blog banner
Starting a Crypto Hedge Fund in the U.S. in 2018 | Corporate Attorney Explains

Starting a Crypto Hedge Fund in the U.S. in 2018 | Corporate Attorney Explains


Hi this Brett Cenkus, the right-brained
business attorney and today we’re going to talk about setting up crypto asset
hedge funds. So something that, at this time, is increasingly popular. So this is
a one on one about hedge fund setup; just to help you understand the lay of the
land, because it’s very confusing. There’s regulation and securities law
and pieces that intersect and can very easily get your head turned around. So
I’m going to try and demystify some of that and just give you a broad overview of
hedge fund set up, generally; and then a few specifics that make crypto asset
hedge funds a little bit different than some other types of hedge funds. So I’m a
corporate attorney and part of my practice is around securities offerings
and fund work; so fund work has a heavy securities offering piece, which
we’ll get into in a minute So hedge funds, private equity
funds, real estate funds, that’s part of what I do and I’m seeing a lot of
activity and I’ve had a number of clients in the crypto space, including
setting up crypto asset hedge funds; so those are fundamentally a lot like other
hedge funds, in certain ways and we’ll get into that they’re a little bit
easier, depending on what you’re trading, but this is something then in
the post ICO days after that’s sort of cooled, we’re still seeing a lot of
activity around setting these up and people wanting to trade tokens and raise
money to do it. So any fund, so it could be a real estate fund, it could be a
private equity fund, it could be a crypto asset fund, a
venture capital fund; I think about in three broad separate
projects, okay I’m gonna think about it three different phases or aspects to
the project. One is the funded founder formation piece, so that’s setting up the
actual entities; choosing where they’re going to be set up;
what type of entities we’re gonna use; figuring out the deal among the
founders, the principals, the sponsors, whatever
you want to call those, the people who are making the fund happen, the
interaction between the entities we set up; so usually there will be a general
partner and a limited partnership the general partner manages the limited
partnership, which is the fund. It’s more and more common to see two LLC’s; so the fund
is an LLC and the manager of that LLC is another LLC; so
but fundamentally you’ve got two different entities: one is the fund and
one is the manager or the general partner. Now sometimes there’s a reason
to have a third entitiy an investment manager; there is in Texas for example
because it’s tax driven, it has to do with franchise tax, but you don’t have
that in every state, it just depends on where you are usually. But you’re
always gonna have two entities; the partnership, the fund entity is often a
Delaware entity, doesn’t have to be–we’re not gonna get into that, but feel free to
call me if you have questions about that and we talk about why you would do that and not
do that–but you’ve got your two entities; you’ve got your deal among the founders;
you’ve got their deal to the investors; and how the partnership, how the fund all
works, that I call founder in formation. And that exists in any business set up,
I mean a fund is no different. So when a technology startup comes to me,
we’re doing a formation and founder piece; it’s simpler in ways and it’s more
common and more lawyers should do it but that piece exists in almost any kind of
initial business relationship creation then you have a piece that’s a
securities offering and be very careful to distinguish this piece from
the next one, which is the regulation around managing the money; so you’ve got
a piece that, think of the securities offering to get the money. So the fund
issues interests in it, partnership interests or if the fund is an LLC,
membership interests, in return for capital contributions. So those limited
partners in the fund make capital contributions, they get an interest in
the fund, that’s a securities offer. So you have issued a security, which you’re
getting money and there’s an expectation of profit from the investor off your
efforts, that how we test its 70/80 years old, that’s clearly there; so you
have to figure out how do you do that? And there’s only two ways to do
that in the United States: one is to register the securities with the SEC,
which is time-consuming and expensive; another’s to find available
exemptions. The most common fund exemption we use is 506 B, its Regulation
D 506 B; it’s considered a safe harbor for a
private offering. And if you don’t take in accredited investors, excuse me, if you
only take in accredited investors, which you absolutely should only take in them
or higher–and we’ll get to that in a minute and there’s a different standard
called a qualified client that you may actually need to be taking them in for a
different purpose for that third piece the money management piece–but again
stay in the second bucket here; we have founder formation now on securities
offering to get the money. 506 B is the most common one we use and it’s a very
easy hoop, they’re very easy hoops to jump through to get the benefit of the
safe harbor, if you only take money from accredited investors; there are no
specific disclosure requirements if there’s no non-accredited investors,
although it’s very common that we put together in fund world a private
placement memorandum, which is a 50 or 60 or something page document that’s quasi
business and legal and lays out how everything’s gonna work; the kind of
people you’re taking, the investors you’re taking money from; their rights; their
obligations; the risks, you know what you’re gonna invest in, things like that.
So that’s universally produced for in fund world; is it in actual requirement
of 506 B? It’s not but there’s a reason you would want to do it, I mean there’s a
few reasons. But that’s all the securities offering piece, so you’re
jumping through a hoop in order not to register the interest that you’re giving
out, you’re finding available exemptions from the SEC and 506 B is the most
common one. And 506 B is a federal exemption but the securities that are
issued pursuant to it are called covered securities and what it means is the
states can’t impose their own obligations on the offering; you don’t
have to worry about finding state by state by state exemptions; you have to do
notice filings in each state and it’s a chance for the state to grab a couple
dollars from you, but you don’t have to worry about complying with every
individual state, which makes it really a lot easier if you’re casting a wide net
and bringing a lot of limited partners and that’s what most funds expect to do.
The third piece is money management; so remember that second piece is getting
the money, the third is putting the money to work.
