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I’ve raised venture capital before, but understanding the nuances between crypto venture capital firms and hedge funds was a great learning experience. Ben runs a fund that invests in other funds, so he knows what’s up. This episode is helpful to understand the incentives of how both of these investor types (VCs and HFs) have fared over the past 2 years and what lies ahead.
Speaker #0
Cool. So to get started, can you explain the different types of crypto funds, hedge funds versus venture capital versus any other kind of structures you see in the market?
Speaker # 1
Yeah, thanks, Kerman. First, just a quick introduction of my name is Ben Jacobs. I’m the managing partner of Scenius Capital.
Scenius Capital Is a fund to funds asset manager focused exclusively on blockchain and digital assets Uh in 2021, we launched our first fund which is a fund of crypto native hedge funds Uh, and at the end of this year, we are launching our second fund which is a fund of early stage emerging manager for Uh venture capital funds so the way you think about Hedge funds is hedge funds are focused on executing trading strategies around live liquid tokens So all of the same trading strategies that are available to traditional traders and equities bonds Uh derivatives, etc commodities all of those exist in crypto So there may be a long biased discretionary fundamental research driven hedge fund strategy Where the managing partners, the CIOs, the analysts, they are evaluating which tokens, uh, have clear value drivers to them and therefore there’s a dislocation between its current price And where its price can go over x amount of time That’s one type of strategy that’s called long bias.
There could be long short there could be Uh more systematic where it’s just according to an algorithm then there’s also more market neutral Low beta, meaning less tied to the market, um, or or or non directional strategies where they’re purely looking for returns, irrespective of if the market is going up or down or sideways.
So. Those often, uh, are strategies pursuing arbitrage, so it could be cross exchange arbitrage, it could be DeFi to CeFi arbitrage, uh, it could be staking, it can be, uh, liquidity provisioning, etc. So there are a number of different strategies that hedge funds pursue, and they all have different mandates.
The long bias, discretionary, fundamental research ones are more so like Liquid VC. Um and some of the other strategies or so, uh, like true pure absolute return Trying to just go up 15 plus percent net per year annualized So that’s the hedge funds the venture and those are only investing into live liquid tokens So that they could be trading around btc and eth they could be trading sol They could be trading any asset that’s live and available on a DEX or a CEX the dc funds Typically have longer fund lives.
They typically have a 10 year fund life, a 3 year investment period, 7 year harvest period, and they are investing into the companies behind some of the most critical Blockchain, uh, and digital assets, protocols or, um, technologies. So, you can see something like, who were the early investors in Eigenlayer, or who were the early investors in Optimism.
Prior to any of these projects having tokens, there was typically a founding team that came to market with an idea of something they wanted to build. They went to the venture capitalists, they raised money at X valuation, and then a number of VCs participated. And then there’s sequential rounds seed series answers be, uh, until there’s ultimately a liquidity event.
Um, in crypto, the novel primitive is tokens. So historically in traditional venture, the only means of getting an exit and therefore having capital return to the VC funds, which then trickles down to the limited partners, the investors in the VC funds was if there was an M and a acquisition or an IPO, what’s novel about is that you could effectively achieve liquidity.
Far earlier in your company’s life cycle typically like a series b, which is when you would launch a token Now that obviously adds complexity. There’s a reason that a lot of series b companies don’t have a live token price Associated with them because they’re still nascent. They’re still looking for customers looking for product market fit But that is kind of the trade off of crypto.
It’s live. It’s public earlier on um The public can participate therefore democratizing access To some of these startups. And so, um, yeah, once these VCs exit the position, um, then they, uh, distribute capital back to their LPs. So. I’ll pause there. Hopefully that was a good quick overview. Obviously, I could talk an hour about the topic, but hopefully that covers it.
00:05:13
Speaker #0
Yeah, no, I think all that, like, makes sense. I think what is really the nitty gritties of the incentive structures of the two? What are both, what are the people who are running these? What are their incentive structures? And how do they operate? Because that invests, uh, what their actions inform at the end of the day.
