Research On The Risk Management Of Private Real Estate Equity Investment Funds

After nearly twenty years of development, the real estate industry in China has become one of the pillar industries of the national economy and the people's livelihood. The demand for huge funds called for during the development course of the real estate industry, under the economic circumstances where very few channels are available for fund-raising and financing, has resulted in its over-reliance upon financing from the banks, thus putting the risks almost only on the state-owned banks and the newly established joint-stock commercial banks. As yet, financing through bonds, trusts, and the stock markets has not quenched its thirst for funds due to the industry's rapid development. For this reason, in order to further accelerate the switch from indirect financing to direct financing, the exploration and opening of new financing channels become an inevitable demand and objective trend for the industry's development.During the 25 years from 1980 to 2005, private equity fund (abbreviated as PE) has grown in an explosive way around the world, with its scale close to one trillion US dollars. In 2006, funds raised through PE reached 360 billion dollars in the USA. As for financing for the enterprises in that same year, the total enterprise financing through the three stock exchanges was 154 billion dollars as compared to 162 billion dollars from PE, which was the first time that PE surpassed the stock exchanges as the most important financing avenue. In the first half of 2007, the assets of PE in the USA had increased by the amount of 137 billion dollars, a 42% increase over the same period of 2006. The average annual rate of returns of a quarter of PE firms was 39.1%, higher than the 12.3% average in S&P 500 index over the same period. PE has already become a vital driving force for the economic growth in the USA and around the globe. In China, both"PE"and"Fund"came into people's view through the securities markets during the upsurge of interest in the stock exchange beginning at the end of 2005. However, that kind of PE, which invests privately raised money in the secondary stock market, is different from the PE discussed in this dissertation, which invests mainly in the non-listed stock rights or corporate controlling rights.As a subdivision of private equity investment fund and one of the most important innovative financing instruments in the real estate industry over nearly 20 years of economic practices abroad, private real estate equity investment fund (thereinafter abbreviated as"PREE"in this dissertation) has developed quite rapidly and has been gradually researched and put into practice in our country. The US sub-prime mortgage crisis started in 2007, along with the global financial storm (tsunami, crisis) as a direct result of it, has exposed the market risks of PREEs and posed new research topics on its risk management. In our country, the theoretical research on and the practical manipulation of PREE as a new financing instrument have just been started. In order to make sure it will develop in the right direction and has a future, it is essential for us to take necessary precautions through reinforcing the researches on the general risk management of PREE by learning from the foreign successes and failures.As yet there has not been any systemic research on the general risk management of PE in our country, let alone the theoretical research on the general risk management of PREE. Even in foreign countries, PREE is generally categorized and studied as a subdivision of PE. Therefore, by drawing on the experiences of other countries, this dissertation intends to investigate the economic mechanisms for the generation of PREE risks in our country by making use of the risk management procedures of the Basel Banking Supervision Commission (abbreviated as BBSC)and the COSO (abbreviation of The Committee of Sponsoring Organizations of The National Commission of Fraudulent Financial Reporting) general risk management framework as the reference systems and by taking into consideration of the macro- and micro- economic environments and the policy and law environment of the development of the real estate industry as well as the risk characteristics of PREE. Through using the new general risk measurement method to set up a model framework for the domestic PREE risk measurements and generalizing the relevant experiences abroad to put forward measures and systems for controlling the risks of the domestic PREE in a relatively complete manner, this dissertation hopes to systematically address the question of great theoretical and practical significances, which is"How to Implement Risk Management in the Future Development of the Domestic PREEs".This dissertation has seven chapters with its main content and concepts as follows:Chapter 1, Introduction. This chapter is for the representation of both the theoretical and practical significances of the topics chosen, for the description of the status quo of researches on the topics both at home and abroad, for the introduction to the structural framework of the dissertation, and for the demonstration of possible innovations and shortcomings to be found in the dissertation.Chapter 2, Development of Private Real Estate Stock Rights investment Funds. The first part discusses the concept demarcation, the business scope, the main characteristics, and the general classification of PREEs from both the intensive and extensive perspectives. The second part introduces the emergence and progress of PREE in some foreign countries by tracing the evolvement of their REITs (Real Estate Investment Trusts) and comparing the relationships between real estate investment funds and the two kinds of REITs, i.e., the contractual REITs and the corporate REITs. In order to react to the fierce competition and the depression of the real estate market, the newly established real estate funds overseas, by using as reference the real estate limited partnership funds that have shown great strengths in capital resources, have normally adopted the congregate investment form with partnership of limited liabilities, thus guaranteeing a relative stability of the long-term investment even during the economic depressions. At the same time, through incorporating the features of the second equity REITs in capital manipulation into their operations, they have also realized a higher rate of returns for their investments by investing indirectly in the real estate industrial capitals through investing in the stock rights of the real estate corporations. These newly established real estate investment funds have become the embryonic form of the partnership PREE with limited liabilities, and gradually developed into the mainstream form of PREE in USA. From 1987 to 2007, PREEs in USA have seen rapid growth in numbers, scale, and financing. And a lot of PREEs with the global market in their view have also sprung up in Japan, UK, and other European countries.Chapter 3, Necessity and