How to Start a Cryptocurrency Hedge Fund in 2024: All Basics Covered

Introduction

For the uninitiated, a crypto hedge fund (HF) is a firm that places investors’ money in the crypto markets. Like other traditional firms, the sole purpose of such an entity is to provide a cushion against market volatility or perform better than the market to earn profits. For those who want to know how to start a cryptocurrency hedge fund, they must know details about its internal structure, strategies, regulation, and other crucial details first. Let’s try to understand these in detail.

About the PWC Report

Before we dig deeper into the details, it is important to know the annual global report by PWC. This report comes with some crucial data insights, which is indicative of the fact that the interest in crypto hedge funds is rising year after year. One such insight goes like this: “We estimate that the total AuM of crypto hedge funds in this year’s sample increased by 8% to about $4.1 billion in 2021, compared to $3.8 billion reported by our respondents last year.”

How to Start a Cryptocurrency Hedge Fund?

Before you even start, you must have the following points clear in your mind:

Team: If you are thinking about starting such an HF, you cannot thrive alone. It is very important to have several C-Suite Executives onboard: Chief Executive Officer (CEO), Chief Technology Officer (CTO), Chief Operating Officer (COO), Chief Investment Officer (CIO), and Chief Risk Officer (CRO). A CEO oversees the company’s operations, trading, acquisitions, and expansions. A COO would look after the day-to-day operations, which include creating plans and implementing them. He reports to the CEO.

A CTO makes sure that the trade execution process is a smooth-sailing process. A CIO participates in the decision-making processes of investment and strategy. A CRO is responsible for managing risks associated.

In addition to all this, you must have a Portfolio Manager who participates in the decision-making process: s/he looks after the portfolio assets and decides when to buy and when to sell these assets. A Portfolio Manager also implements the strategies. If your focus is on Quantitative marketing strategies, you can hire Quants, who use complex mathematical models for analyzing markets.
Money: This is the most important factor for starting your HF. You need money from your investors so that you can invest it in the market and garner profits for them. Not only this, capital is required for paying your team and employees, paying office rent, and other day-to-day expenses. For the money, you need to rely on LP Capital, i.e. capital from Limited Partners. We will see who an LP is later on in this article.
Service Providers: These are people like administrators, lawyers, auditors, accountants, and others who provide services according to their expertise. Having security providers in your company is important as they not only make the overall running a whole lot easier but also prevent you from falling prey to complex risks and regulations associated with crypto. You will read more about these service providers later. Most of them do not work full-time and can be hired from third-party sources.
Fee Structure: You need to decide the fee structure best suitable for your firm. Generally, the companies follow the most common 2 and 20 fee structure, i.e. managers take 2% as the management fee (annual fee on Assets Under Management) and 20% as the performance fee (performance in a year). You can, clearly, decide on a different fee structure for your team.
Strategy: A good strategy is quintessential for you to succeed. It is your strategy that will make or mar your firm and would bring either fruitful results for your investors or dreadful results. You must be aware of the pros and cons of each strategy that you employ. You make sure that you invest only in liquid assets and that these strategies provide a nice hedge to your investors against market fluctuations, There are several of these that you can choose from: Discretionary Long/Short, Discretionary Long Only, Market Neutral, Quantitative Long/Short, and a combination of some of these. Choosing a strategy would form the basis of how your fund performs.

Using AI and Machine learning can play a great role in setting up effective ways to bring about positive results. You will also need wealthy investors who can invest a sizeable amount of their money. You will need to apply and test your strategies time and again to see their effectiveness. Make a thorough study of the market and analyze your results with carefulness.
Platform: For trading assets, you will need a platform that is secure and can be trusted. Most people look for platforms that come with avant-grade technologies, automation, and robust infrastructure. To curtail risks, you can opt for more than one platform.
Products: Before devising a strategy, you must decide the digital assets that you will invest in: it could be a store of value coins like BTC, or it could be Defi or infrastructural assets like Ethereum and Matic. You could invest in stablecoins, cloud, NFTs, Metaverse, or gaming.
Infrastructure: According to the Oxford English Dictionary, “For hedge fund managers and their service providers, infrastructure describes the people, processes, and technology that facilitate operations.” These days institutional investors look forward to those that provide portfolio security and managers who have track records for high returns.

