The Rise of Blockchain-Based Funds:

NEU Blockchain Organization
11 min readApr 12, 2023

A New Era for Alternative Investments

Written by NEU Blockchain Alpha Research:

Katie Gjelaj, gjelaj.k@northeastern.edu

Owen Johnson, johnson.ow@northeastern.edu

Introduction

Private equity, venture capital, and other alternative investments have proven to be lucrative investments but have high entry barriers for investors. These investments require significant amounts of capital to be locked up for several years, and as a result, often only the wealthiest 1% of the population are able to invest in this space. Through the application of blockchain technology, investment companies can tokenize funds, moving them onto a blockchain. Financial firms can then offer investors the opportunity to engage in secure and transparent transactions and to invest in more liquid shares — shares that have lower minimum investment thresholds, lower transaction fees, and higher transaction speeds. In an age of new technologies, one can only wonder how these technologies will be adapted to the fields of high finance.

Before understanding how blockchain technology can be applied in the private equity and venture capital space, it is important to understand: What is private equity and venture capital, and how can Blockchain technology be applied to the PE/VC space?

What is Private Equity and Venture Capital?

Private equity (PE) refers to a form of investment in which investors pool their capital to acquire private companies or acquire public companies and take them private. PE firms typically invest in mature companies, which are past series A funding and have already established themselves in their respective industries. PE investors are typically investment firms or accredited investors — investors who meet certain financial criteria established by the Securities and Exchange Commission (SEC) in the United States. As PE is considered an alternative investment, PE investors often have their money tied up until the sale of their shares in the company occurs, through an initial public offering (IPO) or an acquisition by another company, which generally take place three to seven years after their investment. Private equity investment has overall increased in popularity, with as much as $1.1 trillion in private equity buyouts in 2021.

Venture capital (VC) is a type of PE financing that involves investing in small, early-stage companies in seed or series A funding, that are believed to have high growth potential in the long term. Like private equity, investment in venture capital is typically limited to institutions and individual investors with high net worth, who are required to commit significant capital for years. Investors may also offer support and expertise in areas such as management and technology.

How can Blockchain technology be applied to the PE/VC space?

Blockchain is a digital ledger technology that enables assets to be securely and transparently tracked and transferred across a business network. Blockchain can be used to create tokens that represent ownership of assets. In the case of PE and VC, the tokens can represent ownership of a fund or the underlying assets held by a fund. Shares in a tokenized fund — a fund on a blockchain — can be quickly traded at a low cost. This makes shares in a tokenized fund more liquid than those in a traditional fund and, consequently, more attractive.

An Introduction to Tokenized Funds:

Tokenized funds have the potential to cater to investors whose needs are not being met by the current financial landscape. Tokenized funds use digital ledger technology (DLT) to create a decentralized database that securely and transparently records transactions between multiple parties, promoting direct-to-market access.

According to an analysis conducted by The World Economic Forum, up to 10% of global GDP will be stored and transacted via DLT by 2025. By 2027, tokenized markets are predicted to be worth as much as $24 trillion. The World Economic Forum claims PE/VC, hedge funds, and real estate are “the alternative asset classes regarded as most likely to be the first to attract relevant levels of tokenization.”

Invictus Capital offers investment opportunities in the digital asset space and is an early adopter of tokenized funds. Invictus Capital offers a variety of blockchain-based investment products, one of which is the Crypto20, a tokenized index fund that tracks the top 20 cryptocurrencies by market capitalization. Invictus Capital also offers the Invictus Hyperion Fund, a tokenized venture capital fund that invests in blockchain-based startups. This fund provides early-stage financing to these companies and works closely with them in making business decisions. With its funds existing on a blockchain, this technology is at the core of Invictus Capital’s business efforts and success.

Currently, PE/VC funds require custom onboarding, asset managers, cash settlement accountants, custodians, and share creation teams, among other employees. These requirements create a high cost per investor, which encourages fund managers to decrease the number of investors in a fund and, consequently, increase the minimum investment threshold. With tokenized funds, many of the costs of funds can be digitized and, thus, minimized. On The Delphi Podcast, Matthew Finlayson, the Co-Founder of Invictus Capital, highlighted that moving a traditional fund onto a blockchain can result in an 80% cost saving.

