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  1. 1. Fund & Asset Manager Rating Group  Asset Managers  Criteria Report  Reviewing and Rating Credit Asset Managers  Analysts  Summary  London This report sets out Fitch Ratings’ criteria for reviewing and rating the operations of Manuel Arrive, CFA credit asset managers, and reflects Fitch’s overarching methodology applicable to +44 20 7862 4099 asset managers set forth in “Reviewing and Rating Asset Managers” dated 18 June 2009. This report describes the criteria sub‐set that Fitch has developed to assign New York operational risk ratings to credit asset management. This criteria addresses Fitch’s Roger Merritt +1 212 908 0636 process specifically as an independent assessment of the investment management capacity and vulnerability of a credit asset manager to operational and investment Nathan Flanders manager failure. +1 212 908 0827 Fitch’s rating methodology has been designed to capture, evaluate and report on an asset manager’s key characteristics via a multi‐criteria approach that provides for Gwen Fink Stone +1 212 908 9128 the aggregation of rating factors into five distinct groupings. This facilitates focused gwen.fink‐ analysis, clear expression of rating conclusions, and the profiling of rated credit asset managers. The five category groupings are: Chicago Russ Thomas +1 312 368 3189 · Company and Staffing; · Credit Selection; Paris Aymeric Poizot, CFA, CAIA · Portfolio and risk management; +33 1 44 29 92 76 · Investment Administration; Charlotte Quiniou, CFA · Technology. +33 1 44 29 92 81 ‘M’ ratings supersede and replace CDO Asset Manager (CAM) ratings, incorporating all types of investment vehicles and not only CDOs. Since M ratings supersede CAM Frankfurt ratings, all CDO Asset Manager ratings will be converted into M ratings. The move is Roger Schneider, CIIA +49 69 7680 76242 also in recognition of structured credit market trends that have resulted in CDO  managers increasingly transitioning to credit fund management, broadening their credit asset management platform, and building on their existing core expertise in Related Research the (sub‐) credit asset class. Fitch intends to focus on the investment platforms · Changing Trends in Credit Asset irrespective of the types of structures managed. Management (February 2009) · Reviewing and Rating Asset Managers The scope of the M rating analysis covers the full credit management platform that (June 2009) is under assessment and may focus on certain sub‐asset classes, such as Investment · Reviewing and Rating Fund of Hedge Fund Grade Corporates (IG corp), Leveraged Loans or Structured Finance. However, the Managers (June 2009) analysis extends across all types of credit‐oriented investment product (e.g. funds, · Reviewing and Rating Real Estate Asset Managers (June 2009) segregated mandates or structured credit products) and sub‐ strategies (long unlevered, long short, concentrated, diversified, regional, global). Fitch will disclose the scope and limitation of the rating in its rating action commentaries and rating reports. In its assessment of credit asset managers, Fitch places increased emphasis on an asset manager’s financial condition and business sustainability, with a low score in this area resulting in a lower overall M rating. In response to the challenges facing asset managers in the post‐crisis market, Fitch is also closely focusing on governance, organisational structure and third‐party involvement, credit selection (fundamental credit research and relative value analysis), and investment risk management processes (credit, market and liquidity risks). In periods of unprecedented stress, rising defaults and changes in the asset management industry, these are key factors that will differentiate market players.  27 July 2009 
  2. 2. Fund & Asset Manager Rating Group The five main rating categories are similar to those addressed in the overarching methodology, but the weightings and focus may differ. Qualitative inputs from analysts serve as the defining input in the assignment of the final ratings, allowing for the consideration of individual asset managers’ circumstances.  Rating Methodology Overview  This criteria is based on the general framework Fitch has developed in its report “Reviewing and Rating Asset Managers”, dated 18 June 2009, where more details on the generic rating methodology can be found. The discussion below is focussed on specific aspects of assessing credit managers.  Company and Staffing  When reviewing credit asset management platforms, Fitch places particular focus on the following: · institutional experience and track record in the relevant credit sub‐asset classes (IG corp, high yield, etc), types of investment vehicles (funds, CDOs), style and investment strategies being reviewed; · impact of the credit crisis on the company’s business franchise, financial standing and reputation; · company’s commitment to the relevant credit sub‐asset classes and related business lines, as indicated in the share of AUM and revenues and dedicated resources and business plans; · nature of, and ability to, retain or develop the investor base; · investment professional’s experience and track record in the relevant credit sub‐asset classes; · match between credit research staffing resources and credit universe coverage and research style. Fitch’s ultimate objective in this category is to assess the asset manager’s ability to maintain, adapt or rebuild credit platforms to ensure long-term business and financial viability and launch new funds or investment solutions that match investors’ revised risk-adjusted return expectations. Fitch incorporates the views of its rating analysts in the assessment of available capital and operating revenues to maintain or improve operational aspects.  