Items to Consider for Fund Terms / Structures
We are moving into the next phase of operations after the FTX collapse – for those crypto funds that did not face issues with assets on FTX (and even for those who did and who are remaining in business), we are now examining how this disruption changes the way managers operate their business and/or how do investors look at crypto fund terms and operational structures.
As managers deal with questions from investors, or how they will proceed with their operations post-FTX bankruptcy, they may want to be thinking about the following items:
- Side Pockets – some managers may have seen their investment in FTX turn from individual crypto assets into a single asset (a bankruptcy claim) that has much different liquidity parameters. The single asset bankruptcy claim may need to be sidepocketed and if so managers should review their fund documentation to see how that works and also discuss the mechanics with their fund administrator. Of course, when sidepocketing any asset, managers should be careful with accounting and valuation. There are a number of other issues applicable to side pockets that managers may want to think about, including maximum percentage allocable to side pockets and when assets can be so designated.
- Lock-ups – in general liquid crypto funds have been able to institute longer initial and ongoing lock-up periods than traditional managers. How these periods interact with the withdrawal provisions will determine required liquidity for any withdrawal periods.
- Suspension of withdrawals – most offering documents (both in the traditional and digital asset spaces) have pretty standard suspension of withdrawals discussions. Normally to suspend withdrawals there needs to be a major disruption in the industry. My normal talking point is that it would be a 9-11 type event. Here, for managers who had assets on FTX, this may be a suspension type event depending on the various circumstances of the particular fund (including total liquidity and normal withdrawal provisions, which may include a gate provision). Managers may want to take another look at this language given the recent market events.
- Custody – this is always one of the most important disclosures for managers. Custody in the digital assets space, while much improved from 2017-2018, is still all over the place. Some managers will self-custody as much assets as possible while keeping certain assets with actual qualified custodians, and some managers will keep some or most assets on-exchange. Whatever the technical expertise the manager has, and the mix of cold/hot storages and off/on-exchange, should be reviewed to make sure that a manager’s current practice mirrors the disclosure in the offering documents.
- Conflicts of interests (COI) – COI is always a vitally important section in any offering documents and managers should always try to over-disclose here. For most groups with streamlined structures (GP-Fund entities only), there are standard COIs. For groups with multiple management level entities and different agreements between them, or for groups with multiple fund structures and outside entities (like staking, mining, other service businesses) there will need to be more robust disclosure of the activities.
- Discussion of investment program – the purpose of the investment program disclosure is to provide investors with some kind of an overview of how the assets will be invested. Some managers have multiple pages of disclosures and some will have a couple of paragraphs. Some will include a discussion of everything they could potentially do and percentages etc, and some will be purposefully vague (and then augment the discussion with more detail in a pitchbook or other marketing materials). Managers sould review the program and make sure it accurately describes their current state of affairs as well as how the program may change in the future.
- Risk factors – perhaps the most important part of the documents for a crypto fund manager is the risk factor section. There are some limitations in what ultimately is disclosed because at any particular time because the industry is constantly evolving, and quickly. For managers in the traditional investment management space, most risks for any particular investment strategy has been developed over a long period of time. In the digital asset space, risk factors are constantly being added and also modified over time. For our manager clients, the risks related to exchanges and counterparties, both domestic and offshore, were robust and accurately depicted the issues that the FTX bankruptcy brought to the forefront. Many times we work hand in hand with managers to understand the risks of a particular part of the industry and we develop them together. Our specific risk factors have been informed by our interactions with regulators.
For each of the sections above, there are many different ways for managers to think about the issues presented. We believe that it is important to discuss and think about these items on the front end, and we also believe that investors will be giving greater weight to these items in the future (especially with respect to side pockets and liquidity) so crypto fund managers should give these items extra thought during the fund formation process. While the above items were written with the crypto space in mind, the concepts apply equally to those groups in the traditional investment management space.
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.