00:05:32
Speaker # 1
Yeah, absolutely. I think there’s areas in which hedge funds and VC funds are similar to one another and then other ways in which incentives are different. So the ways in which they’re similar is that they typically have the same fee structure uh where they charge a 2 percent management fee and then a 20 percent performance fee.
That’s base. Um, so 2 percent management, uh, is basically how they pay their teams, how they pay for the software, the travel, the things they need to do to execute on their strategy. So, uh, 2 percent of whatever they have a U. M. typically gets charged quarterly. Um, so a quarter of 2 percent gets charged each quarter.
Um. Then the 20 percent incentive fee or performance fee, this is where it slightly, uh, is different. So on the hedge fund side, incentive fee or performance fee, quote, crystallizes typically on an annual schedule. So say you invested 100 and at the end of the year, uh, after fees, uh, and the management fee, your 100 is now 200.
That means you’ve made a hundred dollars in profit for your LO. At the end of the year, you are then taking 20% of that a hundred dollars in profit as your performance fee. So now the value of the LPs capital account is $180 going into the, the next year. So 2024, for example. What’s interesting say is that your, your value of your account is $180 now, and then the crypto market dumps.
And it goes all the way down to the value of your capital account is $80. You are not paying performance fee, say at the end of 2024, 2025, whenever, until the value of your capital account is above 180 again. And that’s called a high watermark. So say the next year went from 80 to 120, you’re not paying performance fee there.
You are only paying if it goes above the highest point that your capital account has ever hit. That’s distinct, uh, for hedge funds. Another thing about hedge funds and their, um, and how they’re structured, they’re called open ended or evergreen vehicles. So they typically take in a subscription, um, monthly.
So you would subscribe, say you’re subscribing 100K. You’re subscribing 100 K and then your capital is locked up for X amount of time. It could be a year. It could be, there could be no lockup. It could be three years. Each strategy has a different lockup and then pending on the lockup, you can redeem your capital, meaning get all your capital out.
Uh, or a fraction of your capital out based on, you know, once you put in your redemption, it’ll take a quarter to provide notice and then you’ll get your capital distributed back to you. That’s a hedge fund structure. The venture fund structure, uh, typically follows a waterfall, uh, and it’s slightly different.
So say hedging a VC fund. This is a closed end structure. So I’m not being in each month. Rather, I’m saying I’m raising a 10 million fund. Once I hit 10 million, no more. New investors can come into this fund. I might raise a new venture fund in a couple of years, but no new ones coming into this fund. Say I raised 10 million.
There’s typically what’s called a capital call schedule. So you’re having, uh, the GPs of this fund, either they’re, they’ve made it like a cadence, like every quarter, every six months, or maybe on a deal by deal basis. Once they call capital. So say I subscribed 100 K. They may be like, we’re calling 30 percent up front or we’re calling 10 percent to make this investment into this seed stage company.
And we think it’s a great opportunity. So we’re calling 10%. I would then send 10 percent of my a hundred K 10 K to the fund. They would then make the investment. They then continue to do that for a certain amount of time, which is falls within their investment period, which is I’d say typically three years.
So over three years, they’re calling the capital and within that capital call included is the management fee, the 2 percent that they’re taking. And the expenses. So they, you know, that comes out to about 2 percent over a 10 year fund life. So, they have about 80 grand worth of capital to deploy on behalf of me because 20 K of that is management fee and expenses, and these are all just rough numbers.
They’re then investing that for, um, three years and then after three years is the harvest period. So they have already placed their bets. And maybe some of their companies launch a token And it’s live on CEXs and DEXs they choose to exit some of that position Um, maybe there’s an acquisition Maybe the company is like, uh, the next coinbase and it goes public on the new york stock exchange at that point They get liquidity and then they distribute that liquidity back to LPs and then Here’s where it’s a little tricky, because there might be a European waterfall, which is when you’re paying out your LPs back all of their money before you take any performance fees.
