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.

FiFive Capstone Executive Summary: Fintech as a Potential Disruptor to Traditional Private Equity Accessibility. Meredith Baker, Bailey Jensen, Andrew Hughes, James Akers, Manuel Dominguez. 2024