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Several market factors help explain the pressure on the fee structure of the private investment fund industry. In a total of 1, private investment funds closed down, exceeding the 1, liquidations of private investment funds in , and falling just shy of the record 1, closures in Other factors that help explain the pressure on fees in the industry include the inadequate performance of the private investment fund industry, the ability of large investors to negotiate special terms, the withdrawal of private investment fund investments by large institutional clients and public retirement funds, and the consolidation of the industry, among several other market-driven factors.
A factor contributing to the market pressure on the fee structure that has not been examined by commentators pertains to the increasing use of use of blockchain technology, artificial intelligence, and big data by private fund advisers. Anecdotal evidence suggests that the majority of private fund advisers that use blockchain technology, artificial intelligence, and big data in different aspects of their operations or strategy have a substantially lower fee structure than those who do not use them.
Using a dataset of 98 private investment fund advisers that utilize blockchain technology in their investment strategy or internal operations, this article shows that the fund advisers who use the new technology are able to charge overall lower fees.
The article explores the reasons for lower fees in those funds and examines possible future applications of the technology in the private investment fund industry. While the overall proportion of strategies of private investment funds that apply modern technologies, including blockchain technology, is still small, as the use of blockchain technology grows in the private investment fund industry, the pressure on the fee structure is likely to continue to grow.
The fee structure of private investment funds has changed substantially in the last ten years. It has become increasingly common in recent years for investors to negotiate fees with fund managers, particularly with newer fund managers who may be more willing to engage in such negotiations to induce seed investors at the time of fund formation. Alternative fee arrangements include but are not limited to modified highwater marks, incentive hurdles, and triggers, as well as clawbacks.
First-time or new managers are particularly affected by the new fee structure. Moreover, the industry is increasingly seeing contested track records for new managers, i. Another phenomenon that affects first-time managers pertains to early limited partnership investors who increasingly throw their weight around to negotiate tough terms on fees.
A prominent example, exemplifying the pressure on the fee structure given the performance of the industry, is the wager between Warren Buffet and Ted Seides. Seides entered into the bid despite a huge disadvantage—hedge funds have a much higher fee structure and the wager pertained to compounded annual interest net of fees.
The increasing pressure on the traditional fee structure manifests itself in several new fee-related outcomes affecting private investment fund managers. In recent years, private investment fund management fees can deviate from the market rate of 1. Other important factors for the downward pressure on the incentive fee side include blackened carried interest and changes in the calculation of hurdle rates.
Some industry observers are now talking about a movement towards blackened carried interest, meaning a private investment fund manager cannot collect carry until all limited partner investors have had their capital returned within the lifetime of the private equity model. A similar trend is observable in the hedge fund industry.
Moreover, hurdle rate calculations have changed substantially. Inflation-indexed hurdle rates are now calculated on a monthly not a quarterly basis. Blockchain technology has been defined in many different ways, and no truly uniform definition seems to exist.
Others define blockchain by focusing on its central elements, e. Rather than attempting to agree on a mutually acceptable phraseology for a definition, a description of the core elements of ledger technology can help define the blockchain. The chain of transactions is distributed to a limitless number of participants, so-called nodes, around the world in a public or private peer-to-peer network.
Blockchain technology removes fraudulent transactions. Network connectivity allows multiple copies of the blockchain to be available to all participants across the distributed network.
The decentralized, fully-distributed nature of the blockchain makes it practically impossible to reverse, alter, or erase information in the blockchain. That model also allows node verification of transactions without compromising the privacy of the parties and is therefore arguably safer than a traditional model that requires third-party intermediary validation of transactions. Cryptographic hashes further increase blockchain security.
Cryptographic hashes are complex algorithms that use the details of all previous transactions in the existing blockchain before adding the next block to generate a unique hash value. That hash value ensures the authenticity of each transaction before it is added to the block. A different hash value makes any form of manipulation immediately detectable.
Smart contracts and smart property are blockchain-enabled computer protocols that verify, facilitate, monitor, and enforce the negotiation and performance of a contract. More complex smart contract arrangements in which several parties are involved require a verifiable and unhackable system provided by blockchain technology. Through blockchain technology, smart contracting often makes legal contracting unnecessary as smart contracts often emulate the logic of legal contract clauses.
A recent trend in the private investment fund industry pertains to the increasing use of blockchain technology to facilitate investment and process optimization.
Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model. Several private investment funds have spearheaded and continue to expand the implementation of blockchain technology and smart contracting in their business models.
In February , Northern Trust and IBM entered into a partnership for the commercial use of blockchain in the private fund industry. The partnership provides an enhanced and efficient approach to private equity administration.
The implementation of the Northern Trust and IBM blockchain is intended to increase the efficiency, transparency, and speed of private equity transactions, improve security, and bring innovation to the private equity market by simplifying the complex and labor-intensive transactions in the private equity market.
