How To Set Up A Cryptocurrency Hedge Fund

Get the Next Michael Burry: How to Setup and Run Your Own Crypto Hedge Fund

In what follows, we explain how setting up your ain hedge fund is less daunting and expensive than frequently assumed, and tin be done in a week.

Christian Bale as Michael Burry in Adam Kay's 2022 picture show adapation of The Big Brusk by Michael Lewis.

Michael Lewis' volume The Large Short and the movie it is based on became instant classics.

The story of its primary hero, Michael Burry, an outsider who places loftier-conviction bets with the small fund he runs from his basement, shows how everyone tin be right alone confronting the earth, despite — or peradventure because of — existence shunned from the big boys' tabular array on Wall Street.

Express yourself!

Many of our clients trade crypto just don't accept a vehicle to express their views. A subset are coders who have developed proprietary algorithms for systematic trading which testify very encouraging results.

What they don't accept is meaningful amounts of upper-case letter of their own. At what point is setting up a fund to concenter outside investors worth the expense?

We'd say if (i) you got some verifiable rack tape — even if but in an exchange account held in your personal name — and (ii) you're prepare to seriously dedicate yourself to managing outside coin.

Both will go a long way in persuading outside investors to requite you capital to deploy.

Investors intermission downward the risks of farming out money into investment take a chance and infrastructure take a chance.

Investment risk comes from being exposed to the marketplace and the director's strategy. An investor who decides to stay passive east.grand. past just holding BTC however takes market risk.

An investor who allocates majuscule to you lot will add active portfolio management run a risk — even if you lot run a adventure-neutral strategy. That risks could come e.g. from your algos non performing as expected, your chance direction blowing up, or even a fat finger order entry mistake.

Investors therefore volition want comfort nearly your strategy, which will include how it performed in the past, your team and their roles, your hazard direction policies etc.

The second take a chance comes from your setup. This infrastructure take a chance includes where y'all decided to set your fund, who you custody with, who is your fund admin and who did the legals.

Here, investors will want to see ii things: a stable of recognizable names e.k. custodians, legal counsel and fund admin, and best practices, i.e. a structure they recognize. Crypto is already a new asset form, therefore adding an innovative structure may scare off investors. Meliorate stick to tried and tested.

In what follows, we'll suspension downward the master infrastructure risks, list solutions we know piece of work, and share means yous can salvage money.

Take it until y'all rake it

Earlier we swoop in, let's talk coin first.

For many aspiring manager, whether or not to fix upward a fund may be a simple matter of budget. But how much do you need?

The skilful news is that many service providers will accept it that they don't go paid until you rake the money in and can share in your fees.

Every bit a result, the upfront expense tin can be drastically reduced. Count about USD 5k to comprise the bodily vehicle and 15k — 18k for the fund's legal documentation.

On the latter, here are a number of impaired things we've seen people exercise:

If you don't accept budget, don't get with some snooty white-shoe counsel who does non come out of bed for less than 50k: some legal firms but bargain with the Blackstones and Goldmans of this world and can afford to say no to poor clients. For what you demand, second-tier counsel will do.
Don't let counsel tell you that your setup is rather special and their template documents won't be relevant: they've used the same set up of documents many time over and there are simply that many variables in a setup. We all know that after your initial telephone call with the partner, a low level acquaintance will pretty much press "print screen" to generate your suite of documents with your fund's proper name slotted in. That should not price 40k.
What will cost 40k or more is if you use billable hours to brainwash yourself about the very basics of a fund setup. Nosotros have seen clients eat through their unabridged legal budget by request questions they could have Googled (or got the answers from us for free!). Instead of clocking up fourth dimension to get a Hedge Fund Structures 101 course from a-grand-dollars-an-hr -Partner at a legal business firm, you could spend some time reading up and salvage yourself 5 figures.

A. The Typical Setup

To get you started, we put together the diagram of a typical hegde fund setup which we'll utilise equally a guide for the give-and-take to follow. We volition utilise the Cayman setup as a reference every bit over 85% of the globe'due south hegde funds are incorporated there:

1. The Fund

The Cayman open-end fund is typically set up as a limited company with variable majuscule. This visitor grade lends itself ideally to effect shares as more investors come in and buy dorsum shares when they redeem.