Credit Selection  The review of the organisation’s credit selection processes is designed to determine the degree to which the organisation has a well‐defined, consistently implemented credit research and investment selection/divestment processes. The quality of these processes forms the basis of Fitch’s evaluation of whether the company has sufficient resources in place to meet its stated investment selection criteria and whether these processes are relevant for specific credit portfolios and related investment mandates. In today’s context of increasing credit performance dispersion and rising default rates, Fitch views positively an asset manager that demonstrates strong analytical rigour in selecting eligible, undervalued securities, which may offer the best capital protection for its investors. Credit investment processes that are weighted towards a bottom up, research‐driven process, with a focus on credit dynamics, will be viewed more positively. Fitch examines individually and collectively the various modules of the credit selection process. Reviewing and Rating Credit Asset Managers July 2009  2 
  3. 3. Fund & Asset Manager Rating Group Credit Universe Screening and Sourcing The definition of the firm’s investment universe and research coverage universe is the critical first stage of the investment process. While some managers have deep research resources to cover a meaningful portion of the universe, others implement quantitative screens to focus research efforts on a selected number of credits. Fitch will seek to understand the analytical framework and processes by which the manager reduces the credit universe of opportunities to an investable and workable size, according to its investment criteria and the research resources available. For instance, Fitch would consider as disciplined a screening of the Investment Grade bonds investment universe, combining a quantitative and qualitative credit approach, based on key risk parameters (possibly through systematic credit scoring tools to rationalise the selection). For the relevant asset type, access to deal flow on the primary market is largely dependent on the quality of the relationships established with the company’s sources (private equity sponsors and banks’ arranging and syndication desks for leveraged loans for example). While larger organisations may tend to have broader access, smaller companies, through specific individuals or long and active market presence, may achieve similar relationship networks. Fitch reviews the number and diversity of sources a company uses, the allocations obtained, and the commitment of the manager to maintain or develop relations with key dealers and underwriters. To the extent that affiliates play a sourcing role, Fitch looks for appropriate Chinese walls and independence, which are also addressed under the “Corporate Independence and Governance” criteria of the “Company and Staffing” category above. A lack of sufficient corporate governance controls would negatively impact the ‘M’ rating. Sector and Macro‐Economic Research Top down views, derived from market, economic, and industry analysis, contribute to the development of key performance credit drivers. Fitch will review the rigour with which these projections are formed and factored into the portfolio allocation process (and ultimately their contribution to the enhancement of credit portfolio risk / return profiles). For instance, the agency will review how portfolio allocation strategies (by sub‐credit asset class, region, sector, industry, capital structure) reflect the manager’s economic outlook, formed from an analysis of interest rates, exchange rates, economic growth, credit cycles and political trends. Similarly, the agency will assess how macro‐economic assumptions are used to stress test credit fundamentals during the asset selection process, as well as to position the portfolio within the asset class (e.g. up or down in quality, credit barbell or bullet, long or short duration), relative to macro considerations. Underwriting and Credit Analysis While credit‐intensive research is often required for superior asset selection, the agency recognises that credit evaluation practices are largely dependent on the underlying asset type, investment style, and resources available. Fitch considers the extent to which a firm’s expertise matches the rigour needed for asset selection. For investment grade, high yield bonds or loans, Fitch views positively an analytical process based on the fundamentals of the company and the industry, and the characteristics of the debt issued. For structured finance securities, Fitch considers as appropriate a qualitative analysis which focuses on examining the collateral (principally its quality and diversification), the structure (including subordination, trigger events, spreads, etc), and the servicer/manager (including its historical performance and organisation). For these types of transactions, Fitch will evaluate the use of quantitative analysis and the sufficiency of a structure’s stress tests. Fitch reviews the quality of the inputs and outputs for the bottom up research analysis in its core components, as illustrated in the chart below. Reviewing and Rating Credit Asset Managers July 2009  3 
