As distributed ledger technology continues to enter mainstream financial markets, it is displacing intermediaries that have a decreasing relevance, and may require others to shift their role.
The primary intermediaries at risk are those responsible for record keeping, compliance, and managing counterparty risk. This article explores which types of entities may be disrupted in the private equity sector, so you may better understand how to adapt.
Record Keeping
The distributed ledger is the most efficient form of a record we have many respects, particularly when sharing information between parties. This puts many entities at-risk whose primary responsibility was to share information and store information between parties.
Custodians: Mainstream securities today are not often stored by the investor themselves, but a custodian representative. Rather than the investor storing a physical stock certificate, transactions may be stored on an order book system with the DTC.
While it may make no difference to investors if they are holding their shares directly, working without a custodian to store shares makes shareholder administration a challenge. With DLT Securities, shares may be stored by the investors, without sacrificing the administrative capabilities of re-issuance, transfer, and authentication — thus removing the need to pay for this intermediary.
- The distributed ledger will server as a record system for parties to verify ownership of shares without the need for an intermediary or stock certificate.
- Issuers will allow investors to store their securities directly, without sacrificing any of the administrative and tracking capabilities formerly required.
Brokerage Accounts: Investors are beginning to trade directly with DLT Security exchanges, or with the company directly using a decentralized Transfer Agent, removing the need of an intermediary brokerage account.
With custodian removal of shares and a shared order book across exchanges, the role of a brokerage software is declining and they may need to reconsider their fee structure. Other disruptive companies such as Robinhood are also placing downward pressure on the brokerage model, further suggesting they should explore new fee structures.
Virtual Data Rooms: Many virtual data rooms today are systems whereby companies may share transaction information and files. Today, they may exist as a specialized software for investment banks, or simply consist of a shared Google Drive.
Despite the relatively low costs associated with storing this data, they are subject to theft or file manipulation due to being stored on a central database and changes made to files are often difficult to track with authenticity.
Information pertaining to transactions are shifting to a shared, distributed ledger, where all participants in the transaction will share the storage and have a consensus of information pertaining to the transaction, resulting in a higher level of security.
- Data room files stored on the distributed ledger will be less exposed to a hacking or manipulation risk, while maintaining a more accurate audit trail of changes to prevent internal unauthorized activity.
- Files will be more seamlessly integrated with existing legacy systems and workflows without requiring the need to use third-party software.
Cap Table Software: Much of the Cap Table administration software we are aware of today will likely need to change its role. In the past, it served as a system of maintaining records and automating rules such event driven RSU vesting.
With a decentralized model, it would need to be increasingly open to third-parties and these rules would not be restricted to these systems any longer.
Hence, the Cap Table software would need to focus more on configuring decentralized rules using DLT Security protocols and sharing information on the distributed ledger, rather than being the single point of truth and reliance of the company to private shareholder governance and equity administration.
- Systems will be less of central point of authority and securities management and more of a visual interface and method to interact with the distributed ledger.
- Companies will be less reliant on the software used to automate systems on single Cap Table software and more so on the decentralized DLT Security protocols.
Service Providers
While service providers are very unlikely to be displaced, they may see their role in transactions shift. In order to remain relevant, they will need to adapt to new workflows and be ‘masters of automation’ to serve a larger audience cheaper and more efficiently.
By seeing such technology as a tool rather than a risk for displacement, service providers can use it as a short-term competitive advantage.
Private Equity Managers: Fund managers may see an inflow in direct investment by family offices and increased participation of private equity secondaries, largely since LP on-boarding and management is now largely automated and secondary transfers are easier to execute and now open to global markets.
If private investors are less concerned with counterparty risk and managing transactions/investors is easier for both parties, this will likely lead to a higher number of transactions and direct investment, circumventing the fees of fund managers.
At the same time, this provides significant opportunity to fund managers to reduce their operating expenses, focusing on expanded investment strategies (E.g. secondaries market, security bundles, new asset classes, private index funds) or more relaxed terms (E.g. decreasing the lock-in period).
- Reduction of fund administration fees past down to investors as higher post management fee returns.
- Creation of new asset classes and investment strategies such as private market index funds, secondary transactions, and securities bundles.
Attorneys: The role of attorneys in private market transactions are primarily designed to reduce legal exposure and counterparty risk. This comes in two forms — compliance and shareholder regulation.
With much of the rules that presently put companies ‘at risk’ being automated, attorneys are less concerned about these complications and contracts being deduced to ‘click and drag functionality’ with smart contracts, they are now generated internally by companies or developers building DLT Security protocols that may later be standardized into templates.
It is, however, far from accurate to assume attorneys will be irrelevant.
Attorneys will be able to manage more clients by providing oversight and arbitration services when a rule is violated and more involved with ensuring the at-risk areas not able to be automated do not cause complications.
- Shifted role to oversight and consultation, or less time spent carefully phrasing legal documents and structuring arbitration or contract violation provisions.
- Spend more time focusing on areas that require manual review, which may shift after some areas become automated, making them the focus of legal attack or risk.
Investment Banks: With an inflow of direct investment, decentralized information, and automated agreements the role of an investment bank must also shift to meet the changing infrastructure and set of workflows.
Without adapting, banks are at risk of companies conducting direct issuances and either only using their fundraising network or assisting with transaction oversight.
For the foreseeable future, legal documentation and solicitation material will still be required, but investment banks should be comfortable sharing information on distributed ledgers and using DLT Securities for issuance, but not rely solely on one extreme.
Streamlined transactions will also allow them to service more clients and structure syndicates with other broker-dealers and finders more easily, along with streamlining and automating investor communication upon Issuance using the distributed ledger.
However, the role of an investment bank is at risk of shifting to a performance based approach where they are compensated for the money they subscribe and should focus on establishing relationships with high net worth families and institutions and carefully screening the clients they bring on to establish trust, otherwise these individuals may bypass them to find transactions directly with an increasing number of family offices hiring their own portfolio managers and direct issuance.
- Focus on building trustworthy relationships with buy-side clients that trust you represent their best interest and have the best transactions.
- Consider restructuring your fees and reducing your administrative overhead to focus more on end-results rather than compliance, transaction structuring, and deal advisory for sell-side engagements to remain competitive.
The future of DLT Securities and its role in displacing private equity transaction participants is in many ways, subject to the same philosophical logic of AI.
In one mode of thought, it is adversarial for most service providers and companies. On the other, its is a tool to help them perform more effectively. By adopting the former, you can shift your company to stay ahead of the curve, embrace technology, and deliver more efficient solutions to your users or clients.
