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Why Crypto Hedge Funds Are Closing (And Why It’s Bullish)

November 23, 2018
Devin Milford


Why Crypto Hedge Funds Are Closing (And Why It’s Bullish)

The money trail shows institutional money, the smart money, is definitely looking to get into cryptocurrency. Some are rushing in.  Blockchain technology is far from going away, never mind crashing. The coins and tokens needed as the gateway to use blockchains are simply for sale at huge discounts. (At least, compared to early 2018 but not, I note in this report, to 2017.)

But you may be hearing about crypto hedge funds closing. Maybe you have seen not-too-bright newbie journalists (who get paid by the click) write that it’s because of this Great Market Manipulation Crash of 2018. Something doesn’t make sense, you ask.

Follow the value instead, the money instead. It is the hedge fund managers’ belief in blockchain technology’s potential, future growth and adoption that is causing their current funds to close (because they’re going to turn around and start new ones). This is bullish. But, you ask, it still doesn’t make sense why hedge funds are closing. That seems like a sure sign of failure — the “Going Out Of Business” sign. Let me explain how hedge funds work, so you’ll see why this is a good sign.

The Basics

Hedge funds and similar organizations (they might be called venture cap funds, and so on) are run by managers who get paid based on performance. This means they make money when investors make money. A hedge fund (really a fancy title for a limited partnership) is just a private little club for rich investors. You have to look at the fund’s internal documents like its partnership agreement.

(This is where I have an advantage. In my old career, I actually wrote these documents for clients as their lawyer. The other crypto commentators don’t have this experience. They don’t really know what the hell they’re talking about. And now, you know.)

How Hedge Fund Managers Make Their Money

Managers are paid in two ways. One is from a percentage (1 to 2%) of assets under management. The second and much bigger payout is from a percentage (like 20%) of profit. However, the funds measure profit against the previous “high water mark” of the fund, and not from the last period. That almost guarantees that any down performance, especially after a crash like now, makes the manager ineligible for the profit share.

Here’s how that works. For example, say a fund’s net assets grow from 10 at its formation to 12 after one year. That works out to a 20% profit, and 4% for the manager. If the fund drops to 8 in the second year, there’s no profit. If the fund recovers, it has to exceed its “high water mark” of 12 for the manager to get any success fee. So even if in the third year, in this example, the fund has a 50% profit (from 8 to 12), the manager is not eligible for a profit share. That’s because in the long term picture, there are none.

What Managers Will Do Next

A down market assures a steep climb back to “break even” and then to the high water mark. Managers can, and will, look for a fresh start. This means closing old hedge funds and returning money to investors. Why? It’s to start a new fund with a fresh clean slate at a market low point. That’s because it’s much easier (one assumes) to capture all the market price rebound — and the 20% profit share on all that gain!!! — right away.

A choice between a next-quarter profit share from easy gains rebounding from a sharp crash, or waiting perhaps years to recover lost ground. You can see what anyone would pick.

There’s one other element: You cannot start a new fund without having new interested investors. There is interest. That, and the down market, are why funds are rushing to close. It’s because the managers are rushing to start the new ones. It’s because they want to take advantage of the structure to restart their benchmark hurdle they must overcome to get fees. In this crash-and-burn market, that benchmark is getting close to the ground.

The Takeaway

Now that you’ve got the context, you will see through the manipulative headlines you’ll read everyplace else. This isn’t FUD. It isn’t even bad news. It’s actually a sign of managers’ greed. That means they see profit ahead. So should you.

PS: The author is an American securities lawyer who has formed private investment entities (aka hedge funds) in many jurisdictions.