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Many organizations in crypto are in more trouble than people realize.
First, crypto hedge funds are going to start shutting down due to high water mark issues. A high water mark is a contractual clause in fund documents that ensures fund managers only receive their performance fee (usually 20% of profits for crypto funds) if the fund’s net asset value is higher today than in any previous investment period.
December 2017 was the end of the last investment period for majority of the funds, but it was also the top of the last bull market. We have seen 50-80% decreases in net asset values in some funds since then. This means these fund managers will not receive a performance fee in 2018, which drastically reduces the income of the individual manager. Additionally, the fund managers won’t receive another performance fee until they are able to 2-4X increase the net asset value of the fund from current levels.
It wouldn’t surprise me if fund managers won’t be able to achieve those levels of profits until at least 2020, if not further out. This lack of eligibility for their most important financial incentive will lead to many fund managers shutting down their funds and returning capital to investors. They are likely to sit out of the game for a few months or even a year, before returning with a new fund that will not be subjected to the high water mark challenges.
As I’ve thought about this issue more, I keep coming back to a single question: Why haven’t more crypto fund managers realized this already and shut down?
The most plausible answer is that many of the managers are young/inexperienced and they won’t realize the issue until they don’t receive their performance fee for 2018. If true, we could be less than 60 days away from many of the fund managers experiencing the pain of being ineligible for the bulk of their compensation. Time will tell how many decide to close up shop versus ride out the prolonged bear market.
This brings me to the challenges facing ICO projects. Most teams raised millions of dollars in cryptocurrency leveraging the new financing mechanism. Unfortunately, majority of the ICOs refused to heed warnings of numerous people, including my partners and I. The SEC announced two new enforcement actions and settlements against ICO projects last week. In the case materials, the regulatory body used language that (1) indicates most ICOs will be deemed sales of unregistered securities and (2) the projects that violated the law will have to comply and pay financial fines.
There is a nuance to the financial fines that could be devastating to the industry though. Regulators are requiring teams to issues refunds to investors (if the investors would like one), at the US dollar price when the investor invested. Almost every project raised capital in the form of cryptocurrency — for example, lets say investors contributed 50 BTC to a project at a price of $10,000 for a total of $500,000 raised. This example team would be on the the hook for returning $500,000 to investors on top of the financial fine levied by the SEC.
Normally this wouldn’t be a big problem, except crypto prices are down 50-90% since the all-time high. It is unlikely that an ICO project has enough funds, based in US dollars, to pay investors back (depending on when the ICO was raised — most were in Q3 & Q4 2017). In our example, if Bitcoin is down 50% since investors contributed the 50 BTC, the team would only have $250,000 on hand to repay investors (if the team didn’t spend any of the money yet either). The only options they have is to raise more capital (unlikely) or declare bankruptcy.
The current bear market is going to go from bad to worse very quickly for both crypto funds and ICO projects. The pain ahead is something that many of these entrepreneurs and fund managers have never had to deal with. Fortunately, some teams listened to folks like Keith Rabois as they warned against these future challenges, but not nearly as many as should have.
If ICO projects begin filing for bankruptcy, crypto funds will have to start writing investments to zero at an accelerated rate. The compounding effect of the high water mark issues and deepening losses should be quite discouraging for fund managers and limited partners alike. As both ICOs and funds begin to shut down, it is easy to see a future feeling of panic and desperation spreading across parts of the market.
Then, and only then, will we start to see the capitulation necessary for bear markets to bottom out. The structure of a volatile market like crypto brings many advantages, but the nuances described above are the dark side.
Things will get much worse before they get better. That is okay. Remember, bear markets get rid of the tourists so that the true entrepreneurs can focus on building sustainable value. Watch closely for the founders who are quietly toiling away with talented teams right now…
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