Bachelor of Economics and Business Specialization: Business Administration
How will blockchain enabled tokenization change
private equity markets?
BSc Thesis by Dominique Bos 10764410 Supervisor: Willem Dorresteijn Amsterdam, 26th of June 2018Statement of originality
This document is written by Dominique Bos, who declares to take full responsibility for the contents of this document. I declare that the text and work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Dominique Bos 26th of June, 2018
Table of contents
Statement of originality ………. 2 Abstract ………. 5 Chapter 1 - Introduction ………. 4 Chapter 2 - Literature review 2.1 Blockchain technology and asset tokenization ……… 9 2.1.1: Blockchain technology………. 9 2.1.2: Blockchain enabled asset tokenization………. 10 2.2 Private equity and the relevance of blockchain for this market………... 11 2.2.1: What is private equity? ……… 11 2.2.2: How blockchain enabled tokenization can affect private equity ………... 13 2.3 Conceptual model ……….………. 14 Chapter 3 - Methodology 3.1 Research design …...……….. 16 3.1.1: Approach ...………. 16 3.1.2: Selection of literature ...……… 17 3.1.3: Selection of interview subjects ...………. 17 3.2 Data collection …...………. 18 3.2.1: Collection of literature ...………. 18 3.2.2: Conducting of interviews ...………. 19 3.3 Data analysis …...………. 19 3.3.1: Analysis of literature ...………..19 3.3.2: Analysis of interviews ...……… 19
Chapter 4 - Results 4.1 Analysis of the pre-blockchain private equity market ……….. 20 4.1.1: Actors on the private equity market and their activities ……… 20 4.1.2: Main attributes of private equity market and its mechanisms explained.… 21 4.2 Blockchain technology and asset tokenization……….. 27 4.2.1: Blockchain technology……….. 27 4.2.2: Blockchain enabled asset tokenization ……… 29 4.3 The effects of blockchain enabled tokenization on private equity ………. 34 4.3.1: Influence of tokenization on the attributes of the private equity market ….. 34 4.3.2: Influence of tokenization on the actors on the private equity market and their activities ……….. 39 4.4 Engagement of companies in newly offered options through blockchain enabled tokenization .………. 43 4.4.1: Interview analysis ……….. 43 4.4.2: Interview results ………. 45 4.4.3: Interview results in conclusion ……… 49 Chapter 5 - Discussion 5.1 Research question answered and evaluation of results ………... 51 5.2 Contribution ……….. 53 Chapter 6 - Conclusion 6.1 Summary of results ……….……….. 54 6.2 Limitations ………. 54 6.3 Recommendations ………. 55 6.4 Final note ……… 55 Bibliography………..………. 56
Abstract
The aim of this paper is to create an understanding of how the innovative blockchain technology with possibilities for tokenization can cause change in the private equity market. This is an exploratory research in which two types of qualitative research are conducted, a literature study and semi-structured interviews, of which results are combined. Based on this approach, new propositions are created regarding changes on the private equity market, both regarding its attributes and actors, as a consequence of blockchain technology and tokenization. The findings show that private equity can become a far more liquid, less risky, more valuable, more transparent, and better accessible market through tokenization, with a changing need for activities of intermediaries and new opportunities for actors. Many uncertainties, however, are related to these developments. For academic purposes, this study is an addition to the very few studies existing regarding blockchain technology and the private equity market. For practice, findings of this study can be of help for parties on or related to the private equity market for understanding how and what kind of developments blockchain enabled tokenization can cause on this market. This research will contribute to our understanding of how private equity, one of the biggest asset classes in the world, will change through blockchain enabled tokenization.
Chapter 1 - Introduction “The best way to predict your future is to create it.” ― Abraham Lincoln In Europe alone, private equity was a €640 billion market in 2017 (European Private Equity Activity Report, 2017). One broad definition that is commonly agreed upon is that a private equity investment is ‘any equity investment in a company which is not quoted on a stock exchange’ (Fraser-Sampson, 2011). Modern private equity and its subset venture capital have been around since the 1940s. Since it has evolved in many different aspects, becoming more important both strategically and financially (Caselli & Negri, 2018). Private equity has an important role in financing and fostering innovative firms, and the reallocation of capital to more productive sectors of the economy (Ljungqvist & Richardson, 2003). The private equity market consists of investors, intermediaries and issuing companies, and is characterized by investments that are relatively illiquid, high in risk, inaccessible for many people, and non-transparent (Caselli & Negri, 2018). In 2009 a new technology has been introduced that has the potential to have a far-reaching impact on the private equity market, already having started to do so: blockchain technology. Blockchain technology was first introduced in 2009 as the technology underlying the cryptocurrency Bitcoin but has since shown to be able to have a significant impact itself (Tapscott & Tapscott, 2016). This is the case, since it is possible to use blockchain technology for other areas than cryptocurrencies (Diedrich, 2016), which significantly expands its disruptive potential. The revolutionary potential of blockchain technology is even compared to that of the Internet (Swan, 2015). Nakamoto (2008) defines a blockchain as “a distributed ledger, managed by a decentralized peer-to-peer network”. Blockchain technology combines mathematical cryptography, open source software, computer networks, and incentive mechanisms, enabling value to be reliably transferred between two untrusting, distant parties, without the need for a trusted intermediary, for the first time in history (Davidson, De Filippi & Potts, 2016). On a
monitored, and transacted globally in a decentralized and disintermediated manner (Swan, 2015). The tokenization of private equity can have enormous consequences especially for the private equity market, since many of the attributes of its investments, such as relative illiquidity, high risk, inaccessibility, and non-transparency, can be strongly influenced by tokenization and cause changes in the market. Blockchain allows for minimal transaction costs for trading tokens, enabling smaller investments to be traded in an economically feasible way (Catalini & Gans, 2016). Both these minimal transaction costs and possibilities for the trade of smaller investments significantly increase liquidity of tokenized assets (Gerhold et al., 2014). This higher liquidity can lead to an increased value of private equity that is tokenized, called a liquidity premium, which for example could have caused a 10% increase in value to the €640 billion private equity market in Europe of 2017, meaning an added value of €64 billion by tokenization only in Europe. Furthermore, with the tokenization of private equity possibilities for smaller, tradable investments would provide opportunities for further diversification in a portfolio, lowering risk associated with private equity investments (Amit & Livnat, 1988). These smaller minimum investments make the private equity market also way more accessible for many people, effectively democratizing the private equity market (Preston, 2018). Lastly, transparency in the private equity market can be increased by tokenization since it creates opportunities for the auditing and monitoring of transactions made on the public ledger of a blockchain (Sahdev, 2017). Because so many main attributes of the private equity market can be influenced by the possibility for blockchain enabled tokenization, it is especially interesting to research the changes this technology can cause and is already causing in this particular market. This is why the research question for this thesis is: “How will blockchain enabled tokenization change private equity?” Despite blockchain technology increasingly being a subject of research, not much is known about its influence on private equity. This study can expand knowledge on the topic and contribute to academia. This study is also relevant for practice, since a change in the private equity market can have an impact on many people active on or related to
the private equity market, for which understanding these developments is crucial. This is a qualitative study using two qualitative research methods, a literature study and two interviews, to research this question from multiple dimensions and provide most up-to-date insights through the interviews. This paper proceeds as follows: the next section, chapter two, is a literature review containing relevant literature and its interrelation. Thereafter, the used methodology is described in chapter three. Subsequently, in chapter four, both results of the literature study and of the conducted interviews are presented. Furthermore, chapter five contains a discussion of the obtained results and lastly, chapter six concludes.
