New kid on the block

While the private equity industry is keen to snap up companies in the tech sector, it is notoriously slow to adopt new technology. Almost two-thirds of participants in a recent EY survey said data management was an issue, and that the industry “lags behind” other financial sectors.

But two private equity funds have bucked the trend this year, by adopting blockchain technology to administer their funds. First up is Geneva-based Unigestion, whose blockchain platform was built as a collaboration between fund administrator Northern Trust and software developer IBM.

In this case, the blockchain is a distributed ledger – a list of transactions replicated across a number of computers rather than being stored on a central server. The blockchain is deployed on a high-security cloud, with each stakeholder – including investors, fund managers and administrators – accessing the information via secured means.

“Private equity transactions are complicated, involving numerous investors and a large number of documents to be transferred to stakeholders. The blockchain can automate this process and remove the paper trail,” Justin Chapman, global head of market advocacy and innovation research at Northern Trust, tells pfm.

The technology records all transactions for the life cycle of the fund. This means everything from the initial buying of a stakes to distributions at the expiry of the fund can be done on the blockchain, and the associated documentation stored alongside it.

“Actions on the blockchain are immutable; changes are irrevocable. There is a single record [of all transactions and activity] visible by all with access and appropriate permissions. Each user can view their own activities and where permissions allow, those of others,” Chapman says.

The platform also improves the interplay between all parties involved in the administration and operation of the fund, reducing inefficiencies. In the case of the Northern Trust platform, which administers a Guernsey-domiciled Unigestion fund, the local regulator was engaged throughout the development of the platform, and the blockchain network was designed to support the local regulatory environment. The regulator can also access the blockchain when needed, giving them full transparency on the fund’s activity.

“As all transactions and documentation are captured in real-time, this in the future help audits. Traditionally, an auditor would have to collect all the data and the associated documents, but on the blockchain they could access the most up-to-date information available, along with all the necessary legal documents. It would make things easier for all parties,” Chapman says.

Intellisys Capital launched its blockchain-administered fund, Mainstreet Investment, on February 27. Unlike the Unigestion fund, Mainstreet Investment will raise capital by distributing a blockchain-based token, which can be bought using any one of 29 digital currencies, including bitcoin.

These tokens can be bought by anyone with a digital currency account, and unlike a traditional private equity fund, there is no minimum commitment, and investors can move in and out of the fund freely, with a minimum holding period of 60 days.
“A token represents direct ownership of the underlying asset, so investors get to share in profits made by the companies. Smart contracts based on the [blockchain] network trigger payouts of those profits through distributions,” Intellisys CEO Jason Granger says.

Blockchain has several capabilities for private equity, Granger says, notably allowing it to better monitor and manage its own assets.
“It can facilitate payment, settlement and remove double spend issues and prevent fraud,” he says.
Despite the emerging advantages of blockchain for private fund managers, adopting the technology is a big undertaking, and a decision to do so shouldn’t be taken lightly.
“There were multiple components to the solution and we had to consider the jurisdictional regulatory requirements; this is why we kept the regulator and government up to date throughout its development. We had to make sure we met all the fund’s legal requirements, too,” Chapman says.

The complexity of building a blockchain, a technology still in its infancy, is one reason potential adoptees should be cautious, says Gregory Nowak, partner at law firm Pepper Hamilton. Firms should be wary about investing in a technology whose full benefits are not yet fully understood, and whose potential is not yet fully established.
“We’re years away from understanding how the blockchain can be fully mobilized. It is a tool, but not the be-all and end-all, so I’d be wary of spending money on building technology unless you’re sure it will be of direct benefit,” he says.

Regulation is a big barrier to entry, he adds, as current securities laws were designed 70 or 80 years ago for different markets and circumstances.

“Blockchain could be adopted to provide a market for and to trade illiquid securities. Currently an exchange is used for price discovery, matching buyers and sellers, and facilitating the transfer of assets by assuring delivery of the purchased asset and payment for it,” Nowak says.

“In the future, the blockchain could replace an exchange in certain circumstances because it would fill all three functions (with a data repository acting as the verifier instead of a distributed ledger). Theoretically it’s possible, but in the US at least, we’re still dealing with the distinction of private securities and public securities; we’re years away from the regulatory changes needed for the blockchain to emerge as a viable alternative.”

But he added that while widespread full adoption of blockchain technology was a long way off, there are processes which the blockchain, in its current form, can streamline for private equity firms, including investment decision making, and investor subscription.
“Target companies can put all their information on either a public or private blockchain and the investment decision could be made using the blockchain; it’s less cumbersome than a traditional data room,” Nowak says.

Investor subscription could also be done much more efficiently on a blockchain, removing the need for 80-plus pages of documents.

Emerging markets are likely to be at the forefront of adoption, he adds, leapfrogging established markets and building their own modern market infrastructure, rather than replicating that in mature markets, Nowak says.

“We saw emerging markets bypassing wired telephony and moving straight into mobile technology, so it could happen with the blockchain, too. Those countries without markets and regulatory structures in place could establish international blocks for reporting their financials.”

Nobody is there yet, but it’s a trend that could emerge over the next five years, he adds.