Private Equity: Natural Harbor for Blockchain Applications
Andrew An, senior product manager in Onchain. Andrew Has 5+ years working experience in private equity industry.
After long-term pregnancy, blockchain started to be utilized in real world in 2017. A common saying is “Applications to see finance, financial applications to see PE”. Multiple reasons for that, PE trades are less frequent, PE documents are complicated, process is slow, and custody is always involved. With blockchain utilized, the transparency could be increased, the trust could be built, the efficiency could be improved in private equity.
Blockchain’s Strength in Private Equity
In the past 30 years, private equity industry has developed a lot. At the same time, fees have increased a lot. Some charges are unreasonable or even illegal. Almost every month, we could see over-charging issues. Just take 2 examples, in 2015, TPG charged twice of the fees from its LPs in the buyout case of Chobani(the biggest yogurt manufacturer). In 2015, KKR is reported to charge fees from investors in a failed case.
Thus Fee Transparency has been added to most LPs’ worksheets. In January 2016, there’s a big step, ILPA released the ILPA Reporting Template for fees, expenses, and carried interest, and would require GPs to send termly reports using this template. Per the comments on ILPA’s official site, the aim of the template is to encourage uniformity in these disclosures, both to provide LPs with an improved baseline of information to streamline analysis and drive decision making, and to reduce the compliance burden on general partners being asked to report against a range of disparate formats from LPs.
At the same time, reconciliation is needed for fund’s transparency. To ensure the historical data match the yearly/quarterly/monthly sheets, we need a reliable third party to store all kinds of historical data and all documents involved. We need a reliable third party, which meets the following requirements
1).maintained by GP and LPs,
2).information is traceable,
3).reading and downloading would be recorded,
4).data couldn’t be stolen or destroyed.
The existing platforms (e.g. Intralinks) seem don’t meet the requirements. But blockchain will do.
The traditional centralized platform widely used by private equity institutions seems unable to fully meet the demand.
Firstly, data losing risk. The traditional module usually store the original file directly. Once the system is hacked, a number of confidential information would be leaked.
Secondly, management risk. Some custodians have multiple clients’ access, and could check multiple GPs and LPs’ information. It’s a big risk.
Thirdly, technical risk. Once the centralized system meets crashing, power failure or unpredictable accidents, it would result in irreversible loss of information.
Blockchain Application’s Technical Path
Blockchain would provide solutions for the issues above. What’s more, in some areas (e.g. document storing application), Chinese startups are leading the game. For example, currently there’s a open blockchain storage alliance in China, which could be maintained by GPs and LPs. Especially for fee transparency, blockchain’s strength would make funds of more transparency.
1.Blockchain Storing Solutions
Blockchain storing solutions would record the lifecycle of one document, including participants’ actions, with time stamp used. Taking one example, after GP sends out a capital call notice, would check if the doc has been read by a certain LP and avoid missing the deadline. Also, it would help for evidence in the process of potential recovery.
Using blockchain to do the storage, information could be real-time synchronized to the relevant parties. For each uploaded document, any changes and edits will be recorded. At the quarter end, would conciliate the ILPA template with the date from blockchain, which would help ensure GP & LPs share the same information, maintain the consistency & transparency of data, and protect LP’s rights.
Blockchain storage alliance could provide legal electronic signature solutions, which is in line with China’s “Contract Law” & “Electronic Signature Law”. At the same time, the chain could be equipped with multi-level real-name authentication service system and electronic signature technology, to ensure the online signing’s legitimacy and normative.
3.In private equity side, there are multiple kinds of documents and contracts, e.g. investment agreements, gambling agreements, limited partnership agreements, profit distribution agreements, etc. These docs now could be signed off online, and the contents and results are real-time synchronized. Also, the docs are stored in blockchain, per its characteristics, no one could tamper any information. This would ensure the authenticity & integrity of electronic data. In particular, the provisions of fees could be further identified through the blockchain certificate.
Blockchain could provide seamless docking notarization & forensic services. If notary office establish nodes in the blockchain, would get real-time synchronize information from the blockchain. Which means blockchain could assist with forensic reports. Blockchain’s docking of judicial services, would ensure the effectiveness of evidence from geographical restrictions. When the parties have conflicts in benefit allocation, decision making and other aspects of the dispute, could directly dock justice through blockchain, and ask notarization or forensic center to retrieve the evidences.