Chapter 2 - Literature review
Different categories of existing literature are relevant to the subject of this study: the influence blockchain enabled tokenization will have on private equity markets. In this chapter this literature is discussed. Firstly, publications on blockchain and asset tokenization are described, identifying its main effects on assets. Subsequently, publications on the private equity market and the influence of blockchain enabled tokenization on this market are reviewed. Lastly, the conceptual model is presented, describing the relationships between the different constructs of this study. 2.1: Blockchain technology and asset tokenization 2.1.1: Blockchain technology Nakamoto (2008) defines a blockchain as “a distributed ledger, managed by a decentralized peer-to-peer network”. This means that at their core, blockchains are decentralized databases maintained by a network of computers. Blockchain was first introduced in a white paper in 2008 by Satoshi Nakamoto as the technology underlying the Bitcoin cryptocurrency, the first global and decentralized digital currency. Since, the technology itself has increasingly become a subject of research. Blockchain has a wide range of applications, among which in the economic, political, social and scientific domain (Swan, 2015), potentially disrupting existing businesses and creating new industries. Swan (2015) writes that the blockchain technology allows for “the disintermediation and decentralization of all transactions of any type between all parties on a global basis”. Next to that, Swan writes that blockchain has “the potential for reconfiguring all human activity as pervasively as did the Web”. In a blockchain, blocks of information are linked together in a chain structure, validated by a peer-to-peer network and cryptographically secured (Davidson, De Filippi & Potts, 2016). This way the information on a blockchain becomes irreversible, permanent, verifiable, and secure without a need for a trusted third party. The information on a blockchain is hardened against tampering and revision. The big innovation of this technology is that in this open network participants do not need to know or trust each other in order to safely interact. Everything of value can be recorded on a blockchain, including for example equities,
titles and contracts. Applications can run atop of a blockchain creating more possibilities. Important applications are smart contracts, contracts that self-execute the actions agreed upon between two or multiple parties (Swan, 2015); multi-signature transactions, transactions that require consent of multiple parties to be executed (Omohundro, 2014); and smart properties, digital ownership of tangible and intangible assets that can be controlled via smart contracts and tracked or exchanged on the blockchain (Crosby, Pattanayak, Verma & Kalyanaraman, 2016). 2.1.2: Blockchain enabled asset tokenization On a blockchain a wide range of scarce asset, both tangible and intangible, can be recorded. Scarce assets that can be represented among others are currencies, securities, gift certificates and properties (Buterin, 2014b). This can be done by correlating the rights of ownership to a blockchain-backed token. This process of representing an asset online with a token on top of a blockchain is called tokenization (Sahdev, 2017). Tokens on a blockchain can be recorded, tracked, monitored, and transacted globally in a decentralized and disintermediated manner (Swan, 2015), potentially turning the world into a giant stock market. Not many scientific publications on blockchain enabled asset tokenization exist yet, since blockchain technology has only been used for around ten years as of this writing. Next to that, the Ethereum blockchain, that has been widely used for the tokenization of assets, was only released in 2015. However, multiple effects tokenization has on assets are described in the literature. Blockchain asset tokens are scarce, global, liquid, and tradable, which makes them appealing to global investors (Chen, 2017). Tokenization enhances liquidity of ownership thus investment of assets, since blockchain allows for disintermediation which lowers transaction costs (Catalini & Gans, 2016). This enables economically feasible trade of smaller investments. Both these lower transaction costs and possibilities for smaller investments increase liquidity (Gerhold et al., 2014). Next to that, tokenization leads to lower risk of investment in assets, since smaller investments lead to greater possibilities for risk diversification (Amit & Livnat, 1988). Another effect of the tokenization of assets is that the higher liquidity can cause an increase in the
asset ownership, since transactions made on the public ledger of a blockchain are stored and can be traced. This leads to better recordkeeping and more transparency of ownership (Sahdev, 2017). With regards to regulatory aspects of tokenization, legal enforceability of the ownership rights that asset tokens represent is very important (Preston, 2018). Next to that, ownership of assets, also as an investment, becomes more accessible to people with tokenization, since it creates possibilities for small and tradable investments (Preston, 2018). But for the issuance of asset tokens trusted intermediaries will be needed, providing certainty for investors that they can redeem their assets and that the tokens stay linked with their underlying asset. Furthermore, trusted intermediaries for the provision of data on valuation and rating of assets would be needed (Micheler & von der Heyde, 2016). Lastly, the issuance of tokens representing a share of a project, this share can consist of an asset, can be used to receive financing (Preston, 2018). So overall, studies about the tokenization of assets show there are effects of this tokenization on assets. 2.2: Private equity and the relevance of blockchain for this market 2.2.1: What is private equity? In 2017, in Europe alone there was €640 billion capital under management of private equity firms (European Private Equity Activity Report, 2017). Modern private equity has been around since the 1940s (Lerner, 1997), and since many different aspects of private equity have evolved around the world causing there not to be one specific worldwide definition and classification of private equity. However, one broad definition that is commonly agreed upon is that a private equity investment is ‘any equity investment in a company which is not quoted on a stock exchange’ (Fraser-Sampson, 2011). This simply means that private equity is not public equity. A more specific definition from an institutional point of view provided by Caselli & Negri (2018) is that private equity is “the provision of capital and management expertise given to companies to create value and, consequently, generate big capital gains after the deal”. Private equity has an important role in financing and fostering innovative firms, and the reallocation of capital to more productive sectors of the economy (Ljungqvist & Richardson, 2003).
