Using Blockchain Technology to Increase Fund LP Returns & Portfolio Liquidity
This article is meant for educational purposes only. EquityUp does not provide legal or financial advice of any kind, and nothing in this presentation constitutes such advice. If you have any questions with respect to your own legal or financial, please consult a professional adviser.
Technology is constantly changing the roles of service providers and their clients. The wealth manager, private equity, and investor relationship is also shifting. Wealth managers are at risk of being displaced with those below a certain asset class benefiting from more intelligent Robo-advisory and above finding it cheaper and more valuable to hire waged employees or contractors.
Albeit private equity has less risk being removed, the pressure to perform is on. Some funds, specifically the mid-size funds that struggle between being an agile and lean minimally staffed operation with small Assets Under Management (AUM) and investor poor, and a mega fund that benefits from substantial back-office resources, need to make numerous significant changes. Figure 1 illustrates over the past five years, there has been an overall increase in capital raised by Private Equity (PE) funds, yet a decline of total funds closed — suggesting larger funds are receiving more investment and smaller ones are struggling to remain competitive.
To break out of this difficult period, funds will need to increase AUM or reduce expenses. This article addresses two ways they may increase AUM by increasing potential Limited Partner (LP) returns:
I. Allowing direct investment in portfolio companies.
II. Reducing the lock-in period of investments in a granular manner.
Allowing Direct Co-Investment ___________________________________________________________________
In terms of future allocations, 50% of the family offices reported that they intend to invest more in private equity direct investments over the coming 12 months, according to The Global Family Office Report by UBS (Figure 2). Approximately 7.6% of the family office portfolio is allocated to funds, whereas a much larger portion of 14% is allocated towards direct equity investment, and 17% for real estate.
The value of a private equity fund is in the sourcing, structuring, and orchestration of deals under a tight investment thesis that far outweigh the resources of an independent group. This is advantageous to many investors because their direct investments are typically within a specific industry or asset class, which creates an unbalanced long-term risk profile.
The reasons co-investing is not more common today is not for a lack of want per se, but the difficulty in sourcing attractive deals. 64% of the family offices surveyed cited an inability to sourcing strong deals. (figure 3) While most family offices accomplish only one to five direct or co-investment deals a year, 60 % are within real estate.
Other popular industries to invest in are technology (46%), healthcare / social assistance (34%), and finance and insurance (34%). Hence, if a private equity group can allow for direct investment — it delivers investors all the upside of direct investment and industry diversification (I.e. assuming investors are subscribing to funds outside their direct investment thesis), without the burdens of active management.
Obviously, it is not sustainable to reduce the position entirely, but it may be worthwhile analyzing what portion of the position you may forego in return for higher fund performance. If you can generate higher post fee LP returns, that would be advantageous to raise more capital or increase fee structure for the next fund.
There are several ways in which the direct co-investment may be structured to serve the interest, not work against the fund. One way we propose is to allow an amount, positively correlated to total Fund LP subscription, to be allocated in authorize co-investment deals with a cap for each deal. This not only prevents a single LP from taking all co-investment positions in a single portfolio company, but also allows for incentivization for a higher subscription.
One example to highlight the risk mentioned above is those that may invest into one share of Warren Buffet’s Berkshire Hathaway in order to see his public equity portfolio and mirror his strategy in their own personal portfolios. If Berkshire Hathaway had managed to restrict to visibility of their portfolio holdings, in this case, restriction is required since they are public and non-exclusive publicly traded equities, and slowly permit those access based on higher subscription amounts — the fund very well may subscribe more capital, otherwise, it would have lost by those investing the minimum to mirror his strategy.
In the context of Berkshire Hathaway in private markets, LPs cannot typically engage in the deals a PE fund orchestrates. Hence, these additional returns by mirroring and bypassing fund fees are not realized at all. However, the same concept applies because UHNW investors consider their overall portfolio returns, which all privae equity funds comprise a relatively small (7.6%) portion of.
Historically, the administrative burdens and portfolio level reporting for orchestrating this would have been overwhelming. However, new technology in portfolio administration and security tokens have made this feasible with minimal marginal cost. EquityUp, a Middle Market M&A Automation system, can support this structure using security tokens and is currently working with venture fund EDGE196 to allow this co-investment functionality for both primary issuance and secondary offerings of P
re-IPO technology companies.
