Crypto Fund SPC Structures: What to Know and How to Diligence
When Crypto Insights Group is asked to perform operational due diligence, an important element of our review includes analyzing the legal documents and structure of the funds our clients invest. With most hedge funds, a common structure is what is referred to as a “master-feeder” structure, where investors, such as limited partners, subscribe to a fund through a feeder legal entity, which purpose is to collect the capital of an investor, provide relevant reporting (such as limited partnership statements), and “feed” the capital to a pooled vehicle which sits over it, called a master fund, which then implements the investment strategy. Such structures are often what a fund manager is advised by their legal counsel to set up, as it permits different investor types, who often have different tax treatments, to all ultimately invest in the same investment strategy.
There are other variations of the master-feeder structure, but for emerging fund managers there is another option available, which allows for a “hurry up” type of arrangement, whereby a manager does not technically assume the role of an investment manager, but that of an advisor (or sub-advisor), which is offered through a segregated portfolio company, or SPC, structure.
The SPC offering allows for an advisor to work with a third-party investment manager, who controls the SPC (more on that below) and works with the advisor to create a segregated portfolio, or SP, which is a pool of capital the advisor manages for their particular strategy.
From an investor’s perspective, the way to access advisor A’s SP, or advisor B’s SP, etc., is to subscribe to the SPC fund, often referred to as an umbrella fund, and specifically select a subscription to the particular pool (or SP strategy) offered by the advisor.
For a good amount of digital asset firms, many of which are not yet managing enough capital to offset the costs of running their own fund, or may prefer to leave the full responsibilities of being an investment manager to a third-party, the SPC structure is the chosen arrangement.
However, and for both managers and allocators considering SPC’s, one should be aware of the pros and cons of such an offering.
Working With A Third-Party Investment Manager and Arrangements
As stated above, an SPC structure allows for an emerging digital asset manager to focus on their role as the party that implements an investment strategy through trade idea allocation, execution and ultimately generating a return on investment. Therefore, what participating in an SPC provides is a pre-made investment manager operation by which the SPC investment manager offers the following:
- An already existing legal fund structure by which a digital asset advisor signs an agreement to sub-advise a SP as one of a number of other SPs for an investor to choose from within the SPC offering.
- The SPC investment manager, in managing the SPC entity, will assume responsibility for service provider arrangements, such as choosing a fund administrator, fund auditor, legal counsel, selecting a bank for receiving capital from investors (if they are subscribing in fiat-cash), and in some instances determining a SP asset custodian. However, in CIG’s experience, the choice of a crypto counterparty, either centralized or decentralized, is often determined by the advisor, as the advisor would know which counterparties are the correct options to help implement the respective SP’s investment strategy.
- The investment manager also often assumes responsibility for regulatory and compliance-related operations, as the manager will often register their organization with applicable financial regulators (often based on domicile or locations where they are marketing the SPC). In addition, and related to the subject regulation, the manager will also be the one to implement the respective compliance program, including writing of compliance policies, and ensuring compliance oversight of the SPC, and the associated SPs.
- The investment manager will also be responsible for maintaining the valuation policies of the SPC and its underlying SPs, as that is not only a fiduciary requirement of an investment manager, but as the manager is responsible for the administrative and audit relationships, they will be responsible for providing documentation for the pricing and valuations of SP holdings, which form the basis of the management and performance fees charged by the pooled investment vehicles, and paid by investors.
- Lastly, the investment manager may also assist in marketing efforts for all of the SPs within their umbrella SPC.
In summary and in practice, having a third-party investment manager assume the business of running a fund is a way for digital asset advisors to get to market sooner with their respective investment strategies, as the manager will offer the set up, and often experience, of running a fund.
Where Complications May Arise
Although the SPC arrangement may offer some shortcuts to bringing a strategy to market, and as is sometimes argued, “allows the advisor to focus on investing,” there are limitations and operational risks both advisors and allocators should be aware of, and which are sometimes presented as a “high” or “moderate” risk assessment within an operational due diligence.
First, is the matter of the SPC structure itself, where the investment manager offers the umbrella to various other advisors, as that is their business model. Where this can run into risks, and specifically conflicts, is that one advisor's SP can be running the same strategy as another SP, all within the same SPC entity. This presents a number of issues, some of which include advisors competing with each other over offering the same or similar strategies within one structure, and the possibility of a centralized third-party, which is the investment manager, having real-time access to the positions and trading of all of the underlying SPs, with the related risk of disclosing proprietary information, if they have not developed and enforced an appropriate compliance policy.
Next, is the matter of valuation input, oversight, and final determination. As has been CIG’s experience through years of working with numerous SPC providers and their respective SP advisors, investment strategies that trade complex or sometimes illiquid holdings can create an issue of valuing a portfolio, as an advisor may disagree with how the investment manager, and the respective fund administrator, may be valuing an SP. Where we find this matter often creating risk is where the investment manager of the SPC has not documented a “manager-issued” valuation policy, which would be used as the final control to price a book, and in practice, where the advisor has accepted the manager’s policy by entering into an SP agreement. To add a further control to the process of valuations, and as an industry best practice, the investment manager should also have a valuation committee, whose purpose is to meet with some regular frequency to document any instances where there is deviation from a valuation policy, and provide their documented decisions to both fund administrators and auditors to ensure there is a record as to why a portfolio holding was valued in a certain way.
Another potential risk with SPC structures is with respect to cross-liabilities across the legal entity. Although there has been a focus and developments with respect to Cayman Islands-based SPCs (where many of these structures are established) addressing the subject of containing liabilities, whereby a portfolio’s assets and liabilities are legally separated from the assets and liabilities of the umbrella’s “ordinary account,” and are separate from assets and liabilities attributed to other SPs, SPs are not stand alone legal entities and therefore may be challenged on the subject outside of Cayman jurisdiction.
CIG has also come across instances where additional fees are part of the SPC arrangement, where the SPC investment manager charges a separate fee for their services, that is in addition to the management and performance fees charged to investors. This should be considered by advisors who are marketing their SPs to investors, as needing to explain an additional layer of fees for their strategy, and be scrutinized by allocators as to whether or not such an additional expense is acceptable.
The Value of Fund Structure Due Diligence
While many digital asset fund managers work closely with their legal counsel to create an investment structure which allows them to go to market quickly and efficiently, allocators are often presented with various fund structures which may require further analysis, based on their particular needs, tax considerations and desire to access certain crypto strategies.
However, when being presented with an SPC structure, both advisors and investors should ensure they dig deep into the separation between who is managing the fund entity and who is managing the underlying portfolio, as such arrangements can create nuance and potential risk.
Through years of experience managing crypto assets and allocating to different fund structures, the Crypto Insights Group team has developed institutional research, benchmarks and a due diligence process which supports both managers and allocators through assessments and consultation along the digital asset investment process, including assessing and identifying fund structure risk analysis.
And it is through our proprietary process that we are able to help advisors and allocators discern which structures may work best when developing or investing in a digital asset offering.
Reach out to learn more about how CIG can support your crypto allocation goals.
