I have raised venture capital before, but understanding the nuances between cryptocurrency VCs and hedge funds was a great learning experience. Ben runs a fund that invests in other funds, so he knows what's going on. This episode helps understand how these two investor types (venture and high-frequency investing) have performed over the past two years and where they may be headed in the future.
Speaker #0
First of all, can you explain the different types of crypto funds, hedge funds, venture capital, and any other types of structures that you see in the market?
Speaker #1
Yes, thanks, Kerman. First, a little introduction about my name: Ben Jacobs. I'm a managing partner at Scenius Capital.
Scenius Capital is a fund asset management firm focused exclusively on blockchain and digital assets uh we launched our first fund in 2021 which is a fund of crypto native hedge funds uh at the end of the year we are launching Our second fund, which is a fund of early-stage emerging managers in venture capital funds, so your idea of a hedge fund is that a hedge fund is focused on executing trading strategies around real-time liquidity tokens, so all the same trading strategies Applicable to both traditional traders and commodities such as stocks, bonds, and derivatives, all of which are present in cryptocurrencies, there is the potential for a long-term biased, fundamental research-driven hedge fund strategy, said Managing Partner, CIO , analysts are evaluating which coins, uh, have clear drivers of value and therefore have a misalignment between their current price and where their price is likely to change over x amount of time, which is a strategy called a long bias.
There may be long short, maybe more systematic, just algorithmic, and then there's also more market neutral low beta, meaning less tied to the market, um, or non-directional strategies where they're purely looking for returns , whether the market is rising, falling, or moving sideways.
so. These are usually uh, strategies that pursue arbitrage, so it could be cross-exchange arbitrage, it could be DeFi to CeFi arbitrage, it could be staking, it could be, liquidity supply, etc. So there are a lot of hedge funds that follow different strategies and all have different mandates.
Long-term biased, discretionary, fundamental research investing is more like Liquid VC. There are some other strategies like true pure absolute return trying to net growth of 15%+ per year and that's venture capital hedge funds that only invest in liquid tokens so they can trade around BTC and ETH and they can Trading SOL They can trade any live asset available on DEX or CEX, DC funds generally have longer fund lives.
Their fund life is typically 10 years, with an investment period of 3 years and a harvest period of 7 years, and they invest in companies behind some of the most critical blockchains, digital assets, protocols or technologies. So, you can see, who were the early investors in Eigenlayer, or who were the early investors in Optimism.
Before these projects have a token, there is usually a founding team that comes to market with an idea of what they want to build. They go to venture capitalists, raise money at X valuation, and then some venture capitalists get involved. Then there are the answers in successive seeding series until eventually a liquidity event occurs.
In cryptocurrencies, the novel primitive is the token. So historically, in traditional VC, the only way to get an exit and therefore return capital to the VC fund is if there's an M&A or an IPO, then the capital goes to the limited partners, the VC fund investors. The novelty is that you can achieve liquidity efficiently.
In the early stages of a company's life cycle, typically like a Series B, when you launch a token, that obviously adds complexity. There's a reason many Series B companies don't have real-time token prices associated with them, because they're still in their nascent stage. They're still looking for customer product-market fit, but that's one of the trade-offs with cryptocurrencies.
This is alive. The public can participate, thus democratizing access to some of these startups. So, yes, once those VCs exit the position, then they, allocate capital back to their limited partners. so. I'll pause there. Hope this was a good quick overview. Obviously I could talk about this topic for an hour, but hopefully this covers it.
00:05:13
Speaker #0
Yeah, no, I think it all makes sense. I guess what is the essence of the incentive structure between these two? What are both, and who are the people running these? What is their incentive structure? How do they work? Because that invests in what message their actions ultimately send.
00:05:32
Speaker #1
Yes, absolutely. I think hedge funds and venture capital funds are similar in some ways, but also different in terms of incentives. So they're similar in that they typically have the same fee structure, which is a 2% management fee and then a 20% performance fee.
