Can tokenization expand access to private equity?

At the convergence of regulatory and technological innovation, solutions propose a promising pathway for expanding access to private equity investments. Since 2022, Private equity funds such as KKR, Apollo, Blackrock, and Hamilton Lane, institutions such as J.P. Morgan, Goldman Sachs, Barclays, and Moody’s, and government entities such as the Monetary Authority of Singapore and the Swiss Financial Markets Supervisory Authority have researched and experimented with tokenizing alternative assets, including private equity fund investments (Lobban et al., 2023a). Tokenization, powered by blockchain, offers the potential to streamline the operations, management, and distribution of private equity fund investments significantly, allowing for a lower minimum investment, more standardization across the industry, and enhanced secondary market liquidity. The changes enabled by tokenization could make private equity fund investments more palatable to a lower tier of accredited investors than the incumbent private equity investor class, opening the door for broader access and expanding the investor market for private equity funds.

Limited partner capital is traditionally comprised of institutional investors like pension funds, sovereign wealth funds, insurance companies, or a fund of funds. Capital may also come directly from high-net worth individuals or through family offices. Funds typically require investors commit a large sum of money to be invested throughout the fund's life. A typical minimum is $5-10 million (Shah, 2023). The standard minimum commitment of $5 million and higher creates a significant wedge between individuals who can invest in private equity and those who may be interested but do not have the means to participate. For example, a balanced portfolio might have a 10% allocation to alternative investments (Lobban et al., 2023a). Private equity may be all or a portion of that allocation, alongside private credit, real estate, or other alternatives. Extrapolating that allocation, an individual would need a $50 million portfolio of investable assets to responsibly allocate only 10% of their investable assets to private equity and meet the standard minimum commitment of $5 million. If the minimum commitment were reduced to an amount palatable to individual investors who are not considered high-net worth (a class that this paper will refer to as household accredited investors) the market for private equity capital would expand significantly. Additional potential trillions in investable assets sit untapped in household accredited investors’ portfolios, guarded by the high minimum commitment and complex, opaque traditional private equity fundraising and distribution channels (Lobban et al., 2023b).

To unlock this tier of household accredited investor capital, several hurdles need to be addressed. Standardization and efficiencies in fund operation, management, and distribution need to be established so that funds can afford to offer lower minimum commitments without straining the fund economics. Transparent distribution channels for a new tier of investors need to be established so that household accredited investors can access private equity fund investments. A secondary market needs to be established to support the liquidity requirements suitable for household accredited investors. Tokenization, powered by blockchain, offers the potential to overcome each of these hurdles.

Historically, investment minimums in private equity funds are high for several reasons. It is simpler for funds to work with fewer high-dollar investors from a regulatory and reporting perspective. Regulations restrict who funds can market investments to, who can invest, who can sell the commitments, and what reporting must be disclosed to each investor throughout the fund's life. Currently, it is standard practice to utilize an investor network to source investments in funds privately rather than to market the fund to a broad swath of investors (Lobban et al. 2023b). Once investors choose to invest in the fund, extensive onboarding requirements, including Know Your Customer (KYC), Anti-Money Laundering (AML), suitability verification, and subscription documents must be completed before the investor can participate in the fund. These processes are not standardized across the industry and are often manual and time-consuming, adding significant friction and cost to the onboarding process.

Additional overhead costs are incurred per-investor at each stage of the fund. (Lobban et al. 2023b) Due to the nature of private equity fund investment strategies, each investor’s commitment requires multiple touches by different operators throughout the life of the fund. This includes managing capital calls and distributions, performing fund accounting, and distributing client reporting (Lobban et al. 2023b).

A fund will typically make investments for the first five years of the fund and, during that time, will make capital calls from investors as needed. This is the downward-sloping portion of what is referred to as a J-curve (see Appendix B), which represents the estimated value of an investor's commitment during the fund's life. It slopes downward as capital calls are made and funds are invested, and it slopes upward later in the fund’s life as returns are realized on earlier capital investments. Fund administrators and transfer agents are involved in the capital call process, incurring service costs. Funds use bespoke methodologies to determine the amount of capital to call, perform fund accounting, and maintain the books and records of each investor's commitment. When the fund realizes returns, distributions are made to each investor. Redemptions may also occur throughout the life of the fund. Each process requires manual touchpoints by multiple asset servicers and payment processing fees. Finally, fund closing involves notifying investors, distributing capital as appropriate to each investor, and maintaining fund operations through final liquidation (Lobban et al. 2023b). This complexity makes it difficult for funds to lower the minimum commitment and increase the number of investors in the fund without straining margins. In addition to a 10-20% performance fee, private equity funds typically charge an annual management fee of 1-2% of committed capital to cover these overhead costs (Shah 2023). The management fee is fixed, so fewer investors contributing to committed capital translates to less fund administration and higher margins on fund management.