In contrast with a VC fund, this liquid fund structure has no closing at a pre-determined size (hence "open-stop"), and no defined investment horizon or "vintage".

Rather, investors subscribe by continually purchasing shares from the fund company and redeeming shares back to it at Net Asset Value ("NAV"), which is calculated at regular intervals to coincide with the fund's subscription and redemption windows (typically quarterly but for crypto funds also monthy or fifty-fifty daily).

This NAV is in essence your fund's share toll and captures the capital gains (if any) of the fund minus the management and functioning fees you lot charge.

This setup optimally caters for positions in liquid assets including crypto avails, though the structure also allows for non-core allocations to illiquid assets including stakes in private companies or illiquid tokens, and even a buffer of good sometime fiat.

two. The Investment Advisor ("IA")

Summit right in the diagram to a higher place is the entity that provides the "brain" to the fund, advising what to invest in.

The IA is mostly based in 1 of the world's financial centers e.g. New York or London where it is fun to spend i's money, just as such this is not a requirement.

What clients besides frequently overlook and/or underestimate is that typically the IA will need a local license to manage coin on behalf of third-party investors.

Such license may be expensive and may have a long fourth dimension to acquire, only there are hacks e.g. a license tin can be borrowed for an intial period from another licensed entity until the fund applies for its own.

The Fund contracts directly with the IA nether an Investment Advisory Agreement (IMA), which is i of the key certificate in the legal suite. This IMA is essentially a mandate to the IA to take the investment decisions over the fund's assets.

3. 3rd Party Service Providers

In addition to the IMA, the fund will have to enter into agreements with a number of third party service providers who will aid with the administration of investor subscriptions and redemptions, calculation of the fund's NAV, custody of its assets, etc.

Each of these 3rd-party service providers contracts directly with he fund and their fees are paid out of the fund'southward AUM.

The three key service providers to the fund are the Fund Administrator ("fund admin"), the fund's custodian, and its accountants/auditors.

The fund admin
The fund admin's main part is to handle the onboarding of subscribers including KYC/AML checks, and to provide an contained source for the calculation of the fund's Net Asset Value ("NAV").

The fund admin's overall functions include ongoing services such equally:

Maintaining the accounting records for the fund including general ledger and original books of entry;
Maintaining shareholder capital letter accounts;
Maintaining shareholder information, including tax and contact information;
Calculating distributions from the fund;
Calculating management fees and other contractual fees;
Preparing quarterly account statements for the fund;
Computing yr-to-date and life of fund internal rates of return (IRR);
Distributing fiscal statements, account statements, etc to investors;
Maintaining an online reporting portal.

In addition, the fund admin's year-end services include:

Audit liaison for the year-finish audit procedure for the fund
Handle whatsoever accounting-related questions from investors.
Distribute audited financial statements and tax information.
Complete audit confirmations for investors.

A fund admin would typically accuse a capped monthly fee upward to a determined level of assets under management ("AUM") for its services, with ground points (bps) share in the AUM when the fund reaches a certain size.

This may be your saving grace, since their fees just boot in once yous're up and running. From what we've seen, fund admin fees range between USD two,500–5,000 a month for a medium-size fund upwardly to USD 50mm. Once the fund grows in size, expect the footing points to be in the depression teens.

Note that every bit of today, only a select number of fund admins have on crypto hedge funds clients. Fewer still will allow yous take subscriptions from investors in crypto, since they perceive the compliance risks to be college — even though the technology for whitelisting crypto investors online is much more than robust than the analogue process!

Eventually, smart contracts and blockchain should exist able to supplant a lot of what the fund admin does at a much lower cost.

Custodian and accountants/auditors
Every bit with the fund admin, currently simply a few custodians specialize in crypto hedge funds however the number is growing steadily. Also, some legacy players like Allegiance are at present carving out a proper name for themselves in the digital nugget space.

As mentioned before, investors volition look you to work with recognized players, either boutiques that specialize in custody of crypto assets or established players that co-operative into this new space.

In this context, self-custody is a total no become, as is the lack of outside accountants and auditors to the fund. At least some lessons from the Madoff scandal have percolated into the crypto space!

Look to pay loftier single digit bps sharing in your AUM to your custodian. Auditor fees are typically high (into the 20k) since the big four accounting firms abuse their dominant position. We recommend going with a 2d tier name until y'all rake in the assets.