More specifically, unlike the current deal practice in private equity, which requires parties to reconcile multiples copies of the documents that form the deals to understand the greater picture, the blockchain program announced by Northern Trust and IBM allows all involved parties in an equity deal to look at a single compiled version of the transaction and all other data relating to the deal. Another example of the use of blockchain technology for private investment funds is Numerai.
Numerai is a private investment fund with a global equity strategy that will go live on the blockchain later this year. On February 21, , Numerai, announced: Data scientists working in this model work to solve the same problems in their own unique way with different strategies.
Numerai synthesizes these models to create a meta-model out of all the predictions from the data scientists. In the Numerai model, the use of artificial intelligence ultimately helps achieve the goal of efficiency and optimum capital allocation by reducing overhead costs because there is no cost of human capital. In addition, Numerai eliminates barriers to entry because users do not need capital or any special finance or data knowledge.
Once the investor has created a trading profile, LendingRobot selects and executes trades that are recorded in the blockchain public ledger on a weekly basis.
Established private investment fund managers may consider implementing blockchain technologies in the foreseeable future. Most large fund advisers in the private equity and hedge fund industry have not yet considered implementing blockchain technology in combination with big data applications and artificial intelligence.
This, however, may change in the foreseeable future if and when larger managers realize that their smaller competitors who utilize these technologies gain substantial operational efficiencies and cost savings and are able to substantially diversify their portfolio holdings via such technologies. The threshold for change for bigger managers may be dictated by the implementation cost of such new technologies.
If and when the long-term benefits of using the technologies exceed the implementation cost, which are much larger for larger managers than for the smaller managers who are currently experimenting with such technologies, larger managers are incentivized to start the innovation process as well. Blockchain technology facilitates a seamless and efficient calculation of management fees per transaction. In contrast to the traditional settlement and calculation of fees in a per-transaction model that created a prohibitive amount of work making such operations very difficult to execute, blockchain technology overcomes all of these restrictions.
It enables the fully automated allocation of the appropriate fee to the correct executed trade and associated client account without any manual reconciliation or settlement. While normally the use of this type of fee is prone to human errors that occur during manual calculation or settlement, these errors are removed through the use of blockchain technology which performs the required calculations and settlement procedures automatically and seamlessly.
The blockchain enabled per-transaction fee can be pre-determined or modified by the manager in cooperation with clients. It also can be publicly available which allows the private fund adviser to determine the applicable fee in a competitive market. Accordingly, clients who invest in a more transaction-prone strategy will be able to agree upfront to higher fees whereas clients who invest in a less transaction-rich strategy will pay overall lower fees. While not all blockchain-enabled private investment funds charge per-transaction fees, the majority of private fund advisers that use blockchain technology are able to charge their investors lower fees.
Other factors that help keep the fee low include the increased transparency that allows LendingRobot to expense fewer resources on auditing the fund. LendingRobot claims an average performance of from 6.
As of March an analysis of a broad range of traditional hedge funds shows an average of 8. The Logos Fund is an alternative investment fund that invests in blockchain and cryptocurrency-related investments. It aims to make blockchain-based currencies accessible to professionals and a broad range of investors by investing in the mining of blockchain-based cryptocurrencies as well as into such currencies directly.
To cover base costs and administration, the Logos Fund charges an administrative fee of between 1. Blockchain-enabled platforms for setting up a private investment fund cause significant pressure on the existing fee structure of the private investment fund industry. Platforms such as Melonport or Drago enable competitive gains for their clients through fewer costs and time barriers to setting up and running a private investment fund.
While such competitive gains will benefit the majority of private investment fund managers and investors, the lower operating costs enabled by the platform models will especially enable new and future managers to enter the market because the start-up costs and compliance costs can be significantly reduced. By enabling low set-up requirements and low costs of running a portfolio, platform models may be able to create an unprecedented competitive environment for asset management strategies.
The cost of running a private fund adviser portfolio on the blockchain equals the core usage fees, modular commissions, and the infrastructure costs to be paid on the Ethereum platform. The usage fees are determined by the protocol, and the modular fees are set by the module developers and are a fraction of a cent or a fraction of the trade volume for each usage. While the author was unable to get responses from all managers in the dataset, those who responded suggested that they were able to use an alternative fee structure.
The meteoric rise of blockchain technology and the abovementioned prominent applications of blockchain technology utilizing artificial intelligence and big data serve as prominent examples of the impending seismic shifts in the private investment fund industry. The paper has illustrated that the rise of blockchain applications in private investment funds has an impact on the already changing fee structure of the industry. Private investment funds that use blockchain technology in combination with other technologies, such as artificial intelligence and big data, among others, are able to lower their fees.
As the use of blockchain technologies increases in the industry, the fee structure will be subject to increasing pressure. Changing Fee Structure The fee structure of private investment funds has changed substantially in the last ten years. Blockchain Technology Blockchain technology has been defined in many different ways, and no truly uniform definition seems to exist.
Conclusion The meteoric rise of blockchain technology and the abovementioned prominent applications of blockchain technology utilizing artificial intelligence and big data serve as prominent examples of the impending seismic shifts in the private investment fund industry.