Blockchain-based funds, when compared to traditional funds, allow for a broader range of investors to participate by lowering the minimum investment threshold. A blockchain-based VC fund with an equity value of $10,000,000 may have 5,000 investors investing $2,000 each. Traditionally, a VC fund would have 10–20 investors, each being required to invest $500,000 at minimum. A lower minimum investment breaks down the high capital entry barriers to PE and VC fund investment and opens investment opportunities to a larger pool of investors. Moreover, the minimum investment threshold, by increasing the number of qualified investors, enables fund managers to raise more capital. Individual investors are able to invest less capital, attracting a greater number of investors who can meet the minimum investment requirement.

In addition to lowering entry barriers for investors, blockchain-based funds offer other advantages over traditional funds, such as increased liquidity. The smaller investments in these funds make it easier to locate secondary buyers for those who want to sell their position. It would be more difficult for an investor to find someone willing to buy out their position if they have $500,000 invested as opposed to only $2,000. Moreover, traditional funds cannot compete with the fast verification speeds of smart contracts that are used in tokenized funds. Blockchain-based funds have an approximate one-hour liquidity window while traditional funds can take 4–5 days to liquify. Also, traditional PE/VC funds are often locked up for 5–7 years, preventing investors from adjusting their investment horizon, whereas blockchain funds avoid this lock-up period due to their capacity for liquidity.

Regulation Challenges Surrounding Tokenized Funds:

Regulation often follows innovation, and this applies to the case of moving investment funds onto blockchains. Thus, there is little regulation that is specific to tokenized funds. Companies must follow the same regulation that commands traditional funds. For instance, the Financial Conduct Authority (FCA), the regulator of the financial services industry in the UK, typically demands the same requirements from tokenized and traditional funds on their prospectuses, documents that detail the objectives and strategies of a fund. Furthermore, like traditional funds, tokenized funds generally require the same security checks, such as verifying investor identity — though the exact way in which these checks are to be conducted is often not specified.

However, since there is very little law that directly addresses tokenized funds, there is regulatory uncertainty in this area — a factor that deters many firms from becoming involved with tokenized funds. To resolve this issue, the FCA, like other regulatory authorities, has launched support programs to guide fintech companies to allow for innovation in a supervised and guided way. More specifically, the FCA has launched the Innovation Pathways support system, which guides companies involved in not only tokenized funds but also, robo-advice, open banking, cryptocurrency, AI/machine learning, P2P lending, and other fintech products. The Innovation Pathway provides both access to one on one discussions with officials and the opportunity to participate in a regulatory sandbox. While this legislation aids in the implementation of tokenized funds, such legislation is not customized to tokenized funds specifically, and though it can be applied to tokenized funds, it only addresses the implementation and use of such funds in a single country — limiting the use of cross border transactions.

Some legislation has been initiated on a larger geographical scale and directly addresses tokenized securities. The European Parliament and European Council, for example, have implemented new legislation, as of early 2023, that removes company market capitalization size restrictions, retail investor access limitations, and other constraints, all of which alleviate the legal burdens associated with tokenized funds.

Regulation has therefore prompted companies to create tokenized funds and build investor trust in these funds. Still, aside from legislation, there are several other factors that both companies and investors must consider when evaluating tokenized funds — including the process of getting a fund approved, encrypted, and sold onto a blockchain, the implementation and examination of cybersecurity measures, and the adoption of this type of investment by the general public.

Health Care Strategic Growth Fund II: A Tokenized Fund Offered by Investment Giant KKR

KKR & Co. is a US investment firm that manages over $400 billion in investments across several asset classes, including private equity, energy, infrastructure, real estate, credit, and hedge funds. In 2022, KKR made its Health Care Strategic Growth Fund II, which invests in innovative healthcare companies in North America and Europe, available on the Avalanche blockchain. Avalanche is an eco-friendly cryptocurrency and blockchain platform that competes with the more popular Ethereum blockchain. Offering a smart contract platform and near-instant transaction finality, Avalanche has allowed KKR to build an efficient and customized blockchain service for their fund to be invested through.

