Brazil: An Update On Brazilian Private Equity Investment Funds (FIPs)

Published 04/10/2016

On August 30, 2016 the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários –CVM) issued CVM Instruction No. 578 (ICVM 578/2016), which modernizes the rules on the incorporation, functioning and administration of Private Equity Investment Funds (Fundos de Investimento em Participações – FIPs). The relevant issues to be highlighted are mentioned below.

Nature of the Fund

The FIP is constituted in the form of a closed-end condominium. It is a communion of resources for the acquisition of the following assets (eligible assets)1: shares, subscription bonuses, unconvertible debentures and other securities convertible into or exchangeable for shares issued by publicly or privately-held corporations, as well as securities representing participation in limited liability companies (sociedades limitadas). The Fund must participate in the decision-making process of the invested company with effective influence in defining its strategic policy and management.

Advances for Future Capital Increase

The FIP can perform advances for future capital increase in publicly or privately-held corporations that form its portfolio, provided that: (i) on the date of implementation of the advance the FIP has an investment in shares of the company; (ii) this possibility is expressly provided for in the Fund’s regulation, including the subscribed capital which can be used for making the advance; (iii) any form of repentance of the advance by the FIP is prohibited; and (iv) the advance is used to increase the invested company’s capital within a maximum period of 12 months.

Participation in the Decision-Making Process of Invested Companies

The Fund’s participation in the decision-making process of the invested company can occur through: (i) the holding of shares that integrate the respective control block; (ii) by entering into a shareholders’ agreement; or (iii) the conclusion of any contract, agreement or legal business or the adoption of another procedure that ensures to the FIP the effective influence in defining its strategic policy and management, including by the appointment of members of the Board of Directors (Conselho de Administração).

However, the FIP’s participation in the decision-making process of the invested company is no longer required when: (i) the Fund’s investment in the company is reduced to less than half the percentage originally invested and represents less than 15% of the share capital of the investee; or (ii) the book value of the investment has been reduced to zero and there is a resolution of the unit holders gathered in the general assembly approved by the majority of the subscribed units of the FIP, provided that the Fund’s regulation does not stipulate a higher quorum.

The requirement for effective influence in defining the strategic policy and management of the invested companies does not apply to the investment in any investee listed in a special segment on trading of securities established by the stock exchange or by an administrator entity of the organized over-the-counter market, returned to the access market, to ensure, through contractual bond, stricter corporate governance standards than those required by law, provided that it corresponds at up to 35% the subscribed capital of the FIP. This limit will be 100% during the period of application of resources, established within six months of each of the events of payment of the units set forth in the investment commitment.

If the FIP exceeds the above-mentioned limit (35% the subscribed capital of the FIP) for reasons unrelated to the will of the manager, at the end of the respective month and such declassification will endure at the closure of the next month, the administrator must: (i) communicate immediately the occurrence of the declassification liability to CVM, together with the due justification, as well as present a forecast for reframing; and (ii) report to CVM the reframing of the portfolio at the time that it happens.

Governanance Practices

The privately-held corporation must follow the following practices of governance: (i) to prohibit the issuance of founder shares and not to have outstanding securities of this kind; (ii) to establish a unified mandate of up to two years for all Board of Directors’ members (if there is a Board of Directors); (iii) to provide to the shareholders with copies of related party agreements, shareholders’ agreements and programs of call option of shares or other securities issued by the company; (iv) to adhere to the arbitration chamber for resolution of corporate conflicts; (v) if registered as a publicly-held corporation under Category A2, to undertake before the FIP to join a special segment of the stock exchange or an administrator entity of the organized over-the-counter market to ensure the adoption of at least the corporate governance practices laid down in the previous items; and (vi) to do annual audit of its financial statements by independent auditors registered with CVM3.

Minimum Investment Limits

The FIP must maintain at least 90% of its net worth invested in the eligible assets. As a general rule, the investment in unconvertible debentures is limited to 33% of the total subscribed capital of the Fund4.

Investments Abroad

Investments abroad are also allowed. The FIP can invest up to 20% of its subscribed capital in foreign assets of the same economic nature of the eligible assets located in Brazil (domestic assets). Foreign assets are those assets whose issuer is: (i) headquartered outside Brazil; or (ii) has head office in Brazil and assets located abroad, corresponding to 50% or more of the total assets registered in its financial statements. The assets are deemed domestic assets if the issuer is headquartered abroad and has assets in Brazil, corresponding to 90% or more of the total assets registered in its financial statements.