4. Operation fee vehicle

The higher up diagram is a simplified structure. More convoluted setups sometimes have a Cayman-based AI which in plough sub-contracts with a sub-counselor based outside Cayman. A myriad actress entities can be added, typically for tax planning purposes.

We typically recommend clients not to optimize for tax from day i and rather rejig their structure once functioning fees really outset kicking in.

These performane fees are where the juice comes from: mananagent fees (typically ii%) typically just cover the AI'due south overheads like office and staff in loftier cost centres. The performance fees are what may propel you into the iii comma club of hedge fund billionaires if you do well.

Therefore, we do recall it is important to have a Functioning Fee Vehicle in place from day one to optimize not just for revenue enhancement just also to have the flexibility of how the performance fees are paid out: Most likely your investment team will have been promised a share of the performance they contributed to the fund. When paid out to a Operation Fee Vehicle, fees tin can then flexibly be redistributed by way of dividends out of the company or partnership payouts.

In both cases you desire to utilise an offshore entity so allow the shareholders or partners in that entity deal with their respective tax at the personal income level. Ofttimes, they in turn use a company to agree their shares or as partner in the Performance Fee Vehicle.

If initially you are the only portolfio managing director, functioning fees will become integrally to you. Still, you desire to make sure you accept a vehicle in place to receive them when your fund makes its quarterly payout.

B. Fund Registration and Regulations

The above structure reflects the typical Cayman setup. Other jurisdictions will be similar nonetheless the regulations and taxation may be very dissimilar.

1. Why Cayman

From our comparison, Cayman remains the jurisdiction of option for a apparent fund setup, despite new kids on the block like Singapore and perpetual contenders such as Luxembourg or Republic of mauritius:

The Cayman Islands remain the uncontested leader for fund domiciles: on best estimates, over 85% of the world'southward hedge funds (and VC and PE funds) are registered there. Equally of cease 2022, there was $iii.5 trillion in cyberspace avails under management in shut to eleven,000 registered funds on Cayman.
There is expert infrastructure in the Cayman Islands compared to lesser jurisdictions: There are 106 fund administrators, 48 fund auditors and 35 police force firms who all specialize in fund work. Well-nigh are legacy players but some accept started to build crypto capacity which they and then subcontract to their other offices outside Cayman.
As a result, almost investors you pitch should exist familiar with a Cayman setup and will be comfy subscribing to a Cayman fund, either direct or — in the instance for U.s.-based investors — via a master-feeder structure (come across below).

ii. Light regs allow for quick setup

Like most Cayman hedge funds, your fund would be an "exempted fund" under Section 4(4) of the Mutual Funds Police (2015 Revision).

Such funds do not need to appoint a Cayman-based manager and fund administrator, and are not subject to registration with the Cayman Islands Budgetary Authority (CIMA).

The regulatory regime for an Exempted Fund is light compared to "registered funds" due east.g, they are exempt from notification to CIMA regarding certain changes in their offering particulars and are not required to file a Fund Annual Return along with audited financial statements.

On the other mitt, an Exempted Fund cannot take more xv investors, the bulk of whom should be capable of appointing or removing the operator (i.eastward. the directors).

Yet, most of these restrictions can be structured abroad. For instance, CIMA does not look through the number of shareholders in a feeder entity but rather treats information technology equally one investor on the fund's capable. And then as office of your xv investor cap you can have several feeders with thousands of investors each.

Please notation that the low-cal-bear on regime for iv(4) Funds is changing with new requirements set to kicking in by Baronial this year. Yet, here's a hack: a unmarried-investor fund — this could be a single feeder! — would still be benefiting from the light-touch 4(4) authorities.

As draft regs currently stand, the new requirements exercise non look overly burdensome. For instance, funds located in Cayman will remain entirely unrestricted in the type of assets they invest in or what strategies they pursue. Such strategy will be entirely divers past the fund'southward private placement memorandum and legal documents, which is what nosotros will be discussing next.

3. The fund documents

The first stride in your setup is to form the actual fund entity. This is in many ways a standard limited visitor be information technology with a special operating understanding.

