“Blockchain technology isn’t just a more efficient way to settle securities. It will fundamentally change market structures, and maybe even the architecture of the Internet itself.” -Abigail Johnson (CEO of Fidelity Investments)
No, we aren’t still in the Crypto Dip-Toe series, and today’s topic is perhaps a good one for easing back out of the crypto world and onto other topics. In that series, we covered many facets of crypto and blockchain and why caution is warranted when interacting with those technologies and related investment opportunities. Still, I couldn’t agree more with Ms. Johnson’s general assessment. For years, I’ve been thinking about how cool it would be to have illiquid investments – commercial buildings, for example – sliced up into small pieces and owned by “the common folk.” In the blockchain world, that process is called “tokenization,” and maybe it will be a game changer.
But that future crypto “on-chain” solution is not what we’re talking about today. Because what I’ve learned lately is that the future is already here, and that future is…wait for it…securitization. And securitization is definitely off-the-chain! In the context of a classic Spaceballs scene, this realization gave me the feeling that THEN has become NOW, now.
If you just thought to yourself, “isn’t securitization already a thing?” you would be correct. For some background: securities are what we’ve used to facilitate investing for quite some time. From what I gather, the “securities” nomenclature appeared along with securities laws in the aftermath of the 1929 stock market crash and the Great Depression. Before then, we obviously already had stocks and stock exchanges (hence the crash) and even sales of debt issues (dating back to Venice in the 1300s!). Stocks, bonds, and other investments (derivatives, ETFs, mutual funds) now all fall under the category of securities. And one of the ongoing topics of debate within the crypto world has been whether cryptocurrencies and other tokens are securities or not (which can have implications related to securities laws and taxation). Along those lines, Ripple (XRP) even became the target of an SEC lawsuit.
Securitization also has a long history – one that dates back to the seventeenth-century British Empire, when it was used as a means for the country to restructure “its debt by offloading it to its wealthiest corporations, which in turn sold shares backed by those assets.” But securitization may be more familiar to the modern reader in the form of mortgage-backed securities (MBS). An MBS is more specifically called a “debt securitization.” [And, yes, MBS may be most familiar because they infamously blew up during the financial crisis of 2008, but that is not really relevant to today’s topic]
Securitization is just a process for making something more easily investable. Using MBS as our example, mortgages are pooled together (which isn’t investable/tradeable) and sliced up into pieces of tradeable securities representing various ownership and cashflows from that underlying pool. Importantly, securitization doesn’t just need to be related to debt. As Investopedia puts it, “in theory, any financial asset can be securitized – that is, turned into a tradeable, fungible, item of monetary value. In essence, this is what all securities are” (emphasis mine).
What Has Securitization Done for me Lately?
After the alphabet soup of securities leading up to the Financial Crisis – MBS, CMBS, CDOs, CLOs, etc. – “securitization” has had a negative connotation. That process of shedding that reputation is well underway, and it’s now being used to democratize investments that have otherwise been available to only the wealthiest of investors. The two examples I’ve learned of recently – which have (admittedly) completely caught me by surprise – are in commercial real estate and art. Years of development have gone into these, but we’re now living in the future, where RETAIL investors can participate in direct ownership of these historically hard-to-reach areas.
There’s a case to be made that art is its own asset class, given its potentially low correlation to other asset classes and size. Deloitte estimated the global arts and collectibles market to be about 1.7 trillion dollars in 2019 (roughly half the size of private equity), and in 2021 art transactions were estimated to be about $65 billion. But the usual problems that accompany art are: 1) It’s probably among the most illiquid investments one can find, and 2) “high-end” art has historically only been available to the wealthiest of people or large companies (let’s face it, even if you have $100 million net worth, I’d deem the purchase of a $30 million painting to be unadvisable; if you’re a billionaire, that’s a different story).
The strategy I looked at has helped to solve for these hurdles. How? You guessed it. Securitization. Like other investment managers, the art manager has a team of people employed to research art that fits specific criteria. They’ve also narrowed their focus to only include contemporary art – where they believe they can uncover reliable value for investors. After they purchase a piece of art, they securitize it so that retail investors can buy a piece of some of the world’s most expensive works. Not only can investors right-size a painting for their portfolios, but they can also diversify across many pieces. That said, it’s still illiquid, so the strategy is essentially buy-and-hold until the manager sells a given work (3-10 year hold period for each). Thus, it’s very much like private equity investing, where we commonly advise staggering investments across vintages (investment years) to diversify and help manage cashflows/liquidity.
And if advisors want to utilize art as a portfolio component for their clients, this firm has also thoughtfully constructed a diversified fund that can own a portion of what they offer to the retail crowd or assume full ownership of a given art piece. It’s an evergreen, diversified investment. And similar to other funds in the Alts space, that structure comes with steeper minimums (e.g., $100k) and is limited to accredited investors.
Clearly, where I’m going with this is that I’ve also recently encountered the securitization of commercial real estate. Similar to the art-securitization concept, retail investors can register for a platform to research and buy pieces of real estate that the manager offers. However, it is also very different in that the platform doesn’t own those properties entirely. Instead, they take a minority interest in a property being actively managed by a third party. Tying into our broader world of Alts, sometimes that may even be a property held by a real estate private equity manager! PE managers often need to sell or recapitalize a given property after several years (either to repay existing loans or to send money back to investors), so this platform can fill that void.
It’s a win/win/win: The platform gets a piece of a building to securitize and make available to investors (thus executing on its business model); the manager gets a passive minority owner that allows them to continue efficiently managing the building, and; the end-investors get ownership/access to something otherwise unavailable to them. Like direct real estate ownership, investors participate in cashflows and appreciation.
The other interesting and (from my standpoint) unexpected aspect of this offering is that it goes one step further in trying to solve for some liquidity. Once the shares are all purchased by investors, they are listed on a public exchange. I can imagine the downside of this concept is greater price volatility, but the upside is a potential means of liquidity if it’s needed. And there’s no obligation to sell, so an investor can continue to collect cashflows regardless of price volatility (reminds you of Dividend Growth, perhaps)?
Securities, not Tokens
I’ve only taken an initial look at each of these offerings. Still, it’s exciting that – after all the talk of tokenization accomplishing these outcomes – good ol’ securitization is the first horse to the finish line. It also solves for fitting within our accepted regulatory framework, which is an area where tokenization still has some work cut out for it. Maybe there will come a day when blockchain and tokenization trump more traditional securitization, but, for now, the solution is off the chain!
Until next time, this is the end of alt.Blend.
Thanks for reading,