Private equity, venture capital, and other alternative investments have long lived comfortably behind the twin gates of Reg D and the Accredited Investor Rule. It’s time to equilibrate the neighborhood.
Tokenization refers to the process of issuing, storing, and moving an asset on the blockchain, thus allowing for efficient subdivision and streamlined transfers
Alternative investments are coming to the masses, with tokenization joining the vanguard. Far from fleeing to familiar comfort, however, wealth managers should be welcoming this tectonic shift, and fully embracing investors ready to pile in to these once closed-off asset classes. The tokenization of alternative assets will allow wealth managers to fully demonstrate their value-add by delivering previously inaccessible strategies, thoughtfully sizing and rebalancing those positions, and procuring institutional benefits to everyday clients. Democratization is here, and evolving wealth managers are poised to benefit mightily.
Let’s take, for example, a typical investor who engages a wealth manager to help diversify their portfolio. Consensus on the street is between 10-20% allocation to alternatives, so let’s call it 15%. While minimum investments in alternatives can soar (with many marquis funds closed completely), again let’s go for generic and use $500,000.
Under the current non-tokenized investment regime, in order for that one $500,000 investment to effectively diversify to 15%, our typical investor would have to have an investment portfolio with a value of over $3.3M. That represents a “diversification” of one fund to cover an entire alternatives allocation. Although some fund-of-funds claim this superpower, many clients and wealth managers may not find themselves so convinced.
Now envision that investor requesting a private equity fund, a real estate play, and a venture capital fund. Evenly split into 5/5/5, given the same minimum investments, that investor must now have a portfolio of $10M. Increasing diversification between funds continues to drive that portfolio number linearly higher, and the problems become exponentially harder when rebalancing comes into play.
Examine that same problem again, but apply tokenization. For an investment issued through an STO (securitized token offering), there is no minimum, as the tokens can be subdivided effectively to infinity. Working backwards from the Accredited Investor minimum net worth of $1M, a 15% diversification yields an initial investment of $150k. Split between the three aforementioned funds, the minimum initial requirements drop to $50k each—a much more attainable price tag.
After one year, imagine these three funds have grown from 5% each of the portfolio to 7%. The new net 21% alts allocation needs to be trimmed and redeployed. The problem is a Gordian Knot: unsolvable, except by chopping—and tokenization equips wealth managers with the sword. Each individual position is proportionally trimmed, and the client is rebalanced with surgical precision.
Finally, consider liquidity. Many alternatives sport lock-up periods and subscription and redemption windows, making it arduous to exactly time cash flows and exits. While the secondaries market does mitigate this to a point, at the end of the day, those transactions are still being affected as clunky whole units. This may not be a prescient concern for multi-billion-dollar institutional funds, but the typical investor would certainly find the process unwieldly.
By tokenizing these assets, any fund would become not just immediately liquid, but liquid in the right quantities, and liquid in a way in which both institutional and retail investors can access. It would be misleading to say that tokenization would solve all liquidity issues with private investments; one would still have to find a contra, but the benefits of divisibility mean owners, and their wealth mangers, are able to source from the entire investor universe, and size sales on a customized basis.
Nor are the benefits of secondaries — J curve mitigation, instant diversification, and transparency, to name a few — diminished by the use of tokenization. To the contrary, wealth managers can better articulate their value to clients by delivering these attributes in a bespoke way. These benefits, having proved elusive in the past, are now well within reach of the masses.
The alternative investments industry is at a crossroads. It’s clear which path will be taken, and it’s not the one which leads right back to the same old neighborhood, with the same old neighbors, and the same old rules. Inflection points always mean opportunity, and wealth managers stand privileged to benefit from acting as a much-needed conduit between technology, alternative investments, and clients itching for the opportunity to put money to work.