  4. 4. Fund & Asset Manager Rating Group Detailed (Corporate) Credit Analysis  Structural Analysis  · Capital, tax and legal structure, security package,  covenant… Bottom Up Analysis  Financial Analysis  · Historical and projected financials, leverage, case  studies… Company Analysis  · Management assessment, competitive aspects, site  visits… Industry Analysis · Cyclicality, barriers to entry, concentration, competition  level…  Source: Fitch  Specifically, the agency reviews the related research documents produced to assess the breadth, depth, timeliness, and consistency of credit analysis and adherence to stated credit analysis methodology. The quality of financial models, the relevance of scenario inputs, and the use of outputs in the overall credit assessment are also evaluated. While the level of formalisation of recommendations from research analysts to investment decision makers varies (credit grading system, price/yield target), Fitch will assess the efficiency of the research to determine the degree to which it facilitates pro‐active portfolio management. Fitch will also evaluate on an ex‐post basis the adequacy of the selection process and the quality of the credit analysis through the review of historical metrics, including default rates or upgrade/downgrade ratios (relative to fund’s benchmark or indices). Relative Value and Liquidity Analysis Relative value analysis for security selection in a credit management context weighs compensation received relative to perceived creditworthiness and structural considerations, and can be applied both within and across sectors. Fitch seeks to understand how relative value methodologies, including spread analysis, total return analysis and structure analysis, impact decision making. As dramatically illustrated recently, the liquidity and volatility of credit debt varies over time ‐ influenced by macro shocks ‐ and can be a major hindrance to the implementation of relative value strategies. Credit and Investment Approval To assess how investment decisions are disciplined, formulated, reasoned, and challenged, Fitch examines documentation related to the investment approval process, and adherence to credit approval policies and delegated authority guidelines. Generally, a committee‐based decision making process for the most credit‐intensive and illiquid asset types, such as leveraged loans or structured finance, is viewed positively. The agency however acknowledges that a more flexible decision making process is warranted for more actively traded portfolios, with a total return focus, or for more liquid credit sub‐asset classes. Reviewing and Rating Credit Asset Managers July 2009  4 
  5. 5. Fund & Asset Manager Rating Group Portfolio and Risk Management  Investment Risk Management Investment risk management is given increased consideration in Fitch’s analysis, as credit managers have revisited and/or enhanced their risk management processes in light of the recent financial crisis. To evaluate the organisation’s ability to monitor and manage investment risks, Fitch’s assessment focuses on the following: · credit risk monitoring (default and migration); · sensitivity to market risk factors (including credit spread and interest rates); · risk estimation techniques (value at risk, scenario analysis and stress testing); · risk budgeting; · liquidity (asset and liability) risk; · counterparty risk; · other risks (forex, optionality, prepayment/extension risk, basis) · concentration/diversification by obligor, region, sector, industry, seniority. For each of these risk areas, Fitch will evaluate the coverage and appropriateness of the risk indicators followed by the organisation, and the adequacy of the measurement techniques, as well as the existence of explicit and meaningful limits. The manager may be able to mitigate investment risks by virtue of hedging mechanisms; when that is the case, Fitch reviews the capabilities of the manager to implement systematic and discretionary hedges (through derivatives), including the monitoring of the residual unhedged risk and the overall exposure to basis risk. The frequency and depth of controls and corrective actions are evaluated to determine the degree to which they facilitate proactive adjustments of the portfolio to changing market conditions. The review further considers the resources used in tracking asset and portfolio level performance, as well as tracking portfolio concentrations from both a credit and structural perspective, and how these are compared against various risk exposure limits. The first consideration is the allocation of processes to the appropriate level of staff and its knowledge of the related asset type. Furthermore, the systems and tools used are evaluated for their utility in processing market and industry information to provide key risk indicators ‐ such as early warning signals of credit deterioration. Statistical risk management and portfolio engineering methods have shown their limits during the credit crisis. As such, Fitch will assess the organisation’s reliance on quantitative processes, relative to more fundamental or deterministic approaches to managing downside risk and capturing “out of model risk”. Stress testing is an area of particular focus as it is a primary means of determining the impact of assumptions and market moves on prices, screening results, and risk indicators. Credit Risk Management Portfolio credit risks can generically be broken down into two elements: · Default risk, should the issuer file for bankruptcy, miss a payment, or otherwise not comply with the original contractual terms of the obligation; · Price risk, should the instrument underperform given the market’s perception that the issuer’s prospects have diminished, or should the sector or asset class fall out of favour. A manager that has withstood recent stresses will be viewed more positively as they have an established track record and have demonstrated speed and thoroughness in adapting to new situations. Best practices may include strong, pro‐active Reviewing and Rating Credit Asset Managers July 2009  5 