Keeping in mind the changing mindset of these investors, you should focus on good governance, performance, and transparency in your operations. You should focus on bringing on high levels of compliance, regulation, and scalability. So, in short, setting the bar very high is very important.
Terms: It is crucial to set terms that are more aligned with the cryptocurrency ecosystem. Though most of the terms are similar in structure to the traditional firms, you may require to go differently in certain cases. For example, you will hire people who have an inclination toward blockchain and carry deep knowledge of this space.

As crypto is volatile, you may require to set a different performance and management fee structure than that exists today. Also, you may need to differ in setting the withdrawal limits: the withdrawal periods could be longer and there may be a conscious effort from your side to limit these withdrawals.

A video worth watching:

What is the Cryptocurrency Hedge Fund Structure?

The GP-LP

The structure is broadly divided into a General Partner (GP) and a Limited Partner (LP). The managers are the owners of GP while Limited Partners invest their money in the fund. GP is the decision-making body that manages LP and invests on LPs’ behalf. The founders form the GP while investors form the LP.

The GP is also called a sponsor or a promoter. LPs are like silent investors who are looking for capital investment opportunities that can give them ample profits. LPs do not have a say in decision-making like GPs have. In the end, therefore, it is a GP who has to take full responsibility for the profit or loss made.

This GP-LP structure is governed by two documents called LPA (Limited Partnership Agreement) and PPM (Private Placement Memorandum). These documents contain all the rules and regulations and everything from minimum investments, fundraising period, investment period, capital calls, fee structure, and profit distributions, to name a few.

The general structure in most of the firms is an LP-LLC where LP is the fund and GP is the LLC and the managers have limited liability as the managers of the GP. But it is now common to see two LLCs where the fund is an LLC and its GP Manager is another LLC.

Once the structure is there, next comes the security offering part, i.e. doing investment rounds for raising money. LPs, on account of making capital contributions, receive an interest in the form of a security offer.

Structure for US Exempt Investors

If the HF has only US Exempt investors (Limited Partners who invest within the US and are exempt from federal income tax rules of the US), the traditional Delaware Limited Partnership structure would be ok. According to this, one can create a partnership as long as there is at least one GP and at least one LP. Delaware is the most popular place for creating Limited Partnerships.

Structure for Non-US Exempt Investors

For your offshore clients (investors) you can opt for Master-Feeder Structure: Under it, there are 4 actors: The HF Company, the Master Fund (domestic), the Offshore Feeder Entity, and the Offshore Investors. These offshore investors place their money (subscriptions) in the feeder, which, in turn, places these subscriptions in the domestic Master. The Manager invests directly in the Master.

At the time of redemption, the money is transferred from the Master to the feeder, and then back to the offshore investors. The chart from Cole-Frieman & Mallon LLP can help you understand things better.

This Master-Feeder structure helps in minimizing tax liabilities for the managers and also allows investors to invest via feeders that can be established in different countries and obey their own local jurisdiction. Feeders can be established in multiple countries to comply with local regulations and attract investors from other regions.

What is an LPA Document?

LPA stands for Limited Partner Agreement and is a document that contains the conditions of the agreement between GP and LP. The terms of the LPA are binding to both parties and are in the best of both. An LPA contains the following information:

Fundraising Period: This defines the periods when GPs would be raising money from LPs. A fund has an initial closing and final closing period. and the LPA defines the money raising at these crucial points. There are several other closing periods before the final closing and these too are the times to raise capital from investors.

Term: Usually, the HFs are created for 10 years and an LPA clearly defines this term of operation. But this is not restrictive and the term can be extended for 2 more years.

Capital Calls: An LPA defines the capital calls, i.e. the calls by which GPs request capital from LPs after giving them a short notice period.

Profit Distributions: This defines the ratio in which profits are distributed among LPs and GPs. In most cases, in the first distribution, LPs get all the profits. And in the further distributions, the profits are divided as 80% (to LPs) and 20% (to GPs). An HF’s LPA can have a different distribution also.