Possibility for the Development of Domestic PREEs. They are the very bases for all the arguments in this dissertation. By incorporating the principles of the system supply and demand, this chapter explains the main factors for determining the demand of PREE as a financial organizational system through aspects such as developing and upgrading the industry, broadening the channels for both investment and financing, and others. From the viewpoint of someone who needs financing, the real estate industry has already become the backbone industry of the national economy after the development of nearly 20 years. Ever since the second half of 2007 up to now, the tight money policy and the limited availability of other financing channels under the macro adjustment and control have put an extremely heavy strain on the working capital flows of the real estate companies, temporarily bringing the industry into a periodic adjustment. However, the industry still enjoys broad prospects for development. The adjustment process of the industry will certainly bring about the improvement and strengthening of its weak micro foundation, and force the industry to solve the questions and challenges it is facing through the realization of the industrial upgrading. Therefore, from an objective perspective, there is a strong and urgent need for a new system of investment and finance, including PREE, from the domestic real estate enterprises. From the viewpoint of investors, due to the vigorous domestic demand for investment and finance and the relatively poor returns of the existing financial products such as savings, stocks, bonds, gold, and foreign exchanges, investors, especially those from the wealthy classes in society, become more and more interested in the new ways, PREE included, for investing in and financing for the real estate industry. From the viewpoint of supervisors, PREE helps in reducing the high ratio of assets over liabilities for real estate enterprises and in reducing the credit risks of real estate loans for the domestic commercial banks. In the meantime, PREE also facilitates the healthy and stable development of the real estate industry. Therefore, the domestic financial supervising authorities need to forcefully promote the development of the new financial instruments with PREE included to facilitate the healthy development of the real estate industry. The Partnership Enterprise Law, promulgated and implemented in 2007, with its addition of content regarding partnership with limited liabilities, has opened up new ways for the development of the burgeoning domestic PREEs and the broad private stock rights funds in the legal sense. The fact that foreign PREEs have already made inroads into the domestic real estate market with the help of their relatively mature operational models, has made it possible for us to gradually change the monotonous domestic capital market for the real estate industry by learning from those foreign PREEs. The domestic PREEs, with Jindi, Guomei, and Dinghui as prominent examples, have just taken off. It deserves to be noticed that the purpose for developing PREEs is not simply to eliminate the real estate bubbles by exploiting some unconventional arcane measures under the tight real estate credit to circumvent the macro adjustment and control. Fundamentally, the development of PREEs will go a long way towards reducing the accumulated real estate financial risks of the banks, expanding the investment and financing channels for the real estate industry, leveling off real estate bubbling prices, facilitating the industrial upgrading, and promoting the healthy and stable progress of the industry itself.Chapter 4, Mechanism for Generating PREEs Risks. First of all, this chapter accounts summarily for the background, the causes, and the transmission mechanism of risks of the US sub-prime mortgage crisis. Since 2001, in order to eliminate the impact of the bursting of the neo-economic bubbles, consumption and the real estate investment had become two economic hot spots encouraged by the Federal Reserve under the then-chairman Greenspan. The continuous low interest rate under the loose monetary policy led to a global overflow of liquidity. On one hand, the huge wealth effect triggered by the increase of real estate prices propped up the vigorous growth of the American economy. On the other hand, under the fever of income and confidence growth, the sub-prime mortgage loans were extended in large amounts due to the lack of risk management by the financial institutions. During the course of securitizing assets, financial and credit derivatives such as MBS and CDO accelerated the spread speed of the risks and finally triggered the explosion of the real estate bubbles. The meltdown of the Wall Street and the closedown of a huge number of financial institutions around the world caused great harm to the real economy. While the governments scrambled to salvage their respective economy, the world economy was still faced with the threat of depression and an uncertain future. This financial storm has sounded a wakening alarm for the financial risk management of the real estate industry. It has also become another starting point in this dissertation to put forward the risk management of PREEs for an in-depth research.Secondly, in spite of over 20 years of PREE development in foreign countries, the research on its risk management still falls into the broader categorization of research on the risk management of private stock rights funds, without any specific research targeting the very characteristics of PREE risks. Based upon the four links of the risk management procedures of the Basel Banking Supervision Commission and the general corporate risk management framework of COSO, by incorporating the characteristics of PREE risk management, this dissertation explores the unique economic mechanisms responsible for generating the market, credit, and operational risks of PREEs by making use of the logical deduction and the relevant knowledge of gambling, financial management, finance, macroeconomics and information economics and by taking into consideration the macro- and micro- economic environments and the policy and law environments of PREE. First, the mechanism for generating the market risks of PREES is explored. It is believed in this dissertation that economic cycles and fluctuations of interest rates and foreign exchange rates, the very macro-economic factors impacting the supply and demand of the real estate market and the profitability of the real estate enterprises in our country, are the important factors for generating the market risks of PREEs. The regulatory changes in the financial credit policies, land policies, taxation policies, and industrial policies will have a direct or indirect impact on the real estate market, such as the supply and demand, property prices, and the corporate working capital flow and profitability. Second, the mechanism for generating the credit risks of PREES is explored. On one hand, Factors such as the information