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Private Capital sector explores digitalization

Insights from Disruption and Innovation Summit

Digitalization is reshaping every aspect of financial services, including the investment styles and operating platforms of private capital managers. Dirk Holz, Director, Private Capital Lead at RBC Investor & Treasury Services, moderated a recent SuperReturn panel discussion in Berlin, which explored how digitalization is influencing and disrupting the private capital market.1

Key insights

  • The securitization of illiquid assets could help create new markets and facilitate the retailization of private capital strategies, although the approach introduces new risks
  • Alternative data can provide insights that otherwise may not have been available from traditional sources, although the actual process of obtaining this information requires thorough oversight
  • The use of Artificial Intelligence (AI) in operational processes has the potential to generate savings for private capital managers and dramatically reduce their administrative workloads

Generating liquidity and transparency

While private capital assets are generally considered illiquid, blockchain, specifically the use of tokenization, is emerging as a potential opportunity to open these assets to a wider pool of underlying investors.2

The panel discussed how this approach could enable illiquid assets, such as a fleet of minicabs or physical buildings, to be separated into smaller component parts, linked through blockchain, and traded individually. In theory, through tokenization and securitization, formerly untradeable instruments could unlock liquidity, reduce transaction costs, and enhance transparency.

This type of financial structure could provide small and medium-sized enterprises (SMEs) that have illiquid assets with easier access to capital, rather than relying on traditional venture capital or private equity funding.

While some managers believe securitization and tokenization could enable them to broaden their investor base away from institutions and tap into the retail market, others are less confident. One panelist cautioned that digitalization of untradeable or illiquid securities could result in the instruments becoming excessively correlated with public markets, adding that many real estate investors put capital in that asset class precisely to diversify away from those correlations.

Big data as a performance enabler

Deeper insights and intelligence can help inform private capital strategies, and private capital managers are increasingly turning to alternative data to complement traditional investment analytics. For example, the integration of unconventional data might include trends pertaining to credit card transactions at significant retailers,as a useful addition to in-depth analysis of retail tenant reports and financial statements. Real estate managers could also consider using anonymized geolocational data sourced from cell phones to track movements which would provide more precise information about foot traffic at their commercial properties, as well as insights on visitor frequency.

Tokenization and
securitization could
unlock liquidity,
reduce transaction
costs, and enhance
transparency

Alternative data does have drawbacks, however, and it is important that managers conduct due diligence on data providers and sources to make sure the information they are receiving is accurate. For example, poor data due diligence could result in further risks particularly if managers are making investment decisions based on confidential materials.Managers must carefully consider privacy rules, particularly if they use information where individuals may be personally identifiable.Following the introduction of the European Union’s General Data Protection Regulation, private capital managers need to pay particular attention to ensure they uphold data privacy provisions.

Producing operational alpha through AI

Private capital managers are increasingly turning to alternative data to complement traditional investment analytics

To remedy these challenges, managers are increasingly utilizing automation tools to streamline aspects of their operations. One speaker said simple coding solutions and programs were already being used by a handful of managers to generate standardized or rule-based legal contracts such as non-disclosure agreements (NDAs). Adoption of AI across financial services is now becoming increasingly normalized, as firms look to obtain cost savings and efficiencies and improve accuracy. Many private capital managers have found themselves engulfed by regulatory and investor reporting obligations, which may cause financial and operational strain.

Adoption of AI across financial services is now becoming increasingly normalized, as firms look to obtain cost savings and efficiencies and improve accuracy

AI applications such as machine learning are being trialed by some firms to mark up NDAs with their comments. The use of machine learning technologies has expedited the administrative process and negated the need to consult with external counsel for routine issues. Meanwhile, optical character recognition, another form of AI, could help managers convert contracts into machine readable formats, which would allow the process for changing these documents to be fully automated. A panelist acknowledged that such technology would be useful for managers amending legal contracts ahead of their transition away from LIBOR or implementation of contingency plans because of Brexit.

Many of the innovations underway in the private capital industry, whether it be asset securitization, application of big data or adoption of AI, will help the sector identify new sources of investment and potentially produce operational alpha. While these technologies have advantages, their risks may require further clarity before the private capital industry further entrenches such approaches into their business models.

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Sources

  1. SuperReturn Disruption and Innovation Summit (February 26, 2019) Panel discussion: How is the digital age effecting private equity strategies?
  2. Deloitte (November 2018) The Tokenisation of assets is disrupting the financial industry – are you ready?
  3. Bloomberg (November 29, 2018) Parking lots don't tell the whole story: The trouble with alternative data
  4. Duff & Phelps (April 19, 2018) Alternative data brings different problems
  5. Ibid.