So say I invested 100k, I get paid 100k back, and then with, say there’s the next 100k, the GP would take 20k for the 20%, and the LP would get 80k. Then there’s a U. S. Waterfall where that 80 20 split of the performance fee and capital getting distributed back starts at 1 1 as opposed to after all the capital has been returned.
It’s getting a little in the weeds, but that’s the difference between a European and American waterfall. Uh, just something toe to make sure you ask GPs and how they distribute. Um, the key metrics for venture are TV P I. Which typically it represents unrealized gains and DPI, which is realized gain. So TVPI, say I invest in a stage seed stage company at a 10 million valuation.
And then they raise a monster series. I had a hundred million dollar valuation. That’s a 10 X TVPI say, then they have an exit at, uh, or say then, uh, the GP is like, we’re going to sell a piece of. Our investment into this fund to a growth stage or later stage downstream and then we’re going to distribute that capital.
The capital they’re distributing back to the LPs is DPI. So say they returned. You know, 50 percent of the capital that the LPs had invested. So say they distributed back 5M out of a 10M fund. That would be a point. Five X DPI. So those are, uh, some of the high level metrics and just general, uh, incentive structures, um, and how both venture funds and hedge funds operate.
00:12:59
Speaker #0
Perfect. That was really helpful. Now let’s kind of get to the more fun part where we’ve had, uh, the past two years where there’s been a lot of exuberance, then a crash and the landscape has changed drastically in that time. So how have. Let’s start with hedge funds. How have they fared? Um, throughout the thing with their incentive structures and their investors and what sort of choices have they made and what are the consequences of those choices that they’re facing now?
00:13:28
Speaker # 1
Yeah, uh, a lot to cover here and There’s been different implications on different strategies of hedge funds. So if first talking about long biased strategies, these are funds that we’re allocating to Sol and D. Y. D. X. and G. M. X. and Eth. Lido, etcetera. Those funds did exceptionally well in 2021. And 2022 is a very challenging year where they were typically down 60 to 80 percent off their highs.
So if you remember about my, my previous comments about a high watermark and how the incentive fees work at a hedge fund, say the value of my capital account, I invested a hundred K at the start of 2021. Now I had 500 K I’m feeling great. Um, and now my 500k is back all the way down to 100k that means the hedge funds one They’re managing less aum.
So their management fees the two percent of whatever their aum is is lower And then they may not see incentive fee Until the next time the value of the capital accounts is above whatever the high water markets. So I’ve seen a number of funds that were scaling thinking it was up only forever that were bringing on new members of their team, uh, and, and just like not really protecting to the downside.
Who now have had to lay people off or they just don’t see a path in which they can get back over Um their high water mark, so there’s almost like a business risk associated with hedge funds And that’s why we’ve seen a lot of these long bias hedge funds Struggle because they have a finite amount of time where they can pay all their salaries and all their burn With lower aum and without a clear path to earning incentive That’s some of the long bias strategies focusing on the more low beta non directional arbitrage strategies.
Those funds were doing exceptionally well in a traditional world. A market neutral hedge fund earning 15 percent net of all fees would be exceptional. In crypto with yield farming and all the arbitrage that was available due to the volatility and the funding rates um and the advent of yield farming And and a lot of retail participation, which is typically less sophisticated.
It was very easy for these funds to generate 20 30 plus net performance fees, which is uh, exceptional, um, however with Retail washed out with TVL collapsing, low liquidity, low volatility. A lot of those easy trades, uh, no longer exist. And so now those funds that maybe, uh, raised a lot of capital, have too much capital to deploy into capacity constrained strategies.
So we’re also seeing a number of those funds struggle as there’s more opportunities. Uh, as there’s more capital entering the market with the DTC spot ETF with, uh, you know, uh, increasing efficiencies with, uh, cross chain liquidity and AMMs like that, like the DeFi world is coming. Um, and I think this, like the market neutral funds, uh, and even the long bias funds going back to this category are now doing much better in 2023, but it was a very tough road, um, in 2022, um, given.
