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The worst kept secret in crypto right now is that most funds are struggling to raise money.
We have seen fund managers, both experienced and inexperienced, fall short of fundraising targets, while also having to drastically shift strategies in an attempt to attract capital. Majority of the funds that have successfully raised capital to date have relied on individuals and family offices for the bulk of the capital.
As we know from the legacy financial markets, there is a finite amount of capital available from these sources though. Without institutional investors who can write tens of millions of dollars per check, there is a low artificial cap on the amount of capital that can be raised across the crypto fund landscape.
Unfortunately, most institutional investors (endowments, pensions, foundations, sovereign wealth funds) are not in the game yet. It would be nearly impossible to identify every reason for this, but here are some of the most noticeable:
Market drawdown — Fundraising was easy in 2017 when every cryptoasset kept increasing in value, but the bear market has changed that. Most potential LPs have been scared off by the 80-90% declines and many are wondering if the industry was a classic bubble that will now fade into obscurity.
Direct exposure — Similar to public equities, crypto’s liquid market allows most capital allocators to buy and hold assets themselves. Whether they stick with Bitcoin and Ethereum, or venture into less well known cryptos, these investors don’t see the advantage of agreeing to high fees (usually 2 and 20 structure) and multi-year lockups.
Due diligence failure — There are probably fewer than 10 crypto funds that have the staff, regulatory licensing, and process & procedures in place to pass the due diligence of major institutional investors. This type of infrastructure will come with time, but don’t expect deep-pocketed institutions to jump in the game without it.
Headline risk — Institutional investors are very risk-averse. It is scary to many of them to allocate capital to an industry where daily headlines include words like “hack,” “scam,” or “money laundering.” As we know, most of these issues are less serious than they seem, but that isn’t apparent to professional investors who only spend a small portion of their time on the asset class.
Past performance looks bad — While 2017 provided triple digit financial returns for many funds, most of those same funds were down double digits in 2018. In some cases, well-known fund managers who have been around for years are down over 50%. Although past performance shouldn’t be an indicator of future performance, we are all human and these atrocious returns make it increasingly harder to convince potential LPs that they are likely to make a profit moving forward.
Lack of incentives — Great fundraisers know that forcing functions can be one of their most powerful tools. Unfortunately, the current environment doesn’t provide one. Additionally, these capital allocators are rarely compensated based on their performance. This means that they can’t make more money if they financially outperform (ex: take risks and are right), but they can lose their jobs if they underperform (ex: take risks and are wrong). The incentive structure, both from the crypto industry and the institutional investment world, are working against crypto fund managers.
Absence of education & understanding — Potential LPs have a fiduciary duty to understand the assets that they invest in, underwrite the risks, and conduct proper due diligence on fund managers. Crypto is unique in that it currently has very little consensus on how to value assets, along with a high degree of disagreement on the best strategies to deploy capital. If a capital allocator asks 10 fund managers the same set of simple questions, they are likely to get a wide variety of answers, which increases the confusion and lack of confidence the allocator has in choosing to make an investment.
Difficulty deploying large amounts of capital — Lastly, even if a major institutional investor can get comfortable with the industry and a specific fund manager, there are major restraints on the amount of capital that can be deployed today. Let’s say the potential LP has to write a minimum check size of $50M and can’t be more than 20% of a fund. That means the fund manager would be required to raise a minimum of $250M...but where do you deploy that? There are 10-20 late stage companies that could take $25-50M checks and 20-30 larger market cap cryptoassets. Not exactly the robust potential deal pipeline that instills confidence and fear of missing out in a professional investor.
None of this is fun to talk about, but it is important. There is a lot of work to be done by crypto fund managers in order to attract large institutional investors. We need more seasoned investment professionals who understand the requirements of these capital allocators. We need more time to educate and demystify the technology and opportunities. And most importantly, we need more funds showing multi-year track records filled with attractive profits.
Although the fundraising environment has cooled off for fund managers, a small group of the very best remain unaffected. Over the next few weeks, there will be announcements of numerous funds that have convinced LPs of the benefits to gaining exposure to crypto, both the public and private markets. Having a small group of elite fund managers finding success isn’t good enough though.
In order for this industry to thrive and reach sustainability, we need hundreds of fund managers investing billions of dollars. We will eventually get there, but not before a lot of time, money, and resources are put into building the foundation for the globally dominant investment firms of tomorrow.
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Nothing in this email is intended to serve as financial advice. Do your own research.