Firms investing in private equity, private equity firms, make investments in different kinds of companies: from starting companies to readily established companies. Investments in starting companies are generally done by a specific type of private equity firms, venture capital firms. Venture capital is usually defined as “the investment by professional investors of long-term, unquoted, risk equity finance in new firms where the primary reward is an eventual capital gain, supplemented by dividend yield” (Wright & Robbie, 1998). Alternatively, there are private equity investors investing in more established companies in generally more developed sectors (Sullivan, 2017). In recent years, the American definition of venture capital: “a cluster of private equity dedicated to finance new ventures” (Caselli & Negri, 2018), where venture capital is embedded in the private equity label, has been further adopted in Europe. For this reason, that approach is used in this writing. When private equity is mentioned, this also includes venture capital. When venture capital investors and private equity investors are specifically mentioned apart from each other, the further distinction within private equity in venture capital investors and private equity investors based on the life cycle of the company invested in is meant. The private equity market can be further described looking at the actors active on the market and the main attributes of the market. In line with Fenn, Liang & Prowse (1997), three different groups of actors are discussed active on the private equity market: investors, intermediaries and issuers. Investors consist wealthy individuals and large institutional investors. Often investors need to be accredited, which means only more affluent investors that meet certain income or fund requirements, are allowed to invest. This leaves the private equity market not accessible to everyone (Choi, 2000). Intermediaries consist of private equity firms managing funds in exchange for a compensation. Issuers are companies issuing equity shares in exchange for investment. Investments into companies are either done directly, from investor to company, or indirectly, from investor via an intermediary into a company (Bance, 2004). The attributes of the private equity market included in this study are determined following what Ljungqvist & Richardson (2003) have described to be the three most important attributes of private equity: liquidity, risk, and return. Furthermore, transparency and regulatory monitoring are described as important attributes of the private equity market.
Private equity is a relatively illiquid asset compared to other asset classes. Investments have long holding periods and a secondary market for existing investments is very poorly developed (Ljungqvist & Richardson, 2003). In terms of risk and reward, the private equity market is generally speaking a relatively high risk - high reward market (Wright & Robbie, 1998). Because of high minimum investment amounts, less risk diversification options in a certain investment portfolio exist (Bance, 2004). With regards to transparency, information about companies, which is crucial for investors, is mostly privately held (Wright & Robbie, 1998). This causes information asymmetries. Lastly, with regards to monitoring, private equity markets are not very regulated in comparison to public equity markets (Caselli & Negri, 2018). Contracts between parties are leading. 2.2.2: How blockchain enabled tokenization can affect private equity Private equity is one of the largest asset classes in the world (Fraser-Sampson, 2011). As an asset, private equity can be tokenized, which can lead to many changes in how the private equity market functions. It is interesting to look at how blockchain enabled tokenization can influence especially the private equity market, since many of the effects the tokenization of an asset could have, can have a big influence on characteristics of the private equity market. As described, tokenized assets, among other things, become more liquid, enable fractional ownership, offer greater possibilities for diversification, democratize investment opportunities, and create new models of capital raising (Preston, 2018). All of these points are applicable the private equity market and potentially change its main attributes such as relative illiquidity, high risk investments (Wright & Robbie, 1998), few diversification possibilities (Bance, 2004), and inaccessibility to many investors (Choi, 2000). Many publications mention the effect and potential of blockchain technology and tokenization on private equity. Such as in the study of Lamarque (2016), writing that equity markets can be transformed by blockchain technology by offering valuable opportunities to overcome existing inefficiencies and frictions, and expecting increased transparency in private equity markets. However, just a few scientific studies about the possibilities and influence of tokenization on private equity markets have been published. These studies focus on different aspects of how the private equity market is
influenced by blockchain and tokenization. A study published by Sahdev (2017) looks into blockchain enabled equity crowdfunding, describing its effects as increased liquidity, new models for equity pricing, increased transparency and market-making possibilities. Preston (2018) has published a study describing the regulatory monitoring surrounding Initial Coin Offerings, the issuance of tokens as a new way of fundraising, in the United States, suggesting policy-makers should adapt regulations to this new possibility. The potential for democratization of investment opportunities with more accessibility and network effects surrounding ICOs are identified and described in this study as well. Chen (2017) writes about more possibilities to engage stakeholders through ICOs, forming a community of token holders. Kaal & Dell’Erba (2017) write about the use of blockchain technology within private equity firms, posing that “the innovation benefits for private investment funds and their clients promise lasting change for the industry.” An extensive research focusing on the private equity market and how this market changes, looking at its main attributes and actors, because of the possibility for blockchain enabled tokenization, has not been done yet. That is what this study attempts to do, providing a contribution to academic literature. 2.3: Conceptual model Figure 1: Conceptual model
In this conceptual model the relationship between the different constructs of this study is showed. As can be seen, the independent variable, blockchain enabled tokenization, influences the dependent variable, the private equity. This cause - effect relationship is the subject of this study, providing clarity regarding the way private equity changes due to this blockchain enabled tokenization. This is done by looking at different attributes of blockchain technology and tokens on a blockchain, and the effects they have on private equity’s attributes and actors. Firstly, with regards to blockchain enabled tokenization the most important attributes of blockchain technology are 1) distributed ledger technology, 2) cryptographically secured transactions, and 3) possibilities for decentralized applications (Davidson, De Filippi & Potts, 2016; Swanson, 2014). When assets, such as private equity, are tokenized and represented on a blockchain with a token, the possibilities blockchain offers with its attributes apply to these tokens. With the tokenizing of private equity, by creating tokens representing shares of the equity, the attributes and actors of private equity change because of this new possibility. In order to formulate an answer to the question of how private equity is going to change because of the possibility of blockchain enabled tokenization, firstly an analysis of the pre-blockchain private equity market is made, also referred to as the traditional private equity market. Identifying the main actors and attributes and the mechanisms behind these attributes of the private equity market helps to create an understanding of how the market can change. With regards to the actors active on the private equity market, in line with the overview Fenn, Liang, and Prowse (1997) made of this market, three groups of actors are discussed in this study: investors, intermediaries, and issuers. Furthermore, five attributes to describe the private equity market are included. The first three attributes are the attributes Ljungqvist and Richardson (2003) have described to be the most important attributes of private equity: liquidity, risk, and return. The other two attributes are transparency and regulatory monitoring, which Wright and Robbie (1998) describe as important attributes of the market.
