(Blog) Private Equity 2.0 - How Digital Securities Are Changing The Game

(Blog) Private Equity 2.0 - How Digital Securities Are Changing The Game

New liquidity options coming up with a secondary trading availability is causing excitement. Digitally represented products tradable on a ledger/database have the prospect to open up a completely new world of financial products combining the best parts of both the private and the public markets.

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What is a security?

A security could be referred to as a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. … debt securities (e.g., banknotes, bonds and debentures) equity securities (e.g., common stocks) derivatives (e.g., forwards, futures, options, and swaps), “traditionally” ownership of securities is recorded on paper.

What is a digital security?

A digital security is a digital representation of an asset that happens to be a security, an investment contract or ownership tied to the same securities examples above, for which ownership is verified and recorded on a distributed ledger. A distributed ledger is a consensus of replicated, shared, and synchronised digital data geographically spread across multiple sites or institutions.

"The benefits of digital securities over traditional paper-based securities include greater transparency, new investment products and enhanced liquidity for illiquid assets." – Alice Chen

Digital Securities allow investors to get the return profiles of the private market offerings combined with enhanced liquidity provided in today’s public markets. Although solving the illiquidity issues related to private equity investments is an exciting prospect, below we highlight even more beneficial effects that come along with issuing and investing in a digital format, specifically in the private equity (PE) space.

The issues and challenges with traditional fund structures

Typically, traditional private equity fund structures offer some benefits but also many downsides for both investors (LPs) and issuers (GP). The following sections will articulate some of the most common pain points that occur with todays fund structures. The next section will then elaborate how Digital Securities can solve them.

Case Study: DSO Evergreen Fund vs. Traditional Fund

Private equity managers need large amounts of capital upfront so they can put their foot on the best deals in the market as they come along. The typical way that capital is formed is through a fixed life defined fund structure, but this comes with many disadvantages for both issuer and investors.

  1. Private equity funds are usually highly illiquid. Capital commitment spans range from several years up to decades. Moreover, investments in privately held companies are only transferable (when that is possible) with “heavy” transaction costs or forced discounts on the seller. Due to regulation, structuring, financing and the complexity of the private markets, it is a time and cost-intensive procedure to change the ownership of an asset.
  2. Furthermore, the life-cycle management of funds nowadays is highly inflexible. Private equity funds have predetermined long life spans due to the fact that most assets are considered to be illiquid. These fixed life spans results in a situation where fund managers have to take on pre-determinant decisions which are not always in accordance to the investors interests.
  3. Fund managers in traditional fund structures are incentivised to harvest their best performing assets early to pay back preferred returns. However, this in effect means that investors cannot profit from compound interest and miss out on real returns.
  4. Private markets are open only to an exclusive group of investors (namely, institutional and high net-worth individuals). The new trend will open up the possibility for a broader range of investors to access the alternative investments. It will also improve the chance for the fund managers to complete subsequent fundraising rounds. The research below shows that the mid-market PE groups are finding it increasingly difficult to raise funds and it is taking more time than before.

Key Takeaways

Traditional fund structures (RE & PE) offer:

  • No liquidity due to opaque private markets structures
  • Inflexible life-cycle management as fund managers take pre-determinant decisions
  • Manager is incentivised to harvest the best assets early to pay preferred returns
  • Low diversification options for the fund manager (issuer)

DSO fund structures offer an alternative way to resolve the pain points of the opaque fund structures of today. The following section describes how Digital Securities overcome the status quo.

  1. First of all, DSOs can solve the liquidity issue occurring in private equity funds. This is possible through the secondary trading options for tokenised assets. Secondary trading over a secure public or private Blockchain opens a new world of financial options. For instance, assets and funds can be partially sold down, freeing up new liquidity in a cost and time-effective manner.
  2. As Digital Securities bring in an unprecedented level of liquidity into illiquid asset classes, fixed life funds and liquidation deadlines belong in the past. Digital Securities help to align both the issuers and the investors interests.
  3. In traditional fund structures the fund managers were incentivised to harvest the best performing assets first to reach the minimum hurdle rates to get to their profit bonus.

In the new world of DSOs, fund managers are not in the same position anymore. They can manage investments that are cyclical (real estate, private equity) without the constraints of a defined timeline. Managers can now take equity in the project instead of profit, which brings real alignment to the manager/investor relationship.

  1. Fund managers of a DSO PE fund can now reach a much larger investor base. Due to the large minimum fund commitment for most private equity deals, only larger investors with huge capital are able to access most deals. It can be an enormous challenge for a fund manager to acquire such funds. However, fund managers can use of DSOs as a fundraising tool to acquire other accredited investors with shorter capital commitment requirements to complete the fundraising stage.

Example: Traditional PE Fund vs. DSO PE Fund

1. Traditional Private Equity Fund

Traditional PE funds only allow limited LPs participation according to deal sizes, deal complexity and the unavailability of secondary trading.

2. DSO Private Equity Fund

Issuer has wider access to a wider investor base through the fund backed digital securities. The GP can buy sell economic interests held by the digital securities through a licensed secondary exchange creating new liquidity for investments.

Key Takeaways

Digital Securities offer:

  • Enhanced liquidity due to tradability on secondary exchanges
  • No constraints of liquidation deadlines
  • Benefits from compounding growth
  • Diversified funds

InvestaX has identified the benefits of Digital Securities and teamed up the leading consortium of key stakeholders to provide the full end-to-end solutions for a digital securities issuance, including fundraising on a licensed compliant technology-enabled platform.

Join us on our mission to build out the new financial ecosystem of digital securities for private equity investing sign up at www.investaX.io