- 26th July 2018
- Posted by: Manolis
- Category: Blockchain
We are operating in an era of digital disruption – where fintech is no longer a buzz word, but the norm. One specific area which has traditionally been largely unaffected by technological progression is Private Equity. However that is set to change with the industry beginning to embrace the opportunities provided by blockchain and artificial intelligence. Within this article we will explore the use cases for the technologies themselves, and consider how they may transform Private Equity as we know it.
The cryptocurrencies industry has been characterised by high levels of volatility with huge potential gains, but also huge potential losses. The question is, how can this align to PE and provide opportunity? First it is important to understand that what we are talking about is the technology underlying the cryptocurrencies– not the currencies themselves – the likes of bitcoin, ethereum, and so on. That underlying technology is called blockchain, and at a basic level it is a decentralized ledger of transactions across a peer-to-peer computer network. It is ‘decentralized’ because each user on the network can have their own synchronized copy of the ledger. This means that all users can see and therefore confirm that a transaction has happened and been recorded at the same time. Blockchain has been hailed as an immutable, unchangeable, and uncrackable record of transactions. It therefore becomes of great interest in areas which have previously been under threat of malicious attack – the financial services industry clearly being a prime target in recent years.
Blockchain technology has the ability to make workflows with multiple parties far more efficient and secure due to its unmatched data integrity. With more asset records being moved to blockchain-enabled systems, transferring ownership will not only be simpler and cheaper, but also far more secure. The knock on effect should ultimately be lower fees for investors. This is a huge potential benefit since closing transactions is not only expensive, but can take a fair amount of time. We believe that the blockchain technology is just an extension of the existing massive digitalisation process across all sectors and industries we are observing today. For Private Equity firms there is an opportunity to realise efficiencies in the underlying portfolio companies and reduce risks. Creating competitive advantages for the underlying portfolio assets will generate improved margins and increase exit multiples. To some extent it can even change entire business models in particular in the financial services sector.
Northern Trust is a good example of a financial services business who have implemented a blockchain deployment – their private equity ledger – which went live in 2017. It allows private equity managers to securely execute and store transaction records. It creates a single version of the truth for participants such as advisers and regulators to rely upon. Stuart Lawson, alternative global product manager at Northern Trust said of the benefits, “Transactions which involve multiple participants, such as a capital call, can be fully processed on the platform with all the requisite approvals, document delivery and movement of cash seamlessly processed with minimum intervention.”
In 2018 they developed and put live an audit node which provides audit firms with an immutable master record of the fund’s data from their own offices. The auditors are then able to transfer the required data into their own internal applications or develop tools to allow them to directly complete the audit within blockchain itself. Northern Rock continues to work with PwC to refine the application. However it is clear that in this example it allows the auditor real time access to a trusted and unchangeable data set. And there are many more examples across different industries of blockchain being deployed across underlying portfolio assets.
Other Use Cases
This is one real life example of blockchain implementation, but at present most PE firms are working out where the use cases and opportunities reside. Further potential uses include:
- Improved operational efficiencies through increased transparency, automated compliance, and smoother data flows.
- Transferring of funds – Payments can be verified, tracked, processed and distributed on the one blockchain which could reduce the reliance on traditional banking. This could in turn reduce transactional times and costs.
- Initial coin offerings (ICOs) to bypass the traditional ways of funding. Most recently Telegram, an encrypted messaging app, has raised a total of $1.7 billion after its second round of funding, making it the world’s largest initial coin offering to date. Telegram raised $850 million in March and $850 million in February, the British Virgin Islands-based firm reported, according to filings with the Securities and Exchange Commission (SEC).
The mention of AI tends to bring to mind robots – but what we are really talking about is clever machine programming – usually complex algorithms. If we think about the traditional private equity environment, fundraising was often done by putting in calls to institutional investors one on one. However these days technology can make this process more efficient. It is easy to see how digitally assisted fundraising campaigns are more effective in targeting materials to investors who based on their profile are more likely statistically to be interested. In fact many companies already use AI to track customer interests and private equity firms are beginning to use customer data to do this too.
AI Use Cases
Once the available data is being utilised and providing benefits to firms, it is easy to see how the use case spreads, for example to reveal insights into how particular groups of investors might also be interested in other types of investments due to their characteristics.
Where are the other potential areas in the PE industry that AI could transform?
Deal Sourcing – One of the primary roles of a GP is to continuously scan the market and find opportunities. This process takes a lot of time and effort as it is essentially manual. It also requires relationship building, which again takes time and effort. It is reliant on human information exchange which I think we would all agree is imperfect. However a machine for example could review all financial statements of a certain group of companies and identify any opportunities. AI could take into account new information which is not necessarily financial in nature. AI could identify new opportunities through other metrics such as online media channels, which track online trending metrics (OTM), the track record of previous shareholders and management and exit opportunities in a few years on the back of new emerging technologies. What does PE really look at today when identifying and assessing opportunities? AI can become the dominant source for sourcing, evaluation and management of investments.
Deal Evaluation – Programmed well, machines are very smart when it comes to quickly evaluating investment decisions. In fact it could be that evaluating deals is where most of the efforts of the GP are involved. Using AI, models can be built fairly quickly to take away this effort. Furthermore, every time there is a change to a deal, it can just be replayed through the model. Scoring models will take into accounts factors which today are overlooked. Scenario analysis tools not only based on pure financials but the ecosystem portfolio companies are operating in will become a key driver of performance. Should we not look at how the hedge fund industry has developed over time? Today, the largest hedge funds in the world are based on quant strategies, which run mainly independently, without any human interaction. Will PE not develop in a similar way? AI will be able to analyse market data on a much granular and reliable basis than a vendor due diligence team. AI will be able to take into account not only 3 years, but 20 years of data. We believe this will reshape how the entire PE industry is operating in the next ten years. It will create a new generation of investment firms.
Private equity is a traditional industry and relationships and networks have been the backbone to many firms and individual’s successes. Therefore it is understandable that the implementation of AI has been fairly slow compared to other areas. However looking at the use cases for AI, the technology takes away some of the manual process, and leaves the individuals involved with more time to build those all-important human relationships.
It is evident that the application of artificial intelligence and blockchain is fairly limited within the private equity industry at present. However, the benefits of both technologies are clear. There has already been adoption by Northern Trust of blockchain with reputed success. As firms continue to look for ways to differentiate and get an edge over their competitors, it is likely that these technologies will become more prevalent in the industry.
 Telegram’s Initial Coin Offering Raises $1.7B, Investopedia https://www.investopedia.com/news/telegrams-initial-coin-offering-raises-17b/#ixzz5FUUN4pau