How Blockchain Can Improve Private Equity

What is Private Equity?

Private equity is an alternative asset class that consists of capital from the private capital markets. It is a form of private financing in which funds and investors directly invest in companies or engage in the acquisition of such companies. Those who invest in private equity cannot buy or sell on the stock market and these funds are usually managed by professional fund managers.

Investments in private equity mainly come from institutional and accredited investors. This is because of the nature of investment and restrictions imposed by regulatory authorities such as the Security and Exchange Commission (SEC).

Assets in Private Equity

Private equity firms raise money from investors to fund various assets. Some of the popular types of private equity funds are:

  • Real Estate Private Equity: As the name suggests, funds are deployed in commercial real estate and real estate investment trusts (REITs). Real estate funds require higher minimum capital for investment. Investor funds are also locked away for several years in this type of funding.
  • Mutual Funds and Hedge Funds: Both mutual funds and hedge funds are managed portfolios which consist of pooled funds with the goal of gaining returns through diversification. These funds offer an alternative entry for investors who cannot afford the minimum funding capital required in certain funds. However, these funds have higher management fees (because they are rolled up from different sources).
  • Venture capital: This is a form of private equity in which investors provide capital to entrepreneurs. Funding can be provided at different stages of the establishment of a company or startup. Seed financing refers to the capital provided by an investor to scale an idea from a prototype into a product or service. Whereas early stage financing can help an entrepreneur to grow a company while a series A financing helps to bolster their market footprint.
  • Venture Financing: Money in this type of funding is invested in troubled companies with underperforming business units. Companies that have filed for bankruptcy are often the candidates for such investment. The intention is to turn these companies around by making important changes in the operations or management or, selling their assets for a profit.
  • Leveraged Buyouts: This involves buying out a company in order to fix its business and financial infrastructure and reselling it for a profit to an interested party or conducting an IPO.

It can be observed that these investments require substantial sums of money for extended periods. In most cases, private equity investments involve long holding periods in order to ensure a turn around for troubled companies or creating liquidity through IPOs. Thus, investors who deal in private equity are usually high net worth individuals with sophisticated financial expertise.

Regulatory Restrictions

The SEC requires that whenever an issuer sells securities, both the offering and securities themselves must be registered with the federal government. However, that registration process is onerous, so private companies raise capital through private capital markets.

Since these markets are not regulated and deal with unregistered offerings, they are only limited to accredited investors to ensure investor security. To be an accredited investor an individual should have a net worth of at least a million dollars and have an income of over $200,000. Such high eligibility requirements limit ordinary investor’s participation in the equity market.

Advantages of Private Equity

Private equity offers various benefits to companies and startups. It gives them more control by using the capital to explore unorthodox growth strategies. Companies consider it to be a favourable option to access capital without traditional methods of loan and public market listing.

Unlike a debt finance agreement from a lending institution, companies are not required to make monthly payments to investors. Otherwise, the pressure of quarterly earnings greatly reduces the time frame available to management to turn a company around or have the liberty to explore
better options of making profits.

Disadvantages of Private Equity

Liquidity: It can be difficult to liquidate holdings in private equity because, unlike public markets, a systematic way to match buyers with sellers is not available. A firm has to search for a buyer in order to sell its investment.

Pricing: Prices of shares for a company in private equity is determined through negotiations between buyers and sellers and not by market forces. Hence the definition of value is very specific and limited.

Entry barriers: The high entry barrier ensures that only institutional and accredited investors can buy into private equity funds. Many investors are unable to penetrate into the lucrative fund investment products.

Lack of governance: The rights of private equity shareholders are generally decided on a case-by-case basis through negotiations instead of a broad governance framework that typically dictates rights for their counterparts in public markets. Moreover, the lack of a public marketplace for these securities means there is hardly any secondary market trading as compared to public equities.

Digitally Transforming Private Equity

Looking ahead, the advent of blockchain is sending shock waves in the private equity market. Its promise of speed, transparency and accessibility has valuable applications in the private equity market.

A shared blockchain ledger could produce a single interface between a PE fund, its investors and any other permissioned stakeholders, increasing transparency, efficiency, providing real-time updates to fund managers and investors.

The fund administration cycle-traditionally a manual and time-intensive process can also be automated using blockchain. Importantly, the network can be designed to support compliance in view of current local regulations.

In the PE market, one of the biggest challenges is regulatory compliance. Blockchain can leverage compliance via smart contracts and rapid settlement of transactions. Regulatory agencies can maintain near-real-time access to secure compliance-related data held on the blockchains of regulated financial organizations.

As discussed above, the PE asset class is illiquid by nature intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however, that can change with tokenization.

Tokenization

A token is a digital representation of an underlying asset exchanged over a digital network. Issuers and market infrastructure providers are developing facilities for secondary market trading of these tokenized instruments. This could lead to significant liquidity, an interesting development for any PE fund looking for syndication or exit opportunities.

Moreover, digital assets can capture information. This could make it easier to detect assets that have been used in criminal activities, and potentially increase the liquidity of assets across financial markets through enhanced transparency.

References:
Chen, J. (2020, April 30). Private Equity Definition. Investopedia.
https://www.investopedia.com/terms/p/privateequity.asp

Private Equity and Blockchain: New Infrastructure or New Asset Class? (2018, September 20).

The Harvard Law School Forum on Corporate Governance.
https://corpgov.law.harvard.edu/2018/09/20/private-equity-and-blockchain-new- infrastructure-or-new-asset-class/