Asset Tokenization will, no doubt, be at the heart of the wealth management industry sooner or later, revolutionizing fundraising, investments and unlocking new capital. It is the process of converting real-world assets into digital tokens on a blockchain network, whether private or public. These tokens represent ownership/other rights to, usually, illiquid and/or otherwise inaccessible assets, and can be traded, bought, and sold just like any other financial instrument.
For private funds, this solves a number of issues, from the reduction of transaction costs through the automation of certain intermediaries' services (such as authentication, settlement, book-keeping and custody) to the improvement of transparency and real-time reporting of fund data. While many hedge funds have already recognized these benefits, the biggest selling point for private equity and venture capital funds, in particular, remains increased liquidity, provided that certain structural and operational hurdles can be overcome, including the valuation of the fund tokens.
The question of liquidity is at the core of the distinction between closed-end and open-end funds and the main key to the valuation conundrum. While all private funds will need to carefully consider their valuation methods, closed-end funds such as private equity and venture capital fund will have additional layers of difficulty to face.
Closed-end funds and open-end funds
Typically, closed-end funds often invest in equity or debt instruments in private companies, which are illiquid in nature, with a longer time horizon, usually 10 to 12 years or longer in today's economy, as they focus on the growth and development of portfolio companies and rely on specific exit strategies, such as IPOs, mergers, or acquisitions, to realize returns for their investors. Moreover, closed-end funds have a committed capital structure whereby the fund is able to draw down from fixed pool capital to execute its investment strategy and use significant leverage, without having to worry about any unforeseen redemptions during the lifecycle of the fund, while investments are yet to ripen. Here, tokenization would facilitate investors getting in and out of their investment, as they are able to buy and sell tokens representing limited partnership interests, at any moment and in fraction or in whole, as long as they meet the qualification requirements set by the fund in compliance with private placement regulations. The issue here is the necessity to have regular and compliant valuations for highly challenging and complex underlying assets to value, while taking into account the fluctuation of the offer and demand on tokens. For private funds, this is not such an easy task especially when having to comply with increased regulatory scrutiny.
In contrast, the open-end fund structure is more suitable for hedge funds due to their inherent flexibility and liquidity. Hedge funds invest in a variety of publicly traded securities, often with shorter investment horizons and more frequent trading strategies. Generally, the net asset value (NAV) per share of such funds can be calculated more frequently and accurately (despite meaningful complexities) given the availability of the fair market value of the underlying assets at the end of each trading day. This allows investors to continuously or semi-continuously buy and sell shares directly from the fund at the NAV at the end of the trading day, subject to certain redemption fees or minimum holding periods. While tokenization can fit more seamlessly in this structure, valuation of hedge fund tokens presents its own set of challenges, token value must not only reflect the NAV per share of the hedge fund, the offer and demand of the token, but must take into account equalisation, which can create variable pricing for each token whether issued by the fund or resold by an existing member.
Valuation - practical and regulatory perspectives
Valuation of private funds, such as private equity funds or hedge funds, is a critical process that involves determining the fair value of the fund's assets. Accurate and reliable valuation is important for various reasons, including investor reporting, performance measurement, and compliance with regulatory requirements.
Private funds that follow IFRS accounting standards must comply with specific valuation requirements outlined in IFRS 13 - Fair Value Measurement, and those subject to US GAAP must adhere to the valuation guidance provided in the FASB Accounting Standards Codification Topic 820 - Fair Value Measurement, each of which establishes the principles and disclosures requirements related to fair value measurements. Furthermore, Private Equity and Venture Capital funds may need to also adhere to the International Private Equity and Venture Capital Valuation (IPEV) Guidelines.
In the United States, private funds that fall under the regulatory oversight of the SEC must comply with specific valuation requirements. The SEC provides guidelines in various regulations, including the Investment Advisers Act and the Form ADV, which outline the disclosure obligations, conflicts of interest, and reporting requirements related to valuations. In Europe, private funds may be subject to regulations and directives issued by ESMA, including the Alternative Investment Fund Managers Directive (AIFMD). These regulations establish guidelines on valuation principles, procedures, and reporting obligations for alternative investment funds (AIFs) within the European Union.
The complexity and novelty of tokenization would not excuse a lack of discipline in the valuation methodology or disclosures, if anything the fact that it creates a larger, more frequent secondary sale market, might put a private fund under more scrutiny , similar to that of a publicly traded fund, even when it complies with private placement rules.
