From my experience as an institutional allocator researching and assessing the risk of a crypto fund’s valuation process, the pressing matters from such a vantage point should be focused on the areas of policy, process and standards.
Recently, I had a conversation with an industry colleague about crypto valuation analysis. The two perspectives of substance were, “Is it managers or third-party pricing agents who are calculating values for tokens, crypto projects, ICOs, etc.?” and “What are the actual tools used to analyze crypto values?”
The conversation led me to give a good amount of thought to the already ongoing debate of traditional fund financial accounting vs. crypto financial accounting, and about which valuation metrics are the “right” ones to apply to digital assets. There are the tried and true methods of discounted cash flow, market capitalization, realized capitalization and comparables - all of which fall under the traditional measures - or network value & effects, token supply & locks (commonly known as “tokenomics”), and basic supply & demand - which are often the metrics for the crypto crowd.
However, until such analysis is consolidated around what is either accepted or proper as industry standard, there are established fundamental ways of considering fund valuation processes which are not in question.
Fund Valuation Basics
Whether it is for crypto hedge funds, crypto ETPs, crypto venture funds, or really any funds for that matter, the industry standards on fund accounting have been long established and well tested, and are often used as the foundation for an allocator's due diligence process. Some of the most important matters include:
- A well documented valuation policy - Fund investors rely upon an investment manager’s (or advisor's) expertise and discretion when valuing portfolio holdings, as such discretion is often relied upon for using reliable and consistent pricing sources, and in certain instances, hard-to-price holdings; All of which is incorporated into the finalization of fund books, records and fee generation.
It is a manager's fiduciary responsibility to be the ultimate determination in how a portfolio's holdings are valued, regardless of any third-party utilization for portfolio valuations such as valuation agents or fund administrators.
- Consistency and adherence to process - Whether asset valuations are compiled by either a manager or an independent valuation/pricing agent, the operational process of utilizing any number of valuation methodologies should demonstrate that a control exists in which the chosen method is employed period over period (or in the instance of a fund, NAV after NAV). Deviations, or frequent reselection of valuation methods, could be an indication that a manager is picking and choosing which methods provide the best result, thus having the effect of a valuation that benefits a manager over their fund investors.
- Conformity to audit standards - Ultimately, both of the above points are tested when a fund undergoes an independent audit. Here a qualified auditor will ensure that the valuation methods chosen, the calculations (or models) used, and the adherence to policy and process, have passed commonly accepted fund audit practices… or not.
However, and admittedly this is a current gap within the industry, and the topic of the aforementioned conversation, there still remains a lack of standard methodologies for valuing many digital assets on an individual basis.
Fund Valuation Red Flags
In conducting due diligence, and in speaking with managers, allocators and other industry colleagues, there have been examples of questionable practices executed by managers, which are specific to managing a crypto portfolio.
One example which stands out was when two different managers holding the same asset in their respective portfolios took different approaches to assessing an asset valuation methodology. In both instances, the managers determined to initially hold the asset in question within a side pocket in each of their respective funds, as the assets were initially “locked.” However, as the assets had a liquidity event occur sooner than expected, the paths for valuation diverged. One manager chose to keep the asset in a sidepocket, and continued to hold the value at cost. The other manager, upon advice from their auditor, chose to utilize a mark-to-market valuation, as the project’s tokens were already being traded via exchanges.
In this example, one could argue the former manager, keeping the assets in a side pocket and valued at cost, was attempting to control the NAV of their fund, and therefore smooth out the fund’s returns and resultant high watermark. While the latter manager properly acknowledged the liquidity event and assessed a fair valuation, allowing the assets to appreciate in value, and also accept the volatility risk of liquid assets.
A second example, which unfortunately has been found to be a common matter, is where a manager has not written their own valuation policy (which as a reminder, is a fiduciary responsibility), but has determined to “...use the policy of the fund administrator.”
Here again is a problematic matter, as all fund administrators make clear in their administration agreements that they are responsible for calculating books and records, and that a manager has final authority over how assets are valued.
From an investor’s perspective, who then is responsible for pricing a hard to value or illiquid asset? And more specifically to crypto and the fact trading occurs 24/7, what is the correct cut off time of pricing (i.e., an exchange price at 4pm ET, average market price at 5pm somewhere in the world that a manager or their fund administrator needs to track, etc.)? If the result of such a dispute is finger pointing, it could result in a delayed fund NAV, a miscalculation of fees, or worse yet, a delayed audit or qualified opinion.
A Place to Start
Until there are industry valuation standards set from an accounting principals perspective for specific digital assets, what any allocator should stick to are the standards already in place for fund operations and accounting, through the practice of rigorous due diligence.
As Crypto Insights Group serves both fund managers and institutional investors, and has a team with decades of experience in both managing assets and allocating capital, we are able to advise on best practices and analyze potential risks related to crypto fund valuations. In addition, our platform utilizes proprietary features which score a manager’s operations, inclusive of identifying investment firms which have not properly documented their valuation policies, have delayed NAVs, or have had qualified audit opinions.
If you are an investment manager who is unsure of how to implement detailed crypto valuation processes that will attract institutional capital, or if you are an allocator looking for support in assessing related operational risks, we want to support you.