That's the basis. So the 2% of management, that's basically how they pay their team, how they pay for their software, their travel, and what they need to do to execute their strategy. So, uh, the 2% they own UM is typically charged quarterly. So a quarter of 2% is charged every quarter.
Then there's the 20% incentive fee or performance fee, which is where it's a little different. So, on the hedge fund side, incentive fees or performance fees, quotes are often specified on an annual basis. Suppose you invest 100. At the end of the year, after deducting expenses and management fees, your 100 is now 200.
This means you have made a hundred dollars in profit on your LO. At the end of the year, you will receive 20% of this $100 profit as your performance fee. So now the LP capital account is worth $180 going into next year. Take 2024 as an example. What's interesting is that your, your account value is now $180, and then the cryptocurrency market plummets.
Until your capital account is worth $80. You don't have to pay a performance fee until, say, end of 2024, end of 2025, whenever, until your capital account value is above 180 again. This is the so-called high water mark. Let's say you increase from 80 to 120 in the second year, you don't have to pay a performance fee.
You only have to pay if it exceeds the highest point your capital account has ever reached. For hedge funds, this is obvious. Another thing about hedge funds and their structure is that they are called open-end or evergreen vehicles. So they usually have a monthly subscription.
So you would subscribe, let's say you subscribed for 100K. You subscribe for 100K and then your funds will be locked for X amount of time. Maybe a year. That may be the case, it's impossible not to have a lock. It might take three years. Each strategy has a different lock-in period, and then before the lock-in period, you can redeem your funds, which means you can withdraw all your funds.
Or a small percentage of your capital, you know, once you put in the redemption, it takes a quarter of the time to give notice and then you have your capital allocated back to you. This is how hedge funds are structured. The structure of a venture fund, which usually follows a waterfall style, is slightly different.
For example, hedge venture capital funds. This is a closed structure. So I don’t participate every month. Instead, I'm saying I'm raising $10 million in funding. Once I hit 10 million, there won't be any more. New investors can join the fund. I may raise a new venture fund in a few years, but no new funds are coming into the fund. Let's say I raise 10 million.
There is usually what is called a capital call schedule. So, uh, the general partners of the fund, they're either, they set a cadence, like every quarter, every six months, or maybe deal by deal. Once they call capital. Suppose I subscribe for 100K. They might say, we'll pay 30% up front, or we'll pay 10% to invest in this seed-stage company.
We think this is a great opportunity. So we call it 10%. Then I would put 10% of my 100K, 10K into the fund. Then they will invest. And then they continue to do that for a period of time, which falls within their investment horizon, which I think is typically three years.
So, over three years, they kept calling capital, and that capital call included a management fee, which was the 2% they charged. There are also fees. So, you know, over a 10-year fund life, the return is about 2%. So, they have about 80 grand that they can deploy on my behalf because 20,000 of that is management fees and expenses, and those are just rough numbers.
Then they invest for three years, and then three years later it’s harvest time. So they've made the bet. Maybe some of their companies launch a token and it's listed on CEX and DEX and they choose to exit some of those positions and, um, maybe there's an acquisition and maybe the company is like the next coinbase and it's listed on the New York Stock Exchange that when they acquire liquidity and then allocate that liquidity back to the limited partners, and then that's where it gets a little tricky because there can be a European waterfall, which is when you charge any performance fees before you paid out all the money to the limited partners.
Suppose I invested 100,000 and I got 100,000 in return. Then, assuming there is the next 100,000, the GP will take 20% of the 20,000 and the LP will get 80,000. Then there's American Waterfall, where the 80 20 allocation of performance fees and capital allocations starts at 1 1 rather than after all capital is returned.
It's a little overgrown, but that's the difference between a European waterfall and an American waterfall. Uh, just make sure you ask your GP and how they allocate it. Well, the key metric for venture capital is TV PI. It typically represents unrealized gains and DPI, which represents realized gains. So TVPI, let's say I invest in a seed-stage company at a valuation of 10 million.