These overseas investments can be made by the FIP, indirectly, through other funds or investment companies abroad, regardless of their form or legal nature. The FIP’s participation in the decision-making process of the invested abroad, with the effective influence on the definition of its strategic policy and management, must be ensured by the manager of the FIP in Brazil and can occur through the administrator or manager of the intermediate vehicle used for the overseas investment. The above-mentioned minimum requirements of corporate governance must be met by the invested abroad, subject to the necessary adaptations arising from the regulation of jurisdiction where the investment is located.

Other Allowed Investments

The FIP can invest in units of other FIPs or units of Stock Funds – Access Market (Fundos de Ações – Mercado de Acesso) to comply with the minimum threshold of 90%. The FIP investor is required to consolidate the applications of the invested funds, including for purposes of calculation of portfolio concentration limits, except the investments in funds managed by third parties not connected to the administrator or the manager of the FIP investor. The application in units of FIP that invests directly or indirectly in the FIP investor is prohibited.

Classification of FIPs

The FIPs are classified in the following categories as to the composition of their portfolios: (i) Seed Capital (Capital Semente); (ii) Emerging Companies (Empresas Emergentes); (iii) Infrastructure (Infraestrutura – FIP-IE); (iv) Intensive Economic Production in Research, Development and Innovation (Produção Econômica Intensiva em Pesquisa, Desenvolvimento e Inovação – FIP-PD & I); and (v) Multi-strategy (Multiestratégia)5.

FIP – Seed Capital

Corporations or limited liability companies invested by FIP – Seed Capital: (i) must have annual gross revenues of up to BRL 16 million6 ascertained in the fiscal year ended year prior to the first contribution to the Fund without having presented revenue exceeding this limit in the last 3 (three) years; and (ii) are exempted from following the above-mentioned governance practices.

If, after the investment by the Fund, the invested company’s annual gross revenue exceeds the limit of BRL 16 million, the invested company shall, within two years from the date of closure of the fiscal year in which it presents annual gross revenue in excess of the limit: (i) meet the provisions of items III, V and VI of article 8 of ICVM 578/2016, while its annual gross revenue does not exceed BRL 300 million; or (ii) comply with all the provisions of article 8 of ICVM 578/2016, if its annual gross revenue exceeds BRL 300 million. The annual gross revenue must be ascertained on the basis of the consolidated financial statements of the issuer.

Furthermore, corporations or limited liability companies cannot be controlled directly or indirectly, by a company or group of companies, in fact or in law, which shows total assets exceeding BRL 80 million or annual gross revenue higher than BRL 100 million at the close of the fiscal year immediately preceding the first contribution to the FIP. This provision does not apply when the company is controlled by another FIP, provided that the financial statements of the FIP are not consolidated in the financial statements of any of its unit holders.

If the FIP – Seed Capital is not qualified as an investment entity, in accordance with the specific accounting rules, the invested companies must have their annual financial statements audited by independent auditors registered with CVM.

The target audience of the FIP – Seed Capital comprises all qualified investors and not only professional investors7.

FIP – Emerging Companies

The rules are quite similar but the limits are different. Corporations or limited liability companies invested by FIP – Emerging Companies: (i) must have annual gross revenues of up to BRL 300 million ascertained in the fiscal year ended year prior to the first contribution to the Fund without having presented revenue exceeding this limit in the last 3 (three) years; and (ii) are exempted from following the above-mentioned governance practices.

If, after the investment by the Fund, the invested company’s annual gross revenue exceeds the limit of BRL 300 million, the invested company shall, within two years from the date of closure of the fiscal year in which present annual gross revenue in excess of the limit, comply with all the provisions of article 8 of ICVM 578/2016. The annual gross revenue must be ascertained on the basis of the consolidated financial statements of the issuer.

Corporations or limited liability companies cannot be controlled directly or indirectly, by a company or group of companies, in fact or in law, which shows total assets exceeding BRL 240 million or annual gross revenue higher than BRL 300 million at the close of the fiscal year immediately preceding the first contribution to the FIP. This provision does not apply when the company is controlled by another FIP, provided that the financial statements of the FIP are not consolidated in the financial statements of any of its unit holders.

