Blockchain Applications and Fee Structure Developments in Private Investment Funds

The traditional 2/20 fee structure of private investment funds has come increasingly under pressure in the last ten years. Typical factors considered to 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.

An additional factor that contributes to the pressure on fees, one that has largely been ignored by commentators, originates in private fund advisers’ use of blockchain technology, artificial intelligence, and big data. 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. Prominent examples of lower fee structures driven by the use of blockchain technology include those of Lending Robot’s Lending Robot Series, and platforms for blockchain-enabled fund management, such as those offered by Melonport or Drago, among others.

Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model. While some funds simply focus on trading bitcoin and other cryptocurrencies to avoid market fluctuations, others invest in and/or acquire companies that use blockchain technology to provide synergies to their other portfolio companies. Yet others go much further by fully automating a hedge fund secured by blockchain technology, using blockchain technology to improve administrative procedures of private equity deal making, or using cryptocurrencies as incentives for data scientists’ competitive models that facilitate investment analysis efficiencies. Examples include private investment funds, such as Polychain Capital, the Northern Trust in cooperation with IBM, Numerai, LendingRobot, Intellisys Capital LLC, and Melonport, among many others.

Blockchain technology enables managers to charge per-transaction fees which undermines the existing 2/20 fee model. It 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. 

Using a dataset of private investment fund advisers that utilize blockchain technology in their investment strategy or internal operations (N=[98]), 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 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 illustrates that the rise of blockchain applications in private investment funds can exacerbate the already changing fee structure of the industry. Private investment funds that use blockchain technology in combination with artificial intelligence and big data are able to lower their fees. As the use of modern technologies increases in the industry, the fee structure is likely to be further affected.

Wulf A. Kaal is an Associate Professor at the University of St. Thomas School of Law (Minneapolis).