Here is a scenario many institutional investors have come across all too often… You're researching an investment strategy that you want to add to your portfolio. You’ve found a few investment managers that have put up good performance over the years, over the last year and over recent months, and you begin to focus on that one manager that checks most of the right boxes from a portfolio diversification and risk management perspective. You reach out to request marketing materials, a due diligence questionnaire (DDQ), and offering documents.
As you scan through the marketing deck, the story looks good, the investment thesis makes sense, the pedigree ticks the right boxes, and the few details about the fund terms seem reasonable. Then you move to the DDQ. The organization appears sound, and the fund terms check out. Finally, you begin to open up that 100+ page fund prospectus, and really start digging into the details of those previously allusive fund terms. Then as you get through the legal jargon you pause and ask yourself… “Does this fund structure work for me?”
And there it is. The moment an allocator says “Thanks, but no thanks,” because of onerous fund terms.
Unfortunately, it’s become a common occurrence in crypto hedge fund-land where investment managers have gone through the time and expense of drafting a fund offering document, often based on the feedback of that one big limited partner, or a few industry colleagues, or the advice of their legal counsel, to find out that their offering is just not very commercially appealing to a broader investment audience.
Terms of Endearment
As is nearly always the case, rarely does a fund manager get the opportunity to ask for a reset on providing better fund terms, with the typical course of action resulting in timely, expensive and inefficient negotiations of side letters (and once you issue one, most other investors will ask for the same).
So, for those of you managers out there that are just starting to pull together your fund offerings, or are experiencing a bit of a quiet investor due diligence period and want to take the opportunity to tighten up those fund terms, here are some helpful guidelines for consideration:
- Ensure fund liquidity matches that of underlying assets - We’ve seen a number of crypto funds manage a portfolio of very liquid assets (it is crypto, afterall), but determine the right move is to lock-up investor capital for a year or more. Some advice… if an allocator is looking for your fund to be a liquid vehicle, try to stay in that lane. In an institution’s total crypto allocation, you are competing with venture capital and liquid venture, who have a better argument for lock-ups than a hedge fund does.
- But, if you really need to lock-up capital… - As a crypto fund manager, you may have opportunistic investments that require longer time horizons to work out their investment returns (SAFTS, pre-ICOs, a macro event, etc.). If such instances arise, consider creating side pockets. However, let side pockets be a choice of “opt-in” or “opt-out,” otherwise you arrive back at the first point above.
- Gates, Gates & Gates - Let me tell you about gates… We’ve got fund-level gates. We’ve got investor-level gates. We’ve got all kinds of gates. The rule of thumb here is as follows… If your investment strategy requires the whole portfolio pot to be pushed into the center of the table (I’m looking at you, directional managers), consider gating across the fund so as to manage skittish investors exiting in lockstep during volatile times. However, if your strategy allows you to place little bets here and there (that’s right market-neutral folks), an investor-level gate will allow someone an off-ramp without needing the whole caravan to take a break.
- High fee, can hurdle - It goes without saying that most hedge fund managers have a high degree of confidence in their ability to make money. And with that bravado, many set their fees at the industry standard 2 & 20, with the occasional 1 & 30 showing up. However, what many crypto hedge funds seem to forget about their chosen asset class is how choppy those crypto markets can get. Counterintuitively, we’re not referring to the downside of volatility, but the upside. To be more specific, a vast majority of investors are benchmarking your performance to the returns of Bitcoin, and if you are not one of those enterprising managers that have created crypto-denominated share classes, you may find yourself coming back to the problem of an investor saying, “What am I benchmarking your fund to?’ One option to consider is setting hurdle rates. If you can’t (yet) define what you are creating alpha on top of, at least meet an investor some way with setting a bar to justify those fees you are advertising.
- Directors? We don’t need no Directors - Your fund's legal structure will determine if your offering requires governance (Limited Partnership - Nope / Corporation - Yup), but take it from us former institutional allocators; We really want that independent director(s), or for limited partnerships, that independent advisory board. There are the tried and true reasons from hedge funds of old for independent fund governance; someone who is not an employee of the manager to review and approve of fund audits, or someone who can authorize (or not) conflicts of interest. But here is a crypto fund specific reason. Your fund’s valuation process. Time and again, many crypto managers are intervening in how certain assets are to be valued, because at the end of the day, a fund administrator is likely going to take the pricing of difficult-to-value holdings (and that does not necessarily mean illiquid holdings) that is provided by the fund manager, despite the fact that they are a client fiduciary too. Therefore, it gives investors a higher degree of confidence in a fund allocation to know that there is someone outside of the manager’s employ who has the responsibility and authority to ensure those valuations are fair, or in certain instances, do not delay the finalization of a monthly fund NAV.
On Friendly Terms
Crypto Insights Group sits in the unique position amongst the emerging crypto fund asset class to work closely with both institutional allocators and fund managers, speaking with both groups about what is working, and what is not, through executing on our mission of supporting institutional growth in the digital assets market.
As our platform helps identify, diligence, and monitor funds, we are also guiding funds and institutions on negotiating comingled fund terms that are fair and acceptable, as setting industry standards for both manager and investor alike.
If you are a crypto fund manager who would like us to provide feedback on your fund terms and operational readiness, or if you are an institutional investor seeking crypto funds which meet your criteria for investment, we want to support you.
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