Valuation of underlying assets
Unlike publicly traded securities that have readily available market prices, private equity and venture capital investments involve assets that are not as easily valued due to their illiquidity and lack of observable market data. Determining the fair value of these investments, in the absence of benchmark, requires more extensive analysis and reliance on subjective assessments.
Due to their extended time horizon, private equity and venture capital funds' investments may undergo changes, such as some companies in the portfolio going public or merging with others, or the fund holding shares of publicly traded companies for an extended duration. Moreover, a startup company acquired by the fund may evolve into a mature company operating within a competitive industry landscape. Additionally, if a fund invests in mezzanine debt, it may end up owning a significant portion of a portfolio company's equity following a debt restructuring. Therefore, it is crucial to adopt appropriate and consistent valuation approaches and techniques tailored to each specific investment. It is erroneous to assume that the nature of the fund or its mandate should restrict the range of valuation methods employed.
In traditional closed-end funds, the same challenges are faced, however, due the time horizon of the fund, the asset manager's priority is to reduce the impact of market volatility on the investment portfolio, rather than strictly reflecting current market conditions (as the exit valuation is what truly matters), they aim to avoid overvaluing their investments during favorable periods or undervaluing them during challenging times. In a tokenized fund, valuations during the fund's lifecycle need to not only be more frequent but require a higher level of accuracy due the higher liquidity of the interests in the fund.
Tokenomics
Tokenomics refers to the economic principles and mechanisms governing the tokenized fund. It encompasses the design, distribution, and management of the tokens associated with the fund, as well as the underlying economic incentives and dynamics. Such market dynamics, as small or large as it can be, will influence the value and price dynamics of the fund's tokens, through factors such as supply and demand, token utility, market sentiment, and external market conditions. Tokenomics may include mechanisms to stabilize token prices, such as price floors or ceilings, token buybacks, or the introduction of economic incentives to encourage token holding or participation.
The issue of equalisation.
Equalisation is an accounting method designed to ensure that both the investment manager and the investors are appropriately compensated based on their respective contributions and returns. It ensures that each investor only pays the incentive fee based on their respective uplift or increase in the value of their investments, rather than being charged based on the overall fund's performance.
To illustrate this, consider an example where an investor purchases a share in a fund for $100. As the NAV per share rises to $110, the investor is required to pay an incentive fee of $2, representing a 2% share of the $10 profit. However, if the NAV per share falls back to $100 and a second investor enters the fund, they would only be obligated to pay an incentive fee once the NAV exceeds $110. In this scenario, the second investor benefits from a "free ride" by not having to pay an incentive fee when the fund's value increases from $100 to $110, while the original investor does not receive the same benefit. Another reason for equalisation is to address the "claw back" scenario, this pertains to the accumulation of an incentive fee as the fund's value increases. If new investors join the fund and subsequently the value of the fund declines, the previously accrued incentive fee is reversed, benefiting all investors in the fund. This means that even though the new investors have not yet incurred the cost of the incentive fee, they still receive the benefit of the reversal when the fund's value decreases.
Tokenized funds often involve secondary market trading of tokens. This can create challenges in maintaining equalisation, as token holders may buy or sell tokens at different prices and at different times, while equalisation typically involves the distribution of profits and losses at regular intervals. Some token holders may buy tokens just before a significant increase in the fund's value, while others may sell tokens at a lower price, determining the appropriate time to calculate and distribute profits can be challenging, as it needs to account for the varying trading activities.
Moreover, tokenized funds rely on smart contracts to automate certain processes, including equalisation calculations and distributions. Ensuring the accuracy and reliability of smart contracts is crucial, as any errors or vulnerabilities in the code could lead to inaccurate equalisation calculations. Thorough testing and auditing of smart contracts are necessary to mitigate potential risks.
To overcome these challenges, fund managers may consider implementing smart contracts that automate the tracking, calculation, and distribution of equalisation. They may, for example, track the individual tokens held by investors, including information related to the purchase price, timing of acquisition, and subsequent sales, allowing for a more precise calculation of individual investors' contributions and returns. Equalisation can then be determined based on the specific token transactions, considering the impact of secondary sales. Additionally, fund managers should establish clear policies and procedures that outline the equalisation process, including guidelines for valuation, timing of profit distributions, if any, and ensure that the methodology used for equalisation is well-defined, consistently applied, and clearly communicated to the investors.
Tokenization offers revolutionary solutions to the wealth management industry, however, the trust of the public, and perhaps the future of decentralized finance as a whole, will be built on carefully considering and solving issues pertaining to token valuation, among many others.
Sara Mana, Esq
Managing Lawyer, Moorinvest Counsel
New York Lawyer | England & Wales Solicitor