An evolution in private markets operations is long overdue — enter blockchain technology

Private markets, as we understand them today, gained prominence in the 1980s, primarily due to the advent of leveraged buyouts (LBOs). These LBO funds harnessed substantial capital from institutional investors, such as endowment schemes, pension plans, and insurance companies, and invested in a diverse array of private businesses, generating immense profits in the process. Notably, the large capital requirements and requisite expertise made this asset class primarily accessible to sophisticated institutional investors.

The regulatory framework now exists to enable broader participation. Vast sums of private wealth, estimated at trillions of dollars, are eager to be deployed. Top-tier private equity managers are keen to tap into these deep reservoirs of fresh capital. So why can’t financially astute individuals, keen on accessing private markets to benefit from the well-documented outperformance and other advantages, still not gain entry?

The answer lies in operations. And the key to dismantling this barrier lies in blockchain technology.

Why regulation alone won’t cut it

Until very recently, the ability for a private investor to subscribe directly to a private markets fund was largely not possible due to the regulatory environment enacting barriers to entry.

In the US, the JOBS Act has led to developments around Regulation Crowdfunding and Regulation A. Within Europe and the United Kingdom, the ELTIF and LTAF regulations, respectively, have broadened the ability for private investors to access private markets products. Retail investors are now able to subscribe directly to a fund product and invest alongside the institutional behemoths that have had almost exclusivity to private markets.

Even in light of these regulatory changes, it is still difficult for a retail investor to gain access to top quartile managers and retail private markets products. Many managers do not wish to onboard retail investors directly due to the increased administrative and operational requirements, notwithstanding the difficulty involved to attract these individual investors directly. As such, asset managers rely on distribution partners and platforms to tap into these pools of private capital.

Additionally, structuring and education are another challenge. Private markets are inherently very different from public markets, which retail investors may be more familiar with. One example is that private markets funds typically call down capital from investors incrementally as and when a deal presents itself and the capital they commit is typically tied up for 10 years or more. More entrepreneurial asset managers, who have worked to deliver a product to private wealth clients in a digestible manner, have structured their fund products in a way so that they are fully paid in and, to some degree, semi-liquid.

Even if a top quartile manager has the internal resources to manage a product structured for private wealth investors, has a friendly regulatory framework and the necessary distribution partners and platforms to tap into that private wealth capital, the operational gap to onboard such a high volume of investors in a scalable and cost effective manner is still non-existent. That is where blockchain technology can revolutionise operations.

Solving operational issues with blockchain

Blockchain technology, put simply, is a decentralised and distributed database that is run on a series of computers in a network called nodes. The blockchain records transactions and other data on the network and is designed to be secure, immutable and transparent. There are many variations of blockchain networks and they can be public or private, permissioned or permissionless.

The ability for blockchain technology to revolutionise operations lies in this open data architecture and the immutable nature meaning that it can act as the one golden source of truth and has the ability for smart contracts to be deployed on a blockchain to automate tasks.

At Hedgehog, we believe the two main benefits to be realised from integrating a blockchain technology solution are decreased costs and decreased risks. The decreased costs and risks cut across more than just the operational aspect of running a private markets product, however, for the purposes of this article, we will look at some of the operational aspects and what problem blockchain technology solves for.

Registrar and Transfer Agent Functions

The Registrar and Transfer Agent is typically responsible for maintaining a product cap table, managing the issuance and redemption of shares, managing transfers, managing voting and proxies and taking care of distribution payments, amongst other things. While some off-the-shelf or proprietary technology solutions can be utilised in processing these tasks, the solutions are not fully automated and can be quite siloed in nature. The tasks can also be quite manual in nature taking up valuable hours of personnel and opening to potential human error.

When blockchain technology is utilised, the cap table for any product, no matter how frequently it is traded, will be maintained and updated in real time, along with an immutable record of previous token holders and any trades or transactions that took place with their associated data. Units in a tokenized offering can be issued or redeemed automatically and distributions made to the token holder’s respective wallets. Likewise, voting requests and voting proxies can more easily be distributed throughout a network of tokenholders and the results verified in real time due to the data infrastructure of a blockchain network. Transfers of tokens can also be executed in an automated manner via the deployment of smart contracts. These smart contracts can be coded with the necessary compliance rules to ensure that only eligible investors who have a whitelisted wallet / account are able to purchase the tokens and that a transfer will only take place once all the pre-coded rules are met.

Reporting and Auditing

As all the necessary data can be stored on the blockchain and is maintained in real time, certain reporting functions can be automated and fund level reporting can be disaggregated between individual token holders, important when dealing with such a high volume of private investors. Compliance and risk functions can monitor the data in real time to ensure all necessary rules and parameters are complied with and that risk controls are within the correct bandwidths.

The transparent and immutable nature of blockchain networks also lends itself to a more expedited audit of fund products, as fund information can be stored onchain, for example, the cap table, any transfers and movement of capital, NAVs, as well as compliance data on the underlying investors.

In a recent report, the European Union estimated that around EUR 4bn could be saved on reporting per year through the use of blockchain technology.

Compliance Onboarding and Ongoing

KYC / AML checks of investors can now be automated using solutions such as Veriff or Onfido. Once an investor has completed their KYC / AML checks and been verified, their wallet / account can then be whitelisted and able to invest into fund products. Smart contracts can be deployed to ensure that there is an ongoing monitoring of accounts and that all AML / KYC is up to date.

Through the use of smart contracts, compliance rules can be enforced on wallets / accounts to prevent distributions, further investment or transfers if there is any suspicious activity associated with that wallet / account. Compliance rules can also automatically be enforced if the wallet / account holder has not maintained their AML / KYC checks as prescribed by the smart contract.

Payments and Settlement

A massive use case for blockchain technology is the payments and settlements infrastructure. Payments can be made for mere cents and transfers completed within seconds. This stands in contrast today where a payment from one jurisdiction to another can take a day or two to settle and incur not insignificant fees. This is certainly one barrier which can hinder returns for retail investors investing into a private markets fund with a drawdown structure. This payment infrastructure then lends itself to atomic settlement, whereby payments and securities are exchanged instantaneously, reducing or eliminating any settlement, counterparty or volatility risk.

The next logical step

Now that there is a regulatory framework for private individuals to invest into private markets products, and there are pools of private wealth capital amassed in various distribution pipelines, the next logical step is to reimagine the siloed nature of the current data infrastructure and automate operational processes to make way for this new capital in a scalable and cost effective manner. We believe the key to realising this change lies in blockchain technology.