This level of complexity also limits the number of secondary sales that occur in the private equity market. It is difficult to price a trade and to transfer ownership before the fund closes. While limited in occurrences, trading does happen, and cash redemptions can happen during the fund's life. Each is equally complex and difficult to achieve in high volumes. If funds aim to expand access to household accredited investors, it is important to establish a secondary market to generate a level of liquidity that is suitable for investors with smaller portfolios. The typical structure of a private equity fund includes a lockup period, during which the funds cannot be redeemed. This lockup period can be ten years. “[This] illiquidity can pose significant risks, particularly during market distress or unexpected financial needs" (Ventricelli et al. 2024). This is typically too illiquid an investment to be suitable for the risk tolerance of household-accredited investors. Tokenization offers the ability to streamline and standardize the valuation, redemption, and transfer of ownership processes to facilitate liquidity of private equity investments in a secondary market.

It is important to understand three key components of tokenization: blockchain, smart contracts, and tokens.

Blockchain

A digitally distributed, decentralized ledger that exists across a computer network and facilitates the recording of transactions; as new data are added to a network, a new block is created and appended permanently to the chain. All nodes on the blockchain are then updated to reflect the change. This means the system is not subject to a single point of control or failure.

Smart Contracts

Software programs are automatically executed when specified conditions are met, like terms a buyer and seller agree on. Smart contracts are established in code on a blockchain that cannot be altered. A powerful characteristic of smart contracts is that they contain both the records of ownership of an asset (how much each investor owns) and programmable, automated rules for the updating of those records (computer logic that defines how and when an asset can be bought or sold, for example) (Lobban et al. 2023b).

Tokenization

The process of issuing a digital representation of an asset on a blockchain. It involves converting the ownership of an asset into a digital token stored on the blockchain. The token represents the asset and is used to track and transfer ownership.85 Tokens can include cryptocurrencies, stablecoins, central bank digital currencies, and NFTs. They can also include tokenized versions of real assets like art or concert tickets or a representation of an asset, like ownership in a fund. There are two standard methods of tokenizing traditional assets (Lobban et al. 2023a).

·        Native Asset Tokenization refers to issuing the financial instrument as a smart contract on a blockchain, including the contractual rights and obligations without requiring external asset backing.

·        Asset-backed tokenization refers to maintaining a traditional asset in a custody account, immobilizing it, and representing the owner's claim on the asset digitally via a token on a blockchain. This works similarly to depository receipts (Lobban et al., 2023a).

Because tokens can contain embedded business logic called smart contracts, tokenization can streamline the operational processes required to manage and distribute private equity investments to individuals in a more scalable manner (Lobban et al. 2023b). Nuanced and expensive operational processes described earlier, from onboarding and KYC to initiating capital calls and distributions as capital is invested, performing fund accounting, and distributing client reporting, can be automated via smart contracts that fire commands when certain conditions are met (Lobban et al 2023b). Automation can significantly reduce the number of touchpoints, reducing or eliminating overhead costs at different stages in the fund's life.

Securitize offers an example of managing capital calls with tokenization. In traditional private equity investments, not all capital is collected upfront; the limited partner commits a future amount of capital to be invested, for example, $10 million. As investments are made, capital is called from each investor throughout the fund's life in proportion to the amount of money the investor committed. By the end of the investment period, all the investor's capital has likely been called and deployed to the fund's investments. This format introduces complexity because each time capital is called, the fund administrator must calculate how much to call from each investor, communicate the need for capital, and then receive and track wires until the funds are collected. Securitize takes a unique approach that allows smart contracts to govern capital calls without a human intermediary. Securitize collects investor funds upfront and invests them in an interest-earning money market account while the funds are idle. When the time arises for capital calls, smart contracts automatically transfer the funds from the client's money market fund into the appropriate investment vehicle. Smart contracts similarly govern distributions which can be reinvested into the fund or deposited into the client's money market fund account (Securitize 2024).