dissymmetry and the unsound credit system will impact the gambling of cost versus yield for investments in real estate enterprises, thus giving rise to subjective credit risks stemming from moral risks and inverse selections. In the meantime, factors such as excessively high market risks and the information dissymmetry will probably generate objective credit risks, which are the loss of ability to keep faith on the part of the real estate enterprises being invested. On the other hand, the internal credit risks inside PREEs will probably be generated due to the rent-seeking and opportunist behaviors of the fund managers. Third, the mechanism for generating the operational risks of PREES is explored. The operational risks such as the legal risks, internal management deficiency risks, and contingency risks could probably be triggered due to the imperfect and unsound legal environment, the high risk investment features of real estate investments and private stock rights funds, and the inefficient internal regulatory system etc.Chapter 5, PREEs Risk Measurement. PREEs are regarded as one kind of financial instruments. By reviewing documents on financial risk measurement, with the latest researches such as the general risk management and conditional risk values as the starting point, this chapter proposes and establishes the theoretical thinking for the domestic PREEs risk measurement model by application of innovative methods, such as combinatorial investment theory, dynamic optimization technology, Copula function and so on. From the optimal conditions of the theoretical model, this chapter continues to point out the main trend towards PREEs risk management, thus offering ways of thinking for the domestic PREEs on risk control. First of all, as far as the general methods for financial risk measurement are concerned, the methods for market risk measurement have gone through the nominal approach, sensitivity analysis, fluctuation method, and VaR and its innovations, while the methods for credit risk management have gone through the expertise approach, grading method, credit marking method, structural model, reduced model, and innovative methods. On the basis of VaR, the methods for operational risk measurement have been developed, which mainly include the basic index method, the criteria method, the advanced metrological approach. And the advanced metrological approach can be further divided into the internal judgment method, the distributive method of losses, theory of ultimate value, and scoring card method. The measurement of the general risk management is still based upon VaR with more factors and broader categories being taken into consideration at the same time. Secondly, beginning with the starting point for research, model demonstration, and model hypothesis, this dissertation makes innovations on risk measurement methods by integrating the general risk management into CVaR conditional risk values. By combining the characteristics of PREEs market, credit, and operational risks and their corresponding economic mechanisms, this dissertation establishes the marginal distribution function cluster for PREEs market and credit risks as well as the conditional risk values of their consolidated distribution. Based upon the conditional risk values of the operational risks, the overall conditional risk values of PREEs can be derived. And the model for PREEs risk measurement can be developed by incorporating relevant constraints. From the developed model, the optimal solutions, as well as the explanations of their corresponding economic implications, can be derived under different variables and constraints, thus pointing out the different ways of thinking and methods for PREEs risk control. In the meantime, based upon risk analysis and the conclusions of the risk measurement model, this chapter introduces the calculation system of PREEs risk values. In accordance with the changes of PREEs and its environments, stress tests and regression tests can be conducted in order to verify and revise the model and its parameters.Chapter 6, PREEs Risk Control. By drawing on the risk control strategies adopted by foreign PREEs, this chapter expounds the risk control strategies for the credit and market risks of PREEs, which involves phase investment, diverse investment, consolidated investment, guarantee measures, commercial insurance and hedge funds. By focusing on the control strategies for PREEs operational risks and learning the internal control systems from foreign PREEs, this chapter attempts to establish the internal control system for the domestic PREEs, which is made up of the internal organization structure, check and balance of power and responsibility, incentive and restraint mechanisms, internal information system, risk pre-warning mechanism, and inspection and examination systems. In addition, the important aspects of the internal control system are given a special emphasis. At the same time, this chapter expounds the prevention strategies for PREEs risks, which include the promotion of professional levels, pre-survey of risks, moderate regulation of financial leverage, compound securities, the restraint of risk budgets, constraints on contract provisions, the disposition of the stock controlling rights, participation of administrative consultation, and risk undertaking etc.Chapter 7, Obstacles and Counter-Measures. In order to develop PREEs in our country, we will be confronted with a series of legal obstacles, the taxation policy obstacles, and the market environment obstacles. In view of those obstacles, this chapter proposes a series of policy measures as follows: to establish and perfect law and regulations, to define the legal status and operational standards of PREEs, to strengthen the self-discipline of the supervision authorities, and to establish and improve supervisory rules and regulations.Ever since its inception, private equity fund has been an arcane and low-profile game of rich people. It is distinct from other kinds of funds in its special profit-making model, high-leveraged capital manipulation, hidden transaction methods and capital sources. The lack of transparency of its management and investment is regarded as a prerequisite for the realization of its high returns. For this reason, there are very few reference documents available for the author to do research into the new topic that closely combines the theory and practice of the domestic PREEs risk management, a task whose difficulty is way beyond the author's anticipation. As an employee of a real estate enterprise, the author has not only learned the entire process of banking financing and trust financing from his own working experience, but also profoundly realized the important role that the broadening of financing channels has played in enhancing the core competition of the real estate enterprises. Therefore, through his tentative research on this new financing channel (PREEs) and its risk management, the author sincerely hopes that further and more valuable researches will follow.