The rise of cryptocurrencies such as bitcoin and ethereum has sparked a host of innovative activity. Numerous companies have cashed in on the trend by issuing their own digital currencies and tokens.

While the Securities and Exchange Commission has been clamping down on some of this activity, the rise of “tokenization” has continued. As George Salapa, co-founder of Swiss securitization advisory firm Bardicredit, observed in an article published in Preqin's third-quarter update, tokenization represents an important emerging trend for the private equity and venture capital sectors:

“Tokenization is about ‘cutting’ assets into tokens. These digital securities have emerged out of the hype over initial coin offerings (ICOs) – a method of raising funds through the use of cryptocurrencies. Security tokens are intelligent and regulated securities that give small businesses the ability to raise funds from investors globally, 24/7/365. As they are ‘pre-programmed’ with smart contracts, security tokens could remove middlemen like central depositaries, automate dividends, and govern trading rules and voting rights among other things. In short, security tokens are transforming securities into computer programs.”

Based on Salapa’s analysis, it is quite apparent that tokenization, if widely adopted by private capital markets, could have profound and varied implications.

Lowering barriers to entry

One of the key benefits Salapa cited is the power of tokenization to lower barriers to entry, both for investors and fundraisers:

“Tokenizing alternative assets, such as venture capital funds, would open the market to a more diverse range of investors, not just pension funds and high-net-worth individuals. Even more importantly, tokenization could empower independent fund managers and young talent looking to raise capital.”

In essence, tokenization subdivides private assets and makes them tradable, lowering the cost to many would-be investors. Equally important, funds looking to raise capital will be able to engage with a wider pool of potential investment, while creating a more attractive value proposition for many allocators:

“Ultimately, tokenization will streamline the fundraising process. Instead of a structure involving multiple actors (issuer-lawyer-authority-investor), fundraising via tokenization will be very direct: from issuer to investors.”

Removing time-sensitivity from exits

Virtually all private equity and venture capital funds are closed-end funds. This means that they are expected to both make investments and exit from them in a fixed time window, usually 10 years. This feature of fund organization architecture can create problems when it forces a fund to push for exits at suboptimal times. According to Salapa, tokenization can eliminate this pressure:

“Investors in tokenized funds...can sell their stake at any time and are therefore freed from the 8-10 year lock-up. Removing the urgency to exit also gives fund managers more freedom to operate and to be transparent about their fund investments. They can allow their portfolio companies to grow at a more natural pace and build sustainable businesses for the long term.”

Fund managers, and their limited partners, may be able to build greater flexibility via tokenization. They can exit, hold or lighten up at will, providing the potential for both smoother and more efficient returns.

Adding liquidity to private markets

The biggest problem facing private capital investments, apart from accessing them in the first place, is the issue of liquidity. Investors have proven to be remarkably willing to accept illiquid investment opportunities if they provide market-beating returns. However, lack of liquidity can cause serious problems when cash is tight, as Salapa explained in his Preqin contribution:

“The tradeable nature of tokenized funds is also expected to bring much-needed liquidity to today’s illiquid alternatives market. In recent years, there has been massive growth in the private equity secondaries market, highlighting the hunger for liquidity. This market was tiny just 20 years ago. Since then, Europe-based private equity secondaries assets under management has risen significantly, more than doubling from €43bn in 2015 to €87bn in 2018. Tokenization could further boost liquidity in private markets by making it easy and simple to trade stakes in funds.”

Obviously, a tokenized fund or asset is not going to be as tradable as a stock or bond, but it is far more liquid than a private asset. Injecting liquidity can create numerous ancillary benefits, such as improving price discovery; valuations can be seen in real-time and be impacted by a host of actors, not merely intermittent funding rounds that can be. Such private rounds are susceptible to being gamed by lead investors; Softbank Group Corp. (TSE:9984) did just that with its investments in the likes of WeWork and Slack Inc. (NYSE:WORK), which resulted in woefully inefficient asset pricing.

Verdict

Tokenization is a new trend and may yet prove to be a passing fad, especially if the regulatory apparatus opts to crack down further. However, it is hard to envision a future that does not include this technology. Its potential to improve, if not wholly transform, private capital markets cannot – and, indeed, should not – be ignored.

Disclosure: No positions.

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