In the ever-evolving landscape of venture capital ( VC ) and private equity ( PE ) funds, the need for innovative liquidity solutions has become more critical than ever. As a VC/PE fund nears the end of its term, managing the fund’s remaining illiquid assets often becomes a significant challenge. With the development of blockchain technology that enables the recording of ownership interests on a decentralized digital ledger ( tokenization ), we have seen an emerging market for tokenized fund offerings.   

Tokenization provides more benefits for fully invested VC/PE funds near the end of their life cycle, versus at the fundraising stage, and approaching fund tokenization from such an angle could be the impetus for greater adoption of tokenization of this asset class.

Tokenization involves converting rights to real-world assets ( RWAs ) into a digital token on a blockchain. This process offers numerous benefits, including enhanced liquidity, transparency and efficiency in transactions. In the context of VC/PE funds, tokenization can revolutionize how fund interests are managed and traded by enabling instant transaction and settlement through smart contracts. However, we have not seen rapid adoption of blockchain and tokenization technology for newly organized VC/PE funds.   

Challenges at the fundraising stage

Some of the reasons why we have not seen a great number of tokenized VC/PE funds are the same as in other asset classes – including, for example, network effects not being present at the moment, legal and regulatory uncertainties, and a lack of a central bank digital currency or an accepted trading venue, such as a licensed crypto exchange. More importantly, there has not been a compelling use case for tokenizing a VC/PE fund at the fundraising stage.

• There is no immediate need for liquidity. At the beginning of a VC/PE fund’s life cycle, there is typically no immediate need for liquidity, since the fund at this stage is not yet capitalized and is only valuable because it is comprised of a number of investors – limited partners ( LPs ) – that have a contractual obligation to contribute capital to the fund based on their respective commitments. 
• LPs are not anonymous.  Oftentimes, general partners ( GPs ) would want to raise a VC/PE fund with a strategic group of investors, each of whom offers a unique value to the partnership. The terms of a fund agreement are usually also bespoke based on a complex negotiation of the value proposition of the group, its ability to operate as a real partnership, and its outlook on the market that the fund is seeking to address.  Tokenization of LP interests at this stage generally does not enhance these goals for either the GP or the LPs, and as such, tokenization itself does not enhance the fundraising process.   
• Price discovery issues. Valuing and pricing tokens for a new fund with no existing underlying assets can be speculative, leading to potential mispricing and investor uncertainty. The need for price discovery will emerge once the fund has drawn down capital and made some investments ( therefore no longer a blind pool ). It is only at this point that LPs who have a view may want to transfer their fund interests and seek a market value of the assets that is beyond the valuation that the GP presents.
• Limited benefit from improved cost efficiency.  Overall, at the beginning of a VC/PE fund’s life cycle, the cost savings from putting fund interests “on chain” do not bear as much significance as the issues stated above.

Benefits of tokenizing fully funded VC/PE funds

Compared to tokenizing a VC/PE fund at its inception when the fund itself is a blind pool, tokenization may be better suited for fully funded VC/PE funds and can serve as an alternative liquidity solution – in particular, for long-dated funds with illiquid assets that the GP has difficulty realizing.

• End-of-life liquidity. For VC/PE funds nearing the end of their term, liquidity becomes paramount. Tokenized fund vehicles can provide an effective solution by converting illiquid assets into tokens that are tradable in certain crypto-favourable jurisdictions, allowing LPs to liquidate their holdings more efficiently. Unlike a fund at the beginning of its life, the GP’s need for strategic alignment with its LPs is not as important as finding a ready market to liquidate the fund’s remaining illiquid assets. There is a renewed emphasis on liquidity, and the ability to discover the price of the fund’s underlying assets is enhanced as a result of using a fully digitized platform, as transparency can create demand for assets that are otherwise traded in a traditionally opaque market.
• Value preservation. Tokenized investment vehicles offer LPs a mechanism to preserve and potentially enhance the value of their investments in a long-dated VC/PE fund. By tokenizing the fund’s remaining illiquid assets, GPs can avoid “fire drills” and potentially capture more favourable market conditions for asset liquidation.
• Exit flexibility and trading. Unlike transfers of limited partnership interests, which typically require the GP’s prior written consent, tokenized fund interests can be structured to trade on secondary markets in certain crypto-favourable jurisdictions, providing LPs with flexibility and easier exit options. This is particularly beneficial for LPs who may have policy restrictions on holding illiquid assets.
• Using tokens in secured transactions and derivatives transactions. Existing frameworks for secured transactions can provide alternative channels for liquidity to LPs after tokenization. Tokens may be used as collateral in secured transactions. A third-party custodian may be engaged to hold the tokens for the benefit of the secured party subject to a wallet control agreement. LPs also may enter into derivatives transactions on the tokens to further divest their exposure to the value of the underlying illiquid assets. 

Built-in tokenization flexibility in new fund formations

GPs forming new VC/PE funds may consider building future tokenization flexibility into the fund governance documents at the fund formation stage. The GP may prescribe a set of “master rules” for future tokenization of limited partnership interest after the fund is fully invested. Such “master rules” will allow the GP to control the key aspects of tokenization, such as jurisdiction, blockchain, exchange venue, liability, and investor and transaction white lists, while preserving flexibility for future implementations.

Tokenized fund vehicles offer a promising solution for fully funded VC/PE funds, particularly as they approach the end of their life cycle with illiquid assets. By taking advantage of the new tools to digitize assets, VC/PE funds can enhance liquidity, preserve value and provide flexibility for investors. This approach not only addresses the immediate challenges, but also might be the asset class that will set the stage to prime the market for more rapid adoption of tokenization of VC/PE funds in general. 

Pang Lee, partner at law firm Cooley, advises on partnership, corporate and securities law matters related to the organization and investment in private funds and strategic investments in the tech industry. Shimeng Cheng, special counsel at Cooley, focuses on structured finance, asset-backed financing, synthetic derivatives and cryptocurrency investments. Joyce Wang, counsel at Cooley, covers all areas of corporate, partnership and securities law, with a focus on the representation of institutional investors in their global investments in private funds.