Chapter 3 - Methodology
In this section, the chosen research methods are described for answering the research question: How will blockchain enabled tokenization change private equity? 3.1: Research design 3.1.1: Approach To answer this research question two qualitative research methods are used, consisting of a literature study and interviews. Using two methods, the limitations of a single method research design can be overcome. Besides that, a qualitative research approach is useful whenever current literature on an area is vague or it entails a new area of research (Blumberg, Cooper & Schindler, 2008). One of its main characteristics is that it has an explorative nature. Blockchain technology is a relatively new phenomenon and the influence it has on many different industries, including private equity, is a new area of research.This makes a qualitative research approach suited for the subject to obtain a deeper understanding. In the literature study, relevant publications on the topic are going to be summarized and subsequently combined to create an understanding of how blockchain technology and tokenization have the ability to change private equity, based on previous research. In addition to the literature study on the subject, another form of research will be conducted: interviews. The interviews are conducted in order to get a perspective on the subject from people and companies who already engage in the possibilities of blockchain enabled tokenization, giving insights in how this already changes private equity markets and in which new directions private equity markets develop. Innovations enabled by blockchain technology are very fast-paced, causing studies to become outdated very soon after their publication. By conducting and including interviews in this study, presented findings can be as recent and relevant as possible.Furthermore, this study follows an inductive approach in which the literature study and interviews lead to propositions and theories. The study is conducted in a predetermined time-frame, from April 2018 to June 2018.
3.1.2: Selection of literature To systematically review the existing literature, studies are divided into categories with different fields of research, of which consequently the most relevant and important publications will be included into this study. The main fields from which literature will be included are private equity, blockchain technology and tokenization and its effects on assets, combined with the little literature already written about blockchain technology in combination with private equity. Concerning private equity, literature on the functioning of private equity markets up until now will be reviewed, identifying its main attributes and actors. Also, studies about the mechanisms behind the main attributes of the private equity market will be reviewed. The attributes of the private equity market that will be described in this study are based on the three most important attributes as described by Ljungqvist and Richardson (2003), which are: liquidity, risk, and return. Furthermore, transparency and regulatory monitoring will be included, which Wright and Robbie (1998) describe as important attributes of the market, and that are very relevant with regards to innovation by blockchain technology and tokenization. With regards to the actors active on the private equity market investors, intermediaries, and issuers will be discussed, important groups on the private equity markets as described by Fenn, Liang, and Prowse (1997). Furthermore, literature on attributes and the working of blockchain technology and tokenization and its effects on assets will be included. The most important attributes of blockchain technology as found in publications of Davidson, De Filippi, and Potts (2016) and Swanson (2014) will be discussed: 1) distributed ledger technology, 2) cryptographically secured transactions, and 3) possibilities for decentralized applications. Furthermore, literature on the effect of blockchain and tokenization has on assets is going to be discussed, in order to understand how private equity, an asset as well, could be influenced and changed. 3.1.3: Selection of interview subjects For the interviews, companies actively engaged in activities using blockchain technology and relevant for private equity are chosen for interviews. CEOs of two
companies based in Amsterdam are approached and have both agreed upon a face-to-face interview. The first company interviewed, Taranis Exchange, is a company building a blockchain enabled exchange for private equity tokens. On the one hand issuers, consisting of startups, accelerators and VCs, can create security token offerings in exchange for investment. On the other hand, investors can invest in these tokens and participate in equity ownership of the issuers. All of this while maintaining liquidity and transparency (Taranis Exchange, 2018). The interview is held with its CEO, Michael David Sayre. The reason to choose for this company was that this company is building a whole new infrastructure for private equity investments enabled by blockchain technology, contributing to the change of private equity markets. A better understanding of what this company is doing can help gather a better understanding of what changes blockchain technology can bring upon the private equity market. The second company interviewed, Effect.AI, is a company building an artificial intelligence platform that has successfully raised €11 million via a blockchain enabled Initial Coin Offering with utility tokens recently, not giving up any equity in the company. The interview is held with CEO Chris Dawe. The reason to choose for this company was that this company has successfully engaged in a blockchain enabled new way of fundraising. Because of that, insights from this CEO can be very useful for understanding how the future of fundraising and venture capital, a part of private equity, is going to look like and how this is going to change private equity markets. 3.2: Data collection 3.2.1: Collection of literature Literature is collected using data bases of existing studies. These publications can be found in data bases of e.g. the University of Amsterdam and using search engines such as Google Scholar.
3.2.2: Conducting of interviews The interviews were held in a semi-structured way, because semi-structured interviews are useful for assessing behaviors, opinions and emotions (Clifford, Cope, Gillespie & French, 2016). Both interviews are held in the same week in May, between the 28th and the 30th of May. Based on literature two interview guides are created. The first one, for Taranis Exchange, consisting of open questions on 7 areas. The second one, for Effect.AI, consisting of open questions on 5 areas. The guides of the interviews are included in the appendices A and C. Both interviews are held at the companies’ respectively office buildings in a quiet room, recorded with an Iphone and later transcribed. The first interview lasted 51 minutes, the second interview 45 minutes. Transcriptions of both interviews are included in the appendices B and D. 3.3 Data analysis 3.3.1: Analysis of literature An analysis in the literature study is made by including most important and relevant findings of publications into this study, eventually combining those to come to new insights with regards to the change in private equity as a consequence of blockchain enabled tokenization. 3.3.2: Analysis of interviews Transcriptions from the two interviews are coded using open, axial, and selective coding. Consequently, with the coding findings from the two interviews can be compared and analyzed, providing relevant information for the study creating and understanding of what companies engaging with blockchain technology and private equity are doing exactly and how this influences and changes private equity.