FIP-IE and FIP-PD&I

The FIP-IE and the FIP-PD&I8 shall keep their respective net worth invested in shares, subscription bonuses, debentures convertible or not into shares, and other securities9 issued by publicly or privately-held corporations stocks, provided that they develop in the Brazilian territory new projects of infrastructure (in the case of the FIP-IE) or intensive economic production in research, development and innovation (in the case of the FIP-PD&I), in the sectors of: (i) energy; (ii) transport; (iii) water and sanitation; (iv) irrigation; and (v) other areas regarded as priorities by the Federal Executive Branch.

New projects are those implemented after January 22, 2007, as well as: (i) intensive economic production projects in research, development and innovation implemented after June 27, 2011 in accordance with Law No. 12,431, of June 27, 2011 by special purpose companies that comply with the regulation of the Science and Technology Ministry; and (ii) the expansion of existing projects, already implemented or in the process of being implemented, provided that the investments and the results of the expansion are segregated by means of the formation of a special purpose company.

Each FIP-IE and FIP-PD&I must have at least five unit holders. Each unit holder cannot hold more than 40% of the units issued by the FIP-IE or at FIP-PD&I or obtain a higher yield than 40% of the income of the Fund. The regulation and disclosure material of the FIP-IE and the FIP-PD&I, including the prospectus (if any) should highlight the tax benefits of the Fund and the unit holders, if any, and the conditions that must be met for maintenance of these benefits.

FIP – Multi-strategy

The FIP – Multi-strategy is the one that does not qualify in the other categories because it admits the investment in different types and sizes of invested companies and will have the same benefits attributed to the FIP – Capital Seed and to the FIP – Emerging Companies, regarding to the exemption of governance practices, whenever it follows the rules applicable to such Funds.

This FIP can invest up to 100% of its subscribed capital in assets issued or traded abroad, if intended solely to professional investors, provided that: (i) there is a express provision in its regulation admitting the possibility of investment in foreign assets and establishing the maximum percentage of the subscribed capital which may be allocated; (ii) the regulation is explicit as regards the exclusive participation of professional investors; and (iii) the expression Investimento no Exterior (which means Overseas Investment) is included in its name.

Different Classes of Units

Regardless of the type of investor, the FIP regulation may assign to one or more classes of units distinct financial and economic rights, exclusively as regards: (i) the fixing of administration and management fees; and (ii) the order of preference in the payment of income, depreciation or balance of liquidation of the Fund.

Beyond the above-mentioned financial and economic rights, different rights may also be attributed to FIPs intended exclusively to professional investors or those that receive direct financial support from promotion agencies (organismos de fomento).

The FIP that receives such direct financial support is authorized to borrow directly from promotion agencies, limited to 30% of the assets of the Fund. The exercise of this option is only allowed after obtaining the formal commitment of financial support from promotion agencies in making investments or granting funding in favor of the FIP. To this effect promotion agencies are multilateral organizations (organismos multilaterais), development agencies (agências de fomento) or development banks (bancos de desenvolvimento) that have funds arising out of contributions and dues paid mostly with budgetary resources of one or several Governments, and whose control is governmental or multi-governmental.

General Assembly of Unit holders

In addition to other matters, the general assembly of unit holders of the FIP is privately competent to: (a) approve the acts that characterize potential conflict of interest between the FIP and its administrator or manager and between the FIP and any unit holder or group of unit holders having more than 10% of the subscribed units; (b) include any charges not provided for in ICVM 578/2016 or authorize its increase above the maximum limits established in the Fund’s regulation; and (c) approve the appraisal report of an independent specialist company for payment purposes of units in investment-related assets or rights (including credits) in companies in the process of judicial or extrajudicial recovery or financial restructuring, determining the fair value of such assets or rights.

The votes are calculated according to the quantity of the subscribed units, excluding the delinquent portion, i.e. the units subscribed and not paid in. Therefore, the delinquent portion must be excluded so much for voting power as for purposes of calculation of quorum10.

The unit holder shall exercise the right to vote in the interest of the FIP. The following persons cannot vote in the general assemblies of the FIP: (i) its administrator or manager; (ii) the partners, directors and employees of the administrator or manager; (iii) companies related to the administrator or manager and their respective partners, directors and employees; (iv) the service providers of the FIP and their respective partners, directors and employees; (v) the unit holder whose interest conflicts with the FIP´s interest; and (vi) the unit holder, in the event of deliberation on the evaluation reports of its/his/her assets that will contribute to the formation of the net worth of the FIP. These restrictions do not apply when the sole unit holders are the above-mentioned persons or if there is express consent of the majority of the other unit holders, manifested in the assembly, or in a proxy that refers specifically to the assembly that will allow the vote.

