Blockchain and Private Equity – An unusual match

Figure 1: Blockchain process

When a block is filled it is set in stone and becomes part of the chain, with an exact timestamp. One advantage of this system is that it makes an immutable, irreversible timeline of data when implemented in a decentralized fashion.

Blocks in the blockchain are stored linearly and chronologically – they are added to the “end” of the blockchain – and so each block has its own position on the chain. Each block contains a timestamp, its own hash (a block’s unique identifier) and the hash of the block anteceding it. These hash codes are calculated using a math function (by miners) that turns digital information into a string of numbers and letters, that is of fixed length and unique to the information stored in the block. Since each block also contains the hash of the previous block, it creates a unique and secure chain of blocks. Thus, as the hash changes when the information inside the block is altered, all blocks after it are invalidated. This security feature of the blockchain is further enhanced by its incorporation of “proof of work” (or other equivalents), which essentially slows down the creation of new blocks (e.g., 10min for Bitcoin), such that computers cannot quickly revalidate a tampered block by recalculating all the hashes of blocks after it.

The distribution feature of blockchain, allowing a peer-to-peer network to manage the chain rather than a central entity, creates even more security. Each person joining the network receives a full copy of the blockchain and can verify everything in it. When a person creates a new block, it is sent to the whole network, which verifies its legitimacy, creating consensus among the network. It is thus highly difficult to go back and change the contents of a block once it has been added to the chain, unless the majority consensus allows this. If a particular copy of the blockchain does not align with the others in the network it will be rejected, which also means that hackers need to be in control of more than 50% of the copies of the blockchain to succeed with a hack (in addition to changing the hashes on all the blocks and redoing the proof of work for each one).

What are the applications?

Blockchain can be used for digitalizing currency (such as in the case of Bitcoin) but can also be used to hold information like legal contracts, state identifications, or a company’s product inventory. The transparency, security, and immutability of data through blockchain is valuable in most industries.
For instance, in democratic elections, blockchain can be used to curb fraudulent voting, by issuing a token for each citizen, which they can send to the wallet of whichever candidate they please.
In terms of finance, blockchain has arguably some of its biggest applications. Integrating blockchain into banking would improve the speed and security of transactions by many orders of magnitude. Moreover, can help to shorten the checking and clearing process in the stock trading business. Cutting such transit times can significantly cut costs and risks for banks, as the sums involved in these transactions are immense (saving $15-20b p.a. according to Santander). Moreover, in terms of currency applications, by spreading its operations across a network of computers, blockchain allows cryptocurrencies to operate without a central authority, which is especially useful in countries with an unstable government, where the value of the currency might be at risk. Thus, this reduces currency risk for citizens and gives countries with unstable currencies/financial infrastructures a more stable currency.
One of the most powerful technologies within the blockchain are the so-called smart contracts which are computer codes built into the blockchain to facilitate, verify or negotiate a contract agreement, without a middleman involved. These operate under a certain set of conditions to which users agree to and when are met, cause the terms of the contract to automatically be carried out. Smart contracts have applications in industries such as finance, insurance, medicine, product development and many more, essentially becoming an alternative to standard contracts.

Blockchain shortcomings

Having now understood blockchain and some of its many applications, we also need to understand that the technology is still currently in its early stages and that it has some significant drawbacks that need to be overcome.

• Technological costs, e.g., those associated with bitcoin’s “proof of work system” used to validate transactions, require astronomical amounts of electricity. This problem is even more significant for non-cryptocurrency blockchains, as miners must be incentivized to validate transactions (by receiving payment of some kind).
• Speed inefficiency, e.g., Bitcoin can only manage 7 transactions per second (TPS), while Visa for instance can process 24000 TPS.
• Other disadvantages including illegal activity (associated with blockchain) and potential government regulation (e.g., Turkey banning cryptocurrencies in 2021).

However, there are already efforts on the way to alleviate these shortcomings, allowing for the widespread application of blockchain technology, giving people access to the significant security, accuracy, transparency and decentralization that it brings.

What about Private Equity?