These "Articles" class part of the wider suite of investor and operational documents required to enhance money for the fund and operate it solar day-to-twenty-four hours, which includes:

Offering memorandum;
Subscription agreement;
Certified re-create of Certificate of Incorporation/Registration;
Ramble documents (Memorandum and Manufactures of Association of the express visitor);
Investment direction understanding;
Administration agreement;
Prime brokerage/custodian understanding;
Organizational and directors' resolutions.

This is where your initial legal spend will go and it is the major fixed toll in setting up a hedge fund — or any blazon of fund for that thing.

Withal, information technology is accepted practice that fixed setup costs are paid back to you as sponsor out of the fund's initial assets. To make it fair to early investors, these costs are and so amortized over the first year of the fund.

4. Feeder entity

We referred to feeder entities above. They are a special entity that funnels subscriptions into the "master" fund and is typically setup in a jurisdiction that is different from that main fund. Subscription monies at the feeder level go arranged and the feeder in plough becomes a subscriber in the master for the amass amount.

To become started and attract seed investment for your fund, no feeder should exist required.

Notwithstanding, when nosotros help clients setup their fund, we make sure that their fund documents come standards with feeder "ports" which allows for an instant master-feeder setup. Think of this port equally a USB-type port which allows for easy connection with feeders if and when they are put in identify. This avoids expensive reverse-engineering.

For funds that cater to United states of america investors, mainly for United states of america tax reasons there volition always be a feeder, typically a Delaware LLC that offers shares on a private placement basis.

And so if you plan to tap into a United states investor base, y'all will demand to add Usa counsel fees to your legal spend, since all subscription and offering documents volition have to be duplicated at the LLC level. All the same, here likewise there is 90% communality betwixt feeder setups, so we are typically able to cap fees with counsel nosotros piece of work with at around 15k.

An eventual 2nd feeder could exist a Europe-domiciled company e.g. in Republic of ireland or Luxembourg to accommodate for European investors who cannot subscribe directly to shares in an offshore entity, typically as a consequence of restrictions in their investment mandate. Asian investors however typically subscribe straight at the Cayman level.

C. The Economics

The economics of a hedge fund deserve a separate mail every bit there are a lot of moving parts.

Here, nosotros limit our discussion to three cardinal areas where nosotros have seen a lot of mistakes being made and which can become a matter of dead or alive for your fund: (i) the level of fees, (2) how functioning fees are defined, and (three) the redemption notices and window. We close this chapter with some thoughts on tokenization of the fund's shares or issuing tokens that give token holders the aforementioned economic rights as directly subscribers.

1. Level of fees

This is delicate. Here are some pointers:

Investors are typically not buying the narrative that because crypto is a new asset class, higher fees can be justified, at least non until you accept proven yourself as an outstanding manager.
Legacy hedge fund fees likewise take come under force per unit area in the least years, with the standard two% management fee and 20% functioning fee negotiated downwardly. In addition, seasoned traders who recently started their fund have to content themselves with lower initial seed money.
You will typically just have a very short rails record, if whatsoever. Most likely it volition be a non-audited Excel spreadsheet showing transactions from your Coinbase or Kraken account together with some back-tested results. Hence yous may have to exist flexible on intial fees or rebate early investors.

2. Performance fee calculation

Your performance fee in itself is a meaningless number unless you indicate how you calculate it.

If y'all charge say 20% on absolute performance, then just when you accept a downwardly month or quarter will you *not* be able to charge your investors performance fees. This makes your 20% performance fee look high.

Past contrast, if you merely charge fees on outperformance over some previous performance record (the and so-called "high-water marker"), y'all tin can get fee-less for a long fourth dimension until you do improve than your past record. This tin come up back to bite y'all and some stellar funds accept died as a result.

Nevertheless, investors like loftier h2o marks since they don't accept to pay you when you "climb out of a through", a scenario in which you lot lost them say twoscore% in one quarter and charge them operation fees whilst you're making your way dorsum over the side by side quarters.

Instead of a high-water mark, we typically inquire clients to consider a hurdle rate. This is only a rate of return over a defined period (typically a quarter), below which no performance fees can exist charged. For example, if you await a passive BTC holding to return 20% over the year and use that as your hurdle rate, y'all would only be able to collect quarterly functioning fees on returns that exceed 5% per quarter.

