Distributed Ledger Technology (DLT) has breathed new life into the old idea of representing value through tokens and alternative investments is one area where they can bring great efficiencies and benefits. In a previous post we described what tokenisation is and their benefits. In this one, we discuss their limitations and challenges for alternative investments.
Alternative investments are generally used to describe all investments which are not stocks, bonds or cash. The main categories are private equity, real estate, hedge funds, debt, commodities, collectibles and structured products. These investments are traditionally reserved for high net-worth individuals and institutional investors, as they are generally less liquid, regulated and transparent, while requiring a high minimum investment.
Although tokenisation is an old idea, Distributed Ledger Technology (DLT) has breathed new life into it, by enabling tokens to be digital representations of assets that are issued and traded within a distributed ledger. In a previous post, we outlined the key benefits from tokenisation: 1
- Faster and more transparent investing;
- Cutting transaction costs;
- Increased liquidity for projects;
- Wider access for investors; and
- Better diversification opportunities by lowering minimum investment sizes
In this post, we describe its main challenges and limitations.2
This structuring of tokenised investment products is split into two distinctly different levels:
- The structuring of alternative investment funds
- The structuring of underlying alternative assets
The structuring of tokenised fund products, particularly closed ended funds, is relatively straightforward, inexpensive and not too different to the traditional fund structuring process. One key consideration, however, are funds with future capital calls, which will affect who can purchase the tokens and may affect pricing around capital call events. For open-ended fund products, things can be more complex, depending on the liquidity of the underlying investments. This requires careful consideration by the investment manager. The liquidity of the underlying assets is something which can itself be improved via tokenisation. The difficulty and cost of tokenised fund structuring will also be much higher for non-standard and more exotic investment products.
For underlying investments, the complexity and cost of tokenisation is driven largely by the regulatory requirements and industry standards around due diligence of the investment to be tokenised, similar to the securitisation of an asset. Again, heterogeneous, non-standard and more exotic assets will have far higher tokenisation costs.
When the tokenisation of underlying assets is common, investment managers and their service providers (custodians, administrators, depositories, brokers, prime brokers, exchanges etc.) can realise substantial cost savings in middle and back-office operations through automation and data sharing. However, to realise these benefits, companies must first switch to tokenisation compatible systems across their departments. This is a non-trivial and costly undertaking, but the long-term benefits may be large. This may be complicated by a lack of industry standards, resulting in completing standards which may not be interoperable in the short term before a few dominant specifications standards “win out” and dominate the market.
Diversification and Network Effects
Tokenisation may offer investors benefits from easier diversification in alternative investments. It can increase the ability of investors to participate in a greater number and range of investments as the minimum economical investment is lowered, given lower research and transaction costs for investors, financial advisors, and investment managers. However, for a token platform and exchange to attract a wide pool of investors in the first place, there needs to be a range of tokenised investment products already available on the platform or tradable on the token exchange. In other words, a big part of the added value of tokenisation stems from the network effects that materialise as more investors and investment managers participate and increasingly liquid secondary markets emerge.
Although many of the benefits accrue to the investors, the initial cost of building a network of tokens in a particular asset class falls mostly on tokenisation platforms and service providers, who act as middle-men between investors and investments. But building the technology, which in itself is expensive, is often the easy part. Attracting either investors or investments before the other side of the market is established, is the key chicken and egg problem faced by two sided markets generally. Until this is overcome and the ecosystem benefits from network effects, tokenisation provides little benefit.
Due Diligence and KYC
Participating in alternative investments requires higher levels of due diligence, KYC and capital requirements on the part of investors. For example, relatively few information disclosures are required for private equity funds, hence the burden of due diligence by investors is much larger. For this reason, private equity fund investors need to prove they are sophisticated and understand the risks. As part of this, there are typically legal initial investment minimums to prevent access from retail investors, which are $100,000 or 100,000 EUR in many popular alternative investment fund jurisdictions.
Tokenisation will generally not affect these legal investment minimums for investment funds, though it will have an impact on direct investments into assets like property or private equity, with investors more easily being able to buy a small share of real estate or private companies. This may present challenges from a regulatory point of view, as retail investors might now be able to buy higher risk and more complex investments, if regulatory and investor onboarding processes are not adjusted appropriately. This has been the case with other recent innovations in finance such as crowd funding for start-ups, where many countries have added new regulation to help protect retail investors from losses via these higher risk investments.
This means that there may still be need for fund platforms with lengthy investor onboarding processes in the short term, like those currently in existence. The longer term ideal would be to decentralise these processes and hence platforms, and for them to be interoperable between the main specification standards. The challenge is to create a digital identity system, which provides investors with automatic rights on the tokens they can buy, based on their profile, in a decentralised setting. Although technically possible, such a decentralised system is not yet in place. As such, existing decentralised finance platforms have created permissioned pools, for example Aave with Aave Pro, as an interim solution.