  6. 6. Fund & Asset Manager Rating Group fundamental credit research skills to anticipate default and credit migration risk, or robust cross‐market surveillance capabilities (to anticipate the effect of technical market factors on credit spreads. The agency will therefore assess the analytical processes and tools used to monitor individual asset and portfolio credit risk, in order to anticipate the effect of market dynamics, rating migrations and spread variations. In particular, the agency will review early‐warning signals that detect, or better, anticipate credit deterioration, as defined and used by the manager for monitoring and decision making. For example, for IG corp, Fitch considers that strong credit risk monitoring practices by portfolio managers are based on a combination of fundamental credit risk metrics and quantitative signals (such as credit spread or equity volatility, default probability, Value‐at‐Risk, and expected shortfall changes). Liquidity Risk Management Fitch reviews the processes used by the manager to assess the liquidity of its portfolio (as determined by the outstanding amount and nature of the exposure, volumes traded and active dealers, bid‐ask spreads, etc). The manager’s objective is to maintain a sufficient level of portfolio liquidity to meet anticipated redemptions (or other cash calls), while allowing a sufficient cushion for unanticipated redemptions or events (such as an extreme liquidity squeeze or defaults of payments). Furthermore, Fitch will assess to what extent the manager’s funding risks are mitigated (in particular during periods of high stress) by its ability to maintain access to capital at a reasonable cost through committed long‐term sources of funding complemented by established relations with diversified providers of liquidity facilities. When a fund manager employs leverage (reverse repo, bank lines or derivatives), the agency examines the manager’s ability to maintain leverage at a sustainable level in order to face contractual obligations (eg margin calls) and, where demonstrated, an ability to de‐lever in an orderly manner, avoiding forced selling of assets. Counterparty Risk Management Counterparty risk arises from exposure to derivatives counterparties (CDS, total return swaps, interest rate swaps, currency swaps), repurchase (repo) counterparties, or time deposits. Asset managers use a number of methods to measure and manage counterparty exposure. For instance, Fitch would view positively a counterparty risk management process based on the comparison of a risk exposure, calculated as the sum of a mark‐to‐market value (instant risk) and an add‐on (potential risk) against an agreed counterparty limit. Fitch will review both the counterparty selection process and the counterparty risk monitoring process, including margining procedures, used by the manager. Portfolio Construction/Adjustment and Trading Fitch reviews how the various inputs to the portfolio construction/adjustment process (such as fundamental research, relative value determination, macro considerations) are combined and processed in line with investment objectives and constraints, as illustrated in the graph below. The agency will thereby form an opinion on the discipline of the portfolio construction and adjustment process, as well as the manager’s adherence to this process, over a representative period of time. The extent of portfolio trading varies greatly depending on the investment strategy and credit sub‐asset class of the portfolio, and ranges from buy‐and‐hold to active trading. Fitch will seek to understand the typical rationale for trading (and not trading) and the strategies employed, eg relative yield pickup, sector rotation, cash flow reinvestment, yield curve positioning, downgrade/upgrade trades. Reviewing and Rating Credit Asset Managers July 2009  6 
  7. 7. Fund & Asset Manager Rating Group Structure Diagram  Macro  Fund  Considerations and  Objectives/  Portfolio Risk  Tactical Allocation  Constraints  Profile  Investment Decision  Trading and Fund  Allocation  Relative  Liquidity  Value  Credit Approval  Analysis  Analysis  Credit Analysis  Credit Universe  Screening  Source: Fitch  As trading has a cost and relies on operational processes, it may result in a financial loss, when real and opportunity costs are misjudged or when processes fail. Fitch will evaluate the manager’s overall stated trading style, process and adherence to it, and its ability to ensure good execution. The agency will review the traders’ ability to assess market characteristics (breadth and depth) and conditions (liquidity, volumes, through bid/ask spreads etc), minimise costs (price impact costs, timing costs, opportunity costs, etc), and access counterparties and dealers. Particular focus will be placed where relevant, on the trading of credit