Then they came up with a monster series. I was valued at $100 million. It's a 10 Our investments in the fund are in growth stages or later downstream stages and then we allocate that capital.
The capital they allocate to limited partners is DPI. So they are back. You know, limited partners invest 50% of the capital. Let's say they allocate back 5 million from a 10 million fund. This will be a point. Five times DPI. So those are, uh, some high-level metrics and general incentive structures and how venture funds and hedge funds operate.
00:12:59
Speaker #0
marvelous. This is really helpful. Now let's get to the more interesting part, there were a lot of booms and then crashes in the last two years and the landscape has changed dramatically in that time. So how can there be. Let's start with hedge funds. How are they doing? Well, throughout this process, their incentive structures and their investors and what choices they made and what are the consequences of those choices that they're facing now?
00:13:28
Speaker #1
Yes, there's a lot to cover here, and different strategies for hedge funds have different implications. So if we talk about long-biased strategies first, these are the funds we have allocated to Sol, DYDX, GMX and Eth, Lido and others. These funds performed exceptionally well in 2021. And 2022 is a very challenging year, with their stock prices typically down 60% to 80% from their highs.
So if you remember my previous comments about the high water mark and how hedge fund incentive fees work, let's say the value of my capital account, I invested 100K in early 2021. Now I have 500K and I feel great. Now my 500,000 is back to 100,000, which means the hedge fund has less assets under management.
So their management fee is a lower two percent of their AUM, and then they may not see incentive fees until the next time the value of their capital account is above where the high-water market is. So I see a lot of funds scaling up thinking it's only going to go up forever, but then they're bringing in new members to the team and, like, not really protecting against the downside risk.
They're having to lay off people right now or they just don't see a path back to those high water levels so it's almost like the business risk associated with hedge funds and that's why we're seeing a lot of these long-term biased hedge funds struggle because they have limited Time to pay all wages and all cash burn Management scale is low and there is no clear incentive path to profitability This is some long-term biased strategy that focuses on lower beta Non-directional arbitrage strategies.
These funds have performed exceptionally well in the traditional world. It would be very rare for a market-neutral hedge fund to earn 15% net of all fees. In cryptocurrencies, these arbitrages are generally less complex due to volatility and funding rates, as well as the large number of retail investors involved.
These funds easily generate 20 30+ net performance fees and are the exception, however, retail is being wiped out by TVL collapse, low liquidity, low volatility. Many simple transactions no longer exist. So now those funds that may have raised a lot of capital, have too much capital to deploy into strategies that have limited capacity.
So as the opportunities grew, we also saw many funds get into trouble. As more and more capital comes into the market through DTC spot ETFs, you know, cross-chain liquidity and AMM and so on increase efficiency, just like the DeFi world is coming. I think like the market neutral funds, uh, even the long-biased funds that are back in this category are doing a lot better now in 2023, but it's a very tough path to take, given 2022.
All the investment challenges are layered on top of all the operational challenges that require due diligence on counterparties. You can't even tell you how much capital has been lost through Genesis and ftx and may have been concentrated into Luna and ust, so you need to keep thinking. You're operating um and just trying to find alpha um so that's the hedge fund side of the venture fund side and if you look at the funds that are some of the stalwarts in the asset class today, they typically launched between 2016 and 2019.
Their operating capital rarely exceeds 30 million. My favorite is the multi-coin one, I think it’s 18 million. Uh, a lot of these funds are under 20 million, even those funds, because the LP conviction is lower. They took some leading opportunities in the asset class, or some leading opportunities in the asset class, and delivered extraordinary returns.
10x, TVPI, some of them will go back to, even 30, 40, 50, 60x TVPI, depending on how they monetize, and over the last few years, their DPI has been outstanding. You don’t see this in traditional businesses. These are like mind-boggling numbers that cannot be calculated in the normal VC mind.
