With institutional investor interest and investments in Bitcoin and other digital assets increasing significantly over the past 12 months, including a number of listed entities investing in Bitcoin and significant improvements in regulations, it’s only a matter of time until these investors start looking towards crypto hedge funds as an investment option.
Is your hedge fund ready for these investors?
With investors such as Mark Yusko calling for institutions to #getoffzero and invest at least 1% of their assets in Bitcoin and other digital assets there may soon be a flood of investors looking for potential investment opportunities. Unfortunately there are limited options for these types of investors to gain exposure to this asset class.
In last year we’ve seen a massive increase in demand for Grayscale Bitcoin Trust (GBTC) with over $1Billion flowing in to GrayScale products in Q3 2020 alone. However with products such as GBTC trading at a premium of 35% to holding Bitcoins investors are starting to look for other options to gain exposure to the asset class. We’ve also seen a pickup in the interest in other digital assets, not justBitcoin, with Grayscale seeing a massive increase of interest in its Ethereum Trust.
Unfortunately investors may be left wanting when they start looking for digital asset funds that meet all the requirements that an institutional investor has before investing. Based on the PWC and Elderwood 2020 Crypto Hedge Fund Report the industry still lacks some maturity with an average fund size of $44.4M and only 43% having independent directors on their board of directors.
So what does your fund need to do to attract institutional investors?
Institutional investors have many requirements when vetting a potential investment, the following are just a few off the easy fixes any fund can implement to show their maturity:
Given the nature of the digital asset space custody is still a concern for many investors. Luckily we’ve seen a number of traditional crypto custodians mature significantly in the last few years gaining insurance cover and SOC1/2 certification. We’ve seen even more new entrants with a background in traditional finance enter the space bringing knowledge of the requirements institutions have.
This gives your fund some good options to custody assets, but may you may still face issues with custodians only supporting a limited number of assets. In these cases you may have to look into self custody for a small percentage of your portfolio and all the requirements around this.
Additionally you will need the necessary policies and procedures around your custody procedures in place to ensure your operations are secure and take into consideration all possible scenarios.
As shown in the PWC and Elderwood Crypto report a number of crypto funds still don’t have independent directors on their board. Appointing independent non-executive directors is an easy way to show to your investor that the required level of corporate governance is in place at your fund. Knowledgeable and experienced directors will give investors additional comfort that their assets are managed as specified in the offering documents and the fund is complying with all laws and regulations.
When looking for independent directors to appoint on your fund make sure they have experience dealing with custodians, exchanges, DeFi and crypto fund administrators. An added bonus would be if they have experience in accounting, tax and auditing of digital assets as this could save the team lots of time and unnecessary hassles.
Vendor due diligence
Vendor due diligence is important in any industry, but in the digital asset/crypto currency space it’s critical that you properly vet the vendors you use. Firstly due to the nature of digital assets third parties will control or have access to your private keys in many instances which poses a significant risk to your organisation.
By performing a proper review when initially appointing a vendor and continuous reviews afterwards you can ensure you are aware of any risks and can put in place potential mitigating controls. This shows a level of maturity to institutional investors which will give them more comfort when allocating capital to your fund.
Risk management is part of the operations of any entity and a well designed risk management process can ensure you are aware of all the risks faced by your organisation and whether you are eliminating, mitigating or accepting these risks.
The following are just a few of the risk a crypto company faces that traditional organizations don’t have to consider:
- Smart contract risk;
- Transaction front running;
- DeFi interaction and transaction fees;
- Hacks though wallet applications and many more
The good news is that most of these risks can be mitigated to an acceptable level if you design the procedures you follow well and make sure everyone in your team follows them. You can also achieve this by working with a team that has experience in designing these procedures for entities of varying sizes and complexities.
A well designed risk management process gives a lot of confidence to any investor when considering which fund to invest in and can set you apart from your competitors.
Operations link with many of the points we’ve already discussed above such as custody and risk management. We can all agree that the operations of a crypto fund is different to that of a traditional fund. Teams and transactions are much faster moving and face challenges traditional funds will never have to solve.
Good operational design can remove many attack vectors that exist because of the nature of your operations. This can be as simple as the email applications you use to the way that you review and approve transactions.
As institutional investors start looking at digital assets and an allocation for crypto funds we will see a wave of maturation over the entire industry. You want to ensure that your fund rides this wave and isn’t left behind. The best way to do this is to ensure you are prepared before the time and have all the high level requirements these investors will have in place already.