View from Brazil: Increased regulation and supervision is here to stay, and that’s a good thing

Brazillian hedge funds avoided most of the problems that plagued their counterparts
globally. What was their secret?

By Luis Vicente D’Amato, Felipe Prata, Enio Shinohara & Marcos Toledo

In no way can we say that the financial earthquake that shook the structures of global capitalism in the past
year left Brazil unscathed. The aftershocks we witnessed in Brazilian capital markets, however, were of a
significantly lower magnitude than those faced by other countries, both developed and emerging. Banks
going under, funds wiping out the savings of hundreds of investors, protests against executive bonuses—
none of these issues made the headlines in the local news.

Much of this “tranquility” we experienced throughout the crisis was the result of a robust regulatory
framework and the structure behind Brazil’s fund industry, built up over many years to withstand similar
crises on a local scale that occurred in the past.

In the turbulent environment of the 80’s and 90’s, amidst which the equity fund industry was developed,
transparency and risk control were fundamental prerequisites for any institution operating in the Brazilian
market. Daily net asset values, “clearing houses” consolidating all counterparty risk and active regulators
have together created an environment of transparency in the system.

The end of 2008 turned out to be this system’s ultimate stress test!

We came out unshaken by the earthquake. There were no “gates” nor “side pockets” erected, while
redemptions were paid in full, on time. Daily net asset values were published according to public mark-tomarket
guidelines for all institutions. More importantly, according to regulation/legislation, no manager is
allowed to alter any rule of a fund’s prospectus without convening a shareholders’ meeting and obtaining
approval of the majority of shareholders as well as the administrator, usually a separate and independent
entity from the fund manager. What is a new development in many parts of the world has actually been a
common practice in Brazil for over 10 years.

Among the drivers for the success of the Brazilian fund industry, we may include:

—Unified regulation. Local hedge funds are subject to the same regulation as local mutual funds.

—Centralized counterparty risk. Our settlement agencies, such as CBLC and Cetip, maintain substantial
liquid positions and advanced collateral controls which significantly reduce the possibility of a systemic
crisis.

—Separation of management, administration, custody and audit functions. Most managers outsource administration and custody functions so that the best practices in mark-to-market are implemented in an independent and unbiased manner. The administrator has the power to intervene in the management
process, summon a shareholders’ meeting and even replace the fund manager, if the latter is not following
the fund’s investment objective. According to local regulation/legislation, the administrator is ultimately
responsible for share calculation, marking-to-market, making withdrawal payments and providing
information to the market.

—Transparency/Daily Net Asset Value. The publication of daily net asset values permits efficient
monitoring of existing funds by investors and the market. The requirement of daily net asset value
quotations also obligates service providers (administrators) to mark-to-market every day.

—Transparent pricing policy. Public pricing guidelines constitute yet another instrument of protection for
investors.

—Governance. The CVM (Brazilian SEC) has the power of supervision and regulation over all investment
funds in Brazil, including the absolute return funds, or hedge funds. The CVM has the power to intervene
and has previously used this power to prevent events that could have affected equal and fair treatment of
investors.

—Active regulator. Initiatives by the CVM and the Central Bank, such as the publication of the fund
portfolio position with a 90-day delay, contribute to the wide adherence to transparency standards.

—Initiatives for self-regulation. Independent entities such as Amec and ANBID provide an additional
source of influence to ensure ethical standards and best practices are adopted all those participating in the
system.

Finally, even in cases in which funds faced difficulties involving less liquid assets, or excessive leverage,
posing a threat to its continuity, the regulator demonstrated outstanding performance in summoning shareholders’ meetings and assessing the situation before insolvency jeopardized the rest of the system.

It is worth noting that the stability of this regulatory and operational framework is the result of many years
of trial and error as well as from Brazil’s experience in dealing with different crises during which the
financial system as a whole was put to the test. Also noteworthy is that the evolution of this framework was
only made possible through the combined efforts of government entities (the CVM, Central Bank and
Treasury) and the main players in the investment fund industry, represented by ANBID.

Invaluable lessons have been learned from the crisis by all. Indeed, it is at times like these that we learn our
greatest lessons. We hold the view that increased regulation and supervision in the worldwide markets is a
trend that is here to stay. On this point, our experience of more than 10 years building this system can
contribute significantly to the development of supervision and governance models that mitigate future risks
of systemic problems.

Even more importantly, the tranquility provided by the local regulatory environment to investors and
managers has enabled the financial indicators of the Brazilian market to recover more swiftly than those of
other financial markets, with the Brazilian real appreciating more than 20% and local equities (represented
by the Ibovespa) more than 50 % year to date in 2009.

About the authors

Luis Vicente D’Amato, CFA, is a partner with Credit-Suisse Hedging-Griffo, where he joined in 1991. He has
14 years’ experience at the equities trading desk at CSHG Brokerage House, focusing primarily on foreign
investors.

Felipe Prata is a partner at Nest Investimentos in charge of invsetor relations. He previously served as a partner at Open Fund Asset Management.

Enio Shinohara is a partner at Claritas, heading the fund-of-funds team. He is also a member of the firm’s
asset allocation committee. Prior to joining Claritas in 2005, Shinohara worked at Hedging-Griffo in1994,
where he built the fund of hedge funds business.

Marcos Toledo is chief operating officer and partner at M Square: From 2001 to 2005 Marcos was with JP
Morgan Private Bank Brazil, where he was responsible for clients’ fund of funds allocation, monitoring the
Brazilian hedge funds industry and generating tailor-made portfolios.