Blockchain is the “buzzword” of 2018, but does it have any real use and purpose in relation to private equity? Blockchain is growing in popularity across multiple industries, with new applications emerging. But in reality, what are the potential benefits for private equity managers in embracing this new technology?
First of all, it is important to understand how blockchain works in practice. It allows companies to record their transactions directly into a joint register with a number of permitted parties, and this in turn creates a highly secure, interlocking system of verifiable and enduring accounting records. In such a system, there is complete integrity of accounting records and fully traceable audit trails that greatly reduce the problem of human error and do not permit variation of the data.
Private equity is an area that has often seemed immune to technological advances, but this is set to change as blockchain and artificial intelligence begin to demonstrate their worth. Deloitte’s 2018 Global Blockchain Survey noted that while businesses were once exploring blockchain’s potential to streamline business processes, they are today beginning to create actual applications for use. The report also highlights that when it comes to more traditional businesses (such as those in the financial sector), the focus is mostly on applying blockchain solutions to the current business model. Deloitte notes that 74 percent of traditional businesses can envision practical use cases, but significantly fewer are implementing them. Still, more than 40 percent believe their organizations will adopt blockchain in the future.
When aligning blockchain technology with PE, some commentators argue that it has the ability to make workflows with multiple parties far more efficient and secure due to the unmatched data integrity. With more asset records being moved to blockchain-enabled systems, transferring ownership will not only be simpler and cheaper, but also far more secure. The knock-on effect should ultimately be lower fees for investors.
This is a huge potential benefit, since closing transactions is not only expensive but it can also be time-consuming. Private equity firms can avail of real opportunities to generate efficiencies in the underlying portfolio companies and reduce risks. Furthermore, there is a possibility that creating competitive advantages for the underlying portfolio assets will generate improved margins and increase exit multiples. To some extent, it can even change entire business models – in the financial services sector in particular.
So what success stories can be identified so far? Partners Group, one of Europe’s largest market investors, has launched a blockchain-based security protocol that aims to ensure data and transaction security online. The system facilitates the exchange of important documents with third parties. Right now it seems that most PE firms are working out where the opportunities reside.
Further potential uses include improved operational efficiencies through increased transparency, automated compliance and smoother data flows and transferring of funds. Payments can be verified, tracked, processed and distributed on the one blockchain that could reduce reliance on traditional banking. This could in turn reduce transaction times and costs. There is also real potential for initial coin offerings (ICOs) to bypass the traditional ways of funding.
Most recently, Telegram, an encrypted messaging app, raised a total of $1.7 billion after its second round of funding, making it the world’s largest initial coin offering to date. Telegram raised $850 million in March and $850 million in February, the British Virgin Islands-based firm reported, according to filings with the Securities and Exchange Commission. An additional use is the ability to raise funds in cryptocurrencies, which allows wider investor and market liquidity for investors if security tokens are offered.
If we look at the benefits of technology in private equity, then we really start to have a winning combination, despite some initial “switching costs.” First, when it comes to deal sourcing, one of the primary roles of a GP is to continuously scan the market and find opportunities. For example, a machine is able to review all financial statements of a certain group of companies and identify any opportunities. AI could identify new opportunities through other metrics, such as online media channels, which track online trending metrics (OTM), then track the record of previous shareholders and management to predict exit opportunities in future years.
Second, in the areas of deal evaluation, machines are very smart when it comes to quickly evaluating investment decisions. Using AI, models can be built fairly quickly to take away this effort, and the blockchain will ensure complete transparency and real-time reporting. AI will be able to analyze market data on a much more granular and reliable basis than a vendor due diligence team. AI can and will reshape how the entire PE industry is operating in the next 10 years, creating a new generation of investment firms.
Private equity is a traditional industry, and relationships and networks have formed the backbone of many firms’ and individuals’ successes. Therefore, it is understandable that the implementation of new technologies has been fairly slow compared to other financial services or sectors. However, looking at the use cases for blockchain and AI, the technology takes away some of the manual process and leaves the individuals involved with more time to focus on real life human relationships.
While the application of artificial intelligence and blockchain is fairly limited within the private equity industry at present, this is now changing. There has already been adoption of blockchain by private equity houses with apparent success. As firms continue to look for ways to differentiate their offer and maintain an edge over their competitors, these technologies will surely become more prevalent and will help private equity managers to make better investment decisions over the long term. Use of technology can deliver efficiencies that reduce costs (potentially for managers and administrators) resulting in better internal rates of return.
Stuart Pinnington is group funds client services leader at SGG.