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.