Administration and Management

The administration of the FIP comprises the set of services directly or indirectly related to the operation and maintenance of the Fund, which can be provided by the administrator or by a third party hired by the administrator on behalf of the Fund.

Only legal entities authorized by CVM for the professional exercise of securities portfolio management can be administrators of the FIP. The legal entity must appoint a director or managing partner responsible for the FIP’s representation at CVM.

The administrator can hire on behalf of FIP with third parties properly enabled and authorized, the following services to the Fund, with the exclusion of any other not listed: (i) management of the portfolio of the Fund; (ii) investment consulting; (iii) activities of treasury, control and processing of financial assets; (iv) distribution of units; (v) registration of issue and redemption of units; (vi) financial assets custody; and (vii) market maker for the units of the Fund.

As the representative of FIP, the administrator must hire the service providers, by careful prior analysis and selection of the contractor, and will sign the agreement as intervening consenting party.

The contracts for services of portfolio management, activities of treasury, control and processing of financial assets and registration of the issue and redemption of units shall contain a clause stipulating the joint and several liability (solidarity clause)11 between the administrator and the third-party service providers for any damages caused to the unit holders as a result of any conduct contrary to law, to the Fund’s regulation and the normative acts issued by CVM12.

The FIP administered by a financial institution does not need to hire the services of activities of treasury, when they are carried out by its administrators, which in this case are considered authorized to provide such services.

The management of the Fund’s portfolio is the professional management of its assets, as set out in the FIP’s regulation, carried out by a legal entity accredited as securities portfolio administrator by CVM, with powers to: (i) negotiate and hire, on behalf of the Fund, the assets and the intermediaries to perform operations of the FIP, representing the Fund to this effect for all legal purposes; (ii) negotiate and hire, on behalf of the FIP, third parties for the provision of advisory and consulting services related directly with investment or divestment in assets of the Fund, as established in the FIP’s investment policy; and (iii) monitor the assets invested by the Fund and exercise the right to vote as a result of these assets, performing all other necessary actions, subject to the manager’s voting policy13.

In the absence of a specific provision in the FIP’s regulation or in the contracts entered into between the administrator and the manager, the manager must forward to the administrator, within five working days after its signature, a copy of each document signed by the manager on behalf of the Fund, without prejudice to the submission, in the form and schedule established in advance by the administrator of any additional information allowing the administrator to correctly comply with its legal and regulatory obligations towards the Fund.

The market maker service can be provided by legal entities duly registered with the administrator entities of the organized markets. The administrator and manager of the FIP cannot provide the market maker service for the units of the Fund. The hiring of related parties to the administrator and manager of the FIP for this purpose must be previously approved by the general assembly of unit holders. The hiring and termination of market maker must be disclosed as a material fact.

Subject to any legal limitations and those provided for in ICVM 578/2016, the administrator has the powers to perform all acts necessary for the operation of the Fund, being responsible for its incorporation and the provision of information to CVM in accordance with ICVM 578/2016 and when requested.

The custody service of eligible assets issued by closely-held corporations and limited liability companies is dismissed. To use this exemption, the administrator must provide custody services for such financial assets, in order to ensure its proper safeguards, including: (i) to receive, check and keep the documentation which shows and proves the existence of financial assets ballast; (ii) arrange for it to be kept at its expense to date and in perfect order the evidentiary documentation of financial assets; and (iii) collect and receive on behalf of the Fund revenues and any other payments related to the assets under custody.

The hiring of custody service is also dismissed in the case of investments in assets intended for the payment of costs of the FIP, provided that they are limited to 5% of the subscribed capital and admitted for trading on stock exchanges or in the organized over-the-counter market or registered in any registration or financial settlement system authorized by the Central Bank of Brazil (Banco Central do Brasil – Bacen) or CVM.