All of the investment challenges layer on top of that all of the operational challenges of needing to diligence your counterparties Can’t even tell you how many funds lost capital, uh via genesis and ftx and may have gotten lumped into Luna and ust so you need to be constantly thinking about your operations Um and also just trying to to find alpha Um, so that’s the hedge fund side on the venture fund side If you look at the funds that are some of the stalwarts of the asset class today, they typically launched between 2016 and 2019.
And they were operating funds rarely bigger than 30 million. Most like multi coin one, I think was 18 million. Uh, a lot of these funds were sub 20 million, even those funds, because there was less conviction among LPs. They. Got into some of the leading opportunities in the asset classes, um, or in the asset class and delivered exceptional returns.
10x, uh, TVPI with some of them, um, returning, you know, even 30, 40, 50, 60x TVPI with pending on how they, they took profits, uh, over the last few years, uh, their DPI was exceptional. And you don’t really see that in traditional venture. Those are like unbelievable numbers that don’t compute in a normal, uh, VCs mind.
However, a lot of those funds took their success. They invested, uh, their funds. So say they invested their entire 20 million fund. They were doing well. They had good marks. They already had the relationships, the connectivity, the brand and the asset class. And then when the market got super hot and everyone wanted to invest in VC, they were five times over subscribed at a 300 million fund size.
So now, and some of them scaled even larger raising funds North of a billion. So they raise these massive funds and then the crypto market. And then they’re investing into the bull market when valuations are insanely high. Rounds are so competitive there’s just no diligence being done. Uh, and they’re just so competitive so you have to overpay.
And then the market crashes and there’s less high quality opportunities because everyone’s kind of licking their wounds. And it takes a little while for, uh, you know, the brush of the forest fire to clear. Um, but now they’re struggling to generate returns, given that the TAM of the crypto space currently is relatively small.
So, those funds have to either A, invest into liquids, B, invest into a lot more opportunities than, um, maybe they would in a typical, like, 40 deal fund, or C, they have to basically do these combo rounds, where it’s like, uh, they’re investing into the The precede seed and the series a all in one check just because they have so much dry powder to deploy and they need to be able to put it to work into some of the best deals.
And again, there’s always a finite amount of best deals. Otherwise, they want to be the best. Um, and so those are very competitive and the prices get driven up. I think we’re still very early in the life cycle of these 2021 2022 2023. Vintages and the asset class will grow and the landscape for exits will improve as there’s regulatory clarity.
As the M& A and IPO markets open up, um, as it’s easier for tokens to launch on DEXs and CEXs. Um, so we’ll see how those funds do in the long run. Um, I personally, personally have an inclination towards smaller managers. Uh, focus on the earlier stage side as I think, uh, they have an edge while the market, uh, is still relatively small
00:21:33
Speaker #0
For sure with the larger phones, which have like, uh, which raise like multi hundred million dollar funds.
Like, he doesn’t distinction is they don’t actually have that money, but they have that money committed to them by their LP. So, like, what is the, there’s definitely like an incentive here where. They wanted to play all of that within, say, three years. Right. Um, and it’s some point because they have to raise the next fund.
So how do you see that dynamic playing out? Right? Is it like you think maybe it’s this year or next year where it’s kind of like the last year where they’ve got left to deploy. And as market turns around. There’s going to like push aggressively into new company to start raising the next one. Like, how do you see that dynamic playing out?
Because they can’t raise the next one until the depleted the last one.
00:22:20
Speaker # 1
Yeah, it’s a great question. Um, I think we saw a number of GPs that deployed way too quickly and the LPs remember that. So first we saw. Some funds take advantage of the feverish opportunity to raise capital in 2021. And so they deployed, you know, very quickly, uh, maybe their 2020 or their 2021 fund.
And then they went to market in 2022. So LPs, remember that because your job is to be disciplined and to deliver returns, not to Raise more funds and collect management fees. So people, uh, you know, are aware of those funds that were maybe trigger happy. Um, one of the, the positive, uh, ramifications of us being in a frigid fundraising environment is that these funds realize that it won’t be easy to raise subsequent capital.