Management Fee: The document details the structure of the management fee for an investment manager in return for his services.

Expenses: The Limited Partner Agreement details all the structural and operational expenses that can be expended on the running of the HF. This may include expenses related to formation and raising money.

Contributions by GPs: The GPs need to make a substantial amount of their capital contribution. This is hailed as a positive sign by potential investors These contributions are usually called GP Commitments.

In addition to the above details, an LPA also contains conditions of GP Clawback (if GPs receive more carried interest, a clawback holds them responsible and the extra sum needs to be paid back to the LPs).

Regulatory Environment

The regulation around crypto has remained the talk of the time but nothing concrete has ever been established. Some time back, the Securities Exchange Commission (SEC) considered all ICOs as security but coins like Bitcoin and Ethereum were considered commodities. So, for the crypto hedge funds, it was like this: If you engage purely in trading crypto assets, you will have to undergo very light regulations and as long as your investors are only accredited, you can go for various exemptions too.

But if you are dealing in assets that are classified as securities, you will have to go under a tight and heavy regulatory system. For example, if an HF not only deals in trading cryptos like Bitcoin and Ethereum but is also investing in some DEFI protocol, this would be considered as security. And you will need to register yourself as an investment advisor. You will have to go through an intense regime of the regulatory authorities.

But the latest revelation from Gary Gensler (SEC’s chairman), a few days back has changed things drastically.

According to SEC, it considers almost every crypto asset (except Butcoin) as a security and not as a commodity, and therefore, the funds dealing in one of these securities would have to come under the radar of SEC jurisdiction.

Are There Any Exemptions?

For the creation, you can do one of two things: either register your securities (if your crypto assets are identified as securities) with SEC OR find available exemptions. 506 B is the most common exemption. Under 506 B, you do not need to register with SEC if you take money only from accredited investors (and/or non-accredited investors with 35 as the maximum limit).

For this exemption, you must meet certain qualifications. Your set of assets must be purchased only by accredited investors (investors with a gross income of more than $100,000 consecutively in the last two years or $300,000 if they have a partner or spouse). This allows you to raise an unlimited sum of money and sell the securities to an unlimited number of accredited investors. Usually, there are no specific disclosure requirements expected from you if you have no non-accredited investors under these exemptions.

You need to prepare a Private Placement Memorandum (PPM) which is a document that details information like the type of investors to whom securities are offered, rights and obligations of these investors, and risks involved in investments made.

Also, as it is a federal exemption, securities covered under it are called covered securities: it means you do not have to go through the exemptions state by state and can bring in a lot of LPs from a number of the US states. To cut a long story short, instead of being registered as a full-fledged investment adviser, you can opt for the exemptions available and curtail the long and arduous process of licensing and regulation.

Should Crypto Hedge Fund be Registered as Investment Advisor?

According to Gary Gensler, “If somebody is raising money selling a token and the buyer is anticipating profits based on the efforts of that group to sponsor the seller, that fits into something that’s a security”.

According to this, the funds that invest in crypto securities should register themselves as Investment Advisors and this should be done even before anything is set up.

This brings the firm under the jurisdiction of state and federal regulators. Whether or not it would be classified as an investment advisor depends on criteria like if the HF would invest in securities, what is its size, what is the location of the manager, and what is the location of the investors. The firms investing in securities must be registered as investment advisors.

But if it invests only in commodities, currencies, or futures, it need not do so if the size is more than $150 million. But if the manager also manages Separately Managed Accounts (for individual investors), this amount is further reduced to $100 million. Go through this article to understanding this concept in detail.

Should you Start With an Hedge Fund Incubator (HFI) First?

If you are thinking of creating an HF, but do not have any prior experience or the initial investor capital, you can take an alternative route: Hire a Hedge Fund Incubator firm that will help you create a track record over a span of 3-12 months.

With an HFI, you can go a long way as it will help you establish a record that can then be advertised to accredited investors who can analyze your performance and show interest in capital contribution. You, as the manager, need to invest your own capital for this. After you have a good performance record to show, you can convert yourself into a full-fledged firm.