Tokenization standardizes collecting and distributing capital between investors and the fund, reducing the need for multiple expensive touchpoints. The reduced overhead creates a more scalable solution for providing and managing smaller fund commitments more suitable for household accredited investors.

Tokenization also offers automation in the fund's trading and liquidity phases. This phase includes the distribution of capital, processing cash redemptions, ownership transfers, and secondary sale requests. Historically, these activities require a registered transfer agent (Securitize 2024). Since fund tokens resemble ledgers that record ownership of Limited Partner interests and the rules under which those Limited Partner interests can be transferred, tokens can act as an alternative recordkeeping system that a transfer agent could use instead of a traditional registry of shares. “When combined on the same blockchain ledger with other forms of tokens, such as deposit tokens [or money market fund tokens], it is possible to enable automated, instantaneous settlement, which would be a material improvement on today's lengthy, multiparty processes involving siloed data and costly reconciliations” (McKinsey 2024).

McKinsey & Company summarized the impact of tokenization, "Tokenization [has the potential to] catalyze modern operational infrastructure, which would benefit fund managers, distributors, fund administrators, and investors through a more streamlined investment process, with the added potential for enhanced liquidity, greater borrowing ability, and customization" (McKinsey 2024).

Tokenizing private equity investments on a large scale presents some difficulties that leading institutions like J.P. Morgan and Apollo are currently examining. One primary concern is a "a lack of interoperability among different blockchain systems… interoperability is necessary for the advantages of tokenized alternative assets, such as liquidity and accessibility, to be realized" (Ventricelli et al. 2024). If secondary markets remain fragmented on separate blockchains, efficiency is hindered, liquidity is reduced, and the risk of pricing arbitrage becomes apparent.

In Project Guardian, J.P. Morgan, Apollo, and Wisdom Tree partnered to test the automatic rebalancing of tokenized asset portfolios containing assets hosted on different blockchains. As a part of the proof of concept, Project Guardian tested interoperability solutions to provide seamless connectivity between blockchains. "Specifically, Alexar was used to connect Onyx Digital Assets (an EVM chain) to Provenance Blockchain (a non-EVM chain) and LayerZero was used to connect Onyx Digital Assets to Avalanche (an EVM chain)” (Lobban et al. 2023a). EVM refers to Ethereum Virtual Machine which is an execution platform for smart contracts on the Ethereum blockchain. The project's success showed that by deploying interoperability solutions like Alexar, separate blockchains, including proprietary, permissioned, institutional blockchains and public blockchains can be connected to perform transactions and settlement.

While large private equity funds with research and technology resources, like KKR and Apollo, are experimenting with tokenized assets, smaller funds may not be equipped to explore this approach directly. For smaller funds, fractionalization may be an option. Fractionalizing a standard limited partner commitment would enable the fund to continue to operate "business as usual" by allowing the fund to outsource the operational burden of managing smaller investments. From the fund's perspective, a $5 million limited partner commitment would be invested the same way as other single limited partner commitments. With an intermediary providing fractionalization as a service, the $5 million commitment could be divided into multiple shares and tokenized so smaller investors can participate. For example, the $5 million commitment may become 100 shares of $50,000 that are each represented by a token containing all the share information and ownership details.

Fractional ownership emerged in the real estate industry in the 1990s as a way for individuals to co-invest in real estate properties. Initially, groups of colleagues or friends began purchasing second homes in a shared ownership structure, with the rights to the property and allocation of usage time documented among the co-owners (Vlasenko 2024). In the last ten years, fractional ownership methodologies or "fractionalization" has expanded to Real World Assets (RWAs) such as fine art and collectibles, even racehorses and sports teams to lower the barrier to entry for household investors and expand access (Vlasenko 2024).