Reducing the lock-in period of investments in a granular manner
Portfolio liquidity may not be a constantly pressing issue, with many private equity investments entered with the intent of seeing the asset or fund through to maturity, when the full returns are realized. This is especially the case in assets that experience a J-Curve, whereby returns are negative and the IRR is fully realized at the final years of a three to five years holding period or more. However, there are several instances in which liquidity is valuable to investors.
· Macroeconomic Shifts: The spread between three-month and 10-year Treasury yields (Figure 4) — a relationship known as the yield curve — on Monday inverted to its widest level since 2007. This recession indicator is signaling a portfolio restructuring where many may want to shift their assets to either long-term or recession assets. The recent US manufacturing policy implemented by the Trump Administration has also had immediate and long-term effects, the long-term effects are unpredictable, yet unrealized, or both.
· Geopolitical Shifts: Influenced by public policy, for instance, Brexit has wide influence on many industries — some more than others. The portfolio strategies implemented under the previous economic policy may need to be revisited. In certain regions, a substantial opportunity exists before or after a major political event that can rapidly make returns unstable for a long period of time.
Specific Asset Classes
· Startup Companies: The returns of Pre-IPO or M&A companies are historically binary and typically increase in a stepwise fashion by restructuring the valuation at any period. It behaves like a clinical trial phase Biotechnology company, but without the volatility. Liquidity would enable those that wish to cash their shares at each stage the option to do so. Therefore, they could make a significant profit regardless of the exit, by allocating their risk tolerance to those that wished to hold on longer for a better outcome or may be entering at a later stage.
· Assets with Fixed Returns: Not all private assets are subject to the J-Curve, Binary, or Stepwise return distribution of other alternative asset classes. For instance, lending and many real estate instruments typically have a stable rate of returns. Even while real estate increases over a long period of time, it is typically the market overall that increases, not a specific property as is commonly the case with private equity.
Applying Blockchain Technology to Overcome Co-Investment and Liquidity Complications
Despite the clear benefits associated with the prospect of co-investment and liquidity, historically, the implementation of this has not been very feasible. Technologically, a few things have happened that have made this feasible. Not only that, several funds are piloting this strategy, which may signal effectiveness to others or encourage LPs to request such as structure for a firm’s next fund.
Market Changes Enabling this:
· Fractionalized Ownership: Security tokens have enabled for the fractional ownership of an asset. Historically Funds have owned, for instance, 10% of a given asset and LPs in the fund have owned 1% of the fund. Therefore, LPs don’t directly own the asset, but rather fund holding the asset. Such as shift allows for portfolio-level liquidity whereby funds become ‘flexible pre-set templates’ rather than set in stone and unable to be altered.
· Documentation Automation: Because Security tokens allow for contracts and ownership records to be embedded into them, legal paperwork can largely be automated associated with the sale on such assets. Even with the stop-and-go negotiations of today’s security space and preference for physical documentation, automations will continue to evolve to rapidly streamline this process.
· Privacy & Reporting Controls: A major challenge the private market experiences is the sharing of private information. Private assets are extremely cautious about sharing financial information required by fundamentals analysis. Traditionally, sending electronic financials could easily end up anywhere and many people will happily send them to whomever they are asked, loosely signing a difficult to track and protect NDA. Using platforms such as EquityUp and other virtual data rooms, privacy controls can be set to encrypt information, prevent downloading, and IP white listing to prevent out of office access. Paradoxically, information could be shared in a more controlled setting online.
· Direct Investment Platforms: Platforms designed to facilitate direct investment, such as EquityUp, are beginning to take shape. EquityUp is a private (i.e. closed network) or open (i.e. exclusive deal network) of buy-side and sell-side clients that uses a variety of tools including a Deal Screening System, Virtual Data Room, and Cap Table designed to take advantage of internal liquidity sources to bypass Alternative Trading Systems (ATS) or Exchange reliance. Platforms such as these will make direct investment, co-investment, a liquidity rapidly easier from screening to management secondaries.
While this article presents some interesting thoughts of what many innovative PE funds are doing to increase LP returns and assets under management (AUM), it may not be a long-term advantage, but a requirement. The market’s position on liquidity and co-investment is largely mixed and one could argue more efficient liquidity infrastructure doesn’t exist simply because it is not desired.
However, like many things, a benefit quickly becomes a need. An advantage rapidly evolves to a requirement. Even larger funds that enjoy reputation and strong historical performance ought to monitor those that are implementing this strategy, because even they are competing, if only in a different league.
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