As Blockchain development accelerates, countless use cases continue to emerge. While these applications span a diverse range of market segments, many in the space aim to bridge the gap between conventional and digital finance. Typically, these platforms intend to overcome the pitfalls of traditional finance and legacy investment products.
Arguable, this emerging trend has been the driver of asset digitization. In converting typically illiquid assets into liquid ones, the investment opportunities are hard to dispute. Investors are empowered to explore previously unattainable assets through fractional ownership, diversifying markets and improving accessibility.
Almost anything can be digitized, and several companies are exploring the space. For instance, Harbour is pursuing the tokenization of real estate. Republic aims to digitize startup fundraising, and Securitize is putting funds on to the Blockchain. However, very few platforms have endeavored to take on alternative investment products like debt and private credit.
As one of the fastest growing asset classes in private capital markets, private credit is poised for successful digitization. With the asset class growing at 20% CAGS since 2000, the numbers don’t lie. And while there are undeniable benefits of investing in this alternative market, there are significant challenges to widespread investment.
What Are Alternative Investments?
Global markets have been through a lot in the last decade. Many portfolios have borne the brunt of ongoing volatility and lingering recessionary pressures. Alternative investments such as private credit are an excellent way for investors to hedge against this volatility while generating passive income that current low-yield investments can’t. However, because of its relatively new arrival. the private credit market remains notoriously opaque.
Understandably, this presents challenges for both investors and specialty lenders alike. Unlike mature public markets, where technology continues to evolve in response to the involvement of large banks and exchanges, private credit markets remain antiquated. As a result, the specialty lender fundraising process is still mostly manual; wasting time, capital and resourced.
On the other side of the market, those looking to participate in the private credit market can’t find these opportunities or are denied access to viable investments due to high barriers to entry. To facilitate further growth in the space, there are certain hurdles to private credit deployment that must be addressed.
Why is it Challenging to Partake in Alternative Investments Today?
To partake in today’s private credit market, the average investor needs the right contracts – a challenging baseline requirement. Institutions such as Family offices and credit hedge funds maintain their competitive edge by hoarding relationships with credit issuers to maximize their returns. As a result, alternative investment opportunities are typically offered on a who-knows-who basis.
Beyond this, private credit markets have typically been reserved for accredited or institutional investors simply because of the amount of capital required. Even if an investor were to have the necessary connections, investment opportunities with attractive yields usually require high minimum investment. Further, these investments may present a long term to maturity with few liquidity options, further restricting investor participation.
To provide further context, the conventional process can be presented as a typical scenario on both sides of the market:
- A specialty lender is lending a borrower $1M for manufacturing for the borrower’s product
- The lender must create a legal entity for the deal, engage in fund formation, engage lawyers to create investment documentation such as subscription agreement and private placement memorandum.
- The lender must solicit investors to fund this loan, undergoing investor relations and underwriting process with each new investor, usually spending money on marketing.
- The lender may choose to partner with a credit facility, usually provided by a fund and on disadvantaged terms to the lender.
- On average, fundraising like this takes 2-3 months, costing the speciality lender around $80K for each new investment vehicle.
- For investors who want to participate, they would have to source these investments either through introductions or cold searching.
- Since the on-boarding process is so costly to the originators, they don’t take on new investors easily.
- Even when a new investor is accepted to participate, the investment minimum for a $1M deal can be $100K or more, restricting many investors
In reviewing the current process in detail, it’s evident that there are several challenges for originators and investors. However, by leveraging the power of distributed ledger technology, several of these hurdles can be overcome.
- A specialty lender is lending a borrower $1M for manufacturing the borrower’s product.
- After passing an investment platform’s risk management due diligence process, the lender posts the investment opportunity on the platform to start fundraising – immediately.
- In the traditional market, the fundraising process takes a few days to a few weeks.
- Depending on the regulations and exemptions filed, investors can sign up for the various security token platforms available after passing standard financial services screening including: Know Your Customer (KYC), Anti-Money Laundering (AML), and the Office of Foreign Assets Control (OFAC).
- Investors log onto the platform to view a list of investments and participate as they please.
The Inherent Properties of Digital Assets
While this process is much improved, the inherent benefits of digital securities can be further analyzed to explain the altered workflow.
Streamline Operational Process
Currently, fractionalizing asset ownership requires a significant amount of manual effort from both buyers and the sellers. Financing originators spend upwards of 25-30 hours per investment offering on operational tasks. This time includes addressing requirements such as Know Your Customer (KYC), Anti Money Laundering (AML), investor relations, subscription documents, Private Placement Memorandum (PPM), and investor on-boarding.
Also, investor and regulatory can take up to 20-30 hours each quarter. Through digitization, these processes can be fully automated. The resulting efficiencies enable companies to focus on growing their business rather than operations and reporting, resulting in significant time and money savings.
- Domestic Investors: Domestic investors on both the retail and institutional side will be able to deploy and access capital on a scale never before seen
- International Investors: International investors who are looking for US opportunities can quickly increase or decrease their exposure. Due to their ability to expand both the supply and demand of deals, digital assets will help implement a more democratized and inclusive private capital market.