By Andrew Moyle and Stuart Davis
Growth in applications for blockchain and tokenisation, combined with an increasing number of initial coin offerings (ICOs), mean that buyout firms should note developments in this sector.
Why Should PE Be Interested in Blockchain?
A shared blockchain ledger could drive a single interface between a PE fund and its investors, increasing transparency and efficiency, providing real-time updates for LPs on investments, and enhanced investment analytics.
Blockchain technology could also be used to automate fund administration — traditionally a manual and time intensive process. However, back- and middle office process at PE houses are typically low volume, low margin activities, in our view limiting any cost and efficiency savings for a PE fund. Furthermore, investors and regulators will scrutinize any blockchain solution and the operational risks inherent in new technology implementation.
A more interesting development for PE is the trend towards tokenisation of financial assets. Tokenisation refers to the manufacture, issuance, storage, and transfer of digital assets on a blockchain infrastructure. Digital assets can take any form, e.g., shares or bonds, profit participation rights, fund interests, or a hybrid instrument that automatically converts from one instrument to another on the occurrence of a pre-defined trigger.
The technology behind tokenisation stems from ICOs. Typically, ICOs involve early-stage companies issuing cryptographic tokens (essentially proprietary cryptocurrencies on a blockchain platform) to future users of their platform. These digital tokens can be traded on an OTC basis between holders’ cryptographic wallets, or they can be listed and traded globally on crypto exchanges. ICOs have generated recent attention because of the growing investment in instruments (nearing US$20 billion since 2017), but also because of crackdowns by regulators concerned that token issuance is taking place without regard to securities laws.
Growing Uses of Underlying ICO Technology
Nevertheless, we have seen growing interest from issuers (particularly in the technology space) in the underlying technology of ICOs as a way to digitise financial assets and issue them in compliance with applicable securities laws. Why?
First, digital assets can be created, issued, traded, cleared, and settled on a digital infrastructure — which can deliver a lower cost of capital compared with traditional financial market infrastructure. Payments relating to the assets (such as dividends/coupons) can be automated and rendered more cost-efficient. Secondly, digital assets can capture information. This could make it easier to detect assets that have been used in criminal activities, and potentially increase liquidity of assets across financial markets through enhanced transparency. Thirdly, digital assets can be issued as dynamic tokens. Entirely novel investments are possible, such as digital hybrids that automatically convert into the most attractive investment for the investor or baskets of digital assets with automatic rebalancing based on pre-defined triggers. Finally, issuers and market infrastructure providers are developing facilities for secondary market trading of these tokenised instruments. This could lead to significant liquidity, an interesting development for any PE fund looking for syndication or exit opportunities, or for investment in the infrastructure providers that emerge to service this new liquidity.
Is A New Asset Class Emerging for PE?
Quite possibly. We are still in the early stages and technology is developing rapidly. However, the market is also maturing and institutional investors are increasingly considering investing in entities developing blockchain solutions or which may have mined cryptocurrencies. In our view, PE needs to monitor the market closely as risks and opportunities will emerge as quickly as the technology underpinning it.
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