How Blockchain Can Disrupt Traditional Funds by Providing Increased Liquidity for Partners
The explosive growth of technological innovation and exciting new startups in recent years has tremendously benefited the venture capital industry, powering US venture capital investment to a decade-long high in 2018. The space continues to grow, approaching investment levels not seen since the dot-com era. However, even as new technologies disrupt nearly every industry, the way funds manage their stakeholders hasn’t evolved much at all. Today — just like a decade ago — funds have two types of partners: Limited Partners (LP) who contribute capital and General Partners (GP) who actively manage the fund and invest with a defined investment strategy. The returns that the GPs realize are then passed back to the LPs, while GPs typically collect a management fee ranging in the 1-2% range. This is supplemented with carried interest that’s paid as a result of performance, and it can range anywhere from 15-30% — this is where the common “2 and 20” model comes from. That works great for GPs, but what about LPs?
Current Fund Pain Points
Contrary to the managing GPs, the interest of LPs in a fund are considered to be one of the most illiquid asset classes for investors. While the appreciation of the fund directly benefits LPs, their gains remain difficult to access due to restrictions placed on them. LPs are prohibited from selling interests in a fund throughout its duration and can only realize returns on investment in the event of a capital withdrawal such as a merger and acquisition or Initial Public Offering (IPO) — either of which could potentially take 5 - 10 years. With a such a long time horizon until investors actually realize their returns, this dated model can result in an increased opportunity cost for investors, especially in an industry like tech where the landscape is rapidly evolving. This is where blockchain technology can help.
The Evolved Future of Funds
The rise of blockchain technology has brought with it a number of innovations, one of which is the tokenization of assets. By leveraging blockchain technology, investors are able to more easily distribute, trade, and track ownership of different assets from stocks and commodities to intellectual property rights, and settle transactions in real time. The same concept can be applied to LP interests in a fund. In a fund of the future, LP interests will be tokenized and represented via tradeable tokens that can be resold immediately, rather than 5-10 years later. This is largely due to the emergence of blockchain technology that allows for the reallocation of equity with minimal impact on the fund itself. These LP tokens will be tradeable on a secondary market based on their Net Asset Value (NAV) meaning that LP investors won’t need to wait nearly a decade to realize their returns. Conversely, interested investors who didn’t have the opportunity to participate as LPs during the fund’s launch period will have access to gain interest of their own. And finally, because the transactions will be happening on the blockchain, investors can expect lower fees as there won’t be a need for a third party intermediary like with a traditional private placement sale. By shifting the entire investor management process to a digitized system, GPs can manage thousands of LPs as token holders who may not have otherwise been willing to invest in a potentially illiquid fund. In addition, fundraising for the launch of a new fund will be equally easy as managers gain access to a larger pool of investors online, helping to mitigate marketing costs.
Example: Tokenized VC Fund
Bob is a professional venture capitalist with over 10 years of experience investing in early-stage startups. His past endeavors have been so successful that he now wants to create a new fund of his own called “Bob Fund xxx.” Bob reaches out to Vanbex and decides to use Rocket to raise for his new fund where Vanbex will help him prepare a token fundraising activity that will be in the showcase section of the Rocket platform. Investors from across the world will be able to review his team profile, his previous investment performance, and the investment strategies he plans to implement for the new fund. After investors are interested, all of the legal paperwork, KYC/AML checks, fund deposits, and governance features are digitized and streamlined via the Rocket platform where the soon-to-be LPs will use cryptocurrencies, like stablecoins, to invest in Bob’s new fund. And just like that, investing in a new VC fund is as easy as shopping on Amazon. Rocket manages the entire process from the first issuance, thereby ensuring the fund remains fully compliant. One year later, Alice, an investor in Bob’s fund, wants to sell her LP interests and cash out. With this new future-fund, Alice’s LP interests are stored in the form of tokens so the process is simple. All she needs to do is to input a trade on Rocket’s built-in tokenized security trading platform, place a sell order at the going market rate (the equivalent NAV), and she’s successfully cashed out of the fund. Selling LP interests is as simple as selling stocks.
The Bottom Line
The tokenization of LP interests will bring secondary market liquidity to primary market returns and unlock an unprecedented number of advantages never before seen in VC and private equity. Beyond attracting more early investment, the new model also reduces pressure on GPs to chase shorter-term returns. With LPs being able to sell their interest whenever they please, fund managers can focus on longer-term investments with higher upside potential.