As part of the relocation of this fund onto a blockchain, KKR has initiated a partnership with Securitize Capital to aid in the onboarding of investors, KYC and AML verifications, and the issuance of tokenized assets. Securitize Capital is a digital asset management platform that is utilized by over 1.2 million investors and 3,000 businesses. Investors who wish to buy shares in this fund can do so on Avalanche through a tokenized fund feeder that is provided by Securitize. The tokenized fund feeder allows investors to purchase shares in the fund that are represented, traded, and recorded on the distributed ledger of the blockchain.

Traditional private funds are easily accessible to only large institutional investors and ultra-high-net-worth individual investors. The implementation of this fund onto a blockchain has increased the fund’s accessibility to individual investors and worked to resolve the accessibility limitations of investment in PE funds. Typically, the minimum investment requirement for individuals looking to buy shares in a similar fund is in the millions. While it is possible for investors to add a PE fund to their portfolio with a lower minimum investment requirement, the ability to take part in a traditional PE fund that is managed by a very reputable firm, such as KKR, at a low cost is rare. With a digital fund feeder, the minimum threshold of the KKR PE fund immediately dropped to $100,000. As the Head of Securitize Capital explains, through this partnership with KKR, “the tokenized fund we have developed is a significant breakthrough in unlocking investor access to private equity investments.” In addition to yielding lower investment minimums, the tokenization of this fund created enhanced recording processes, through the advanced digitization of investor onboarding paperwork and the immutable transactions of a tokenized fund. Furthermore, through high transaction speeds, low-cost fees for transactions, and the diminished need for intermediary parties, the tokenized shares of the fund also have increased liquidity, when compared to shares in a traditional fund.

While the large firms who have put the PE funds they manage onto a blockchain are few and far between, KKR’s initiative to do so and success upon doing so will pave the way for other reputable firms to offer tokenized funds. The transition of the Health Care Strategic Growth Fund II fund onto a blockchain is building the bridge between paper-based and digital financial products. As the CEO of Securitize comments, “this new fund is an important step toward democratizing access to private equity investments by delivering more efficient access to institutional-quality products.” Though the implementation of funds onto a blockchain would drag traditional financial officers into new areas of technology that they have not yet experienced, the benefits of doing so will likely prompt many financial institutions to follow in the footsteps of KKR.

Why does this matter?

Looking forward, blockchain technology is present in the alternative investment space in ways besides tokenizing funds. Some investment companies are simply investing in companies whose business model is centered around blockchain technology — adding these companies to the portfolio of a traditional fund.

For example, Block Media Labs is a venture capital firm that specializes in investing in Web3-based operations. Block Media Labs has an early-stage investment fund, called “Seed Capital,” that invests in innovative Web3 projects such as metaverse video games, digital tokens, NFT collections, and other Web3 innovations. They mention that they “believe in projects that will shape the future of Web3. Whether that be a metaverse, token, NFT collection, or some new innovation, Block Media Labs can help you on your journey to make it a reality”.

Blockchain technology is still in its early stages of development, with many new applications still being explored. As blockchain technology gains popularity and the trust of the public, more PE/VC will begin investing in companies with this technology at their core. However, there is an important difference in the shift from funds investing in companies that use blockchain technology and investment funds using blockchain technology themselves to tokenize their funds. Now, financial services companies are beginning to put blockchain technology at the core of their own business model, improving the way in which the industry traditionally operates.

Blockchain technology has the potential to revolutionize the private equity and venture capital industry. Tokenized funds, which are fully blockchain-based, offer advantages such as direct-to-market access, lower minimum investment, and the ability to trade and sell shares using smart contracts. These funds can cater to a broader range of investors and lower the high costs associated with traditional funds. Additionally, blockchain technology provides improved transparency and traceability, giving private equity and venture capital firms better visibility into the health and progress of their portfolio companies.

As the adoption of blockchain technology continues to grow, more private equity and venture capital firms likely will begin to explore the use of tokenized funds and other blockchain-based solutions to improve their operations and better serve their investors.

Written by NEU Blockchain Alpha Research:

Katie Gjelaj, Owen Johnson

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NEU Blockchain Organization

A student-led organization dedicated to advancing blockchain education, development, and research.