Chapter 4 – Results
Section 4.1 - Analysis of the pre-blockchain private equity market In this section an analysis is made of the private equity market, without taking in account the influence blockchain technology and tokenization have already started to make on this market. This is done in order to understand the starting situation of this market and how this changes under the influence of blockchain and tokenization. In order to analyze this market, an overview of the main actors active on the private equity market is made, and the main attributes of the market are described and the mechanisms behind these attributes explained. This leads to an understanding of how the attributes of the market can change due to blockchain enabled tokenization. 4.1.1: Actors on the private equity market and their activities Three main groups of actors are active on the private equity market, as identified by Fenn, Liang and Prowse (1997), who made an overview of the market. Those are: 1) investors, 2) intermediaries and, 3) issuers. These groups are discussed in this section. 1. Investors There are three common ways for investors to invest in private equity: 1) by investing in private equity funds, 2) by outsourcing the selection of private equity funds, for example through a fund of funds and, 3) by direct investment in private companies (Bance, 2004). With the first option, if investors invest via an intermediary in the form of a private equity firm, they become a limited partner of a private equity fund. The private equity firm serves as the general partner (GP) of this fund. There are private equity firms that establish new fund every three to five years for which they raise funds (Metrick & Yasuda, 2010). The limited partnerships investors investing in a private equity fund usually last for ten years and a partnership agreement is signed whichprivate equity funds the investment term, called Partnership Term, is 7 to 10 years. Private equity managers generally impose rigid restrictions on the transferability of interests in their funds and during the investment term the investments usually remain illiquid. However, for investors looking for liquidity there are multiple options. Some private equity funds are quoted on major stock exchanges, making investments more liquid. Next to that, there is a market for participations in existing private equity funds, called a secondary market. These secondary markets can offer more liquidity but aren’t well developed. In terms of diversification, a fund can offer diversification through investment in multiple companies, lowering the risk (Bance, 2004). With the second option, the selection of private equity funds to invest in is outsourced by the investor. An option is to outsource this to a fund of funds manager: “A fund of funds is a pooled fund vehicle whose manager evaluates, selects and allocates capital amongst a number of private equity funds” (Bance, 2004). Fund of fund managers act on behalf of a pool of investors and usually have good relationships to leading fund managers, therefore investing via a fund of funds can enable investors to invest in funds with a high minimum commitment and give access to heavily subscribed funds. When investing via a fund of funds manager the investor usually invests in a blind pool. Another option is to outsource the selection of funds to a consultant. A consultant can have similar expertise to a fund of funds manager but can offer a tailor-made portfolio and segregated instead of pooled accounts. (Bance, 2004) The third option is to invest directly into a company. This is usually done by wealthy individuals. A larger amount of capital would be needed to achieve the same diversification and exposure as when one would have invested through a fund. Next to that, a different skills set, more resources and different evaluation techniques would be needed. Rewards can be higher this way (Bance, 2004). 2. Intermediaries Private equity firms have three main activities: fundraising, investing and divesting. There are a couple of typical characteristics of a deal in the private equity market. Firstly, the shareholder composition of a company changes due to the private equity investment since a part of the shares become property of the private equity investment firm in exchange for the investment. This does also mean investors can have
a say in the strategy and management of the company. Secondly, in private equity the financial part is not the only important part of the deal: the advisory services and assistance in the company’s development are important as well. Private equity investors can provide know-how, reputation, a network, relationships, skills, competencies as well, which can contribute to firm growth. These nonfinancial benefits of a private equity investment may be defined as benefits or effects that come alongside with a private equity investment (Caselli & Negri, 2018). Thirdly, with private equity investments there’s a predefined time horizon of the investment: the holding period and exit conditions of the investor are always defined in the agreement. Private equity investors aren’t looking for a long-term involvement. This is the main reason for defining the private equity industry as a financial and not industrial. Most private equity firms investing use a compensation scheme, often referred to as ‘2 and 20’, of a 1.5-2.5% annual management fees of 2% levied on assets under management plus a share of 20% in fund’s profits (Kaplan & Schoar, 2005). 3. Issuers Either the entrepreneur or management team of a company decide there is funding needed for a goal: this goal being the actual start-up of a company or expansion or transformation plans for the company. Hence, an equity investment is for a specific financial need. This financing is needed in one of six stages a company can be in: development, startup, early growth, expansion, maturity & crisis and/or decline phase. (Caselli & Negri, 2018). These stages impact four drivers that determine whether a company needs financing: investment, profitability, cash flow, and sales growth. Depending on which stage a company is in the financial needs differ and is determined by the net cash flow of the company. To get the capital needed there are multiple possibilities for companies. The company can be financed from debt or equity finance perspective. Since private equity is one of the most expensive forms of finance, most issuers are companies that are not able to raise capital via debt or public equity markets (Fenn, Liang & Prowse, 1997). Potential investors for debt & equity financing are: family and friends, other partners, business angels, private equity operators, banks, trade credit operators, financial
depending on the advice and help the investor can offer and the capital it can provide. An equity investor needs to know what the financial need is, what part of this need can be satisfied through equity capital and when the company will be able to pay-off the equity investor after the investment. These question help determine what the risk-return profile of an investment is and what kind of investors are needed. For each stage a company can be in a different kind of investor can fit best, depending on the advice and help the investor can offer and the capital it can provide. There are certain benefits a company can experience because of a private equity investment, such as receiving coaching and positive effects because an investment of a private equity firm is a proxy of potential for a company, which are reason for a company to choose for a private equity investment (Caselli & Negri, 2018). 4.1.2: Main attributes of private equity market and its mechanisms explained There are multiple attributes of the private equity market that are relevant to know. The main attributes are: liquidity of investments in the market, risk and diversification of investments in the market, return of investments and valuation, transparency of the market, and regulatory monitoring of the market. These attributes are described, and next to that, in order to understand how this market can change, the mechanisms behind these main attributes, as found in the literature, are explained. The choice to include these attributes in this study are based on studies by Ljungqvist and Richardson (2003), and Wright and Robbie (1998). 1. Liquidity Amihud and Mendelson (1988) write that “the illiquidity of an asset is reflected in the level of difficulty in trading it, as measured by the overall cost of a transaction.” Private equity shares are relatively illiquid compared to other asset classes since the process of finding a buyer for the share is cumbersome. There is a market for existing private equity investments, called a secondary market, but these markets are not well developed so can not offer much liquidity (Ljungqvist & Richardson, 2003). Difficulty of trading and thus relative illiquidity in the private equity market is mostly a consequence of this absence of well developed secondary markets for private equity investments, and
