DeFi Thesis: Private Markets Pt. 1

Part 1: Private Markets vs Public Markets

Oct 11, 2022

Hello readers,

Continuing with our “thesis” series, this week we explore the current state of private markets. We believe private markets will drive the adoption of digital assets within regulated markets. The private markets are an asset class worth hundreds of trillions of dollars. Zooming out, the impending evolution of the private markets could look similar to the digitization of the public markets in the 90s.

The transformation could provide endless opportunities for asset owners & managers, fund admins, exchanges, general partners, tech platforms, consultants, data providers, and service providers.

In this two-part report, you’ll get a boots-on-the-ground perspective of the private markets today and the tech stack being built to change them. Please note that my employer, Inveniam, sits at the epicenter of this new tech stack. Many of the firms referenced are part of our growing ecosystem.

In Part 1 we cover:

The Current State of Private Markets
Private Markets vs Public Markets & why Private Markets are Illiquid

In part 2 we cover:

The Technological Evolution Underway
Private Markets and the Bridge to DeFi
The Future State of Private Markets

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Inveniam is the data operating system for private market assets.

Let’s go.

Current State of Private Markets

Private assets (also referred to as “alternatives”) encompass anything outside of public stocks and bonds. This includes real estate, private equity, private debt, infrastructure, farmland, art, venture capital, commodities, etc.

The private markets are massive. And they keep getting bigger. Below is some context.

Source: Bain & Company via Prequin and the World Bank

After a down year in 2020, private markets set a new all-time high in 2021 in terms of fundraising.

Source: McKinsey & Company via Prequin

What is Driving this Growth?

Two primary factors: Regulation and Macroeconomics.

2012 JOBS ACT

The 2012 JOBS act was implemented after the Great Financial Crisis in an effort to boost entrepreneurial activity — by allowing companies to raise capital through crowdfunding efforts (Reg CF) without going through onerous and costly SEC registration.

The introduction of Reg CF is democratizing access to private investments for non-accredited investors and spawned the age of equity crowdfunding using the distribution of the internet. Crowdstreet and Fundrise are examples of crowdfunded marketplaces for real estate investment.

In addition to Reg CF, changes to Regulation A allow companies to raise up to $50 million (from $5m) without going through SEC registration.

We can see the impacts on public listing and IPOs in the data. As investors continue to fund private companies, fewer and fewer are opting to go public.

Source: “Listed Domestic Companies, Total,” The World Federation of Exchanges, 2020. Jay Ritter, "Initial Public Offerings: Updated Statistics," University of Florida, June 2, 2021

Macro

From a macroeconomic perspective, below we have a simple chart, but it tells a compelling story.

Source: Federal Reserve

As debt rises, interest rates drop. As interest rates and discount rates drop, investors are pushed into alternative assets in search of yield. Is the trend reversing? It may appear so (red line), but Federal debt actually has not been reduced. The red line dropped a bit due to an increase in GDP that was stimulated by money creation and inflation during the pandemic. Therefore GDP grew faster than public debt.

Meanwhile, interest rates are on the rise again. The critical question is whether we are now moving into a structural shift in interest rates, a la the 1970s. The level of debt in the system today is quite different from the 70s when Debt/GDP was about 30%. It was possible to raise rates and crush inflation without creating a global depression back then. It would appear that there is just too much debt today.

As such, we do not think that this current trend (increasing rates, lower debt/GDP) will continue. Of course, we could be wrong, but we do not share the view that Central Banks will be able to stamp out inflation by jacking up interest rates — the debt problem must be dealt with first (though we may see periods of brief deflation). We believe the only feasible way to do this is by running inflation hot, keeping rates low, and inflating the debt away — as we saw in the 1940s. Monetary policy could then be normalized. The current state of the United States income statement and balance sheet will not allow for sustained high-interest rates. Therefore we think the Fed will have to pivot back to lower interest rates in the coming months.

Recent Moves by Large Asset Managers & Trading Venues

From a quantitative perspective, the data points to further growth of private markets. But what are the large financial institutions signaling? From a qualitative perspective, it appears they see the opportunity as well.

Blackrock is now advising a 50/30/20 portfolio with a 20% allocation to alternative, private market assets
JP Morgan launched “Project Bloom” — a platform for funding and secondary trading of private market assets
The DTCC (which handles global post-trade clearing & settlement) is building a new platform to streamline the issuance, transfer, and servicing of private market assets
Bain & Company is advising that private markets will drive the adoption of digital assets
The London Stock Exchange Group is building a new platform for private company funding & secondary trading
ICE (which owns the New York Stock Exchange) funded a digital ATS for the trading of private market assets on blockchain rails

With revenues in the public markets being pinched, the signal becomes clear: The Opportunity is in the Private Markets.

Comparing Public Markets to Private Markets

Close your eyes. Just kidding. Keep them open and keep reading.

It’s 1990.

You still have to call your stock broker to make a trade. There is no such thing as a robust futures or options market. No ETFs. No CDOs or CDSs. Mortgage-backed securities weren’t really a thing.

There was no such thing as high-frequency trading.

There was no Edgar database. No Yahoo Finance.

The total equity trading value was $5 trillion. [$160 trillion in 2021]

Fast forward to the mid-90s and the age of the internet…

The Internet and Public Markets

The internet has been one of the most revolutionary and disruptive technologies in history, creating paradigm shifts across many industries. Included in this disruption was the digitization of the public markets in the 90s, which was driven by three principal factors. The first was transparency, or the ability for a much broader base of investors to analyze information and come to their own conclusions on how to properly price securities. The second was changes in pricing — which speaks to the demise of full-service brokers. Finally, greater access to information drove disintermediation, which again referred to the ability of investors to bypass old-school, full-service brokers and advisors for information and securities trading.

It starts with the EDGAR database.

The Edgar Database

The Electronic Data Gathering, Analysis, and Retrieval system is an electronic filing system created by the SEC in 1995. Its primary purpose is to increase the efficiency and fairness of the securities market for the benefit of investors, corporations, and the economy by accelerating the receipt, acceptance, dissemination, and analysis of time-sensitive corporate information filed with the agency.

In other words, the EDGAR database provides free public access to corporate information, allowing investors to research a public company’s financial information and operations.

We trust the EDGAR database because public companies are required to file disclosures and financial statements with them. These companies are required to undergo 3rd party audits and can be penalized for any material misstatements because investors are relying on this information. The EDGAR databases is centralized.

Graphic Design: Laerta Premto

Access to trusted information removes information asymmetry in the market. This allows price discovery to occur. Price discovery leads to secondary trading. The EDGAR database went live in 1995. US equity trading value was $9 trillion that year. By 2000 it had jumped to $46 trillion (per Worldbank).

But what about the private markets?

Private Markets and Trusted Data

The mechanisms to commute trust and transparency into private markets have remained largely unchanged. As such, access to data and price discovery remain curtailed.

This leads to…

Source: McKinsey Global Private Market Review 2020

Private markets function today as the public markets did in 1990. The principal reason for this is the lack of infrastructure to commute trust into these markets. It starts with better data. Better data leads to less information asymmetry. Which leads to price discovery. Price discovery leads to secondary trading. Secondary trading leads to more liquidity. Which leads to new markets, a higher velocity of money, broader access for investors, and greater economic output.

The private markets do not have this trusted base layer infrastructure. We don’t have a trusted database.

The solution?

We need a trusted database for private markets. We need a new tech stack. In part 2 we discuss the base layer infrastructure being built today and how this ties into DeFi.

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