Thinking on a tokenized investment vehicle

At the beginning of the year, I participated in Wharton’s course on the Economics of Blockchain and Digital Assets.

The capstone project entailed brainstorming up an idea for a digital asset.

In the spirit of building in public, I thought I’d share where my head was back in February.

If this sounds interesting to you and you’d like to build it — or if you (or someone you know) is building an equity vehicle like this already — then please send me an e-mail here.

This tokenized investment vehicle does not exist. These materials do not constitute a solicitation or any offer to buy or sell any security or financial instrument, or to participate in any investment strategy.


Elevator Pitch

Dhow is a blockchain-based pooled investment vehicle. It provides individuals and institutions with a diversified portfolio of private-market assets in Africa, Asia, and Latin America.

Dhow aggregates capital commitments from global investors through the issuance of its own token (DHOW) and deploys the proceeds (in USDC) into small and mid-size businesses that are excluded from traditional sources of capital (e.g., banks, capital markets). 

The value of Dhow is two-fold: it is an innovative financing vehicle for financially excluded businesses, and it expands the universe of investable opportunities for individuals and institutions.


Problem Statement

According to the International Finance Corporation, 30 million small and mid-size business in developing countries face a finance gap surpassing $4 trillion. These potential users of capital face a variety of challenges. For instance, legacy banks in these markets typically engage in plain-vanilla, collateralized lending. Non-bank lenders, such as private credit funds, have more sophisticated approaches to credit risk assessment and can engage in cash flow-based lending, however there are few of them. 

Private equity (PE) funds constitute an alternative for larger, more professionalized businesses, however the returns of PE funds targeting the developing countries most in need of private capital have essentially been 300 basis points above the 10-year U.S. Treasury. Institutional and accredited investors justifiably ask why they should leave the United States for lower returns. As a result, fewer PE funds in these markets are able to raise capital, depriving SMEs of another source of risk capital.

From the sources of capital perspective, institutions are tired of fee drag eating into returns, the lack of transparency in PE funds, and misalignment between companies’ long-term growth initiatives and fund managers’ pecuniary benefits. In addition, non-accredited individual investors are deprived from accessing investments in private companies altogether.


Vision

A blockchain-based approached to private-markets investments addresses most of the problems outlined above. For example:

  • Addresses the finance gap — Dhow aggregates new capital commitments across individuals and institutions, helping to close the finance gap besetting SMEs.
  • Unlocks new capital — Through the security token, non-accredited investors may participate in private-markets investments through fractionalized ownership, unlocking a new source of investment capital.
  • Lowers fees — Tokenholders participate and benefit directly from the underlying investee companies’ performance; management fees are reduced significantly, while the investment team’s long-term incentive is through DHOW token ownership. The fee drag of carried interest is removed.
  • Brings transparency — Ownership of Dhow tokens would grant access to a portal where investee companies’ financial statements and operational metrics are viewable.
  • Creates alignment — Dhow ameliorates the principal-agent problem and creates tighter alignment between entrepreneurs’ long-term growth initiatives and investors’ desire for long-term capital appreciation. The tokens could also be granted to companies’ employees as part of an incentive plan.
  • Provides liquidity — Dhow tokens would be tradable on a decentralized exchange from day one, enabling liquidity for token owners, while liberating them from traditional PE funds wherein returns are dependent on an exit or liquidity event.

Digital Asset Rights / Demand Drivers

Given that Dhow would utilize a security token (DHOW), holders would receive numerous rights, including:

  • Economic rights — DHOW holders would be entitled to receive a pro rata share of dividends from the underlying businesses. Over time, the token’s value should appreciate as the investee companies attain / exceed their growth plans.
  • Information rights — DHOW holders would have access to companies’ financial statements and other material disclosures. They would also receive the same from the investment team managing the assets.
  • Governance rights — DHOW holders would be able to vote on delegates to serve as Governance Council members (akin to a Board of Directors). The Governance Council would include independent remuneration and audit committees, and would provide approvals for operating expenses. The Governing Council could also seek community feedback on key decisions (i.e., minting tokens to raise a follow-on pool of capital).
  • Community benefits — DHOW holders would be able to participate in a gated community. This could extend beyond the typical Discord server to include members-only content and discounts on merchandise / services produced by investee companies.

Digital Asset Supply

The supply of DHOW tokens would initially be fixed at 100 million tokens in an initial token offering. Given that this would be a security token, we are less concerned with tokenomics / distribution schedules than protocols and dApps. The DHOW offering is akin to a private placement.

At the initial token offering, each DHOW token would be exchanged for 1 USDC. This implies a $100 million raise (gross of fees), the proceeds of which would be broken out as follows:

  • ~ 80% of capital to be used for primary investments in 10 to 15 companies (~ $5M to $8M per investment)
  • ~ 15% reserved for follow-on investments in high-performing companies
  • x% to cover startup / operating expenses (TBD)

Should no companies merit a follow-on investment, the ~ 15 million DHOW tokens could be burned to replicate the economics of a buyback.

