March 10, 2022
The COVID-19 pandemic acted as a catalyst for digitalization in most industries, including financial services. Firms were caught off guard and were forced to rapidly digitize processes to enable customers, and their own workforce to complete tasks that had perhaps previously been omitted from earlier digital transformation projects.
In this blog, we refer to both digitization: making analogue information digital; and digitalization: making existing processes digital.
Controlled data flows, collaborative software, centrally controlled and decentralized software, and secure, decentralized data storage are now standard and have become an integral part of everyday life. This also applies to a class of assets that is not quite as well known to the general public; private equity (PE), or more broadly; the private markets. Private markets is an umbrella term for investments that are not publicly available through a stock exchange. Private markets include investments in private equity funds, bonds that are not listed on a stock exchange (private debt), as well as unlisted infrastructure or real estate investments, also known as infrastructure funds or real estate funds. In addition, there are other specializations such as venture capital funds, which mainly focus on smaller and younger companies in special industries, or so-called impact funds, which invest in industries and companies that are intended to create sustainable value for humanity and the world, or projects to fight climate change.
There are two main players in this field: the fund manager and the investor. The investor provides the capital and wants to be compensated accordingly for the loss of liquidity and opportunity costs in return. The fund manager invests the capital provided in relatively complex and illiquid investments and strives for high returns in line with the risk. Both parties have a great interest in ensuring that processes are (or can be) digitized to benefit from the cost-reducing and value-enhancing effects.
In today's private market environment, fund managers are increasingly exposed to cost pressure. The market can create a lot of capital if opportunity costs are low, and when central banks flood the market with cheap capital. Firstly, this attracts more fund managers into the market and, secondly, allows the formation of much larger funds (multi-billion-dollar funds). This, in turn, means that good investment opportunities are more competitive and thus become much more expensive. Since the success of a fund is strictly measured by the return, fund managers need better control over costs.
On the other hand, capital more often comes from highly regulated institutions, such as banks and pension funds. They have much higher transparency requirements and want detailed and punctual reports in order to satisfy their own internal processes.
Ideally, therefore, the fund manager delivers more at a lower cost. This often means that CFOs must expand their models and let them run more often. This significantly increases the risk of errors, which can run into several millions. It should be noted here that the most commonly used tool is Excel, which in itself has a high error rate and was never built for this kind of sometimes highly complex calculations. Since investors also have a better understanding of the mechanisms, mistakes are more likely to be discovered, thus increasing the risk of reputational damage.
The investor is at best a wealthy person, but more often a family office, a pension fund, or a bank or similar institution. Often, hundreds of millions must be invested in private markets, but this is only a small part of total fixed assets. Let's take a pension fund as an example – in Switzerland, pension funds are the most important buyer of private equity investment products. Only around 1.1% of pension fund assets are invested in PE – a tiny but essential part, as there can be a lot of return in the 1.1%.
However, risk assessments and liquidity planning in the private markets sector are much more complicated than other pension fund investments. Each investment can have different mechanisms, the transparency is much smaller, the commitment is forced to be much longer and a lot depends on trust in the fund manager, which is difficult to measure. This combination of factors requires a deep understanding of the type of investment and many years of experience – in other words, expensive employees. But for 1.1% of total assets, the pension fund is most likely unwilling to make these expenses and want to keep employees over the long terms of an illiquid investment – and if it is, it certainly isn't an entire team.
This exposes the pension fund and most other investors to a risk that is difficult to calculate. Either you completely renounce the expert knowledge and go with the flow in the hope that rapids will not occur. Or you can invest in an employee and make yourself dependent on their expertise.
Of course, this is one of the most important reasons for the digitalization of processes, especially in PE products. The aim is to buy expertise as cheaply and as independently of people as possible. Digital solutions help to automate significantly inefficient activities, to get processes and calculations away from ubiquitous but risky manual spreadsheets, and thus to reduce dependence on a single person with the expertise. Products that can be purchased often already contain in-depth expertise and bring best practices with them. Repetitive activities often become unnecessary with the products and audit costs can be reduced.
Digitalization can therefore be the decisive point as to whether an investment in the lucrative asset class of private markets makes sense.
Digitalization in private markets means that ordinary savers have the opportunity to participate directly in investments. Today, there is a need for expensive middlemen who are licensed. However, there are already an increasing number of platforms that offer investment opportunities in professional funds, although the fees could be high. This would then also offer small investors (willing to take risks) to invest in investments or funds in private markets, with all their advantages and disadvantages. The advantages include a significantly higher return potential compared to a usual market investment; The disadvantages are certainly a significantly higher risk of default and the risk of a higher lack of transparency in investments, as many fund managers do not always disclose in detail why and where investments are made. A minimum investment of one hundred thousand Swiss francs seems very high at first, but if you assume that such an investment is usually reserved only for institutional investors, who, as mentioned before, have to invest a minimum of several million francs, then you can simply put it into perspective. Especially since it can be assumed that this maximum amount is likely to fall further.
Loan financing and direct investments by start-ups are already possible today (crowdfunding). Today, the fund manager has little interest in many small investors, all of whom are involved in intensive relationship management and need reporting – but this could change with the help of smarter products and digitized processes.
Digitalization has also found its way into private markets, although not to the extent that one would expect from such an industry. Private markets invest in the latest products much earlier than others, supports companies in the field of blockchain, artificial intelligence or robotics from an early stage and even uses old technology such as Excel for highly complex calculations.
It is likely to be only a matter of time before this changes and the signs from core markets such as the US show that the change has already begun. It will be the investors and fund administrators who must and should drive this change, as these two groups would benefit the most. For investors, digitalization means greater transparency, faster, which can have a direct impact on returns. For fund administrators, this means more earnings potential in the medium term due to a changed range of services as well as the possibility of estimating resources differently or saving costs.
The next few years will show who will be the first to take full advantage of the benefits of digitalization and thus emerge as the winner from this change, and who will miss the train. For all normal savers and investors, it should only be beneficial, so we can look forward to this future.