However, many of these funds have been successful. They invested their money. Let's say they invest the full 20 million. They did a great job. They got good grades. They already have relationships, connectivity, brands and asset classes. And then when the market got super hot and everyone wanted to invest in venture capital, they oversubscribed five times and the fund hit 300 million.
Now, some of them have raised over a billion dollars. So they raised a lot of money and then entered the crypto market. Then, when valuations are ridiculously high, they invest in bull markets. The rounds were so competitive that no due diligence was done. Their competition is too fierce, so you have to pay more.
Then the market crashes and quality opportunities diminish as everyone licks their wounds. You know, forest fires take a while to clear. But now they are struggling to generate returns because the TAM in the cryptocurrency space is relatively small at the moment.
So these funds have to either A invest in liquidity, B invest in more opportunities than a typical 40-trade fund, or C they have to basically do these portfolio rounds, like, they're investing in lead seeds and series just because They have so much to deploy, and they need to be able to apply it to some of their best deals.
Again, the best deals are always limited. Otherwise, they want to be the best. So competition for these products is fierce and prices are pushed up. I think we're still in the early stages of the life cycle of 2021, 2022, 2023. Years and asset classes will grow and exits will improve as regulation becomes clearer.
As the M&A and IPO markets open up, it becomes easier to issue tokens on DEX and CEX. So we'll see how these funds perform over the long term. I personally prefer smaller managers. Focus on the early stage, they have advantages, but the market is still relatively small.
00:21:33
Speaker #0
Of course, for the bigger phones, they raised hundreds of millions of dollars in funding.
Like, he doesn't differentiate that they don't actually have the money, but they have the money that the limited partners have committed to them. So, like what, there's definitely an incentive here. They hope to complete all of this within three years. This is an important moment as they have to raise their next round of funding.
So how do you see this dynamic playing out? correct? Is it like you imagine, maybe this year or next year, like last year, they still need to deploy. As the market changes. People will aggressively move into new companies and start raising capital for their next company. Like, how do you see that dynamic playing out?
Because they can't raise the next one until the last one is exhausted.
00:22:20
Speaker #1
Yes, that's a great question. I think we see a lot of GP deployed too quickly, and LP remembers that. So what we see first. Some funds took advantage of 2021's frenzy to raise capital. So they deployed very quickly, maybe their 2020 or 2021 funds.
Then they go public in 2022. So LPs remember that because your job is to be disciplined and deliver returns, not to raise more money and charge management fees. So people know the funds that might be happy. One of the positive consequences of the cold fundraising environment we are in is that these funds realize that raising follow-on capital is not easy.
Unless they prove themselves by allocating capital back to DPI to drive TVPI. As a result, they are much slower and more discerning. So it's actually harder. This then trickles down to the founders. So founders, it's harder for them to raise money because the pace of venture capital is getting slower and slower.
They are taking their time. They only want to invest when they feel very guilty because the money they have now is valuable and they don't want to enter the market in the cold crypto winter and all the allocators will probably move with less money to deploy to the asset class with urgency .
00:24:15
Speaker #0
indeed. Yeah, I mean, it's weird because everybody gets wise in a bear market and then every time a bull market comes, the lessons from the last bear market are completely lost. So it's nice to see, err on the side of caution, but it's always very cyclical and a founder.
You'd say, oh, like the due diligence that actually happens in a bear market. But once you enter a bull market, everything goes out the window again. It’s like it’s crazy how cyclical it is. But if you're a limited partner, what should you be aware of when you're evaluating where to put your money in a venture fund or hedge fund?
What kind of metrics, benchmarks, if any, would be best to get some numbers on?
00:25:08
Speaker #1
Yeah, I would say it depends first of all on what your goals are, if you want to be like a hedge fund, your capital statements are marked to market every month. So you're dealing with uh, enduring the ups and downs, the ups and downs, and potentially having to pay short-term gains while you're still locked in um, so it really depends on you know what the goal is, if you already own BTC and ETH, Maybe you want to allocate to a fund that gives you exposure to different types of tokens because you don’t want the work of managing the token book yourself, maybe you want something safer like a more market neutral fund, or maybe you want the long term Of venture capital, you just think of it as an allocation to blockchain technology, um, rather than like real-time liquidity tokens, things to note, you know, obviously on the venture capital side.