In summary, fees require careful consideration and it is good to pulse with your early investors what they'd accept.

three. Redemptions

The same applies for redemption notices and terms, something investors have discovered tin can work to their detriment when markets seize upwardly.

As a money managing director, yous desire to be able to concord on to people's money as long as you tin to avert fickle investors, a.k.a "hot money" that jumps ship equally before long equally you testify some underperformance.

Investors still desire liquidity: ideally, they want to be able to get their money back at brusque notice.

It is these 2 interests that need balancing and this residue is reflected in redemption notices and, secondarily, gating and side-pockets.

Virtually crypto hedge funds have monthly instead of quarterly redemption notices, on the basis that the fund's positions are all causeless to be liquid. If say you require an investor to give you notice latest past finish July to come out of the fund on 1 September (minimum 30 days), yous should have enough time to adjust and rebalance your fund.

Even so, if that investor holds 40% of your fund's AUM and wants out, good assets will have to be sold to meet this massive redemption asking. This will bear on other investors, mayhap leading to a downwards screw.

Some funds therefore "gate" redemptions by imposing a limit on how much whatsoever unmarried investor can redeem per notice. Investor typically frown upon such gates but nearly funds have them.

More frowned upon notwithstanding is when the fund documents allow for "side-pockets": assets that the fund manager can declare illiquid or hard-to-value (east.1000. when markets are in free-fall or seize upward) and that are held in a separate account.

Existing investors commonly cannot ask for liquidation of such side-pocket and may only get their money back later all assets accept been sold and the gain disbursed, effectively denying them their redemption right.

As a general betoken, it will exist more hard for yous as a crypto hedge fund managing director to justify long redemption notices, gating, and side-pockets than in the traditional hedge fund space: crypto is all near tokenizing everything to create new markets. Liquidity and ease of transferability are touted as 1 of the chief advantages of such tokenization. This creates the expectation with investors that they can easily trade in and out of crypto funds, and traditonal redemption terms may be controversial.

4. Should you tokenize your fund?

Earlier nosotros conclude, some observations on tokenization.

We have seen that most of our clients who initially considered tokenizing the shares of their fund— or create a token that gives exposure to their fund's net operation —ultimately decided confronting.

Whilst technologically doable and intellectually appealing, tokenization is not fiddling from a commercial and operational point of view and on the whole may human activity every bit a complexifier.

Commencement, we are not convinced that giving investors extreme exit rights will benefit the fund equally a whole and is in the all-time involvement of the managing director.

Second, we are not sure if in this early stage of crypto investing, investors need or even expect a token to represent their buying in a fund. This may change as the infinite develops and institutional investors become more familiar with the use of digital wallets, merely unless you remember your fundraise will benefit from tokenization, why bother?

That said, accepting crypto equally a means of payment for investor subscriptions makes full sense, withal this is in essence just an culling or additional payment facility you requite your investors, non a token.

Finally, you lot may desire to exist conscientious what you lot wish for when spinning upwardly a token. Once it is traded on the secondary market, your token will start leading its own life and testify its own price. This toll may take a disconnect with your fund's NAV and may attract hyper-speculation.

On residue, equally a fund managing director, tokenization may be more distractive than accretive. For investors, it may discourage them from subscribing straight to your fund, instead seeking indirect exposure via a tradable token.

If one twenty-four hour period we will use a token to gain exposure to the functioning of an investment fund, allow it be the day we have transformed the way nosotros pool uppercase in the commencement place and smart-contractified how such pooling is governed. That day may nevertheless be some time away.

Until then, we expect investors to seek the safety of the familiar, even when they seek exposure to the very asset form that will ultimately change everything!

Invest when everything is depressed

If John Templeton'southward famous aphorism to "invest when everything is depressed" is true, now may well be the best time to ready to deploy capital.

A fund vehicle is the sportsgear of the investment pro. Without a fund, your trading remains a chess game against yourself, your track tape unacknowledged, your ammunition express.

Every individual banker nosotros speak with tells us their client is looking to put some money into crypto, but they lack investment-grade instruments.

If yous've been trading crypto over the concluding years, you already have an edge over a myriad of legacy investment managers in traditional asset classes. What they have and you don't is a fund.

With this in mind, we promise this posting helps lower your threshold towards setting upward your own fund as the natural adjacent step. Do expect us up when you lot're ready to take it!