Without prejudice to the responsibilities of each of the administration service providers of the FIP, advisory councils and/or technical or investments committees can be constituted on the initiative of the unit holders, the administrator or the manager. Their remuneration, however, cannot be paid at the expense of the Fund. When constituted on the initiative of the administrator or manager, the members of the council or committee may be paid with a portion of the management fee. The functions, composition and requirements for convening and deliberation of the councils and committees should be established in the Fund’s regulation. The existence of councils and committees does not exempt the administrator or the manager of the responsibility for the operations of the Fund’s portfolio. The members of the councils or committees shall inform the administrator and the manager about any potential or effective situation of conflict of interest with the Fund. The administrator and the manager shall convey this information to the unit holders.

The obligation to prepare the report about the operations and results of the Fund, accompanying the financial statements, is shared between the administrator and the manager. The manager is responsible for signing on behalf of the Fund the shareholders’ agreements of the investee companies, including a clause which confirms that the administrator intervened and agreed with such agreements. The manager is also responsible for maintaining an effective influence in defining the strategic policy and the management of the investee company, besides being responsible for ensuring its corporate governance practices.

Disclosure of Information

The administrator of the FIP must forward to the unit holders, to the administrator entity of the organized market where the units of the Fund are admitted for trading and to CVM, the following periodic information:

  1. on a quarterly basis, within 15 days after the end of the respective calendar quarter: (a) the net worth value of the Fund; (b) the number of issued units; (c) the quantity of unit holders; (d) the profile of the unit holders, specifying the category, number of unit holders and percentage of units, as shown in Annex 46-I to ICVM 578/201614; and (e) the total committed capital and the subscribed and paid in amounts and up to the reference date;
  2. semi-annually, within 150 days after the close of the respective calendar semester, the composition of the portfolio, listing the quantity and species of the securities that form such portfolio; and
  3. annually, within 150 days after the close of the fiscal year: (a) the audited financial statements, together with independent auditors’ report and the report of the administrator and manager; (b) the classification of the Fund in accordance with the accounting principles adopted for the assessment of its investments; (c) the costs charged to the Fund, specifying its value and percentage in relation to the annual average net worth value of the Fund.

Among the eventual information that the administrator must provide to the unit holders and to CVM, in the case of a material change in the fair value of the investments of the FIP during the fiscal year, the following disclosures are required: (a) the report of the administrator and the manager with the justifications and details on the change of fair value; and (b) the effect of the new assessment of the results for the year and net worth value of the Fund.

In addition, in the event this type of change happens during the fiscal year, the Fund shall prepare its financial statements for the period between the date of beginning of the fiscal year and the date of the accounting recognition of that change, and submit it to the independent audit.

However, if the accounting effects of the material change in the fair value are recognized until two months prior to the closing date of the fiscal year, the preparation of these financial statements is dismissed.

Transitional Provisions

The deadline for adaptation to the provisions of ICVM 578/2016 is: (a) immediately, if the FIP performs any public offer of units registered or exempted from registration; (b) twelve months after the publication of ICVM 578/201615 for a going concern FIP.

The existing Mutual Funds Investing in Emerging Companies (Fundos Mútuos de Investimento em Empresas Emergentes – FMIEEs) can continue to operate in their current templates, without the need for adaptation. The extension of their term of duration, however, is prohibited, unless the new rules are duly observed by the investees.

Preparation and Disclosure of Financial Statements

On August 30, 2016 CVM also issued CVM Instruction No. 579 (ICVM 579/2016), establishing the rules on accounting criteria of recognition, classification and measurement of assets and liabilities, as well as the recognition of revenue, expenditure appropriation and information disclosure in the financial statements of the FIPs.

ICVM 579/2016 sets forth the requirements to qualify the FIPs as an investment entity or not. This qualification determines specific measurement criteria for the assets related to equity interests, forming the Fund’s portfolio, and arises out of the convergence to the criteria contemplated in the international accounting standards issued by the International Accounting Standards Board (IASB).

It also establishes important criteria for the transition to the adoption of these standards, including the treatment of investments in equity interests existing before the term of validity of ICVM 579/2016. The opening balances on the initial adoption of the new accounting standards, that is, to the fiscal year started on or after January 1, 2017, must be adjusted to the criteria set forth in ICVM 579/2016.

It is expected that ICVM 579/2016 will promote significant improvement in the informational regime of the FIPs, unifying the accounting principles adopted in Brazil to those practiced internationally. This will certainly contribute to the generation of useful information for users, and enable comparability between the accounting information of these Funds.