TVPI and DPI are crucial to historical investment. I think, the average ownership size of the deals they're doing, are they leading, are they following? How many deals do they do per year, per quarter, whatever they are. Do they have a track record of making good investments and developing relationships with the founders in the paper that they're trying to express with this fund.
So, there are endless things to do. First, you need to do all your ODD, operational due diligence to ensure this. They will not lose your capital through amateur cash management or counterparty management. Do they have the right risk management, et cetera, but in terms of investment due diligence, I would say that your goals in the early stages are riskier, but there's also a higher potential.
So do they have rules in place. Once you have Series A or Series B, exit the position. Once it triples, will they take 3x or 30% of the capital? Do they have rules? As venture fund managers, how do they plan to manage liquidity tokens? What should you know about time markets? Should you um, because liquidity tokens are very sensitive to overall market dynamics, or is it your job to look for good innovation?
So I know some venture fund managers who wanted to have a token generation bed sold all their positions. They act like it’s not our job anymore. We took the company from a previous stage to a Series B, um, you know now that we're out, those are some of the things to look for, it's hard to really say on the venture capital side, like other than TDPI DPI ownership percentage and deals A raw metric to look at outside of that is the number of leading companies and the percentage of companies that have raised another round of funding, which shows that the portfolio supports, in addition to operational due diligence.
Venture capital happens to be a little soft. What is their reputation? You'll get professional references. They will introduce you to founders who like them, but what about founders who don’t like the VCs who invested in them? And, you know, you should also talk to other founders in the space who may be talking to that VC but choose not to take their check.
So it's important to gauge the reputation of these GPs and these teams, and whether they're respected by the founders, understand what's being built at the forefront, and actually support them once they invest. When it comes to hedge funds, there is much more data.
What differs from venture capital is the monthly track record. You're just waiting for the quarter mark and unless and unless there's a live liquidity token, you're going to be affected by any round, the last round was, but on the hedge fund side, there's monthly performance updates based on NAV capital The value of the account is based on real-time liquid token prices.
So it's much easier to discern past records and then ask, what are your goals? Do you want a higher beta? For Bitcoin and the digital asset market as a whole, or do you want to be more protective but still capture 80% of the volatility? Do you want something with a high sharpness ratio?
Volatility is lower. Yes, it's entirely up to you. I think on the hedge fund side, it's also really important to think about the business risks of those hedge funds. How long can they continue to operate without performance fees? And the management fees are very low. And then one of the things that I think is important is, I always ask, when does this strategy go through alpha decay?
Like, when, when, and how much capital can you deploy into your existing strategy? How do you feel about exiting investments? If you have more of a long bias and liquidity in the market, how do you think about hedging, leveraging derivatives, like, you know, on-chain and off-chain options and derivatives platforms?
It’s certainly far less complex than traditional markets. So, I think hedge funds on the cryptocurrency side have operational, premium, because if you have a team that, you know, maybe has a great trading infrastructure, that's an advantage. If you join all these different exchanges and you have a well-thought-out, well-constructed way to move funds between exchanges faster than anyone else, that's an advantage.
Because next time FTX or Luna comes along, you'll be able to cash out your capital, while the next competitor is slower, but you can't. Or maybe you're, you join a prime broker, so you're, you have insurance or whatever it may be. So there are all these different factors. Hedge fund due diligence is a complex undertaking.
I think that's more important than a diligent venture fund. But I also think that's why there's more obvious data to analyze. Venture funds, on a surface level it's easier, but on a deeper level because you have less data available because these funds are structured to be long-term, you need to really drill down into the more fragile areas, which is reputation.
00:32:45