long horizons of the investments (Ljungqvist & Richardson, 2003). The mechanisms behind liquidity in private equity work in the following ways: Investors are willing to pay more for an asset that has higher liquidity, and require a compensation for transaction costs. In this way asset prices reflect their liquidity characteristics, which is what the liquidity premium, discussed under Return & Valuation, is about (Amihud & Mendelson, 1988). 2. Risk & Diversification Olsen (1997) writes that risk of an investment is a function of four attributes: the potential for a large loss, the potential for a below-target return, the feeling of control, and the perceived level of knowledge. The private equity market is generally speaking a relatively high risk - high reward market (Wright & Robbie, 1998). Minimum investment amounts, both for direct and indirect investments, are relatively high. For a certain investment capital this offers less diversification options (Bance, 2004). Mechanisms behind risk and diversification in private equity work in the following ways. Investors are risk averse and want to be financially rewarded for it (Ilmanen, 2011). There are many theories on risks of specific investment options with private equity having a relatively high risk profile. For the scope of this writing options for diversification of risk is more important. With a portfolio of investments risk can be decreased by diversification. The degree to which diversification can eliminate risks depends upon the correlations among the investment returns. If the investment returns are perfectly correlated no degree of diversification could affect the risk (Levy & Sarnat, 1970). Investment returns for a specific country can be highly correlated, which reduces the effect portfolio diversification within a country has on the reduction of risk. That is why international diversification of a portfolio can further facilitate risk reduction. 3. Return & Valuation Within private equity, the price of the shares is defined on the basis of negotiations between preexisting shareholders and incoming shareholders: the private equity investor (Caselli & Negri, 2018). Returns on the private equity market are
extreme illiquidity (Ljungqvist & Richardson, 2003). In the private equity market, there are costs for private equity firms often asking the ‘2 and 20’ management fee (Kaplan & Schoar, 2005). So it can be a costly process for companies to find investors, since there is no competitive ‘anonymous’ capital market to turn to as is the case with public equity. Companies have access to a more limited set of financiers (Wright & Robbie, 1998). The mechanisms behind return and pricing work in the following ways in private equity. Returns are the main reason for investors to invest, and necessary to compensate for risks (Ilmanen, 2011). Returns in private equity are dependent on how the underlying assets, equity shares in companies, are doing. The amount of risks determines how much return is necessary to compensate for this risk, driving the costs of capital up. A principle affecting the value of private equity is the liquidity premium. When comparing privately held companies to public companies the value of public companies is fundamentally higher, between 20% to 50%. This difference in valuation is frequently attributed to the relative illiquidity of privately held companies. Similarly, this is how the liquidity discount works: relative illiquidity lowers the value of assets (Koeplin, Sarin & Shapiro, 2000). This means that enhanced liquidity has a positive effect on the value of an asset. 4. Transparency In private equity, information about companies invested in, crucial for investors, is mostly privately held. There is no mandatory provision of information, as is the case with public equity (Wright & Robbie, 1998). The following mechanisms related to transparency in private equity exist. Corporate disclosure of information is important for the functioning of efficient capital markets. Whereas in public equity the provision of specific public information is mandatory, in private equity private information is widespread and difficult to reveal (Wright & Robbie, 1998). This causes two problems. Firstly, the lemons problem, a problem that arises from information asymmetry and conflicting incentives between companies and investors. Investors need to know enough information to distinguish between good and bad business ideas, thus investments (Healy & Palepu, 2001). Contracts providing disclosure of information from the company can enable this en be a
solution to the otherwise arising lemon problem (Kreps, 1990). Secondly, there is the agency problem, a problem arising because investors typically do not want to play an active role in the managing of a company, which is the role of the company’s management. Management could make self-interested decisions that are harmful to the interests of outside investors. Mandatory information disclosure can play a role in the solution to the agency problem because relevant information has to be disclosed enabling investors to monitor the decisions and their interests (Healy & Palepu, 2001). Furthermore, increased sharing of information enabling transparency, can enhance liquidity. This is because when information is open to everyone, this reduces the risk for investors of trading against superiorly informed ‘insiders’. This causes narrower bid-ask spreads, thus a greater liquidity and a lower cost of capital (Glosten & Milgrom, 1985). Sharing of information has its costs but can be seen as a liquidity-enhancement investment which may increase, on balance, the value of the firm’s equity claims, both private and public, due to the liquidity premium principle. For public equity there is a lot of regulation on disclosing certain information. In private equity that is not the case, being another reason for the relative illiquidity of the private equity market. 5. Regulatory monitoring Lastly, with regards to monitoring, private equity investments are not that regulated in comparison to public equity investments. In private equity, the contracts between the preexisting shareholder and the private equity investor are leading. Public equity investments, however, are well regulated by domestic and international laws and well supervised (Caselli & Negri, 2018). The mechanisms with regards to regulatory monitoring are as follows. Different capital markets are monitored differently by law. The private equity market is a relatively unregulated market which involves unique risks that could lead to the loss of an entire investment. For this reason only accredited investors, more affluent investors that meet certain income or fund requirements, are allowed to invest. These regulations are determined by governmental institutions such as the Securities and Exchange Commission, the SEC (Lee, 2011). Because of this regulation, the private equity market is not accessible for many people (Choi, 2000).
Section 4.2 - Blockchain technology and asset tokenization In this section, the main attributes of blockchain technology, the way in which tokenization of assets works, and the main effects of this tokenization on assets are described. It is crucial to understand this, in order to understand the effect blockchain enabled asset tokenization can have on private equity. 4.2.1: Blockchain technology A blockchain is a “cryptographically secured, crypto-economically incentivized class of distributed ledger, or decentralized database” (Davidson, De Filippi & Potts, 2016). This means blockchain technology combines mathematical cryptography, open source software, computer networks and incentive mechanisms. This way, for the first time in history, value can be reliably transferred between two untrusting, distant parties, without the need for a trusted intermediary. This development makes new types of transactions, intermediation and business models viable (Catalini & Gans, 2016). Three main elements of blockchain technology are discussed: 1) distributed ledger technology, 2) cryptographically secured transactions, and 3) the possibility to create decentralized applications. 1. Distributed ledger technology Blockchain is a type of distributed ledger. A ledger is a database, and anything that can be coded into a ledger can be recorded on a blockchain. Ledgers are used as the basic transactional recording technology at the core of modern technologies. But up until the invention of blockchain technology, these ledgers had to be centralized in order to be trustworthy. Blockchains are the first ledgers that are decentralized on which consensus can be created, so it can be securely and effectively used without a central authority. As long as ledgers can be trusted, they are useful to provide consensus on basic data of an economy: property, identity, contract and value, all of this in time (Davidson, De Filippi & Potts, 2016). Blockchain is a technology that runs on a network of computers and is in a way the next generation of internet. Wherever internet is, blockchains can run.