Who are the Service Providers?

As we mentioned earlier, service providers help in the smooth functioning of the fund. They provide services like lending money, auditing, giving regulatory advice, fundraising, asset valuation, and assisting with investor subscriptions. As a manager, you must select these people with caution and keep in mind the fruitful results that are expected from you by your investors.

Select only highly-qualified and experienced personnel as your service providers. The investors, in the present times, have become more aware of such things and have very high expectations from you. Before they part with their money, they must have trust in you and your firm.

Service Providers for a Crypto Hedge Fund

Lawyers: Managers usually hire major law firms for this. This is very important, from the very beginning, to have all the offering documents in place and meet all the regulatory requirements. This is done by a law firm that has professionals with a deep understanding of how an HF works. Such a firm can help you with all the compliance matters failing which you could expose your investors to huge risk. Professional legal counsel can guide you regarding disclosure and other legal matters and save you from many threats.

Auditors: To deal with legal and compliance issues, you must employ an audit service provider(s) who has some prior experience in dealing with matters related to cryptocurrency. It is in the best interest of the firm to hire CPAs (Certified Public Accounting) that can advise you during the initial stages of development.

If the HF is registered as an investment advisor, it is mandatory for it to have an annual audit. For an auditor to be qualified to give you the services, s/he must be registered with PCAOB (Public Company Accounting Oversight Board). Having qualified auditors on board brings credibility to the eyes of the investors. An auditor has the following roles to play:

Maintains checks and balances for the firm and follows GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) to perform audits for financial statements.
Works in collaboration with administrators to ensure that all the regulatory and financial aspects have been complied with.
The auditing firm makes sure that you comply with the rules of wash sale and constructive sale. A wash sale happens if you sells a security at a loss and within 30 calendar days (before or after the sale), it buys the same security. When that happens, you can register the loss of your initial security sale as the loss in the tax return for the current year.

A constructive sale happens when you know that your transactions are likely to bring huge losses and you try to offset this loss by placing the same security transaction in the opposite direction so that the effect of the loss is nullified. So, even if you have not sold the security and have placed a put call for the same security to hedge the losses, you must register this as a short-term capital gain in your tax return.
Reviews financial documents including Balance Sheets, Profit and Loss Statements, Cash Flow Statements, fees, and expenses.
Offers tax reporting services.
Evaluates methodologies employed by you to see if these have been created and implemented within the circle of compliance and regulations.

Prime Brokers: Having a prime brokerage firm brings about flexibility concerning the execution and settlement of transactions, A prime broker brings all the transaction data under one roof; this helps the managers to view and review all the trading information at one place and makes the data accessible to other service providers too. This saves a lot of time as you execute hundreds of thousands of trades in a day.

By acting as a connecting link between the managers and the market, prime brokers provide the execution, clearance, and settlement of the transactions. This is very important as the your firm gets introduced to all sorts of markets, be it security, commodity, derivatives, or equity. By providing a unified platform to clear and settle transactions, these firms go a long way in providing a seamless experience to the managers.

Not only this, as prime brokers keep accounts as collateral and thus have direct control over the fund, it helps hedge firms in accessing lines of credit and loans with ease.

Last but not least is the ability of a broker to provide introductions to capital raising; these are called capital introductions and are the instruments that introduce you to High Net Worth Individuals, who could be potential investors for the firm. These introductions also bring about institutional investors and other funds on board.

Risk Managers: Running such a firm is full of risks and if these are not accounted for well in time, it can pose great threats to the firm. Hiring third-party Risk Managers can be beneficial as they bring about their experience and knowledge in tackling these risks.

Administrators: The managers must run Anti Money Laundering (AML) checks on their investors by running KYC (Know Your Customer) and KYB (Know Your Business) processes on them. AML is a group of activities that a firm has to perform to prevent people with a criminal record or having terrorist backgrounds to invest their black money and channelize profit from it. As the processes are complex, the firms hire administrators to perform these checks for them.

But this is not the only task that is entrusted to an administrator. S/he is responsible for reviewing investor subscriptions and their record of transaction redemption. They do this by reviewing the subscription agreements of the customers.