Fractional ownership generally entails the following: A managing party or sponsor establishes a legal entity for owning the asset, acting similarly to a Limited Partner in a private equity fund. This entity then divides ownership into fractional interests by distributing equity, partnership interests, membership shares, or similar rights. Investors are offered these shares to generate funds for reducing debt, covering operational expenses, or other financial needs. Revenue and ongoing expenses from activities such as purchases, investments, rents, sales, or RWAs, usage fees are distributed among the co-owners based on their share, as defined by the fractional ownership agreement (Hayes, Rhinehart, and Perez 2024).

Legal structures like limited liability companies (LLCs) and limited partnerships are commonly employed in fractional ownership arrangements. These setups distribute financial gains in proportion to one's share of ownership while consolidating the management responsibilities with the managing sponsor or general partner. The limited partners, or investors, contribute financially and, in return, gain limited rights to use or receive income from the asset, correlating with their ownership stake (Hayes, Rhinehart, and Perez 2024).

Whether representing a fractional share of a larger limited partner commitment, or natively representing a direct investment in a private equity fund, tokenization offers the unique functionality required to standardize, automate, and scale private equity offerings at the household accredited investor level.

In recent years, leading private equity funds have announced forays into the tokenized asset market through partnerships with companies like Securitize, or research projects like Project Guardian. In response, several jurisdictions globally have begun providing guidance on the treatment of tokenized alternative assets (Ventricelli et al., 2024). Regulatory bodies in Singapore, Hong Kong, United Arab Emirates, Luxembourg, and Switzerland have announced key provisions guiding the tokenized alternative investment space. (Ventricelli et al., 2024). Several hurdles like standardization and blockchain interoperability need to be addressed to form an efficient secondary market, but proof of concepts by institutions like J.P. Morgan and Apollo are proving that effective solutions exist. Questions of liquidity provision persist (i.e., will there be sufficient supply and demand? Will a market maker be necessary?) But as funds continue to recognize the need for liquidity in the household accredited investor tier, the question is being addressed from several angles.

Tokenization, powered by blockchain, opens the door to a new future for the alternative investment industry. One that expands access to a new tier of household accredited investors by reducing minimum commitments, standardizing distribution, management, and reporting, and creating a secondary market for liquidity in a previously highly illiquid, exclusive market.

Welcome to my blog

For years, I've wanted to try my hand at thought leadership in my industry. I wrote a bit during my two years at a fintech, and I wrote a lot in my masters program. I've found there is no better way to crystalize an idea than to put it into words on paper (or on a screen). The purpose of this blog is to get my feet wet with industry writing, get comfortable publishing opinion pieces, and to open my thinking up to questions, challenges, and collaboration that can only lead to improved ideas. I hope you enjoy, and feel free to drop me a message or feedback along the way.

Does Lending Club provide a novel source of investor capital?

Peer-to-peer lender Lending Club does not provide a novel source of investor capital, but it does provide a novel source of credit supply by redirecting investor funds towards peer-to-peer loans and away from other fixed income products with different return and duration profiles as exemplified by the chart on page 5 of Lending Club’s investor deck. Lending club expanded its base of self-direct retail investors from less than 30,000 in 2010 to more than 200,000 in 2018. Concurrently, hedge funds, insurance companies, and pension funds were buying large pools of marketplace loans, including those of Lending Club, seeking returns in a low-rate environment. (Corkery, 2016)

Lending Club’s ability to generate this novel source of credit supply was due to multiple factors. Without reserve requirements or the costs of brick-and-mortar locations, Lending Club was able to grow rapidly and facilitate a boom in supply (Corkery, 2016). The peer-to-peer lender also leveraged technology and data to better serve clients that may not have qualified for a traditional bank loan based on their FICO score and credit history alone. Lending Club had flexibility to provide more amenable financing terms, which increased both supply and demand. 

Lending Club largely captured the market share of existing credit demand, but it did, in part, create a novel source of credit demand by increasing access. Prior to Lending Club, there was unmet demand for credit by individuals who were unwilling or unable to go to a bank for a loan. By providing quick, low-friction, online access to credit, Lending Club captured some of that demand, facilitating over $10 billion in originations to over 3 million consumers in 2018, up from $100 million in originations in 2010. Much of Lending Club’s growth in originations was reallocated demand, i.e., refinanced credit card debt, a better alternative to payday loans, or demand from consumers who would have gone into a bank for a personal loan but now choose to use Lending Club. Some of it came from consumers who have poor credit quality and would have only had the opportunity of working with a high-friction specialty credit provider. Some of it came from consumers who would not have previously considered taking out a personal loan, but with an online, low-friction option with a high likelihood of getting funded with reasonable terms, demand from those consumers was generated.

