Key Points
- Private equity and venture capital fund clients believe that tokenization of private fund interests will introduce new opportunities for liquidity and investor access.
- Certain legal terms need to be tailored to allow for tokenization, in light of the unique legal, regulatory and operational differences between a “typical” private equity fund and the needs of the token-based investor class.
- Sponsors may want to devise structures to deal with the unique governance, capital call and regulatory issues posed by ownership through tokens.
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Tokenization of private equity (PE) and venture capital (VC) fund interests is rapidly gaining traction in Asia, as fund managers and service providers seek to leverage blockchain technology to enhance liquidity, broaden investor access and streamline fund operations.
These tokens typically represent the holders’ fractional entitlement to all distributions of the underlying PE or VC fund. A master-feeder structure is ideal, where the interests of the feeder fund are tokenized and also tailored to the needs of the token-based investor community.
Recent client engagements highlight both the promise and complexity of this evolving market. This article outlines the key legal and commercial considerations, challenges and potential solutions for structuring tokenized private fund vehicles.
Key Considerations and Challenges
Token Fungibility
One of the important benefits of tokenizing private fund interests is the potential availability of a market for the buying and selling of the tokens, allowing investors a channel to realize their investments prior to the fund term expiration.
Such transactions would be administered much like the buying and selling of fund interests in a normal fund secondary transaction, but with the prospect of much lower transaction costs (through automation and disintermediation, and because the fast settlement of transactions over a blockchain also reduces counterparty risks) and, it is expected, greater pricing transparency.
To create this dynamic of lower cost and pricing transparency, the tokens must be fungible, meaning that all the rights and obligations attached to each token must be identical at all times.
Some practical considerations include:
- 100% contributed upfront. The traditional mechanism of capital drawdowns is not consistent with the concept of token fungibility, because drawdowns hinge on the ability of individual investors to meet capital demands. As such, the fund commitment that underlies the tokens should be fully contributed before the issuance of tokens.
- Governance and voting. Preferential rights to the fund’s governance and voting (e.g., a limited partner advisory committee seat) may have to be surrendered to the investment manager of the tokenized feeder fund.
- Re-drawdown. If an active buyer and seller market indeed develops, the identity of the token holders would by definition be constantly changing. This would make it difficult to execute any re-drawdown or “recycling” of distributions. Therefore, we believe that the tokenized feeder fund and the underlying private fund need to create a class of fund interests that is not subject to the recycling of capital via re-drawdowns.
Other considerations to take into account include fees, fee rebates and in-kind distributions that would typically also apply to a traditional master-feeder structure.
KYC/AML and White-Listing
To satisfy local regulatory requirements (for both the fund and the general partner), prospective token holders who wish to acquire tokens from existing holders will need to go through the same know-your-customer (KYC) and anti-money laundering (AML) investor onboarding process as conventional limited partners.
The smart contract for the token should be designed so that only white-listed wallet addresses are permitted to acquire and hold the tokens. These investors should sign an adherence agreement, the terms of which should mirror the terms of the fund’s subscription agreement.
Settlement Finality
Ideally, a secondary market would be available where the fund tokens could frequently change hands among white-listed investors, with each specific exchange of tokens not subject to any preapproval requirements by the general partner.
It is important to note that the transfer of tokens across a blockchain is not instantaneous. Depending on the blockchain on which the smart contract is deployed, the transfer that is proposed to the blockchain may take from seconds to minutes to be recognized by validators of the blockchain as irreversible, permanent and unconditional.
The conditions that must be met in order for the tokens to be deemed transferred from Party A to Party B should be made clear from the outset. A lack of clarity on this point could lead to disputes about who should be entitled to the distributions upon an 11th-hour token transfer before the cutoff time.
Final Thoughts
Tokenization of private fund interests offers significant potential benefits to investors, funds and sponsors, but requires careful structuring and negotiation to address legal, regulatory and operational risks.
Key areas of focus include:
- Investor eligibility
- Transfer restrictions
- Fee alignment
- Robust governance
As the market evolves, close collaboration with clients and counterparties, as well as proactive engagement with regulators, will be essential to successful implementation.
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This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.