2. Cryptographically secured transactions The records on a blockchain are secured through cryptography. Cryptography is defined as “using encryption to conceal text or messages” (Amarasiri & Dias, 1999). Cryptography depends heavily on mathematical formulas that are very difficult to break into. Based upon cryptographic proof, instead of just trust, two parties can transact directly on a blockchain. Blockchain technology can create this consensus on decentralized ledgers with different protocols, mechanisms to arrive at a consensus. A blockchain contains rules and incentives to 1) run a decentralized network, and 2) secure a shared ledger (Catalini & Gans, 2016). The proof-of-work system of the Bitcoin protocol works in the following way. In proof-of-work systems, using cryptographic algorithms, ‘miners’ are incentivized to conduct additional work and commit new blocks of transactions at regular intervals. The miners solve difficult computational tasks in order to participate in what works like a lottery for the right to add the next block to the chain. If a miner adds the new block to the chain it receives a predetermined amount of the cryptocurrency as a reward. This, in combination with individual transactions fees some participants might have added to their transactions in order to give miners an incentive to give priority to their transactions in the construction of the next block, forms the incentive for miners to perform this work. In order to be able to incentivize miners, blockchains usually have a native, built-in ‘token’ of some value. These native tokens are released as a reward and must be enough of an incentive to participate in the extension and security of a blockchain. The purpose of mining in these proof-of-work systems, however, is not the verification of transactions, since that is a computationally lighter task. Its purpose is to secure the blockchain network from the threat of an attack. This works in the following way: as the blocks of transactions are added to the chain of blocks over time, it becomes more difficult to tamper with transactions because more computing power, and with that energy, has been put into it. This way, a malevolent actors would have to change the block containing the record and those linked to it, in order to avoid detection. This would take massive amounts of resource. This is an increasingly difficult task as the chain of blocks lengthens. The network always takes the longest, valid chain as the true state of the ledger, which is the ‘consensus’ in the
resources, in the form of energy and hardware, which is seen as wasteful. These energy consuming mining computations, however, are what keeps the ledger secure. But, alternative consensus systems exist. Such as, proof-of-stake, proof-of-burn and hybrid systems (Catalini & Gans, 2016). With the blocks of transactions a blockchain does not only create security, but also some kind of immutable audit trail. Typically, the resulting log of transactions made are public, as is the case with Bitcoin and Ethereum. The privacy of users can be protected by the use of pseudonyms, or the use of a protocol with anonymity, such as Zcash. This system does create transparency (Catalini & Gans, 2016). 3. Possibility for decentralized applications A blockchain can have programmable functionalities, this way becoming a ‘smart ledger’ (Swanson, 2014). The Bitcoin blockchain has a specialized application, suited for its currency. The Ethereum blockchain, however, is built as a general-purpose development platform. This means the Ethereum blockchain is not only suited for a specific application, but other decentralized applications can be built on top of it. On Ethereum, smart contracts (Swan, 2015), self-executing digital contracts, can be written. Furthermore, multi-signature transactions, transactions that require consent of multiple parties to be executed (Omohundro, 2014), smart properties, rights of ownership of tangible and intangible assets that can be controlled via smart contracts, and tracked or exchanged (Crosby, Pattanayak, Verma & Kalyanaraman, 2016). 4.2.2: Blockchain enabled asset tokenization On a blockchain, the rights of ownership of an asset can be converted to a digital token, for which the Ethereum blockchain has been widely used. Once these assets are tokenized, they can be recorded, tracked, monitored, and transacted globally in a decentralized manner (Chen, 2017). There are multiple types of tokens, depending on what they represent. The SEC distinguishes between three types: 1) security tokens, tokens that represent assets such as participation in companies or earning streams, they can be compared to equities or bonds in economic function. 2) utility tokens, tokens that provide access or discounts to goods and services that a project will launch in the future, and 3) cryptocurrencies, tokens that have the purpose of enabling financial
transactions with inherent value, and are generally speaking not linked to projects or other functions (Medium, 2018). In this section, the effects of the tokenization of assets are divided into the influence they have on different attributes of asset markets and its actors, in accordance with the attributes and categories of actors used to analyse and described the private equity market. The main effects are increased liquidity, more risk diversification options, pricing and increased value of assets, increased transparency, and challenges surrounding regulatory monitoring. Furthermore, new possibilities and needs for actors on asset markets are discussed. 4.2.2.1: Effects of the tokenization of assets on the attributes 1. Enhanced liquidity of investments Blockchain allows for disintermediation which lowers transaction costs, making markets more efficient. Transaction costs decrease because there is a reduction in 1) the cost of verification, and 2) the cost of networking (Catalini & Gans, 2016). Costs of verification arise because key attributes of a transaction need to be verified by parties involved. For example, when a transaction is done using a digital form of payment, a financial intermediary (e.g. a bank) verifies whether the required funds are available at the buyer’s account, and then transfer them to the seller’s account. For this verification service, the intermediary charges a fee. This way verification costs add to the transaction costs, as long as intermediaries are needed. If these verification costs decrease, caused by the use of blockchain system, market thickness and safety increases, because more buyers and sellers can profitably transact on the market. In order to have low verification costs, a secure network is needed. The cost of networking are the costs associated with running a network. These costs were high for decentralized networks before the introduction of blockchain, but have fallen since (Catalini & Gans, 2016). Furthermore, lower transaction costs have made the trade of smaller investment amounts economically feasible. Both low transaction costs and small amounts increase liquidity (Gerhold et al., 2014).
2. More possibilities for risk diversification The ability to have tradable, small investments, caused by lower transaction costs, have another effect: options for fractional asset ownership, owning a certain percentage of an asset instead of its whole, increase. This fractional asset ownership allows for great opportunities for the diversification of risk associated with asset ownership thus investment (Amit & Livnat, 1988). 3. Pricing and increased value of assets Increased liquidity can have a positive effect on the value of the asset underlying the token, because investors are willing to pay more for an asset that is more liquid. This is a mechanism is called the liquidity premium (Amihud & Mendelson, 1988). Next to that, with the possibility of having tradable, small investments new possibilities for fundraising have arised, ICOs. An ICO is the sale of blockchain-based digital tokens to the public to finance a project. Depending on the type of token, there are different rights that come with a token (Rohr & Wright, 2017). With this new form of fundraising network effects arise. This is because people holding specific tokens will want to bring further public attention to this asset to increase its popularity in the market. It is this popularity that can increase the price of a specific token, and its underlying asset or utility (Preston, 2018). 4. Increased transparency The public ledger shows the transactions made, creating a trail of changes in ownership both that can be followed and is indefinitely stored on the blockchain. These historical records then can be easily accessed for auditing and monitoring purposes. Furthermore, since every token is unique, a token with an ownership right can not be duplicated, imitated, or double spend, increasing security and trustworthiness of the data on it. Together, this leads to lower costs, better recordkeeping, and transparency of ownership (Sahdev, 2017). This way, tokenization can decrease information asymmetries and make markets more transparent and fair.