In Nov.2015, Nasdaq announced that issuers were able to use its Nasdaq Linq blockchain ledger technology to record equity transaction, which is the first of its kind using blockchain technology. For this transaction, Nasdaq enabled the issuer to digitally represent a record of ownership using Nasdaq Linq, while significantly reducing settlement time and eliminating the need for paper stock certificates. In addition to its equity management function, Nasdaq Linq also provides issuers and investors an ability to complete and execute subscription documents online.
In general, Linq’s requirements could be well meet with blockchain’s storage functions. Based on blockchain storage platform, blockchain could provide solutions for middle-office and back-office businesses, by building the trust and well protect the participants.
Starting from Linq, more financial institutions have started to work on blockchain applications. Per the media, the top asset management company Northern Trust has been carefully operating a private equity capital chain since early 2016. This chain would record equity issuing, cost calculation, income distribution, capital calls and any fund activities in fund raising, investment and exiting. If needed, the information could be retrieved from the blockchain.
Blockchain could have more applications in private equity side. For example, blockchain could make due-diligence more efficient.
Investors do due diligence because of information asymmetry. When start-up have initial communications with investors, it is impossible to tell the detailed information. Because it’s dangerous to expose details before the investor express a very clear investment intention. Normally the due diligence wouldn’t start until some terms of agreement have been reached, such as the amount of investment, the number of shares, priority rights.
Well, by doing due diligence, investors need to know the actual situation of the company, which would help judge to invest or not. So this would be a problem. While blockchain will provide solutions. Entrepreneurs could use blockchain to store secret letter of information. Through the authority control and smart contract settings, information can be decoupled in stages, and to publish appropriate information.
1) Blockchain Could Help Investors Know Entrepreneurs Better
Blockchain storage alliance could easily be implemented for identity chain. If the alliance includes schools, credit agencies, corporate information platform, government agencies, it would cover most aspects of a person. Of course, the blockchain storage alliance may not cover all the information of the entrepreneurs, which needs them to do the uploading. Above all, uploaded information couldn’t be tampered with, and will be synchronized to the credit and the judiciary, which creates mechanism to protect the credibility of the information.
As for blockchain, through effective authorization and access control, firstly investors can verify the resume of the entrepreneurial team, especially the learning experience and working experience; secondly investors could consider entrepreneurs’ ability match the business they’re engaged in or not; thirdly investors could see if the entrepreneurial team has enough cooperation or not, and the lack of cooperation experience within the team could have potential disputes or disagreement. At the same time, due to the blockchain information can be traced back, investors’ every reading would be recorded. If necessary, by zero knowledge and other cryptographic designing, investors could verify the entrepreneurs’ experience is true or not, without seeing plaintext information, which protects the entrepreneurial team’s personal information.
2)Blockchain Will Help Investors Do Financial Due Diligence
Blockchain will effectively assist investors with the financial due diligence. In particular, blockchain would not only store the financial data, but also financial workflows.
Blockchain could help collect the company’s financial statements over years. By comparison, the investors could know company’s growth rate.
3)Blockchain will Help Investors Do Legal Due Diligence
Blockchain will assist investors to do legal due diligence. Legal due diligence involves a large number of contracts, agreements, documents, etc. All the information is important and sensitive, which needs high degree of confidentiality. Similar to the entrepreneurial team information query, through effective authorization and access control, zero knowledge and other cryptographic design, blockchain would well protect the company’s confidential information.
In recent years, the study of PE Index has become a hotspot for PE institutions, custodian banks and research institutions. One reason why institutional investors always outperform is the expectation of economic trends really matters. The relevant index normally cover different industries, countries, customer types, global capital flows and other factors, and obtain operational information. In practice, customers can use the index to compare the various regions of the market or a variety of investment opportunities for asset-allocation optimization or adjustment.
However, the editing of the index needs a lot of customer data. How to effectively use customers’ data, and not revealing customers’ identity and assets become a problem.
Blockchain storage alliance will provide solutions. The blockchain model will change the “labor-intensive” process that generates prices manually using its transaction data after obtaining customer’s permission. With blockchain, customers’ data will be stored in the chain, using the encryption settings to protect the privacy. By using smart contracts, customers can sign the authority of the data usage to the agency. After the authorization, all kinds of data will support the index editing. In blockchain mode, the data itself is still safe, and the trends shown by the data can be sold. Also, any data usage will be recorded. Customers can require interests accordingly.
In general, blockchain technology has advantages in certain areas, which would help build the trust in a trust-needed industry . Thus foreign private equity institutions have great intention to get blockchain implemented. As mentioned above, blockchain would be beneficial for PE middle office and back office workflows. Also, blockchain technology shall play a bigger role in helping China’s private equity industry’s health and development.