We know that blockchain has immense potential in many industries. But how can it impact PE, a sector where firms have been rather slow to embrace the digital transformation?
Private equity is about driving improvements in businesses over the long term. Their investments are illiquid and generally only traded on acquisition and exit. This is because PE funds have long holding periods of 7 to 10 years, so their underlying portfolio companies can undertake multi-year business transformations. Since the global assets under management (AUM) of PE were valued at $3.4T at the end of 2020, PE represents a massive market for potential blockchain applications.
The industry has long had certain struggles which could largely be alleviated by blockchain technology, such as a lack of access, illiquidity, returns dispersion and the need for diversification.
The first advantage that blockchain provides for PE is a shared blockchain ledger that could enable a PE fund and its investors to have a single interface, giving investors real-time updates on their investments as well as investment analytics. All original fund records can be securely stored and executed on the blockchain and made available to anyone with permission to use them (including auditors or regulators, to ensure regulatory compliance). This could help with PE’s long-standing struggles related to lack of transparency towards Limited Partners (LPs).
However, the most significant blockchain development for PE is the tokenization of financial assets. A token is basically a digital representation of an underlying asset that can be issued, transferred and stored on a blockchain system. These tokens are created through a type of initial coin offering (ICO) referred to as security token offering (STO) and sold on cryptocurrency exchanges or security token exchanges.
These tokens could benefit private equity funds by being able to offer investors the opportunity to purchase tokens that represent units/shares of the fund. They are highly divisible, meaning that the minimum amount of investment (usually around $10M when investing directly in a PE fund) can be significantly reduced. This would enable private equity funds, which are typically only available to large institutional investor groups, to be democratized by becoming accessible to a larger investor base (minimum investment would be decreased to around $200,000 according to BNP Paribas).
Moreover, since tokens can be traded on a secondary market, investors would be able to liquidate their positions much more easily and after a much shorter period, than is usually the case in private equity. Currently, investors are locked into funds for several years or may sell their stakes to secondary funds or other limited partners, which can take a lot of time and can involve many intermediaries. Funds that issue such tokens could also benefit from “liquidity premiums” and might have easier ways to finance projects (new funds) by raising capital. Secondary sales would all be completed using smart contracts with the exchange process being automated (removing negotiation need), thus making transfer efficient. Therefore, while the underlying companies remain private, investors are given some of the benefits of the public markets.
Of course, blockchain can facilitate, but not create liquidity. The benefits of tokenization will only be realized if there is a sufficient volume of buyers and sellers to create liquidity in the markets, which may only be true for the best PE funds. This is especially relevant considering the large returns dispersion within the PE industry, with some funds performing much better than others. Moreover, tokens will be subject to regulations, which means that the initial sale of tokens would only be made available to sophisticated/accredited investors (thus still limiting retail investors). Specifically, according to SEC regulation, to be an accredited investor one must have >$1M net worth or >$200k annual income.
Even still, some private equity firms such as Northern Trust have already begun to leverage the blockchain’s unique capabilities. Northern Trust commissioned Broadridge (a fintech company) to develop a platform providing data and analytics tools connecting the PE lifecycle for all market participants, allowing more efficient communication with investors (and other stakeholders). Moreover, it enhances capital and cash flow (calls, investments, divestments, and distributions) management through smart contracts, allowing faster time to market. According to Stuart Lawson – Northern Trust’s global product manager –, their system has “removed a lot of process friction caused by paperwork and approval chains embedded into current PE fund processes”.
Another start-up firm called the Swarm Fund has already begun to tokenize positions in private equity funds and other alternative investment classes by pooling together smaller investments into larger, institutional-sized blocks. They have built a decentralized investment platform where any real-world project can be brought onto the platform and tokenized using their SRC20 tokens (Swarm’s token specifically created for tokenizing assets easier). New SRC20 tokens are launched for each individual investment opportunity, representing fractional ownership of the underlying asset which holders can manage through a standard voting process on Swarm’s platform. If the asset generates revenues, SRC-20 holders have a right to their share of that revenue. The project is still relatively new but has demonstrated massive potential.

Conclusion

To conclude, blockchain truly is one of the most revolutionary technologies of our time. In the next years, we will see vast implementations of it, changing industries and businesses forever. Private Equity, which has yielded strong positive returns in excess of the market benchmarks for many years, can become an even more powerful asset class through blockchain. The technology can make it more transparent and create greater efficiencies within the PE fund lifecycle, providing advantages for investors and fund managers alike. But most importantly, through blockchain, Private Equity can finally become truly democratized. There are still long ways to go as the true implementation of blockchain technology will need time, especially with strict regulations that also differ between jurisdictions. However, in the coming years, blockchain will definitely play an increasingly significant role in PE and the world as a whole.

Author: Maurits Giese

Editor: Tiago Guardão

Sources

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