Ultimately, Lending Club provides a platform to unite credit supply and credit demand, using information and technology to better allocate supply and meet specific demands, resulting in a reduction of waste. The Economist article, To Do With The Price of Fish, explains how cell phones provided a way for fishermen to communicate with fish markets on their way back to shore. For the first time, cell phones provided a way to efficiently identify demand and match supply with demand in different markets. Access to real-time information created a more efficient market, resulting in an 8% increase in profit, 4% decrease in price. Eventually, no fish were wasted, compared to a previous average waste of 5-8% per fisherman. (The Economist, 2008) Similarly, Lending Club deploys platform strategy to create a more efficient market, matching credit supply with credit demand, reducing waste, and ultimately capturing previously unmet demand in the market.

Sources

 The Economist. (2008b, May 6). To do with the price of fish. The Economist. https://www.economist.com/finance-and-economics/2007/05/10/to-do-with-the-price-of-fish

Corkery, M. (2016, May 10). As Lending Club stumbles, its entire industry faces skepticism. The New York Times. https://www.nytimes.com/2016/05/10/business/dealbook/as-lending-club-stumbles-its-entire-industry-faces-skepticism.html

Pymnts, & Pymnts. (2016, May 13). A brief history of Lending Club - PYMNTS.com. PYMNTS.com - What’s next in payments and commerce. https://www.pymnts.com/news/alternative-financialservices/2016/lending-club-timeline/

https://www.lendingclub.com/ 2024

Lending Club Investor Roadshow Presentation Summer 2019

How critical is cybersecurity risk management in Fintech?

Effective Cybersecurity risk management is critically important in FinTech because the industry utilizes sensitive data which makes it a target for bad actors, and the industry is highly exposed to the risk of financial fraud which directly harms a company’s balance sheet and its customers. Trust is an essential component of a financial services provider’s success. Cybersecurity breaches and data leaks compromise consumer confidence in financial services providers, even if they are not directly impacted by the breach, leaving a lasting impact on the company’s reputation.

Cybercriminals are constantly looking for vulnerabilities to exploit in financial institutions. (Smusin, 2023) The rapid digitization of the financial services sector has made financial services companies prime targets due to their use of sensitive information like credit card numbers, bank account details, and personal identifiable information. Common risks to consider include data breaches, insider threats, emerging technologies, and third-party risk (Smusin, 2023). Companies also need to remain cognizant of compliance with changing regulations, such as the 2023 revisions in the New York State Department of Financial Services (NYSDFS) Part 500.

“A data breach can occur when an unauthorized person gains access to sensitive data…and uses it for fraudulent purposes” (Smusin, 2023) Data breaches can lead to financial losses, loss of customer trust, and damage to the firm’s reputation, which have longer lasting impact than the breach itself. One of the worst and well-known cases of a data breach in the Financial Services industry is Equifax in 2017. According to the Federal Trade Commission’s website, the 2017 Equifax data breach exposed the personal information of 147 million people and cost Equifax a $425 million settlement. (Equifax Data Breach Settlement, 2022) The total cost of the breach is estimated to be closer to $2 billion after a $1.6 billion investment in improving security and technology (Egan, 2022).

Insider threats are cybersecurity risks that come from within an organization (Smusin, 2023). Insider threats can be intentional, for example, an employee or a contractor stealing data or selling confidential information, or unintentional, for example, malicious links and phishing emails. It is a best practice for firms to implement internal data access controls to minimize the risk of an internal actor accessing sensitive data. This can be applied at the consumer level, for example, tokenizing personal identifiable information and credit card information and storing the plain text data in a vault with limited access. This can also be applied at an organization level, for example, separating public and private employees to limit who has the ability to access Material Non-Public Information (MNPI) which can be stolen or sold for insider trading purposes. Limiting data access helps minimize the impact if a single employee’s credentials are hacked.