Now this differs, depending whether you’re a venture capital fund or
a private equity fund or in our case a hedge fund, a crypto asset hedge fund. Now
crypto assets, the worlds struggling to understand exactly what they are and how
they should be regulated, but it’s clear that the SEC is taking the position that
just about every initial coin offering is a security, but things like Bitcoin and
ethereum and litecoin, things that are coins that are well established, that are
traded heavily on exchanges that are flipped around the world; they have
utility outside of outside of the ICO context, when people are just, you know they just
want to get money and people are just buying a coin to flip it,
there’s really not utility usually. In this context there’s a lot, you know
bitcoins a store of value, etherium is, you know ether is something that you can
build off of, it’s becoming sort of the underlying kind of protocol if you will
for smart legal contracts and things; those things are pretty clearly, at least
today, not considered securities, they’re commodities, which means if that’s all
you’re trading–and not just those three there’s others–but there’s a universe of
tokens or coins that if you’re only buying those you’re a true crypto asset hedge fund, then you have very light regulation on the money management
side. You do have to think about commodity pool
issues and the commodity futures trading Commission, the CFTC regulates those
things, but if you only take money from accredited investors, there’s really
pretty easy exemptions there; there’s not, it’s not terribly difficult
today to navigate that world. Now if you want to start buying into other things
so other companies, you know if you could buy into ICO–that’s really hard right
now to do–but other things that aren’t crypto assets that aren’t commodities,
they’re clearly securities; so let’s say for example there’s a company who is a decentralized technology company and they’re raising money; it’s just a
private offering of securities and you think that’s within the the the thesis
that you’ve laid out for investors, because you’re not just trying to flip
coins you’re also trying to get investment into some of the
protocols and properties that are going to kind of run this decentralized
universe, right; so let’s say that’s what you’re doing.
That’s a security so if you’re taking in money and then you’re going to buy
securities, now you’re in the world of registered investment advisors.
An investment advisor is someone who advises people, they’re in the business
of advising people on buying and selling securities; so their stock brokers,
their most private equity fund managers, hedge fund managers,
who are trading in the markets, the public markets; they’re buying and
selling securities so you’re in registered investment advisor territory.
So again, on this third piece if all you’re buying and selling is crypto assets; or
to take it out of this context if all your buying and selling is actual real
estate, then you’re not buying and selling securities. So in those two
contexts, those two types of funds; crypto assets in our case, that could keep you
out of the registered investment advisor world and it’s nice to not be in that
world, because that’s a really mind-numbingly dense regulatory regime
and it’s a kind of state-by-state thing. Now private equity and venture capital
funds have, over the years, developed very strong lobbies and they have a lot of
money and they have, there’s something called a private fund advisers exemption
that effectively makes they’re dealing with that regime pretty easy relative to
say just a straight-up normal hedge fund that’s playing the public markets; but
and this is a state-by-state thing and it’s going to depend on a number of
things but first and foremost where you’re providing
the advice from, like where’s the seat of your primary office, where are your
co-founders; that’s going to drive some of this, but you can assume to take
something away that if you only trade in crypto assets it’s pretty easy; if
you were to be a private equity a real estate or venture capital fund, also
pretty easy for a bunch of reasons; but if you’re going to be a hedge fund that
trades securities, you’re very likely going to have to only take in qualified
clients. So an accredited investor is someone who has a net worth, not
including their primary residence, of at least a million dollars; or makes, made at
least $200,000 each of the last two years or three hundred with the spouse
and has a reasonable expectation of making the same this year; that’s
accredited duster territory. Qualified clients double that from net worth so
2.1 million actually; so it’s a much higher standard of a client. Again,
this is state-by-state and it’s kind of confusing, but just assume you’re
gonna have a lot more sort of red tape to deal with in hedge fund world, if
you’re trading securities and that’s this money management piece and it’s
nothing to do with founder formation, nothing to do with securities offering,
okay? Securities offering you might be able to just take in accredited
investors, that’s fine, you complied; but over here money management, if in order
to not be regulated as a full on registered investment advisor, which
means you need to pass your–I guess it’s series sixty five and seven or just
sixty six, I mean there’s one that, there’s two that are separate and then
there’s one that covers book–but it’s you know, a bunch of licensing and tests
and stuff like that in order not to have to do that, you’re gonna need to find an
exemption and if you’re not a private equity fund or
venture capital fund those exemptions can be pretty hard to find. So in Texas
the way you get it is to only have qualified clients. So again, it helps to
kind of compartmentalize this whole thing into three big buckets and to keep
that securities offering separate from the money management advisor piece and
if you want to be a true crypto asset hedge fund, at least at the time
I’m recording this, you can avoid a lot of this altogether, really could be
pretty simple. For that whole package you could expect to pay, you know, big
law sixty, seventy grand you could expect to pay someone like me less than
half that, but it’s still a whole lot of work and you know it’s gonna take you a
few weeks at the very least and if there’s a licensing piece obviously
that’s a gating item and that’s a whole lot of work to, but general, if you could
stay in crypto asset space, it’s quicker and it’s faster you can be up and out there
in about three weeks. There’s custody issues, there’s some other stuff,
you need some policies, but that’s the broad scope of what goes into forming a
crypto asset hedge fund. So if you have any questions about any of this, any
feedback, anything I did touch on that you’d like me to say more about send me
an email, drop me a line, put a note underneath the video, if you liked it
tell me that. Appreciate you listening today.

