An incremental improvement to capital markets

June 2019  |  EXPERT BRIEFING  |  CAPITAL MARKETS

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The offshoots of blockchain have induced speculative bubbles, promises of new paradigms, talk of disrupting status quo business models and even whispers of creating a new internet. But where are the practical applications that lay people can understand? Where is the product or service that can be referenced as a proof of concept, one that this is more than just an existential exercise in needless techno-hype? Bitcoin is not the answer until at least 1 percent of 1 percent of actual monetary transactions anywhere in the world use it, or any other cryptocurrency, as an actual medium of trade as opposed to what can best be described as a glorified gambling mechanism.

So let us look at blockchain as a transparent and accessible distributed ledger system, and examine a modest use case that can be implemented today to reduce the cost of doing business and hopefully provide some long-term value. In particular, let us focus on the process of capital formation in private markets. Why? Because if the fraud-ridden initial coin offering (ICO) boom era of the recent past taught us anything, it is that there is a massive pent up global demand for ways to invest in private securities: the ability to participate in the next Facebook, to diversify into income generating real estate projects, to help finance social impact initiatives or public-private infrastructure projects, or to provide early access and added liquidity to venture capital (VC) funds.

Historically, VC firms have acted as gatekeepers to some of the most profitable private investment opportunities. This trend, however, is ripe for transformation. By way of example, if we focus on the advantages that digital securities have come to represent, it is clear that securities issued and maintained via blockchain networks can be revolutionary even in this established and already successful niche industry. The ICO boom of 2015-2018 sparked conversation of a workaround, or disruption of the VC fundraising model. Since the Securities and Exchange Commission (SEC) stepped in and declared that ICOs should fall within corporate security laws, what has emerged instead are programmable, blockchain-based securities which are designed to follow all regulatory compliance on a global scale. This new class of digital securities and the advantages they can introduce, while also following a clearly defined legal framework, may actually create an increased demand for VC fund investments because they inevitably make the process more transparent, more accessible and more efficient.

Investors into a VC fund are subject to strict lock-up period on their capital, typically 7 to 10 years. There are some limited private opportunities for trading out of these locked-up investments but they come at a steep cost, usually a discount of 20 percent or more of net asset value. Sourcing a buyer for an early exit of a limited partnership via these avenues can be challenging. The frictional cost of traditional VC fund investment is primarily caused by the legal and administrative fees charged by third parties which are required to verify information and, in turn, serve as trusted intermediaries.

Private security laws mandate that every time an investor transfers ownership of their security asset to another investor there needs to be a system of Know Your Customer (KYC) anti-money laundering (AML) checks. Subsequently, offering documents need to be physically sent to each investor, reviewed by their respective attorneys and accountants, countersigned, then shipped to a third-party administrator. Upon actual asset transfer, there needs to be an escrow agent which holds custody, accepts payment and awaits settlement before facilitating the trade. Transparent and distributed ledger systems solve for these legacy based inefficiencies when they record ownership changes, validate investor status, timestamp transaction history, and automate compliance via an easily accessible and shareable database.

Allowing investors to have an earlier from a VC fund provides an advantage to the general partners as well. The fund no longer needs to have a redemption date, or a fixed date at which it is required to return all capital to investors. This eliminates the stress of exiting holdings simply due to the capital constraints as opposed to an analysis of potential liquidity events and payouts of the fund investments.

Digital securities are programmable. This offers the possibility of interesting new features, one of which is an option for the fund to automatically buy back the principal investment of its limited partners at predisposed time increments as opposed to issuing dividends. This can be a mechanism for returning principal investment to limited partners while allowing the remaining profit to be held at will. These types of features have tax advantages for limited partners since they would not have to declare a gain until they exit the holding. Buybacks also add liquidity to the secondary market and provide a bid at market price. As a result, future capital raising by security issuers can be performed at a reduced cost, since there would be a higher valuation.

Another advantage for issuers of a digital security-based VC fund is the ability to administer the security at virtually the same cost whether it is held by 10 investors or 10,000 investors. This is due to a reduction in the number of intermediaries required to verify information and the frictionless transfer of data and assets, thereby allowing more global investors to participate at potentially smaller dollar-value sizes of investment. This democratisation, or the ability to distribute investment opportunities to a significantly wider audience and in fractionalised increments, has the potential to result in larger and faster overall capital raising.

It is important to not assume that these securities would immediately provide liquidity via secondary markets even though there are a number of exchanges, such as tZero and OpenFinance, which have been formed to facilitate pricing discovery and match buyers and sellers in this new security class. Liquidity will come only when there is a demand for the securities and such demand is a function of expected returns, not simply an automatic by-product of availability.

However, since there is the elimination of the aforementioned 20 percent discount at sale – due to frictional cost – on early exits of traditionally structured VC funds, investors of these blockchain-based security offerings will not be faced with this barrier to secondary market trading, making liquidity at least a higher probability.

After the digital security is issued and is being managed in the marketplace, the issuing company could hold a proxy vote at the click of a few buttons. If the proxy vote is related to additional capital issuance, the general partners could give their current investors the option to participate at a discount to subsequent investors. Being able to more easily expand the capital size of a fund would offer significant cost savings for the general partners as opposed to closing out one fund after seven to 10 years and rolling it into a new fund.

The accumulation of these incremental improvements adds to overall efficiency and the availability of capital for early stage private companies. The implications are that more ideas, and ultimately more successes and more failures, would have a chance to rethink and improve the world we live in, rework how we interact with each other, and retool how businesses operate. Blockchain as a practical application within private capital raising is an incremental improvement, but one that is exponentially accumulative and, ultimately, redesigns the manner in which securities transactions are originated and settled.

Gavin Racz is director of business development at Liquidity Digital. He can be contacted by email: gavin@liquidity.digital.
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Gavin Racz

Liquidity Digital