Introduction

A growing interest is emerging among investors and firms in blockchain technology. A recent study by Deloitte has proved that 60% of organizations believe that they will lose competitive advantage if they don’t adopt blockchain since it will have a disruptive impact on the market.

Among all the players in our economy, several private equity firms are currently gaining financial benefits from using blockchain technology.

Private Equity: State of the market

A Private Equity (PE) fund is a collective investment, managed by a firm or a limited liability partnership, which invests in numerous types of equities and debt instruments. The money pooled in the fund is not traded in the stock market (not public) and the fund is not open to everybody.

The PE model has been reliable and profitable for both investors and fund managers.  Bain and company estimate that funds raised across the private sectors amount to 1.2 trillion dollars in 2021, a 14% increase from 2020 and an all-time high.

These funds represent an outstanding opportunity for a high rate of return. However, they also struggle with some inefficiencies.

How the market works: recent inefficiencies

Managers of PE have tried to work with a relatively small number of investors to minimize shareholder reporting needs. For this reason, only large institutional investors or high wealthy people can buy-in. A huge portion of the demand remains unmatched because of this.

Moreover, when compared to the equity market, the private one does not have the same level of post-trade infrastructure. Indeed, for every transaction, there is a lot of manual and time-intensive work that can be enhanced by technology usage.

What about regulation?

Digital assets are usually defined as anything that exists in a digital format and comes with the right to use. Security tokens are one category of digital assets that are issued on the distributed ledger technology and that respect the definition of security or financial instrument. In the EU, they are under the MiFID II regulation.

MiFID II is a legislative framework instituted by the European Union (EU) to regulate financial markets in the bloc and improve protections for investors. In addition, the proposal for the MiCA regulation and the Pilot Regime DTL includes security tokens as financial instruments.

At the moment, other normative interventions are under investigation to regulate the issuing and circulation of digital financial instruments.All the most important players in the financial services industry are currently experimenting and collaborating on the integration of blockchain technology into their operations.

Why choosing a Blockchain solution and Security token

Blockchain was born as a technology that only supported crypto like Bitcoin and Ethereum. Today, it has been gathering attention as an infrastructure capable of so much more. In fact, using blockchain has the power of transforming a variety of practices and products and adding value to a business.

A shared ledger will build a single interface between PE and investors, enhancing efficiency and transparency, and providing real-time updates for LPs on investments and more detailed analytics.

One of the most disrupting implementations for PE in blockchain technology would be the adoption of the tokenization of financial assets. Tokenization is the process by which the digital financial instrument (backed by a real-world asset) is manufactured, issued,  stored, and transferred on the blockchain infrastructure. What characterizes a Security token from a Payment or Utility token is the type of asset represented, which has a financial nature, like shares, bonds, funds…

The adoption of this financial instrument has many benefits:

  • Economical efficiency: lower costs of capital compared with the traditional way of issuing a financial instrument; 
  •     Fractionability;
  • Operational efficiency: payments related to assets such as dividends or coupons are automated (thanks to the smart contract);
  • Transparency: all information is registered on the distributed ledger;

Given all the above mentioned, the PE fund would benefit from money and time savings that will ultimately potentially increase the liquidity in the private markets since the assets are managed in a smarter way.

Conclusion

The asset management world is becoming more and more aware of the potential of blockchain technology. As of today, there are still few applications but for sure, the financial services world is experimenting with this disruptive technology. One example is Deloitte Portugal’s collaboration with the Portuguese Association of Investment Funds, Pension Funds, and Asset Management (APFIPP) to develop a platform for the distribution of investment funds based on blockchain technology. This initiative was aimed to simplify and make the distribution of funds in Portugal more efficient and reduce the need for third-party intervention.

In the near future, the adoption of the blockchain solution and, most importantly for the PE, the adoption of the security token in their operations can represent a source of competitive advantage against the market as well as a source of value for the investors and shareholders.

Sources:

https://due.com/blog/the-rigid-structure-of-private-equity-investment-funds-need-remodeling-and-blockchain-is-enabling-that-solution/

https://www2.deloitte.com/content/dam/Deloitte/mt/Documents/financial-services/mt-fsi-blockchain-in-im.pdf

https://www.inhousecommunity.com/article/blockchain-effect-investment-funds/

https://corpgov.law.harvard.edu/2018/09/20/private-equity-and-blockchain-new-infrastructure-or-new-asset-class/

https://www.privateequityinternational.com/private-equity-firms-turn-to-blockchain/

https://www.coverfox.com/personal-finance/mutual-funds/private-equity-fund/

https://www.theglobaltreasurer.com/2021/01/29/blockchain-will-unlock-greater-liquidity-for-private-markets/

https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/