How do investment funds work and how can they benefit from tokenization?

Most people don't invest in companies ― they invest in funds, which hire professional investment managers. Thus, if you want to work with a significant amount of capital within your business, you should consider launching an investment fund.

When is your business actually a fund?

There is a difference between running a company and running an investment fund, and a number of factors can point out that it's worth concentrating on the latter option. When is the business likely to be qualified as a fund and not a common industrial or commercial enterprise?

1. It's you who manages the investor's money but not them investing into a particular project directly. If investors put money into a specific project or, say, a real estate object your company offers to invest in, you are running a regular business. However, if the investors give their money to the managers and leave a decision considering the way this money will be invested to them, it is the way an investment fund works. The difference between these two approaches is that people invest in a particular asset in the first case. In contrast, in the other case, they invest in you as an asset manager and your professional skills. Another example may be running an algorithmic trading firm and enhancing profits by trading using other people's money.
2. You are aiming to reduce risks by offering to pool multiple investments. If you give investors exposure to various assets under one umbrella, this umbrella is likely to qualify as an investment fund.

Notice that this isn't a complete definition of investment funds, and this article does not substitute legal advice.

Types of funds

There are many types of investment funds, but we'll go through the most common ones. One way to classify funds is to divide them into open-ended and closed-ended.

• Open-ended funds usually suggest that the investor can enter and exit the fund at any given time. The coefficient in which the fund has grown between the investors' enter and exit minus the management's compensation determines the profit the investor obtains.
• Closed-ended funds usually have a particular fundraising period, and exiting them is only possible at specific time slots. Close-ended funds normally have a limited duration, such as 5 or 10 years.

Open-ended funds usually invest in liquid assets, primarily in publicly traded securities, i.e., equities and bonds. If investors take their money back from the fund, open-ended funds can sell the asset promptly and give the investors their money back.

Closed-ended funds are usually more sophisticated, and they invest in non-liquid assets. Those, for instance, may be venture funds investing in startups or private equity funds investing in Small and Medium Enterprises. You can't simply sell your share in the startup; accordingly, such a fund won't let their investors make an exit out of the blue, as giving the investors their money back, in this case, will be impossible. However, units of close-ended funds are often traded by themselves, which provides investors with some exit opportunities.

• Funds can also be classified as institutional or retail funds. Most funds are only open for HNWIs (High Net Worth Individuals) and institutional investors; such funds are less regulated and, therefore, less expensive to launch and run. Open-ended funds are more often available for retail investors, while closed-ended funds are mainly targeted at professional investors.

There are also a few exotic types of funds. One of such is a fund of funds, which invests in other funds. Another example is rolling funds, which provide a possibility to invest in each certain period of time, e.g., each quarter. Rolling funds have gained popularity recently thanks to a general trend on the democratization of investments. The growing popularity of asset tokenization can also be explained in this way.

Related: Investment crowdfunding as a fundraising alternative to banks and venture funds: how to raise capital with STO!

How should funds be regulated?

First of all, regardless of their structure, the funds should always be approved. Such a rule is implemented because managing other people's money is a highly responsible task. Regular businesses, especially managed by accredited investors, can raise funds without the regulator's approval, but such a requirement is a must for a fund.

There are a few exceptions to this rule, but they are not widespread. One is that a fund with less than 100 accredited investors from the US may not be regulated if compliant with certain conditions.

Secondly, not only the fund itself but also fund managers should be licensed as well. They have to be licensed in all jurisdictions where the investments are attracted. If you are launching the fund, you either get such a license or cooperate with the licensed company.

Thirdly, depending on the jurisdiction, there is also a need for regulated service providers, like custodians in charge of the funds' assets and an auditor. The regulations on this matter are especially harsh in the European Union.

Finally, retail funds are more regulated and limited in their investment policy. They are tangibly limited by the amount of risk they can take. This is why most funds allow only accredited investors to invest.

How should funds be regulated?

A basic structure suggests that a fund manager charges a management fee and a success fee, also known as a carried interest. The management fee is calculated as the percentage of all the assets under management and usually is 2% annually. For instance, if the fund holds $100 million worth of assets, the asset management company will obtain a $2 million compensation. A success fee usually constitutes 20%. For example, if the fund has grown from $100 million in assets to $200 million, fund managers will receive $20 million as compensation.

However, the compensation structure is way more complex in practice, especially in closed-ended funds. After the fund closure, assets are distributed in a waterfall manner:

1. Investors receive all the invested capital back plus an obligatory preferred return. This is the first thing to do before the fund manager gets anything;
2. After that, 100% of proceeds go to the fund managers until they get to a certain rate of return. The percentage may be different from 100%;
3. The rest of the income is distributed in a certain proportion between the fund manager and the investors (for example, 20/80); what the manager receives is called a carried interest.

Sometimes there may be some additional conditions, such as, for instance, a clawback provision: it determines that sometimes the investors can revoke the manager's compensation if it wasn't justified. For example, it can happen if a share of an investor's money wasn't deployed, which makes it unfair to include a management fee, or if some investments weren't successful.

One more thing worth taking into account is an American vs. European waterfall structure. The American system suggests compensating the manager for every single contract. For example, if the venture fund invested in 10 startups, the management is paid for each of these investments at the exit point. On the other hand, European structure means that the manager is compensated only after the fund is closed.

It's crucial to get a sound understanding of how exactly the given fund model functions, as it is a delicate structure with many potential pitfalls. Make sure to obtain quality expertise or consultation on the definition of investment funds before you start this business.

There are innovative technologies that improve the fundraising process for funds. Tokenization enables investing in a fund by purchasing its units in a convenient digital format of tokens on the blockchain. Tokenization has three significant advantages:

1. Reducing the minimum investment threshold, which also opens a possibility to invest for regular people who can bring in as little as $1000 if the fund regulation allows accepting small investors.
2. The entire investing flow becomes more manageable thanks to complete digitalization. Even if you only work with accredited investors, it becomes easier to manage them thanks to convenient platforms. This is especially relevant when it comes to managing retail investors.
3. The investors get more liquidity. Thanks to the Decentralized Finance protocols, tokens are much easier to trade, which makes such an investment attractive, especially for closed-end funds. Selling this funds' token gives the investors a chance not to wait for 5 or 10 years but to make an immediate exit. It also reduces the risk of losing their money, increasing their willingness to invest.

Related: How does DeFi unleash the potential of tokenized securities?

If you wish to launch your own tokenized fund, feel free to request a complimentary 30-minute consultation with Stobox specialists on our website. We provide in-depth consulting, legal advice, technical infrastructure, and develop a financial model as well as the compensation structure.