Over time, the community could vote on a follow-on capital raise / token issuance to expand the number of investee companies. Conceivably, DHOW could become a global index fund for private SMEs.


Protocol Selection

Dhow would launch on the Polygon network for two reasons:

  • Ecosystem — Polygon is an Ethereum Virtual Machine-compatible sidechain of Ethereum, which means it can leverage the existing Ethereum developer network. In addition, Polygon has 7,000+ dApps, including decentralized exchanges. Moreover, Polygon bridges easily to the Ethereum Mainnet.
  • Fees — Dhow seeks to drive financial inclusion, and that includes by enabling individual investors all around the world access to private-markets opportunities. Polygon’s relatively low transaction fees not only enable more people to participate, but also allow for a greater portion of each investment to go toward underbanked businesses.

Smart Contracts

Dhow would utilize smart contracts, primarily for dividend payments. The mechanics would be as follows: upon receipt of a dividend payment from a portfolio company, the Dhow vehicle would leverage a smart contract to convert the proceeds into USDC (if necessary). Upon conversion, the USDC would be transferred to the wallets of DHOW holders as of the date of record.


Stakeholder Adoption Incentives

There are two key stakeholder groups that will need to adopt the asset: investors and the Dhow team. 

Beyond the financial cost of investing, investors would face the opportunity cost of allocating capital to DHOW tokens over other assets. In addition, there would be a mismatch between the liquidity of the DHOW token (virtually day one on a DEX) and the long-term nature of business-building in developing countries. 

The benefits to investors would be dividend payments and long-term capital appreciation through a geographically and sector-diversified portfolio of non-listed assets. This breadth of diversification could reduce macroeconomic, jurisdiction, and idiosyncratic risks.

The Dhow team would need to accumulate DHOW tokens to tighten alignment between the performance of the token and the underlying portfolio companies. Conceivably, members of the Dhow team would be encouraged to purchase a certain percentage of the tokens at launch — akin to a general partner’s commitment to a private equity fund — to ensure the team has skin in the game. As with investors, the Dhow team benefits from dividend payments and long-term capital appreciation.

In a non-pecuniary sense, both investors and Dhow team members could derive benefits from the operational and financial data available to DHOW holders. To wit, enterprising individuals might identify the key value drivers of SME growth in specific markets or sectors. Over time, if the project gains traction and demonstrates value, follow-on capital raises could create a portfolio of sufficient scale to create a (commercial) database that benchmarks key performance indicators (such as SAP), or indeed, become an investable index in its own right.

Separately, one could foresee DHOW tokens being used to pay for third-party services that enhance the operations of portfolio companies, thereby creating tighter alignment between advice and outcomes.


Systemic Risk and Regulation

The Dhow concept could be susceptible to a few systemic risks. The first would be a hack or failure of the Polygon (or Ethereum) network, which would undermine trust in Dhow (and the DHOW tokens), leading to a meaningful deviation in token value relative to investee company fundamentals. 

The second element of systemic risk would be tied to Dhow’s reliance on USDC as the currency for investments and dividend flows. USDC is a multichain currency (e.g., Avalanche, Ethereum, Solana, etc.). If the collateral backing USDC turns out not to be at parity with the U.S. dollar, then a liquidity crisis on, say Solana, could hit the Ethereum chain and thus impact Dhow.

The third systemic risk pertains to regulation. Given that the Dhow concept is a security token, and the vision is to raise capital globally for investments in multiple jurisdictions, regulators could kill the concept swiftly. In practical terms, Dhow would need to start with a small pilot program to prove the concept in one or two jurisdictions, particularly those with forward-leaning regulators that offer a sandbox for crypto innovation.

Is the Dollar Standard Ending?

Last month, world governments learned that property rights do not apply to foreign exchange reserves.

Recall that before Russia’s abhorrent invasion of Ukraine, the United States government froze $7 billion of Afghanistan’s U.S.-based assets. The United States earmarked half for humanitarian aid in Afghanistan, while the balance was reserved to cover potential claims from U.S litigants who sued the Taliban for losses due to terrorism, including the attacks of September 11, 2001.

In effect, the leaders of the world’s largest economy — with a gross domestic product surpassing $20 trillion in 2020 — seized the assets of a country with a gross national income per capita of $500. Data from the United Nations reveal that more than half of Afghanistan’s population wasn’t even alive on 9/11.

Two weeks after the seizure of Afghanistan’s assets, the West froze the assets of the Central Bank of Russia. The implications of these decisions will take time to understand fully. However, three immediate conclusions may be drawn.

First, exporters are likely to slow their acquisition of U.S. dollar reserves going forward. This would mark an important shift, particularly for the so-called ‘emerging and developing’ economies, which have represented the marginal demand for dollars since the Asian Financial Crisis.