  • Thank you counselor for posting this. I am a former series 7 since expired and would not look forward to retaking that monster again. Bermuda is now looking to take a forward approach to this cryptocurrency space. Seeing how the SEC is slow to classify any of this would it be more beneficial to setup overseas?

  • Starting a hedge fund under 506b and finding accredited investors is difficult I'm finding so far. Does it make since to start a hedge fund with 35 non-accredited investors and then pursue accredited investors once established? What are the hurdles I would face? Thank you

  • Thanks for the video. What would be the structure of a crypto only fund (and only established issues like btc, eth, neo, ltc..) that accepts money from from anyone (accredited & nonaccredited) with minimums being something like $1k? Ive been in trading forever and crypto since 2013. I dont have access to whales but have at least 100s of people with up to 100k asking for detailed information. Id be thrilled starting with 1.5mm from ~100 people but unsure how that would be structured? Thanks!!

  • Wow, great explanation. What would I need, regulation wise, for a bare-bones more "hobby" type vrypto fund. So many friends and family have asked me to invest in crypto for them. What Would I need to take their money, buy the crypto, and hold it, trade it, sell it, etc?

  • Great Video and if I had 30k I would choose you because you seem to know your crypto. However, I am confused on some terminology: what if anything do I need to set up if I want to create a "fund" with the sole intention to buy and hold bitcoin and ethereum. But I would like the ability to ask relatives and friends to put in their capital.

Leave a Reply

Your email address will not be published. Required fields are marked *