5. Challenges surrounding regulatory monitoring There are many uncertainties with regards to how tokenized assets are and will be regulated. Furthermore, the legal enforceability of property rights is an important aspect of this. Finally, on platforms where tokenized assets are traded, a digital identity for investors needs to be integrated in order to comply with regulation from regulatory parties worldwide (Preston, 2018) . 4.2.2.2: Effects of the tokenization of assets on actors and their activities With the tokenization of assets new possibilities for actors and their activities arise. For investors, the 1. Investors Caused by the possibility to have tradable, small investments when assets are tokenized, barriers to entry for trading and investing are reduced. This makes investing more accessible for more people, effectively democratizing investment possibilities (Preston, 2018). 2. Intermediaries There is a need for trusted issuers of tokens in order for asset tokenization to work. Owners of asset-backed tokens need to have a certainty that they can redeem the underlying real-world assets of their tokens. When assets are tokenized via a platform, it is important that these platforms develop security standards that ensure tokens stay linked with their underlying assets (Micheler & von der Heyde, 2016). Next to that, trusted intermediaries providing data on valuation and rating are needed, useful for many asset tokens will be highly diversifiable and liquid and not all investors will have knowledge on what kind of assets they possess (Micheler & von der Heyde, 2016). 3. Issuers Tokenization leads to new models of fundraising for organizations through ICOs.
assets, in order to receive financing (Preston, 2018). In 2017 over $3.2 billion has been raised through ICOs (Rohr & Wright, 2017).
Section 4.3 - The effects of blockchain enabled tokenization on private equity In this section different reviewed literature is combined in order to understand how blockchain enabled tokenization can change the private equity market. The findings of the analysis made of the private equity market and its attributes and actors, is combined with the findings from the literature about the effects of tokenization on these attributes and actors for assets in general. Since private equity is an asset as well, these findings about assets are applicable to private equity. The mechanisms of the attributes of the private equity market, as are explained in the analysis of that market, are used to create an understanding of the effect of tokenization on these attributes. Next to that, existing literature about the effect blockchain enabled tokenization has on private equity specifically, is integrated into this analysis where applicable. Together, this creates a complete representation based on literature of how blockchain enabled tokenization can change private equity. 4.3.1: Influence of tokenization on the attributes of the private equity market The effects of blockchain enabled tokenization on the main attributes of private equity are described. These attributes are: liquidity of investments, risk and diversification of investments, return of investments and valuation, transparency, and regulatory monitoring. 1. Liquidity With liquidity of an asset being dependent on the level of difficulty of trading it, measured by the overall transaction costs, private equity has traditionally been a relatively illiquid asset class (Amihud & Mendelson, 1988). The process for investors in and issuers of private equity to find each other has been costly, provided by intermediaries and with a limited set of financiers (Wright & Robbie, 1998). Next to that, secondary markets for private equity investments, offering liquidity, are poorly developed (Ljungqvist & Richardson, 2003). Minimum commitments are often between 5 to 10 million euros, and partnership terms 7 to 10 years (Bance, 2004). A reason for
that, regulations of many government only allow for accredited investors to invest in the risky private equity asset class. Intermediaries have been taking high fees with ‘2 and 20’ structures (Kaplan & Schoar, 2005). Transaction costs in private equity have been high. Tokenization of private equity can lower transaction costs, since cost of verification and networking both decrease by using a blockchain, making the market more efficient. Less intermediaries would be needed taking up fees and a more competitive, anonymous, and global capital market, as exists for public equity, can develop (Wright & Robbie, 1998). Lower transaction costs would make the private equity market more liquid, and smaller investments tradable in an economically feasible way, increasing liquidity even further (Gerhold et al., 2014). With private equity developing from a relatively illiquid asset to a relatively liquid asset, a liquidity premium on the value of the private equity can be expected. The effect increased liquidity caused by tokenization has on the value of private equity is further described under Return & Valuation. In conclusion, by tokenizing private equity the market would become more efficient with lower transaction costs, providing much greater liquidity. 2. Risk & Diversification Traditionally, the private equity market is generally speaking a high risk - high reward market (Wright & Robbie, 1998). Part of this high risk is caused by the illiquidity of private equity investments (Ljungqvist & Richardson, 2003). When private equity markets are liquidized by tokenization, this increased liquidity can lower the risk profile of private equity. Furthermore, traditionally diversification options in private equity are limited because of high minimum commitments. The possibility to trade small investments on a blockchain, enabled by lower transaction costs, provide opportunities for the diversification of risk of tokenized private equity. How small tradable investment amounts can get, depends on how low transaction costs can get. Catalini and Gans (2016) write transaction costs can almost decrease to zero when tokens are exchanged on a blockchain, which indicates that even investments in private equity of just a couple of euros could become tradable. Apart from this exact minimum investment amount, it
is clear that with the possibility for much smaller investments far greater options for diversification arise. This potentially lowers the whole risk profile of investments in private equity. How effective the diversification of risk is to lower this risk depends on the level of correlation between the investments (Levy & Sarnat, 1970). The international diversification of a portfolio can lower the correlation of investments, which further facilitates risk reduction. With the tokenization of private equity, much more global trade in private equity becomes a possibility (Chen, 2017). This way tokenization of private equity can lead to relatively uncorrelated, extreme diversification of private equity investments. In conclusion, by tokenizing private equity, liquidity increases which lowers risk of investments, and options for relatively uncorrelated, extreme diversification of investments arise. Together this can change the whole risk profile of private equity, making it less risky. 3. Return & Valuation Returns in private equity have often been higher than in public equity, compensating for its higher risk (Ljungqvist & Richardson, 2003). The return needs to compensate investors for bearing this risk (Ilmanen, 2011). But since tokenization can lower the risk of an investment through higher liquidity, returns investors demand as a compensation for this risk can decrease. This lowers the costs of capital for companies. With regards to the cost of capital, the other development tokenization causes: creating more competitive, anonymous, and global capital markets (Wright & Robbie, 1998), can make the costly process for companies of finding investors cheaper, decreasing cost of capital. With regards to the valuation and pricing of private equity, increased liquidity causing a liquidity premium can severely influence the valuation of private equity, since asset prices reflect their liquidity characteristics (Amihud & Mendelson, 1988). The value of public companies, a relatively liquid asset class, is fundamentally higher, between 20% to 50%, compared to private companies. This difference in valuation is often attributed to the higher liquidity of public companies. To give an example, if