To wit, these countries increased their dollar holdings from roughly $300 billion to $2.2 trillion between 2000 and 2014 (the year for which this specific IMF data set ended), expanding their share of global reserves from approximately 25% to 50% in the process. Since then, worldwide reserve accumulation has grown to $12 trillion.

Given the poor state of America’s finances, countries sensibly have been diversifying away from the dollar, which has declined from 71% of global reserves in 2000 to 59% last year. Now, governments must not only contend with the prospects of dilution from U.S. profligacy, but also the risks of outright confiscation.

Second, a declining demand for dollars should compel the United States to abandon its credit- and consumption-driven economy. In recent decades, exporters’ voluminous accumulation of dollars helped depress U.S. interest rates, effectively subsidizing American consumption and supporting asset prices. 

A contraction in dollar demand would likely reduce asset prices, eroding the collateral for a swathe of overleveraged businesses and expanding the funding gaps plaguing retirement systems in the process. The reduced need to ‘recycle’ exporters’ dollars could also diminish the outsized role of finance in the U.S. economy and its politics, while a weaker dollar could facilitate a rebalancing toward a revitalized manufacturing base.

Third, large exporters, most notably China, will be incentivized to recalibrate their own economies in favor of domestic demand and consumption-led growth. Though this has been a stated objective of Chinese policy for years, progress has been slow-going. The West’s recent asset freezes may reinvigorate this shift with a new sense of urgency.

Many people believe that a move away from the dollar as the world’s reserve currency remains unlikely. Commentators frequently point to the lack of a viable alternative with ample liquidity and an issuer that adheres to the rule of law. After all, the euro and the Chinese yuan constituted roughly 20% and 3% of global reserves last year.

However, the probability that countries will seek out an alternative has gone up considerably. The issue is not which countries have secure, investable assets that can absorb reserves today, but rather the countries that will create them over the decades to come.

Two possibilities merit consideration.

First, what if large oil exporters and importers agree to price the commodity in another currency, intentions that China and India have floated? Regardless of global net-zero targets, the International Energy Agency projects that ‘emerging and developing’ economies will drive incremental oil demand exceeding 12 million barrels per day under most scenarios through 2030. The West’s oil imports have flatlined over 40 years and are likely to decline, whereas China, India, non-OECD Asia, and Africa are growing. These are, after all, the markets where the people are.

Second, what if a group of large commodity exporters and importers took up Zhou Xiaochuan’s 2009 proposal to resurrect John Maynard Keynes’s Bancor? The Bancor was Keynes’s concept for an international currency whose value was based upon a basket of commonly used commodities. For all the attention paid to finance and technology, it is energy — whether measured by horsepower, watts, or calories — that makes the world go round.

Prophesies decrying the eschaton of the dollar have proven rash and delusional. In a world where central banks’ property rights were observed, there was scant impetus for change. 

That world resides in the past. The decision to freeze central banks’ assets may have been justifiable, but expediency has its consequences.

First submitted to FT on 21 March 2022.

Favorite Books of 2021

For selections from years past, please click here: 20202019201820172016201520142013.

The Key Man by Simon Clark & Will Louch

An engrossing read chronicling the rise and fall of Arif Naqvi and the Abraaj Group. It has the pace of John Carreyrou’s Bad Blood, but with an unbelievable cast of credulous characters who fell for a fantasy.

IndieBound | Amazon | Library

I spoke with Simon on the Portico Podcast.


This Is How They Tell Me the World Ends by Nicole Perlroth

An alarming book about the evolution of the market for zero-day exploits, and how we’re all doomed, basically. As an enthusiast of developments in the crypto space, I’ve not gotten comfortable with the meme that ‘code is law.’ This book hammers home that most software is shit, and the notion that individuals will interrogate lines of code to protect themselves is a joke.

Winner of the FT’s Business Book of the Year.

IndieBound | Amazon | Library


On the Medieval Origins of the Modern State by Joseph Strayer

A thought-provoking take on the development of states and institutions in Europe. All in 111 pages.

IndieBound | Amazon | Library


The Coming of the French Revolution by George Lefebvre

Another thought-provoking book from Princeton Classics. Shared a snippet from the conclusion here.

IndieBound | Amazon | Library


Cryptonomicon by Neal Stephenson

Extremely fun novel.

IndieBound | Amazon | Library


Power of the Dog + The Cartel by Don Winslow       

A history of the drug trade in the Americas told through novels. Loved the first book. Enjoyed the second. Gave up on the third.

IndieBound | Amazon | Library

A Reaction to Rory Stewart on Intervention

I recently finished Rory Stewart’s thought-provoking essay about Afghanistan in Can Intervention Work? It prompted many reactions, but I thought I’d share two:

See also:

Ubuntu

USV’s Albert Wenger inspired me to scoop up a used ThinkPad, boot install Linux, and see if I could peel myself away from the walled gardens of Apple and Microsoft (for fun, if not for work).

It has been decades since I used the terminal / command line in MS DOS to search directories and run .exe files. But as tedious as it was to get started, the nostalgia is real, and it’s fun to be using new muscles.