Cryptocurrency: looking to the future

Private equity remains cautious about exposure to cryptocurrency and blockchain, but as regulators grow to understand the technology, more managers could get on board.

Cryptocurrencies and the technology they are traded on are causing a stir. The most well-known are bitcoin, a cryptocurrency, and blockchain, a distributed ledger technology (DLT), both commercially introduced in 2008.

Blockchain’s capabilities are being championed by financial institutions, and IBM is currently developing the technology for a consortium of banks including HSBC, Deutsche Bank and UniCredit.

Meanwhile, almost $1.3 billion has been raised in cryptocurrency offerings, knowns as initial coin offerings, since the start of 2017, and the currencies are considered a financial revolution by some.

But should the private equity industry follow their lead? pfm spoke with four lawyers working on cryptocurrency fundraises about the viability of the industry entering the cryptocurrency and DLT space, the regulatory issues and where private equity managers should look to find the best opportunities to get in on the action.

Chain reaction
There are three main ways in which private equity can get on board with the digital revolution, with an investment in a DLT developer perhaps being the gateway. Technology private equity fund SICAV, managed by Accuro Fund Solutions, recently took this route with its acquisition of blockchain specialist nChain and a group of affiliated companies.

“Private equity may be interested in backing the firms that are exploiting [DLT],” says Nicholas Thompsell, a partner at European law firm Fieldfisher. “I think people are focusing on the DLT to make processes more efficient and gain some competitive advantage there. Companies that can exploit that have got some advantage, and would be of interest to private equity.”

A second point of access is to adopt DLT technology at firm level to improve operational efficiency.

In February, Geneva-based Unigestion became the first European private equity firm to manage a fund administered on a blockchain. The technology records all transactions for the life cycle of the fund – from the initial buying of a stake to the distributions at the end of its life. Future audits are helped as all transactions and documents are captured in real time, while the need to collect reams of documentation is removed as it is all accessible through the DLT.

Secondary purchases could also lend themselves to the use of DLT, in recording the performance of an existing portfolio. “It could be used to create a more accessible and tradeable market for fund stakes,” Thompsell says.

Out of the blocks
Once they have the technology in place, firms may be more inclined to start dealing in digital currencies – the third way in which private equity firms can embrace this particular digital development.

The most recent industry foray into cryptocurrency saw fundraising go digital. In August, Finles Capital Management partnered with a Singaporean cryptocurrency company to raise €100 million of the €500 million targeted for its Lowestoft Equities Fund in digital currency FundCoin. It did this via an ICO, which closed in September.

This was the second ICO reported by pfm. In February, Intellysis Capital launched Mainstreet Investment targeting $25 million in cryptocurrency commitments.

The venture was backed by Jason Granger, formerly of private real estate manager Granger Trust, and bitcoin expert Charlie Shrem, co-founder of now-defunct BitInstant which allowed users to rapidly pay traditional funds to bitcoin exchanges.

It’s not just fundraising that can be digitized. Increased uptake in DLT may empower firms to have an ICO-driven exit. But Thompsell cautions firms investing in the technology to consider whether they see themselves attempting an ICO-driven exit in the future, and if so to think about whether the fund terms allow for this type of exit.
Rob Mailer, partner at Morrison Foerster, adds: “Because of the fluidity and changing nature of the sector, managers will need to have a wide enough investment strategy allowing for some investment in or exposure to cryptocurrency without being tied in the documents to a very specific form of words.”

Barrier to entry
However, despite a few firms testing the water, there is yet to be widespread interest in embracing digital currencies and DLT. One barrier is the uncertain regulation. The US Securities and Exchange Commission says a cryptocurrency could be considered a security “depending on the circumstances.”

Elsewhere, the Singapore Monetary Authority initially said digital tokens were not securities, prompting a number of ICOs, before backtracking and adding that, again depending on the circumstances, an ICO may be subject to regulation.

Meanwhile, the People’s Bank of China, the country’s banking and securities regulator, has gone even further, implementing a complete ban on ICOs and Korea’s Financial Services Commission has set up a task force to monitor cryptocurrency trading within its borders. Legal barriers aside, however, the results of experiments by the venture capitalists currently examining cryptocurrencies and blockchain in the West may encourage more traditional fund managers to take a closer look.

“In the UK, the market is slowly maturing, though it’s not quite mainstream and the majority of investors remain individuals, enterprise investment scheme funds over private equity,” says Tim Bird, a partner at Fieldfisher.

“In Paris, we’ve advised on two ICOs and in London there is interest from venture capitalists who want to raise cryptocurrency funds alongside more vanilla investments.”
Private equity has slowly adopted new technology in the mid and back office, but DLT could offer further innovation, particularly for compliance executives.

Cryptocurrencies remain an “untested flavor of the month,” but through professionalization, they could become a credible asset for private equity to back and invest in.