Admins also help investors by providing them with detailed information about your holdings and partnerships. This way, an admin acts as an intermediary between the fund and the investors, providing each side the accurate information about the other side. For doing so, they need to collaborate with other service providers.

Another important task of an admin is to calculate the Net Asset Value (NAV) of the fund. S/he is also entrusted with calculating management and Performance fees.

Consultants: If we tell you in simple terms, Consultants help the managers in performing activities that appear cumbersome or “boring” to these managers. For instance, these consultants draft business plans for them and also figure out the loopholes in these plans. They help them by creating marketing campaigns on websites or via pitchbooks ( a resource that contains all the data that investors can use to scrutinize it for investments in the future) or tear sheets (a one-page summary about the firm).

Crypto Hedge Fund Strategies

Like traditional HFs, a crypto HF employs several quantitative and discretionary trading strategies to get maximum profits for its investors:

Quantitative Approach: This involves adopting a quantitative approach based on complex mathematical modeling techniques. The analysts need to evaluate a large number of data sets and employ statistical and machine-learning techniques and make trading decisions accordingly.

Those that adopt quantitative analysis are also called Quants as they adopt a systematic approach to find the long/short positions. They do not adopt the bottom-up fundamental analysis of the assets that they are dealing with. This approach is adopted by a large number of funds. Liquidity is crucial for such an approach, therefore, funds relying on this approach must trade only in liquid cryptos.

Quantitative Long Only: This strategy looks only for the long positions and takes advantage of the crypto’s price volatility. This is a relatively new category for crypto hedge funds and has recently seen a bloom. Under this strategy, they make use of the several arbitrage opportunities that come their way.
Quantitative Long/Short: As the name suggests, this strategy is based on the belief that the underlying cryptos are either undervalued or overvalued, and the long and short positions are taken accordingly. Irrespective of which direction the market is going, they expect gains in both ways. Under this, managers can adopt several trading techniques like arbitrage, market-making, and low-latency trading.

Discretionary Approach: Under this approach, the trading decisions are based on the current market conditions. These firms take positions by using fundamental analyses of the assets done by investment bankers and research analysts.

Discretionary Long Only: HFs with long investment horizons usually opt for this strategy. They take long positions in the assets which are usually early-stage crypto projects. They hold and take favorable long positions in the trades in mostly liquid assets.
Discretionary Long/Short: Under this, there is adoption for the long/short positions based on several hybrid strategies like technical analysis, mining, and event-driven, and like to adopt early-stage projects.

Market Neutral: HFs expect to gain profits irrespective of where the market goes by employing long/short positions that balance each other. This lowers the volatility risks associated with cryptos. As the risk is less, the profits are also expected to be relatively low.

Multi-Strategy: Any combination of the strategies available is used under this approach to reduce the overall risk.

FAQs

What is crypto hedge fund?

A crypto hedge fund takes the money from its investors and invests it in various blockchain and cryptocurrency based projects. Such a fund also invests money in different crypto derivatives and futures.

What is crypto hedge fund structure?

The structure consists of General Partners (who are the founders of the fund) and Limited Partners (who invest their money in the fund).

What is an LPA?

LPA is Limited Partnership Agreement document that has all the terms and conditions related to a Hedge Fund; it includes information like period of investment, minimum investment amount and period, capital calls, management fee, etc.

What is the stand of SEC on regulation of crypto?

SEC considers almost all the cryptocurrencies except BTC as securities thus bringing all of them under the purview of regulatory framework.

What are the biggest crypto hedge funds?

Pantera Capital, Andreessen Horowitz, Sequoia Capital, Morgan Creek Capital Management, and Brevan Howard are some of the biggest players.

Disclaimer

This article is for informational purposes only and is NOT a financial advice. We do not promote, in any form, any cryptocurrencies or trading platforms or funds or hedge funds mentioned herein. The content of this article is based on the information available up to the knowledge. You should be aware that investing in any cryptocurrency/trading platform/hedge fund is subject to market risk and you MUST do your own due diligence (DYOR) before you put any money in any of the coins.