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Institutional Challenges and Opportunities with Coming Tokenization Wave

Power of Ideas
Institutional Challenges and Opportunities with Coming Tokenization Wave

Just ahead of the US Super Bowl in early February 2023—an event watched by 113 million people—a streaming platform released a non-fungible token (NFT) offering owners a portion of the royalties to one of halftime performer Rihanna’s top hit songs. The track, released in 2015, “BBHMM,” was in the top 10 in eight different countries, had over 1 billion streams across platforms, and was dubbed one of the 200 essential songs of the 2010s by Pitchfork. The platform releasing the token offered 300 NFTs at $210 apiece, giving holders each a portion of 0.0033 percent of the streaming royalties.

This event may have fallen below the radar of institutional investors. In total, the NFT-drop raised only $63,000. According to the sponsoring platform, the “likely” NFT holder returns on the song were projected to be approximately 6.5 percent per year ($13.65 per share). If that proved to be accurate, it would take a buyer approximately 15 years to recoup their initial outlay. Clearly, buyers were looking at the purchase as a novelty for Rihanna fans rather than an actual financial investment. Yet, the success of the Rihanna NFT-drop has helped to increase the value of the music catalog owned by the issuing platform by +16 percent. For a platform that released its first NFT song track in August 2022, that is an impressive return.

It is this potential that should be of interest to institutional investors. Connecting with the “crowd” and allowing crowd interest to inform the valuation of alternative investments is likely to soon become a flashpoint for the investment industry.

Tokenization might lead to the development of a growing set of cultural asset alternative offerings.

Institutions began increasing their exposure to alternatives in the early 2000s. The Think Ahead Institute estimates that the top seven pension nations increased their allocations to real estate and other alternatives from 9 percent in 2002 to an estimated 23 percent at the end of 2022. These investments have been quite profitable. A study by CAIA found that over a 21-year period ending June 2021, private equity allocations by US state pension plans generated a net-of-fee annualized return of +11.0 percent, exceeding by +4.1 percent the +6.9 percent return that would have otherwise been earned by investing in public stocks.

Unsurprisingly, there is growing pressure to democratize access to alternatives to allow mass affluent and retail investors to obtain some of the same diversification and illiquidity benefits that institutions get from private equity, private credit, real estate, real assets, and secondaries. Tokenization can facilitate such access given the ability to create fractionalized shares, embed self-executing contract terms, and administer these assets with little operational friction on blockchains.

Yet, the implications of doing so are only just beginning to be understood. Tokenizing a limited partnership-sleeve of an existing private fund can facilitate better access, but in so doing, creates greater transparency, more pressure to mark-to-market, and more information on the value of the fund based on the initial versus secondary trading value of the tokenized shares. These pressures may create increased volatility in assets meant to be held over a long lock-up period and valued only periodically.

Conversely, we see potential that tokenization might actually improve the return potential and lead to the development of a growing set of cultural asset alternative offerings. These funds may offer new diversification options and benefits for all investors—from retail to institutional. Institutions have been buying up unusual assets like art collections, digital music, film, and television catalogs for years but have often found it hard to realize the full value of these assets.

As the Rihanna NFT example shows, sharing ownership and creating liquidity around even a fractional share of these assets and pricing them at values that make them affordable for individuals—who obtain an emotional payout in terms of identification and affiliation with the creator(s)—may democratize access to alternatives, expand the set of alternative investment opportunities, and provide a pathway to realize higher valuations and more liquidity around a broad array of existing institutional holdings.