However, the key restriction for many sophisticated investors is the minimum economically viable investment given the higher due diligence costs involved in complex investments. Tokenisation and increased liquidity can help to meaningly cut investment screening and portfolio construction costs. Visible market prices, for an asset which previously did not have one, can help investors screen, filter and analyse investments far more quickly. Further, early-stage fund managers will not need to rely on centralised fund platforms, which typically have minimum track record and fund size requirements to become listed. In the decentralised environment of public blockchains, investors can search the blockchain for suitable products directly in an automated way using decentralised finance software. This again reduces investment research costs for investors; however, this is subject to the issues outlined earlier. Visible market prices can also help and streamline portfolio construction, cutting costs.
The final consideration is that increased liquidity can reduce risk for investors and the need to do in-depth due diligence. This, however, can lead to a mismatch between the investment duration of an asset and the investment aims and horizon of investors, which may increase risk due to liquidity runs, and may also affect those who depend on the capital provided by investors (e.g. start-up companies).
Tokenisation may not be beneficial for all existing alternative investors. Wider market access and increased liquidity will reduce or remove the liquidity premium of many currently illiquid investment products. This premium is what many existing alternative investors strive for and the removal of this might reduce their appetite for certain asset classes. This effect will, however, also increase access for investors who previously were unable to enter or constrained. This is a key benefit of tokenisation, although it may lead to relatively smaller premiums.
Another issue that arises from widening investor participation is how to deal with debt covenants. These are agreements between lenders (investors in private debt) and borrowers (firms) on how the latter will operate and what changes they need to make, in order to be able to pay back the loan. Debt covenants need to be flexible and adjustable to changing market conditions, otherwise they may become a burden on a firm’s operations. For the same reasons, they may need to be private and not known to the firm’s competitors. These objectives are easy to achieve when the lenders are relatively few and oversee the loan from start to finish. However, this more difficult to achieve if the private debt is tokenised and the number of investors increases significantly. If less sophisticated investors are allowed to invest, then there may be regulatory pressure to make debt covenants more detailed and restrictive, let alone public. These restrictions provide better protection for less sophisticated investors, but conversely reduce the potential upside. Changing a covenant, when required, before the loan term ends might also become a more arduous procedure that involves informing all token holders and voting on proposed changes.
Capital Calls and Price Volatility
Private equity firms generally have a long term horizon, typically between 4 and 12 years, depending on the strategy. This longer investment horizon aligns better with the long term growth and profitability of companies. Investors who try to squeeze as much profit out of companies within a few years can harm the long term prospects of companies. This is already a key criticism of many private equity funds.
Tokenisation increases liquidity and access to a wider group of investors, however, some may be speculators or have short-term investment horizons. The price of tokens for a high risk investment, such as start-up companies, can be extremely volatile, which in turn can influence the decisions of the investment managers holding the token. Private equity funds do not see the “true” price volatility of the companies they hold as there is no observable market price. However, if the price of these companies becomes observable, so does their extreme volatility, which may cause investors to put pressure on investment managers to reduce this volatility and to protect against short term losses. This may lead to less stable capital and financing for private companies, as well as less stable valuations for companies.
Further, a big drop in the price of a token may force a private equity fund, who is a large investor in a particular company, to support the price of the token by buying it, which would essentially amount to a call for more capital that is due to market forces, rather than changes to the “intrinsic value” of the underlying asset. Such a prospect may discourage investors from participating in tokenised projects, especially as these funds may now resemble public equity investors. This may reduce the diversification benefits of private equity.
Finally, the possibility of exit liquidity might also cause investors to focus more on shorter term returns and less on long term returns, which may increase the incentive of private equity investors to damage companies to make a quick buck. This is already a key criticism of the private equity industry, which tokenisation could well exacerbate without the appropriate regulatory and legal safeguards. The short termism enabled by increased liquidity has been by far the largest criticism of securitisation, which can be seem as the predecessor to tokenisation.
Tokenisation on the blockchain has the potential to revolutionise the way investments are made and capital is allocated, by enabling a faster and more transparent process of investing, cutting transaction costs, increasing liquidity and widening the pool of investors and accessible investments. However, the technology is still new and there are significant challenges and limitations for adoption. Importantly, not all projects can benefit from tokenisation, so investors should exercise caution.
1 The post can be accessed at https://en.aaro.capital/Article?ID=2742899f-3441-49a8-b41b-c3a62b8a1554.
2 For more information, see “Tokenisation of Alternative Investments” at https://caia.org/sites/default/files/2021-02/CAIA_Tokenisation_of_Alternatives.pdf.