to guarantee that any situation that warrants-evaluating the investment is timely known, in light of the exit mechanisms analyzed during the Due Diligence. Additionally, the team specialized in the management of conflicts of interest must guarantee that the policies in this matter are complied with. 6.4.The periodicity of the monitoring carried out by the AFP on the value of the unit must be the same with which it is reported by the Management Company, given that the valuation of the FCP is the first indicator of its performance. During the monitoring, the following questions are sought to be resolved: • Is the valuation of the FCP adjusted to the economic reality of the underlying assets? • Has the valuation of the FCP remained stable despite the fact that there are events that suggest changes in the situation of the underlying assets? • Has the assessment of the FCP presented significant changes without an apparent justification? These questions will allow the AFP to generate alerts to the Professional Manager and the Management Company, who in turn must justify any anomalous situation against the FCP's valuation or the value of the unit, as appropriate. 6.5.It is necessary to inform the validation and approval instances of any relevant situation that modifies the investment strategy or that puts its expected results at risk through the reports submitted to the Investment Committee, the Risk Committee, the Board of Directors, and any other body that within the AFP is in charge of monitoring investments. 7. Assessment Although the valuation of unlisted assets -such as some FCPs- may present some degree of complexity, the methodological analysis from the stage of delinquent debt will allow the AFPs 17 This aspect is delved into in section 7 of this document. 18 Article 11.2.1.4.57 of Decree 2555 of 2010 12 Machine Translated by Google Financial Superintendence of Colombia ensure that the valuation model used is adjusted to the nature of the asset and reflects its economic reality, since the valuation constitutes the first indicator of the state of the investment. 7.1.The valuation analysis of the underlying assets of the FCP must be adjusted to the nature and economic reality of the asset. Just as every investment that is part of the portfolio of a Pension Fund must be rigorously evaluated to be part of the FCP strategy, it is also important to have timely, true and reliable information about the value of the underlying assets that make up the FCP. Therefore, it is necessary that, in order to have a price of the FCP that is in accordance with its nature, it reflects its economic reality and can be used to carry out its valuation. 7.2. EsrecomendablequeelFCP oelGestorProfesional, cuentenconunGobiernoCorporativoqueavaleelprocesodevaloracióny/ olosinsumosproporcionadosparaelmismo dondesetengaclaralafuentedeinformacióndisponibleparalageneracióndeinsumos,laperiodicidadymetodologíadere 7.3. It is ideal for the FCP to have a methodology for valuing the underlying asset with technical, stable and comparable criteria, on which backtesting is carried out to validate the fit of the model . 7.4. It is necessary for the AFPs to be clear about the scope of the responsibilities of the Statutory Auditor with the Fund, above, particularly in those cases in which this activity is carried out by the Statutory Auditor contracted by the SA, in order to know the scope of the audit that this control body would carry out, as well as the instances of discussion and approval of its opinions. 8. ESG - Environmental, Social and Governance Criteria The constant changes and the evolution that is being generated in the world in environmental, social, and corporate governance matters 19 are today a reality that has a direct impact on the performance of the investments, for which it is necessary to consider them, to evaluate if the assets in which the investments are made will be affected by them; likewise, in order to mitigate them, they must be included in the investment policies, CP procedures, and investment models. 8.1.DevelopandexecuteastatementwithinitspoliciesthatestablishesthecommitmenttoincludeESGenfactors 19 Some examples of these ESG factors are: (E) Environmental: climate change, water, deforestation, pollution; (S) Social: human rights, labor rights, conflict zones, migration; (G) Corporate Governance: transparency, executive remuneration, corruption. Source: Own elaboration based on what is published on the website of the Principles for Responsible Investment, PRI. https://www.unpri.org/ 13 Machine Translated by Google Financial Superintendence of Colombia theidentification,analysisandselectionoffunds;oneofthesetoolsmaybeachecklistorquestionnairethatintegratescriteriaa 8.2.AssessiftheFCPhasaresponsibleinvestmentpolicy,systemsandprocessestoidentifyandmanageESGrelat 8.3.During due diligence, include an analysis related to the integration of ESG and/or the management of these risks by the FCP. It is during this process that risks and opportunities related to ESG are most efficiently identified and strategies are established to manage these risks during follow-up. At this stage, it is recommended to ask about: • The FCP's mandate, and if its investment policy is focused on issues related to sustainability20 or if it has any exclusion lists21. • In line with what was established in point 3 “risk-return analysis” of this document, it should be considered whether the general approach of the FCP for the integration of ESG is consistent with the interests of the AFP. • The capacity of the FCP to manage ESG matters22. • The experience or trajectory of the FCP in the management of ESG; in this sense, the AFP can inquire of the Professional Manager about situations in which the risks and opportunities related to ESG in the current or potential portfolio have been identified and addressed. • The FCP's process for identifying material ESG issues, including: - The sources of information used by the FCP to identify possible risks related to ESG23. - LaidentificacióndelosriesgosyoportunidadesrelacionadosconESG,teniendoencuentalasgeografíasosecto administered. 8.4.It is important that the AFP integrates into its investment process the analysis of the possible effects of ESG factors on financial performance; in this sense, 20 For example: financial inclusion, clean and renewable energies, economic development, among others. 21 For example: weapons, nuclear energy, business development with forest deforestation activities, among others. 22 For example: responsible resources and teams, specialized people within the risk team, hiring of experts, among others. 23 For example: company data, interviews with the board of directors or management team, benchmarks with peers, initiatives and voluntary guidelines of the sector, among others. 14 Machine Translated by Google Financial Superintendence of Colombia depending on the nature of the underlying asset, it is recommended, for example, to assess the impact that climate change could have on the value of the underlying investments, as a result of physical risks24 and transition risks25. 8.5.It is recommended that the AFP request the Professional Managers to leave their commitments in writing regarding the inclusion of ESG factors in the investment process. The commitments could be described in a memorandum and/or included in the FCP regulation. At this stage, it should be monitored how the FCPs integrate their investment decision, permanence of the investment, and their investment into ESG units. 8.6.ImplementstrategiesfordisclosureofrelevantinformationontheinvestmentpolicybasedonESGfactorsap 24 Physical risks arise from climate-related events; they can be gradual (for example, rising sea level or desertification) or manifest abruptly (such as storms or droughts). 25 Transition risks are the risks arising from the transition to a low-carbon economy; they result from international commitments, national policies and/or consumer preferences that may end up affecting companies, either because they impact their own economic activity or because they affect assets in which they have invested. fifteen Machine Translated by Google Financial Superintendence of Colombia Bibliography • APRA.AustralianPrudentialRegulationAuthority.PrudentialPracticeGuide,SPG530– InvestmentGovernance.November2013. • APRA.AustralianPrudentialRegulationAuthority.PrudentialPracticeGuide,SPG510– Governance. November 2016. • ColCapital. Colombian Association of Private Equity Funds. Guide to best practices in reporting and valuing the portfolio of private equity funds. November 2016. • ILPA. Institutional Limited Partners Association. https://ilpa.org/best-practices/due diligence- questionnaire/ • IOPS.InternationalOrganisationofPensionSupervisors.BestPracticesInRiskManagementInAlternativeInvestmentsI • IOPS.InternationalOrganisationofPensionSupervisors.GuidelinesontheapplicationofESGfactorsinsupervisionofpen October2018. • PRI.PrinciplesofResponsibleInvestment.ResponsibleInvestmentinprivateequity:A guideforlimitedpartners.June2011. https://www.unpri.org/ • Financial Superintendence of Colombia. Requirements to the AFPs and documents of internal work of the Delegation for Pensions. 2018 16