Tokenization of Assets: Revolutionizing Private Equity Ownership Structures

Most of us are constantly looking ahead. We want to know, what is the next big thing? What does the future hold? Where are we headed?

Accredited investors are no different. They are constantly looking to the future. They want to know what the market will do in the future; what the next best investment vehicle might be; how government policies might change and impact business and the economy — and so much more.  

A major part of the future — for investors, investments, and for all of us — is technology. As technology continues to evolve and innovate, it is constantly changing the future of our everyday lives and how we do business. These changes are happening right now — at lightning speed.  

For private equity (PE) firms and funds, the new technology of tokenization of assets just may be revolutionizing private equity ownership structures. 

How Private Equity Funds Are Structured Currently

Before we can get to how tokenization is revolutionizing private equity ownership structures, we first need to understand how private equity ownership is currently structured. 

So let’s take a look.
Private equity funds are closed-end investment vehicles. That means that they are private offerings that are not publicly traded. PE funds are open only to accredited investors and “qualified clients.” PE funds generally only have a limited amount of time to raise capital for the fund from investors. Most PE fund investments are made in private companies (the “portfolio company”). Unlike other investments, PE investors can expect to hold their investments for up to 10 years while the fund finds a private company to purchase, buys it, runs it, and then sells it — hopefully at a profit.

The Jumpstart Our Business Startups Act (“JOBS Act “), signed into law in 2012, made it easier for small businesses and start-ups to raise capital to fund private investment opportunities. The JOBS Act led the Securities and Exchange Commission (SEC) to create several exemptions from the general rule that all securities must be registered with the SEC — notably, Rule 506(b) and Rule 506(c). Verifications of the accredited status of each investor remain an essential part of qualifying for an exemption under either Rule. 

For example, if an issuer wants to qualify for a securities registration exemption under Rule 506(b), the offer cannot be advertised or solicited, and only 35 non-accredited investors may participate. On the plus side, under Rule 506(b), an issuer can raise an unlimited amount of capital from an unlimited number of verified investors. For any investor wanting to participate in a PE opportunity, having an accredited investor certificate can be most helpful in proving one’s status as an accredited investor.

A PE fund is considered to be a separate legal entity, separate from the investors or managers of the fund. While there are several legal structures available to PE funds, currently the most typical fund structure used for PE funds is a Limited Partnership (LP). 

A limited partnership is, of course, a “partnership.” However, members of the LP have different roles and responsibilities.

A limited partnership is made up of:

• General partners, and 

• Limited partners 

In a PE fund, the General partner (or “GP” — there must be at least one) is frequently the manager of the fund. The Limited partner (“LP” — again, there must be at least one) is generally the investor(s).

The GP is responsible for the day-to-day running and management of the fund. GPs also have unlimited liability for the debts and obligations of the fund.

Limited partners (i.e., the investors) have limited liability for the fund’s debts and obligations. However, they also have very limited say in how the fund is operated. 

Since minimum investment requirements for PE funds can range from hundreds of thousands of dollars to several million, most PE funds are open only to high-net-worth individuals and institutional investors.

After holding their investment for typically 10 years or so, the limited partners get a return on their investment — minus the 20% of the profits that the firm keeps for itself — when the fund sells the portfolio company and winds up business. Each LP gets a share of the profits based on the amount of capital that individual LP invested in the fund.

With that basic background on private equity, let’s now turn to how modern technology — and tokenization in particular — is revolutionizing PE ownership structures.

Tokenization. What is it?

Digital tokenization began in 2001 as a means of protecting client credit card information. 

It now has several uses, one of which is the transformation of ownership rights in an asset (for example, artwork, a book, a song, etc.) into digital format. Practically anything that has value can be tokenized. 

By “tokenizing” an asset, creators can formulate a unit of value in that asset that is expressed by a token. This means that ownership interests in any asset (for example, property or ownership interest in a private equity fund) can be tokenized by issuing the asset on a blockchain in a digital token format. Once that occurs, the token represents the ownership interest in the underlying asset. The token (and thus one’s ownership rights in that asset) can then be traded or sold. 

For private equity, tokenization can convert PE funds into digital securities that can be traded. Tokens allow individual assets to be transformed into a digital representation of proof of ownership. In turn, this allows an asset to be more easily traded, exchanged, or sold. 

How Blockchain Technology is Changing the Face of Private Equity Ownership 

The interest in private equity investment has grown in recent years. The recent innovation of blockchain technology to “tokenize” private equity investments is expected to change the face of private equity ownership and increase PE participation exponentially.

Why?