Unless they’ve proven themselves via being disciplined by driving TVPI by distributing capital back as DPI. And so they’re being far slower and more discerning. So it’s actually tougher. And then that trickles down to founders. So founders, you know, it’s harder for them to raise because the VCs are being slower.
They’re taking their time. They only want to invest once they feel highly convicted because Right now the money they have is precious and they’re not trying to have to go out to market in a frigid crypto winter where all allocators Uh, you know, are maybe moving with less urgency into deploying into the asset class.
00:24:15
Speaker #0
Indeed. Yeah, it’s, I mean, it’s so strange though, because everyone becomes sensible in the bear market and then every single time the bull market comes around and the lessons of the last bear market completely go out the window. So it’s like good to see, uh, that kind of like caution being exercised, but it’s, it’s always just very cyclical and is a founder.
You’re like, Oh, like there’s, there actually is due diligence that happens in a bear market. But as soon as you’re in a bull market, everything gets thrown out the window again. Like it’s, uh, it’s crazy how cyclical it plays out. But, um, in terms of like, if you’re an LP, what are things you should be looking out for when, uh, you’re evaluating where to put your money in either into a venture fund or hedge fund?
What are the kind of metrics, benchmarks, um, would be good to get some numbers if you have any?
00:25:08
Speaker # 1
Yeah, I’d say it one it it first depends on what your objectives are if you want like With hedge funds you’re getting your capital statement is marked to market every month. So you’re dealing with uh, stomaching the volatility of Up and down and up and down and up and down and having to maybe pay short term gains while you’re still underneath your lockup Um, so it really depends on you know What your objectives are if you already maybe you own btc and eth maybe you want to allocate to a fund that gets you exposure To different types of tokens because you don’t want to have to do the work of managing that token book yourself Um, maybe you want a safer, uh, that with like a more market neutral fund, or maybe you want long term venture exposure that you just consider this an allocation to blockchain technology, um, as opposed to like the live liquid tokens, um, things to look out for and metrics, you know, obviously on the venture side.
TVPI, DPI on historical investments is essential. I think average ownership size of, uh, deals that they’re doing, are they leading, are they follow on check? How many deals they’re doing per year, per quarter, whatever it is. Do they have, um, a track record of making good investments, uh, and, and developing relationships with founders within the thesis, uh, that they’re trying to express with that fund.
Um, so, you know, there’s, there’s endless things. First, you need to do all the ODD, uh, the operational due diligence just to make sure that. They’re not going to, to lose your capital via, uh, amateurish, uh, cash management or, uh, or counter party, uh, management. Um, and do they have the right risk management, um, etcetera, but on the investment due diligence side, I’d say it’s like, you know, again, what are you going for earlier stage is riskier, but that’s also has a higher potential.
So do they have rules in place for. Exiting positions once there’s a series a or series b. Do they take 3x or 30 percent of the capital once there’s a 3x? Do they have rules in place? How are they planning on managing liquid tokens as a venture fund manager? Are you supposed to you know time markets? Are you supposed to um, and because liquid tokens are very sensitive to Overall, uh, market dynamics or is your job to find good innovation?
So I know some venture fund managers who wants a there’s a token generation bed They sell all their their position. They’re like that’s not our job anymore. We took the company from precede to Series b and um, you know now we’re out um Those are some things to look for it’s hard to really say on the venture side like raw metrics to look at besides um TDPI DPI ownership percentages um deals led um number of companies that Percent of companies that raise another round and that’s indicative of, uh, portfolio support, um, on top of the operational due diligence.
Venture just happens to be a little bit more squishy. What’s their reputation? You’re going to get, uh, professional references. They’re going to introduce you to the founders that like them, but how about the founders that they don’t like the VC that invested in them, that you’re diligencing them. And, you know, you should also be talking to other Founders in the space who maybe were talking to that VC and chose not to take a check for them.
