Liquidity

Despite a few reservations, tokenization stands to streamline the way retail and institutional investors can access the private equity market.

As the burgeoning blockchain technology paradigm has continued to evolve, a whole host of unique asset classes have started to make their way into the mainstream. Private equity tokens are one such offering, serving as digital representations of ownership in private equity investments powered by a decentralized ledger. 

These tokens enable fractional ownership, improved liquidity and simplified management of private equity assets. They are created through a process called tokenization, which involves converting real-world assets into digital tokens that can be bought, sold or traded on various platforms.

Recent research indicates that private equity and hedge fund assets are the most likely to see tokenization in the near future. The study surveyed fund managers in France, Spain, Germany, Switzerland and the United Kingdom, collectively responsible for around $546.5 billion in assets under management, and found that 73% of the participants identified private equity assets as the most likely first to see significant tokenization.

Moreover, the World Economic Forum has estimated that up to 10% of global GDP could be stored and transacted via distributed ledger technology by 2027, with crypto-asset custodian Finoa reporting that tokenized markets may be worth as much as $24 trillion by the same year.

As a result, most fund managers (93%) overwhelmingly believe that alternative asset classes — such as private equity — are highly likely to be targeted for tokenization due to their inherent lack of liquidity, transparency and accessibility compared with traditional asset classes.

The financial proposition of private equity tokens

One of the most enticing aspects of private equity tokens is the potential for enhanced liquidity.

Traditionally, private equity investments have been plagued by long lock-up periods and limited exit opportunities, making them unappealing for some investors. However, by tokenizing these assets and enabling them to trade on secondary markets, private equity tokens can offer a much more liquid alternative.

This new level of liquidity not only allows investors to enter and exit positions more easily but also helps unlock the value of illiquid assets, making them more attractive to a broader range of investors.

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In addition to improved liquidity, private equity tokens also offer increased transparency in an industry that has historically been opaque. The use of blockchain technology, which underpins these tokens, allows for the public tracking of ownership and transactions, providing investors with a real-time, transparent view of the underlying assets. This level of transparency can help build trust and confidence in the private equity space and reduce the risks associated with fraud and mismanagement.

Furthermore, these tokens democratize access to the private equity market, breaking down barriers to entry for retail investors. By allowing investors to purchase fractional ownership in private companies or funds, they create opportunities for smaller investments, thus enabling a wider range of individuals to participate in the growth of private companies. This democratization of access not only diversifies investment portfolios but also fosters innovation and economic growth as more capital is funneled into the private sector.

Speaking to Cointelegraph, Nikolay Denisenko, co-founder of Swiss neo-digital bank Brighty and former lead backend engineer for Revolut, noted the aforementioned benefits of tokenization for private equity. However, he said that “there are factors that could potentially limit the growth and adoption of private equity tokens. One key factor is the regulatory environment, which is still evolving in many jurisdictions. Ensuring compliance with securities laws and Anti-Money Laundering regulations can be a challenge.”

Recent developments surrounding the space

While venture capitalists have eagerly financed blockchain technology to revolutionize the banking sector, they have been more hesitant to adopt it for their own operations. However, recent initiatives to tokenize private funds seem to signal a significant shift in this mindset.

For example, Pierre Mauriès — who previously served as the private equity technology practice director at PwC and a mergers and acquisitions strategy executive for The Carlyle Group — recently founded Nemesis Technologies. The company is tokenizing a $500 million fund that will become available on Securitize, a digital security issuance and compliance platform. The process will transform the fund stakes into digital tokens, allowing investors in the United States and Japan to trade them on Securitize’s brokerage platform, Securitize Markets.

In a recent interview, Mauriès emphasized the importance of tokenization for the future of alternative investments, highlighting several benefits for limited partnerships. For instance, Nemesis fund investors can trade tokens after four years, offering earlier liquidity than traditional models. Additionally, the digital nature of the tokens simplifies fractionalization and sale to other investors compared with the conventional secondary market.

Other prominent firms like KKR, Apollo, Hamilton Lane, Backed and Partners Group are also spearheading jumping into the private equity tokenization movement. Backed, in particular, recently introduced its ERC-1400 security standard-based private equity token, BACD. 

The firm claims that the token’s features include faster settlement speeds, automated compliance through smart contracts, 24/7 trading and better transparency. BACD tokens represent private equity ownership and function as utility tokens for exchange and payments.

Lastly, private equity’s early adoption of tokenization seems primarily driven by the desire to expand investor bases, as tokens provide retail investors with easier access to private equity. By offering digital tokens, PE firms can potentially engage with 13.6 million accredited investors managing $75 trillion in the United States alone, according to Securitize CEO Carlos Domingo.

Potential drawbacks

As the legal and regulatory frameworks surrounding tokenized assets continue to evolve, looming uncertainty can make it difficult for private equity firms and investors to navigate the tokenization process and adhere to local and international regulations.

Furthermore, the market for trading tokenized private equity assets is still relatively nascent, which can result in limited trading volumes and reduced liquidity for these tokens when compared with more established, liquid asset classes.

Technological security, such as the stability of the underlying blockchain technology, is crucial for successfully implementing tokenized private equity. Blockchain networks can be vulnerable to hacks, system failures or other technical risks, which could compromise the integrity and value of the tokenized assets.

Moreover, widespread market adoption is necessary for tokenized private equity to reach its full potential, but this requires significant buy-in from private equity firms, investors and other stakeholders, which may be challenging due to traditional industry practices and resistance to change.

Tokenized private equity assets may also face skepticism from potential investors who associate blockchain technology and tokenization with the volatility and unpredictability of cryptocurrencies like Bitcoin (BTC). Overcoming this reputation risk may require extensive education and marketing efforts.

Tokenizing private equity can also introduce extra complexity, particularly for investors unfamiliar with digital assets, blockchain technology or the process of trading and managing tokenized assets.

Lastly, while blockchain technology can offer enhanced security, storing and managing digital assets requires stringent security measures to protect against hacking, phishing and other cyber threats, which can introduce new risks and challenges for private equity firms and investors.

In the view of Brighty’s Denisenko, these tokens can majorly impact liquidity and market volatility. While increased liquidity may benefit some investors, it could also lead to higher volatility in the market.

This may affect both retail and institutional investors, who may not be prepared for sudden price fluctuations. To mitigate this risk, it is essential to establish robust secondary markets with appropriate risk management mechanisms and to educate investors about the potential risks and rewards associated with private equity tokens.

“The problem is that having an uncontrolled secondary market is not the best-case scenario for the company because it makes it hard to reduce volatility. Hence, total decentralisation is not a workable option, only through oracles and the DAO’s approval,” Denisenko concluded.

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Despite these drawbacks, the potential benefits of tokenizing private equity are significant. As the technology and regulatory landscape continue to evolve, these challenges may be mitigated or addressed entirely.

Looking ahead

While the core concept pervading tokenization may not necessarily provide investors with a significantly expanded pool of potential market participants, the primary attraction surrounding tokenized private equity lies in the simplified experience it offers smaller investors with limited means.

Moreover, as tokenization gains traction in the private equity domain, more established financial entities will likely adopt this innovative approach. With the support of industry leaders such as KKR, Apollo, Hamilton Lane and Partners Group, the tokenization movement is well-positioned to reshape how private equity investments are managed and traded. Thus, it will be interesting to see how this relatively nascent market niche continues to mature moving forward.