Crypto hedge funds are getting creative as the bear market continues to grip crypto

The crypto explosion of 2017 gave birth to hundreds of hedge funds aimed at generating asymmetric returns from the speculative “crypto asset class.” However, this year’s downwards price action is creating a lot of problems for the once high-flying funds, forcing many to shut and others to explore creative ways to stay afloat. Per Crypto Fund Research, 35 cryptocurrency funds have closed shop since the beginning of the year, 5% of the 633 funds the research firm tracks. As for the funds that haven’t shut down, many are identifying new opportunities in the market or cutting costs, an expert tells The Block

Cost Cutting

Ari Paul, co-founder of crypto fund BlockTower Capital, told The Block that his firm has been looking for ways to trim the fat. “Budgeting is a new thing in this market,” Paul said in an interview at crypto conference Consensus Invest. “We are allocating capital prudently and are thinking about ROI. For instance, if we are going to do a trip to Asia, then we are going to make sure that trip will be four times as valuable as a trip to California.”

“It is hard to grow a strong business in a bull market because you aren’t forced to make tough decisions,” Paul added. “Tough decisions leads to better allocations.”

Still, BlockTower is looking to hire two more members to fill its investment team, Paul said. Elsewhere, firms are raising more capital to cover their expenses. “You have to be able to squeeze as much from that management fee as possible,” another hedge fund CEO, who declined to go on the record, said. “Folks are making new pitch decks to try to get more investors.” Paul declined to say whether or not the firm is raising more money, but he did say he expects firms to start raising more capital. 

Subpoenas and LP lawsuits

Still, even if hedge funds manage to cut costs, they still face legal costs tied to subpoenas and LP lawsuits, insiders say. A number of funds in the space have been issued subpoenas by U.S. regulators, including Michael Arrington’s crypto fund Arrington XRP Capital. In September, the crypto executive tweeted that the firm would “not invest in any further U.S. deals until the SEC clarifies token rules.” Elsewhere, Mike Novogratz’s Galaxy Digital — which runs an asset-management unit — was subpoenaed, according to a report by the Financial Times. 

Firms also have to deal with managing investor expectations, according to Paul. 

“The question is what is the benchmark,” Paul said. “There’s nothing wrong with a fund saying that bitcoin is the benchmark and we want to be up 3% from that.”

“What is bad is when your investors have different expectations from what you deliver,” he added. “If investors think you are running a long fund, and bitcoin is down 70% and you’re down 60% after fees then they shouldn’t be too upset.”

A source familiar with Polychain’s business told The Block a number of LPs are suing the firm for not delivering on its investment promises.

New Opportunities

Paul said the days of investing in initial coin offerings or “flipping” early token allocations are over. That stands to reason, given the market for ICOs has been under pressure globally as regulators crack down on many projects for conducting unregistered securities offerings. So what’s a fund to do? Here are some of the opportunities funds are looking at in the bear market:

  • Long/Short: Many funds have made gains this year operating long/short strategies, such as Tetras Capital and Neural Capital, who profited on an ether short earlier this year. Firms operating long/short strategies are generating alpha through exposure from Bitcoin futures and direct lending via firms such as Genesis Capital. 
  • “Generalized Mining”: Originally coined by CoinFund, a Brooklyn-based crypto-asset management firm, so-called “Mining 2.0” strategies aim to capture alpha through active participation in crypto-networks with wide-ranging opportunities from staking (in Proof of Stake-based networks), providing validation services, or provisioning resources (e.g. compute power) directly to decentralized networks. Other firms have adopted similar strategies, with many adjusting LP agreements to allow for this “crypto-native” activity, due to unique custody requirements and tax treatment.
  • Market-making: Due to the downwards-price action and high volatility for much of the year, some of the largest beneficiaries have been quantitative market-making strategies which aim to produce market-neutral returns. Many exchange arbitrage strategies many of these funds employed have diminished as market efficiency improved (as a result of increased market-making), but more advanced strategies imported from traditional capital markets remain profitable. 
  • Venture capital and distressed debt: Many crypto funds are eyeing venture opportunities, whereas BlockTower’s Paul specifically said the firm is interested in capitalizing on distressed venture opportunities. “When public equities collapse it takes 18 months for prices to converge with private assets,” Paul said. “When markets crash, trading is good for a while but then things die … after the crash you want to be a VC.”

What happens next?

Investors such as Morgan Creek Digital’s Anthony Pompliano have publicly written about the ensuing closures of crypto funds that won’t be able to read the high water-marks set in 2017. Due to the decline in crypto-asset prices, many of the funds launched in Q3/Q4 2017 may never reach the peak net-asset value of last years’ highs. Sources inform The Block that many of top funds have lock-up periods of 12 or 18 months, opening up the floodgates for LP redemptions due to poor performance.

As this happens, heavy consolidation in the crypto-asset management industry is expected, with smaller firms shutting down and larger funds like Blocktower and Multicoin Capital launching multi-platform offerings.

Along with this consolidation, more experienced capital allocators from pedigreed firms are launching new firms, such as Paradigm (co-founder Matt Huang is a Sequoia alumnus) and a16zcrypto (led by principal Chris Dixon of a16z). These firms are leveraging the learnings of the 2017’s first wave of gun-slinging crypto fund managers, bringing much-needed risk management, venture capital, and capital markets experience. With it, they also bring institutional-grade LPs, including endowments such as Yale’s.

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Crypto hedge funds are getting creative as the bear market continues to grip crypto written by Frank Chaparro @ December 4, 2018 Frank Chaparro

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