Smart capital: dipping a toe into tokenized funds

May 8, 2024
This post is part of our 2024 Market Tends Report: Smart Capital: tech and AI trends in PE operations. Download the full report for more insights into how firms are implementing emerging technology across their operations.

Early experiments with tokenization of private equity marks a tentative shift in investment and blockchain technology. Firms are dipping their toes in as a potential way to democratize the asset class and create easier liquidity, potentially unlocking up to $400 billion in additional annual revenue for the alternatives industry.

Tokenizing a fund involves converting the ownership or shares of the fund into digital tokens on a blockchain — picture dividing a building into small, LEGO-like pieces — each token (or brick) representing a part of the investment. This process begins with a blockchain platform that supports smart contracts, as these contracts govern the token’s behavior and ensure compliance with financial regulations.

Tokens are then created through the smart contract, which codifies the terms of ownership, transferability, and any specific rights associated with the tokens. These tokens can be sold to investors through various mechanisms, such as private sales, public offerings, or on decentralized exchanges, allowing for easier liquidity and transferability of fund shares compared to traditional investment models.

Some firms may — rightly — balk at the increased admin obligations that comes with a large pool of individual investors. However, tokenized shares can be traded or sold on the open market and establish transaction records, capitalization tables, and smart contracts directly on platforms like Securitize, and trading can be executed with minimal bureaucratic overhead.

The promise of widely available, secure, always up-to-date information on the digital credentials that reside on interoperable blockchains could help solve fundamental problems that plague the industry’s day-to-day operations: someone’s always missing something. There isn’t a complete ownership detail for one of the portfolio companies. An investor’s tax status is not known. A distribution check bounced due to inaccurate account detail. None of those problems are insurmountable but taken together, they are sand in the gears.

Industry forecasts suggest that 10% of the world’s GDP could be tokenized and stored on blockchain by 2027, signaling not just a diversification of investment opportunities but a change in the operational mechanics of investments. However, at this stage it’s one theory and material demand for the technology is yet to be fully tested.

Replacing the old, paper-based system of ownership agreements and side letters with anything else, no matter how promising, represents a big step. The caution that surrounds blockchain may have less to do with doubt in the technology itself and more to do with recognizing the lack (so far) of industry wide standards. Most private equity blockchain adoptions and implementations are working in parallel with, rather than as a replacement to, traditional processes.

But as regulators and practitioners increase their comfort with blockchain technology, this “belt and suspenders” approach is likely to give way to fully blockchain-driven solutions.

This cautiously growing interest in blockchain is reflected in the pilots among traditional asset managers. BlackRock, JP Morgan, Carlyle, KKR, and Apollo have all announced projects in the last 12 months that deepen their involvement with blockchain, albeit on a small scale, and help sharpen their focus on individual investors for future growth.

In 2023, Apollo created Project Guardian as a wide-ranging proof-of-concept using permissioned blockchain infrastructure. The project aimed to test how the firm could leverage tokenization and smart contracts to enable a wealth manager to construct, deploy and automatically manage model portfolios at scale.

KKR has been working with digital-asset management platform Securitize Capital since 2021 to manage its tokenized healthcare fund. The firm has touted the tokens in a feeder of the main KKR healthcare fund as a way for individuals to get access into a private capital fund that is normally out of reach to them.

The potential benefits of blockchain for private equity firms require these foundational pilot projects before they can take their place in everyday operations. At the most basic level, more participants need to buy into the idea of blockchain before it achieves the critical mass that will make people confident in “turning off the lights” on older systems.

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