Private markets and the convergence of two transformative trends

Hedgehog is building a future based on our four core beliefs, a future that will make it easy for more people to invest in the world around us.

Key to unlocking our vision is the convergence of two of our beliefs, and two transformative trends in private markets: the growing demand from retail investors and the digital transformation of financial markets.

If individual investors are to be the next growth engine for the asset class, digitising the distribution lifecycle of private markets investment products is mission critical. The industry reached $13 trillion in size by the end of 2021, operating almost entirely offline. But accessing the capital raising opportunity that is the c$140+ trillion of (largely untapped) private wealth will require the adoption of digital solutions that make the operations involved both scalable and efficient.

A gradual transition is underway

So far, successful use of distribution technology has involved the repositioning of existing products. European web-based investment portals Titanbay and Moonfare, like US platform iCapital before them, have improved access for qualified individuals to invest. Platforms like these provide a simple and intuitive digital experience for users, combined with the use of special purpose ‘feeder’ vehicles that aggregate commitments to help smaller investors overcome the minimum investment amounts required by most private markets funds.

Consolidating individuals as a single investor also reduces the administrative burden for fund managers that built their processes for serving institutional investors, solving a potential problem for them as well. As they achieve scale, these platforms make meaningful allocations and secure access for their users to many of the better performing off-the-shelf funds. The caveat is that investors still need to be ‘qualified’ based on wealth, level of income or professional investment experience.

The next evolution is an emerging range of structures like ELTIF in Europe and LTAF in the UK. These structures are diversified fund products approved by regulators with the specific goal of broadening access for investors to the asset class, beyond that qualified investor definition. These are not existing funds being repositioned for a new audience but dedicated products created for and primarily aimed at retail investors.

For fund and asset managers in private markets, the benefits of digital distribution solutions should be considered in the context of their ambition to distribute investment products to individuals, as well as the digital sophistication of the distribution partners on whom they intend to rely. In simple terms, the bigger the ambition to broaden access, the higher the number of potential investors, and the greater the complexity of operations involved. The reliance on technology to make those operations scalable and efficient goes up proportionately.

Distribution partners are the same, but different

Distribution to private wealth is built on a partnership ecosystem that has traditionally relied on centralised account management. Dedicated wealth managers like private banks coordinate a complex web of incompatible underlying accounts on behalf of their clients. This industry is dominated by institutions that have been operating since long before the digital age, and the advent of the internet was not a catalyst for meaningful structural change. In the US today, the largest wirehouses and private banks are 90%+ of AUM in the private wealth channel*.

Despite playing the same gatekeeper role, different distribution partners are at different stages of familiarity with and appetite for private markets investments in underlying client portfolios. They are also at different stages of digital adoption. That transition to digital solutions involves several key challenges when looking at providing services to their end clients, from third-party provider integration to sub-ledger capabilities, liquidity management and reporting. The distance to travel is greater still when considering digital-asset based services, but more on that later.

Digitalising investor operations like onboarding, subscriptions and distributions has obvious efficiency benefits for the ecosystem as a whole, almost irrespective of the type and volume of investors in focus. But as the number of investors involved in the distribution of a private markets product increases, so does the risk of error or delay in the product operations.

Blockchain can be the infrastructure upgrade the industry needs

Blockchain technology has the potential to unlock this huge distribution opportunity and accelerate the convergence of these two transformative trends — retail investors and digital transformation — for the private markets industry.

When blockchain becomes industry infrastructure, it makes it possible for the transfer of KYC, contracts and payments to be atomic. Said another way, all transactions in the distribution lifecycle of private markets can be executed automatically, instantly and directly.

In that industry paradigm, all rules and terms are written in code held in smart contracts, with actions automatically triggered when conditions are met. Everything is performed and recorded using blockchain, providing an immutable single source of truth. Using blockchain, a tokenized investment can be bought and sold more securely and more quickly than is currently possible, whether in a primary issuance or a secondary trade.

Fundamental is the understanding that we are talking about blockchain, not bitcoin. The experience for the investor should be familiar, like using their online bank account. The technology that enables these seamless transactions should not require the user’s attention. Like the switch to cloud computing from hardware and servers, new possibilities are presented once the transition to upgraded infrastructure has occurred.

Build it, but will they come?

The risk is to see tokenization as the distribution solution itself, and overlook the less glamorous reality that blockchain is the industry infrastructure upgrade that will create new distribution possibilities. It is better infrastructure that can lead to greater operational efficiency, help lower the barriers to entry, and ultimately help broaden access to the asset class. In that order.

As barriers to entry come down for individuals investing in private markets, so should access for the industry to an already captive audience of new investors. Direct to consumer distribution is a tall order for any financial product, but especially in this asset class. While on the increase, private markets typically represent a small allocation relative to the rest of an investment portfolio. Its role is not to be the main event.

Customer acquisition, and the associated costs, is the noose around the neck of digital marketplace models and some are better equipped to succeed than others. Elsewhere in fintech, digital products that lead with non-discretionary financial services like banking, retirement saving or high-frequency trading have done an incredible job aggregating individual users. They appeal to consumers that are taking more responsibility for their finances, with a modern (and mobile) user experience.

These products serve their users with a level of frequency and engagement that is beyond private markets, which are characterised by inherent illiquidity and long duration. In our opinion, the opportunity for the private markets industry is to supply captive audiences of retail investors with digital products, rather than to create a new digital destination of our own and hope to attract retail investors there.

This is an evolution rather than a revolution

Like distributing to the HNWI market via traditional private wealth channels, serving the emerging audience of digitally-native retail investors will likely start with repositioning products that already exist ‘offline’. If distribution is integrated in the digital customer journeys of other financial services, digital tokens that represent an existing financial security can genuinely broaden access to the asset class.

Tokenization can also open access to new, previously unimagined audiences with investment products that are digitally native i.e. born as tokens rather than securities that have been tokenized. Native tokens may (and probably will) be treated as securities — security tokens — but they started life as tokens. That is relevant because it opens the door to bespoke use cases, giving freedom to ideas that sit outside the parameters of traditional funds. One example would be a rent-to-invest product for residential tenants that rewards tenant loyalty with an opportunity to grow equity while renting.

Blockchain technology can change how individuals invest in private markets and open new distribution channels for investment managers to reach them. The opportunity is an industry evolution from an offline past to a digital future: a gradual transition that works for the incumbents in the private markets distribution ecosystem, and also enables the launch of new products that serve an emerging network of fintech apps where the digitally-native retail investor is the primary customer.

*Source: Bain & Company (‘Institutional Level Tokenization’ webinar)