“Emerging technologies like artificial intelligence (AI) and the Internet of Things (IoT) can… introduce new cybersecurity risks.” (Smusin, 2023)creating new entry points and faster detection of vulnerabilities. To combat growing AI threats, companies can implement preventative AI strategies, using the technology to anticipate future threats by analyzing historical data and current trends. “Integrating AI into cybersecurity applications can improve threat detection and incident response. For instance, AI can identify anomalies or deviations that may indicate potential security threats. Previously unseen attacks can be detected.” (Drolet, 2024) Another growing application of AI by cybercriminals is AI-based predictive social engineering. Bad actors can more easily profile individuals and create personalized phishing campaigns at scale. (Drolet, 2024) 

Third-party risk is risk introduced by a company’s vendors. “When fintech companies outsource a certain service to a third-party vendor, they must ensure that these vendors have appropriate security measures in place to protect sensitive financial data.” (Smusin, 2023) In order to properly vet vendors, companies should conduct due diligence, including background checks and security assessments, and ensure that security requirements are included in the contract. (Smusin, 2023) It’s important that vendors’ security standards align with those of the FinTech, since the FinTech’s clients are ultimately exposed to the vendors’ vulnerabilities. It’s also important that vendors comply with the regulatory and compliance standards that are applicable to FinTech companies. Revisions to the New York State Department of Financial Services (NYSDFS) Part 500 cybersecurity regulation require c-suite sign-off on compliance with regulations. “As of December 1, 2023, not only must the highest ranking executive (usually, and hereafter, the CEO) now sign off on compliance with the regulation, but this certification must now be based on data and documentation sufficient to accurately determine and demonstrate material compliance (described further below), including any reliance on third parties and affiliates to meet the requirements.” (PWC, 2023)

To protect against the increasing cybersecurity risks, FinTech companies must prepare, practice, and revise (Germano, 2024). The National Institute of Standards and Technology (NIST) and Cybersecurity and Infrastructure Security Agency (CISA) offer frameworks for preparedness and incident response plans. Incident response plans “clarify roles and responsibilities and will provide guidance on key activities. [The plan] should also include a cybersecurity list of key people who may be needed during a crisis.” (CISA, 2021) CISA’s framework recommends thorough staff training, attorney revisions of the plan, meeting with the regional CISA team and local law enforcement, defining roles and response actions, quarterly reviews, and attack simulations exercises to ensure the firm is prepared for a potential attack. The framework recommends a blameless retrospective, update to policies and procedures, and effective communication after an incident.

Communication is essential for reputation management. The way a firm communicates that it has undergone an attack or that a breach has occurred can maintain or ruin the trust that the firm’s customers and industry partners have instilled in it. The 2017 Equifax breach is an example of poor crisis management. When announcing the breach, CEO Richard Smith said, “This is a bad day for Equifax.” Senior executives sold stock before the breach was publicly announced and shares fell over 6% in after-hours trading after the attack was disclosed. This messaging and “abandon ship” behavior from the executives sent a weak message to the public about Equifax’s ability to handle a crisis and decreased customer trust in the company. Five years later, Equifax experienced another issue and the new CEO, Mark Begor, sent an honest and informative letter to customers containing language like, “There are no excuses, but technology transformations at this scale are not easy”, “Equifax takes this issue very seriously”, and “We stand behind our customers and impacted consumers”. This second Equifax communication is a strong example of positive communication that can help minimize reputational damage following a breach.

The FinTech industry remains a growing target for cybercriminals, due to the vast amounts of sensitive data, financial data, and the potential for financial fraud. It is essential for FinTech companies to prepare, protect against attacks, and to respond immediately and effectively in the event of a crisis. FinTech leaders must be cognizant of rapidly evolving technologies like AI and IoT that create new entry points and vulnerabilities. Firms must protect against third-party risk, and maintain compliance internally and through vendors with changing regulatory requirements. In the event of a breach, FinTech leaders must respond with care, transparency, and strength to maintain the company’s reputation and protect consumer confidence. This is especially critical for FinTechs and financial services companies because the industry relies heavily on trust.