Because blockchain technology has made it possible to “tokenize” private equity. In other words, using decentralized ledgers, blockchain technology allows the creation of a token which in turn will allow investors to have a fractional ownership in a private equity fund. 

Traditionally, because of the high cost of an initial investment, participation in private equity deals has been relegated only to high-net-worth individuals and institutional investors. The tokenization of private equity will change all that. Because blockchain technology has made the tokenization of PE possible, if employed, it will create far more diversification by opening up the pool of investors who can participate in PE funds.

The Impact of Tokenization on Private Equity

Tokenization brings several benefits to the traditional private equity landscape. 

Among them are:

Liquidity.

First, tokenization has the effect of making what is conventionally an illiquid investment (a private equity fund) — liquid. Traditionally, a PE investor cannot redeem, but must wait “for the funds to liquidate.” In other words, investors must wait until the portfolio company is sold before they will see a return on their investment. This long holding period (often 5 to 10 years or more) makes PE investments illiquid.

Tokenization of PE funds, however, is altering this traditional approach to PE investment. Because the token represents a fractionalized interest in the PE fund, it can be exchanged or traded on secondary markets. This allows investors far more liquidity. They can enter and exit the market more quickly. (A note of caution here: please keep in mind that this is general information only. There are always compliance issues that arise in these situations, so please consult with experienced securities counsel.) 

Investor Inclusion

Another benefit tokenization brings to the private equity landscape is that of investor diversification and inclusion. Because of the high cost of an initial investment in a traditional PE opportunity, historically, only high-net-worth individuals or institutional investors could participate in PE funds. 

Tokenization is revolutionizing that old paradigm as well. Because tokens represent a fractionalized interest in the fund, they are far less expensive than traditional PE investments. This means that investors with less capital can still participate in a PE investment opportunity — opening up the investor pool to a wider range of investors.

Unique Investment Opportunities

The tokenization of private equity could also create new investment opportunities. Because tokens allow fractionalized ownership, tokenization can make investing in niche markets or international funds more available to many investors. For those PE funds that adopt tokenization, it can make trading all over the world easier, less costly, and more efficient. 

Real Case Examples of Private Equity Tokens 

Not sure tokenization would work in the real world? 

Indeed, it does. 

Tokenization can be blockchain tokenization or non-blockchain tokenization. Without going into the details regarding the differences (for more information click here and here), suffice it to say that there are several different types of tokens and that tokens have had their successes and failures in several industries. For example, tokens have been used to allow investors to participate in opportunities or to raise initial capital (“Initial Coin Offerings” or “ICO”s) for a fund. Raising capital through ICOs began in 2013. Real world asset tokenization has been successful in areas such as real estate and health care.

To test its efficacy for private equity funds, Citigroup ran a proof-of-concept pilot test. The result was that  tokenizing private equity could completely change the market.

In addition to Citigroup’s pilot test, there is a real-world tokenization example applicable to the private equity market. 

Quadrant Token — In 2018, the U.S. company, Quadrant Biosciences, used tokens as part of its Initial Coin Offering (ICO) to raise capital. The company tokenized all of its equity in the form of a “Quadrant Token.” By diluting 17% of the equity and selling that through tokens priced at $1.25 per token, Quadrant Biosciences was able to raise over $13 million dollars.

The decentralized and inclusive approach to investing that tokenization offers is expected to continue to gain popularity as we move forward. Tokenization of private equity is a technology that is already changing the structure of private equity ownership. As the technology continues to evolve, experts agree that tokenization will revolutionize the private equity landscape. 

Tokenization and Regulatory Considerations

Tokenization of private equity may be exciting given its potential to completely alter the structure of PE ownership, but its implementation presents some significant legal and practical challenges.

The Securities and Exchange Commission (SEC) has stated that it believes that a token will be a security if it meets all the requirements of the Howey Test.

Finally, it is absolutely clear that this is an area that is being scrutinized and regulated by the SEC. For PE funds that are considering using tokens, it is critical to consult with legal and other professionals to take into consideration all business and legal requirements that may apply to tokenizing a PE fund. For example, fund managers that raise capital through the use of tokens (“Initial Coin Offerings”) will need to determine whether to use Rule 506(b) or 506(c) of Regulation D when issuing tokens. If using Rule 506(b), issuers must be aware of verifications of potential investors because only 35 participating investors can be non-accredited investors. 

Private equity is just one area of concern to both accredited investors and issuers. At VerifyInvestor.com we provide a fast, easy, and cost-effective method of compliance for companies seeking to verify their investors. At the same time, our platform shields companies from the potential risk of noncompliance and gives investors peace of mind that their information is confidential and protected.