A number of commentators have remarked that blockchain technology and tokenisation have the power to impact the entire venture capital and private equity industry – from the way funds are raised, to the way monies are invested and how limited partners can realise their investments. But will it?
What is tokenisation?
A tokenized asset is essentially an asset wrapped in a tradeable piece of code. In many respects, it is very similar to old-fashioned securitisation. A blockchain token is issued for each asset which forms a digital representation of the asset. The token may represent the asset in whole or in part – which allows for partial ownership. These tokens can then be traded on a secondary market.
How would a VC/PE fund be tokenised?
Most VC/PE funds are set up as limited partnerships (“LPs”). The LP structure has several advantages for investment funds. It allows investors to participate, as limited partners, without taking an active role in fund management but benefit from limited liability; any LP agreement and, in many cases, the fund’s accounts are not made public; and LPs are transparent to tax, so that each limited partner is taxed directly.
Investors in VC/PE funds, as limited partners, contribute funds to the LP while the general partners invest the fund into multiple companies on the basis of a defined investment strategy.
The investors and managers of the VC/PE fund typically receive a share in the fund’s profits by way of a carried interest in the fund; this may be paid to a carried interest partner, often itself another LP of which the sponsors are partners.
In the context of tokenisation, a fund would be split into units, with each unit representing an “interest” in the economics of the fund. Investors would subscribe for tokens representing an interest in the fund. Funds could be structured as evergreen or open-ended funds (where there are no limits on the number of people who can invest, or the number of tokens issued) or closed ended investments (where a fund would issue a fixed number of units).
Regardless of whether the fund is open ended or closed ended, the tokens are freely tradable once issued.
Benefits of tokenisation
The proponents of tokenisation believe that the technology will provide the following benefits:
The current VC/PE partnership structures are very illiquid. Investors are locked into funds for several years and are often restricted from trading/selling their interests to third parties. Proponents believe that as the tokens can be traded, limited partners will be able to liquidate their positions more easily and can more rapidly deploy capital.
As secondary sales would all be completed using smart contracts with the exchange process automated (no negotiations as required now to sell partnership interests), the transfer would be made more efficient with vastly reduced costs.
Tokenisation would potentially allow more successful funds to raise new funds more easily. Fund managers who realise a better IRR for their investors in a shorter time period will be better positioned to raise a new fund. This removes the problem of not being able to raise a new fund whilst you are waiting to return cash from the portfolio.
VC/PE as an asset class have historically been the preserve of large pension and endowment funds, corporates and HNWIs. Issuing tokens could broaden the investor base by including a mix of institutional investors and HNWIs/sophisticated investors as the investment amounts and holding periods could be reduced. This contrasts with the expensive and friction filled IPOs of VC/PE funds
Investors’ rights and obligations can be embedded directly into the token for the public to see. The token would also only be sold on markets to entities which have undergone the relevant KYC and AML procedures and been certified as sophisticated or accredited investors.
Will tokenisation disrupt traditional venture capital and private equity?
Although having certain technology benefits over its traditional VC/PE fund counterpart, the tokenisation model is not without its challenges.
The biggest perceived advantage of liquidity under the tokenisation model may be overstated as blockchain can facilitate but not create liquidity. Only a market with a sufficient volume of buyers and sellers will create liquidity and therefore only funds with the best portfolios will h attract sufficient liquidity.
It is unclear whether tokenisation will make the asset class more accessible. The tokens will generally be subject to regulation which will mean that the initial sale of the tokens will only be available to sophisticated or accredited investors – and so therefore the target market of initial investors may only be slightly broader.
That said, the technology and its application to the sector is in its infancy. Whilst we do not think it will disrupt the industry in its entirety, we can see the technology making reporting, governance and settlement more efficient.
Giles Hawkins, Partner, and Cynthia Ma, Legal Director, in Ashfords’ corporate team.