Sources 

Smusin, M. (2023, September 8). Cybersecurity in FinTech: challenges, technologies and best practices. Yellow. https://yellow.systems/blog/cybersecurity-in-fintech?secureweb=WINWORD

PricewaterhouseCoopers. (n.d.). Time’s up! New York cyber changes are final. PwC. https://www.pwc.com/us/en/services/consulting/cybersecurity-risk-regulatory/library/nysdfs-cybersecurity-regulations.html

Drolet, M. (2024, February 20). Eight cybersecurity trends to watch for 2024. Forbes. https://www.forbes.com/sites/forbestechcouncil/2023/12/26/eight-cybersecurity-trends-to-watch-for-2024/?sh=5377f9604111&secureweb=WINWORD

CISA. (2021). Incident Response Plan (IRP) basics. In CISA | DEFEND TODAY, SECURE TOMORROW [Report]. https://www.cisa.gov/sites/default/files/publications/Incident-Response-Plan-Basics_508c.pdf

Equifax Data breach settlement. (2022, December 20). Federal Trade Commission. https://www.ftc.gov/enforcement/refunds/equifax-data-breach-settlement

Egan, J. (2022, September 9). Five years after the Equifax data breach, how safe is your data? Bankrate. https://www.bankrate.com/finance/credit-cards/how-safe-is-your-data/

Transformative FinTech in the context of Robert Merton’s financial functions

My idea for a technologically transformative fintech startup touches two of the five financial functions described by Robert Merton. Primarily, the idea provides a mechanism for the pooling of funds to undertake large-scale indivisible enterprise (function two). The idea also provides a way to deal with the asymmetric-information and incentive problems when one party to a financial transaction has information that the other party does not (function six). (Merton, 1995)

Currently, only a small number of ultra wealthy investors called qualified investors (and qualified institutional buyers) have direct access to private equity fund investments. Qualified investors invest in private equity to “earn greater returns, reduce volatility, and further diversify.” (FiFive, 2024) Retail and accredited investors currently do not have the option to seek direct investment in private equity funds to achieve the same benefits. Meanwhile, the demand to raise capital has outpaced the supply of private capital. (FiFive, 2024) By expanding their target market to accredited investors, private equity funds could access 24.3 million additional investor households, 11.6 million of which have over $1 million in net worth excluding retirement investments. (SEC, 2023)

Beyond regulation, there are barriers that prevent private equity funds from extending their investor pool to accredited investors. Primarily, these barriers include the operational cost of facilitating and managing smaller fund investments, the burden of reporting and ensuring investor education, and the lack of secondary market liquidity which would make the profile of private equity fund investments more suitable for the accredited investor profile.

United States regulation continues to evolve alongside fintech. In Europe, accredited investors have the capability to directly invest in private equity. I believe that U.S. regulation has the potential to adjust the accreditation requirements and open up private equity investment to accredited investors in the future. My solution overcomes the operational and functional hurdles that might prevent private equity funds from feasibly offering accredited investor-sized minimum commitments in their funds.

My solution is an intermediary platform that deploys three core competencies to make private equity investments available in smaller bite sizes to accredited investors. The first is fractionalization: a replicable and scalable legal structure that breaks a Limited Partner private equity fund commitment into smaller securities held by accredited investors. Tokenization and blockchain will be deployed simultaneously: tokenized assets will contain encoded business logic that self-manage operational processes like capital calls and distributions. The tokens will be hosted on a blockchain platform that settles trades and keeps a record of asset ownership. Platform strategy will unite supply from private equity funds and demand from accredited investors. The platform will provide a source of secondary market liquidity that makes private equity investment more palatable to the accredited investor risk profile.

The solution is relevant now because private equity funds are seeking new ways to raise private capital, to meet current excess demand in the market. Accredited investors are seeking ways to diversify beyond an uncertain public equity market, and to capture returns that are only accessible through private investments in early-stage companies. The platform will sit on a blockchain. The accredited investors need to load money into digital wallets to hold the tokenized assets. At the on-ramp, the platform will connect to tradfi payment rails, allowing for wires and ACH transactions to fund the wallets. Investor wallets will be connected to onboarding technologies, like Quadrata (https://quadrata.com/), which performs KYC checks for web3 wallets. The platform will need to be a certified transfer agent or connect to digital transfer agent services to facilitate trade and asset operations.