derivatives, in terms of assessing market conditions, valuation and pricing, confirmation controls, and counterparty risk management. Pre‐ and post‐trading allocation between funds will also be assessed to evaluate how the manager seeks to ensure fair dealing with clients. Fitch also reviews the capabilities of staff versus stated strategies. For example, an asset manager can greatly affect portfolio performance in the management of distressed assets. This would be evaluated with a focus on experience with work‐ out situations and ultimate success in achieving a recovery price superior to the distressed market price during the work‐out period. For recent work‐out cases, Fitch examines the manager’s success and actual influence on the restructuring proposal and its implementation, with a particular focus on: the adherence to a pre‐defined work‐out strategy; maintenance of active discussions with the trustee, loan agent, borrower, lenders and lawyers; and the adequacy of the manager’s legal expertise in the required jurisdiction.  Investment Administration  This category focuses on reviewing the infrastructure, processes and related controls associated with the execution of investment administration services, from an operational risk perspective. For a detailed description of Fitch’s analytical approach in this category, please refer to the master methodology report “Reviewing and Rating Asset Managers”, dated 18 June 2009. For credit asset management platforms, Fitch places particular emphasis on the following: · valuation capacity of the manager in terms of frequency, transparency, independence, timeliness, and accuracy of marks for illiquid credit securities; Reviewing and Rating Credit Asset Managers July 2009  7 
  8. 8. Fund & Asset Manager Rating Group · information and workflows for coordinating and reconciling information between a manager of structured credit products and trustees; · modelling of structured, guaranteed or liability‐driven credit products for compliance monitoring.  Technology  Technological resources and the systems that are central to credit asset management, risk monitoring, and administrative functions are assessed. Fitch’s ultimate aim when assessing the organisation’s technology resources is to determine to what extent they match the company’s needs, as determined by its current and projected volumes in terms of types of assets and funds under management, investment universe, and trading activity. For a detailed description of Fitch’s analytical approach in this category, please refer to the master criteria report “Reviewing and Rating Asset Managers”, dated 18 June 2009. For credit management platforms, Fitch places particular emphasis on the following: · Credit portfolio management systems: due to the nature of the OTC credit market, investment managers have often developed proprietary portfolio management systems or have acquired third‐party solutions dedicated to a particular credit sub‐asset class. Fitch therefore focuses on the adequacy of a manager’s overall technological platform in terms of the requirements of differentiated and illiquid credit markets (ie functionality, automation and coverage of instruments). · Risk analytics and pricing models: credit managers are currently rethinking their quantitative risk management processes in the context of risk models that failed to capture “tail risk”. Fitch therefore reviews the adequacy of a credit manager’s risk analytics and valuation tools as per the new credit market environment, focusing in particular on their stress testing functionality beyond VaR and stochastic risk models. · Data access and reporting: with the expansion of the credit universe over recent years, data management has become increasingly central to credit asset management. Easy, secure and rapid access to data is becoming a competitive advantage, particularly for some sub‐asset classes (such as investment grade corporate, structured finance and ‐ to a lesser extent ‐ high yield and leveraged loans). Fitch therefore evaluates the manager’s ability to access, collect, and report key credit data (such as company data) and cross‐market data (such as spreads, marks and volatility). Reviewing and Rating Credit Asset Managers July 2009  8
  9. 9. Fund & Asset Manager Rating Group Appendix A  Excerpts From Credit Asset Manager Scorecard Score Category 1 2 3 4 5 Company & staffing Shareholding and financial standing Credit asset management experience Corporate independence/governance Team structure and segregation of duties Executive management Investment professionals Risk and other supporting staff Weighted rating Credit selection Sourcing and screening Fundamental credit analysis Relative value analysis Credit approval Weighted rating Portfolio and risk management Portfolio construction Trading and market access Investment risk monitoring Weighted rating Investment administration Reporting Fund administration Asset valuation Weighted rating Technology Front‐office systems Risk management systems Middle‐ and back‐office systems Data management and level of integration IT security Weighted rating Source: Fitch Copyright © 2009 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 1‐800‐753‐4824, (212) 908‐0500. Fax: (212) 480‐4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided "as is" without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax‐exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers. Reviewing and Rating Credit Asset Managers July 2009  9