So it’s important to gauge the reputation of these GPs and these teams and whether, um, you know, they’re, they’re respected in by founders in terms of understanding what’s being built at the cutting edge, uh, as well as actually supporting them once they make the investment. The hedge fund side, there’s far more data because there’s.
Monthly track record as opposed to in venture. You’re just waiting for quarterly marks Um unless and unless there’s a live liquid token, you’re beholden to whatever the round is um where the last round is, um But on the hedge fund side, there’s monthly performance updates with nav based on the value of The capital accounts based on the live liquid token price.
So it’s far easier to discern Track record and again, like what are your objectives? Do you want something higher beta? Uh to bitcoin and the overall digital asset market Or do you want to be more protective and still capture 80 percent of a move? Um, do you want something that’s uh has a high sharp ratio?
Um, and lower volatility. It’s, it’s kind of all up to you. Um, I think also on the hedge fund side, it’s very important to think through the business risk of these hedge funds. Um, how long can they continue to operate without performance fee? Um, and with low management fees. Um, and then one thing I think that’s important is like, I always ask, like, when will this strategy experience alpha decay?
Like, when, when, how much capital, um, can you deploy into your existing strategies? How do you think about exiting your investments? Um, if you’re more long bias and the liquidity of the market, how are you thinking about hedging, leveraging derivatives, like, you know, the options and, uh, and derivatives platforms on chain and off-chain?
are definitely far less sophisticated than traditional markets. So, like, I think there’s operational, um, premia in hedge funds on the crypto side, because if you’re, if you have a team that, you know, maybe has excellent trading infrastructure in place, That’s an edge. If you’re onboarded with all these different exchanges and you have a thoughtful, uh, well constructed way to move money on and off exchanges far faster than anyone else, you know, that’s an advantage.
Because next time when there’s an FTX or a Luna, you’re able to get your capital off and, uh, the next competitor is slower, can’t. Or maybe you’re, you’re onboarded with a prime broker, so you’re, you have insurance or whatever it may be. So there’s all these different factors. Diligencing hedge funds is a, um, a complex endeavor.
Uh, more so, I think, than diligencing venture funds. But I also think that’s why there’s more obvious data to analyze. The venture funds, it’s easier at the surface level, but then at a deeper level, since you have less Data available to you because the long term nature of how these funds are structured, you need to really dig into the more squishy, which reputations.
Caliber of team and thought leadership, uh, etcetera.
00:32:45
Speaker #0
Yeah. Wow. No, that was really helpful. And yeah, kind of gives you, you don’t really hear about this side of, I guess the crypto world, cause those people aren’t on Twitter tweeting about it all the time and everything that they do. Um, so, uh, really appreciate this kind of discussion.
Before we wrap up, is there anything else that you’d like to tell the audience, um, that they think they should know or a bit more about what you’re doing? Uh, feel free to, uh, jump in.
00:33:14
Speaker # 1
Yeah. Well, first off, Kerman, thank you for, for having me. I’ve been following your substack for like three years now, and it’s one of the top, um, substacks in the space.
So go ahead to, uh, to have kindled and, and, you know, become friends and get this podcast. Uh, up in the air. Um, for those that, you know, follow me on Twitter, uh, NAP Jacobs, I also host a podcast called Scenius Studio, where I interview GPs of crypto hedge funds and crypto VC funds. So for long form conversations with those GPs, check out Scenius Studio.
We’re live on Spotify and Apple. We also have a substack Scenius Capital at substack.com and then feel free if you ever want to talk about the asset management industry, I’m always available. Love chatting with, uh, with folks and meeting new people. You can email me at Ben at scenius dot capital. S. C. E. N. I. U. S. dot capital.
00:34:18
Speaker #0
Perfect. I’ll include the links in, uh, the show notes above. So, yeah but thank you so much for jumping on today, Ben.
00:34:27
Speaker # 1
Awesome. Thanks for having me. This is great.
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