This business model is a two-sided market. To ensure the platform’s success, I will subsidize price-sensitive users (Eisenmann, Geoffrey, Parker, Van Alstyne, 2006). In this market, accredited investors are exposed to financial risk, providing capital with the goal of earning a return on invested capital. Private equity funds are looking for ways to access a new market of investors and tap into a new source of capital. Accredited investors are the price-sensitive side of the market. Private equity funds typically charge a 2% management fee, and I will not charge accredited investors above that. Private equity firms benefit from accessing a new source of capital. I will charge private equity firms a licensing fee to offer fund commitments on the platform and negotiate a revenue share agreement, capturing a portion of the management fee. Private equity funds will then have access to a new pool of capital, a lower margin but vast and diverse tier of capital in their target market. The fund will essentially outsource all of the operational heavy lifting involved in providing, maintaining, servicing, and reporting on a smaller commitment size to the platform.

I will secure a marquee user, ideally KKR or Blackstone, guaranteeing exclusivity in the first 1-3 years. This benefits the marquee user in two primary ways. Due to the duration of private equity investments, there is a significant first-mover advantage in this market. The leading private equity firm on this platform will have the opportunity to capture and hold a lion’s share of the accredited investor market. The marquee user will have the ability to give feedback as our product iterates, securing a seamless integration to their own internal systems and processes.

This startup will be disruptive. “Disruptive technologies introduce a very different package of attributes from the ones mainstream customers historically value…they generally make possible the emergence of new markets.” (Bower, Christensen, 1995) This startup will introduce a new market of accredited investor participation in private equity. This will expand the wallets of private equity firms and reallocate investments away from public equity, fixed income, and other alternative investment markets (i.e., fractionalized art and real estate ownership).

Sources

U.S. Securities and Exchange Commission. (2023). Review of the “Accredited Investor” definition under the Dodd-Frank Act. U.S. Securities And Exchange Commission. https://www.sec.gov/files/review-definition-accredited-investor-2023.pdf

Robert Merton and the functional approach to financial services: A Functional Perspective of Financial Intermediation Author(s): Robert C. Merton. 1995

Christensen, Clayton M., and Bower, Joseph L. (1995). Disruptive Technologies: Catching the Wave. Technology & Operations. Harvard Business School.

Strategies for Two-Sided Markets. Thomas Eisenmann, Geoffrey Parker, and Marshall W. Van Alstyne. Harvard Business Review, October 2006.

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A little opinion piece on International Women’s Day…

I grew up with a mother who, to this day, shies away from calling herself a “feminist”. The term carried “negative connotations” in her day. My maternal grandmother exhibited clear favoritism, elevating the males in the family while subjecting females to the role of supporting character at best. My mom and I both grew up as understudies of older brothers. By middle school, I was taught to be “one of the guys”. Feminine interests and the color pink were signs of weakness, silly whimsical notions to be squashed for the fear of appearing too girly and annoying or unintelligent. My high school bedroom was blue and green, with Marvel superhero posters on the walls. Even in my dancing career, I took a few years off of ballet, favoring hip hop and tap dancing because ballet was for girly girls. I was proud of my “guys-girl” status and thought it made me somehow superior to other women.

It took me almost a decade into my adult life, and a few strong and extremely loyal female friends to help me understand female friendship and the power of femininity. My career has existed in male-dominated realms of finance and technology which perpetuated the male-favoring notions of my youth. I crossed paths with other similar-minded women who approached our colleague relationship with a competitiveness I now believe to be partially seated in similar upbringings. At 22, I felt the competition was appropriate. I was prepared for it by other women who had experienced this in their careers. At 29, it breaks my heart. I’m grateful to say I’ve proudly become a “girl’s girl” in the last 8 years of my career and life. I understand what a gift it is to be a woman, think like a woman, care about the world and others from a female perspective. If I am blessed with a daughter, I will raise her to understand how valuable her femininity is and to embrace it while encouraging other women to embrace theirs.

Today, I sit in a team of VPs at a corporate bank. I’m the only female VP in my corner and I can’t help but look at my colleagues and think, “I do exactly what you do, I do it well, I do it while feeling under the weather one quarter of the time, while experiencing unexpected emotions and unanticipated exhaustion. I do it on at least 25% fewer calories and at least 45 minutes less sleep because I know you didn’t have to put on makeup or curl your hair. I do it in less comfortable and more effortful outfits. And on top of that, I created a human being in my body.” So yeah, women are awesome and International Women’s Day is well deserved.

Enjoy it, ladies!