Can I start a decentralized investment club and be its paid investment manager?

Back in The Otonomist’s January issue, we took a closer look at Decentralized Investment Pools (DIPs) and how they are different from investment funds.

The appeal of DIPs is that well… anybody can dip in.

A DIP can easily be created by sending crypto to a dedicated wallet, issue tokens to mirror the percentage stake of each contributor in the overall pool, and use Web3 voting to coordinate what to invest in.

Projects such as Syndicate and Weezi facilitate creation and governance of such pools, which essentially function as the Web3 version of the local investment clubs of yore.1

A Square Peg in a Round Hole

The key attraction of such club approach to investing - that it is collective and open to everybody - may also be its key downside: crypto-rich but time-poor investors may simply not have the time to actively participate in making investment decisions.

Is there a way to preserve the club structure whilst adding an element of specialization in who takes investment decisions? And can such manager be remunerated?

This is the key question Weezi recently approached us about.

At first sight, the answer looks incontrovertible: as per SEC edict (see below), an investment club is no longer a club when it has a paid manager who has a carry in the performance. As soon as there’s a paid manager, a club becomes a fund and needs to be setup as a fund.

Legally, this means there will be managers and investors each with very different rights, whilst in a club everybody is an equal member and is guaranteed a voice in how the club’s money is invested.

Blockchains to the rescue

However, we believe there may be a hack.

Clubs can and do generally delegate powers to a subset of members. In real-world clubs, there is typically a Treasurer and - any volunteers? - somebody who is tasked to take minutes during the clubs’ meetings.

For instance, Syndicate’s template Operating Agreement for clubs incorporated as a standalone or series LLC allow for what are termed “Administrative Members” (Article I, Definitions)2:

“Administrative Member” means [Administrative Member Name] or such other Person as may be appointed as a replacement Administrative Member pursuant to Section 5.1(b). For the avoidance of doubt, the Administrative Member is a Member of the Company.

Such Administrative Member “has all power and authority to take all actions necessary to execute the decisions made by a Majority in Interest3 or otherwise delegated to it under this Agreement”.

Section 5.1(b) then deals with how Administrative Members can be appointed and removed by a specified “Majority of Interest” which in our setup would be a specific threshold number of mirror token holders voting onchain (see below).

Article V.1 of the Example Operating Agreement further allows for such Administrative Members to be tasked with matters in relation to how the assets of the club are invested by way of a carve-out of the general principle that management of the club is generally vested in all its Members (our italics):

V.1 Management

(a) Management of the Company is vested in the Members. Except for those matters delegated to the Administrative Member pursuant to this Agreement, the Members, acting by Majority in Interest (or such greater percentage specified in this Agreement with respect to a specified matter), have the exclusive management and control of the Company and its business and affairs, including all decisions related to the acquisition and disposition of Investments or otherwise required to be made by the Company as the holder of an Investment. Except as otherwise provided in this Agreement and subject to the provisions of the Act, the Administrative Member has all power and authority to take all actions necessary to execute the decisions made by a Majority in Interest or otherwise delegated to it under this Agreement.

Further sections fortify this delegation of powers to Administrative Members. Taken together, provided such delegation is specifically made, Web3 clubs can have designated members who decide how to best invest the pool’s assets.

However, the sand in the line is that such designated members can’t get paid out of the investments’ performance.

The source is the SEC itself4, which clearly states that:

A person who is paid for providing advice regarding the investments of the club or its members may be an investment adviser under the Investment Advisers Act of 1940 (Advisers Act) or state law. If so, one or more states or the SEC may regulate that person. Also, if one club member is paid for selecting investments for the club or its members, that person may be an investment adviser.

It is generally accepted that whilst Administrative Members may receive a salary and be reimbursed for expenses, “being paid” refers to the payment of a performance fee (or “carry”), which would turn the club into an investment company, its membership tokens into securities and create fiduciary duties on behalf of the Administrative Members which would then have to become registered investment advisors.

In our view, and based on the regulatory treatment of so called robo advisors, the analysis is no different whether the club’s “investment committee” takes active investment decisions or just lets an algorithm loose on the club’s assets: the committee can’t receive a renumeration linked to how well their chosen strategy - active or passive - performs, since such renumeration would make them investment advisors over a fund with separate fiduciary duties from other members and the need to be registered as such if they advise over assets that are securities.

Just Pay Me In Tokens

The analysis may however be different if, as is the case with Weezi’s proposed design, smart contracts take over from humans to allocate and rebalance the club’s assets.

Once deployed, such onchain algorithms execute committed code without human intervention.

If these contracts are programmed such that they retain part of the returns they generate in fees, it may be difficult to argue that a subset of members is being paid a performance fee as investment advisors within the SEC definition above.

However if some members - most likely the creators or sponsors of the club - can drain the smart contract of the performance fees it accumulated, it could still be argued that these members benefit from a carry and are effectively acting as paid investment advisors to the pool.

This analysis may be different if instead of paying the performance fee out of the club’s assets, it would be paid in a native token issued by the club.

In such setup, the smart contract would receive native tokens linked to the increase in assets it achieved over a specific period.

Example

Say a DIP has 10 members at launch who each contributed US$100k in stablecoin, bringing the pool’s assets to an aggregate US$1MM.

In return for their contribution, each member has been issued with 100,000 mirror tokens5 which at launch of the club were priced at US$1 per token, reflecting the Net Asset Value of the club’s assets at that point.

Under the club’s governance, members now agree to delegate the investment of their collective US$1MM to a smart contract that optimizes returns across various digital assets, say by allocating 50% of the pool’s assets to chase for yields across major DeFi projects and holding the remainder of its assets in constantly rebalancing market-cap weighted long positions in the top 10 digital assets (ex-XRP 😁).

They further agree that the automated investment smart contract shares 20% in any capital gain it achieves over a set period, say one month.

The algo now returns US$200k in capital gains at the end of the accounting period. As a result, the pool’s assets now stand at US$1.2MM equivalent - bravo algo, well done!

This means each mirror token is now worth US$1.2. Note that the amount of issued mirror tokens does not change: each member still has 100,000 tokens, but each token is now worth 20% more, reflecting the capital gain over the month.

A member who wanted to redeem (the word often used in DeF is rage-quit but we like to keep things civilized!) at that point would simply look at how many tokens s/he holds and multiply it with the Net Asset Value per share, a calculation typically done in set intervals by a fund admin in a traditional fund but which blockchains can perform in real-time since all prices are constantly available.

If no fees apply, such redeeming member would receive USD 120,000 and 100,000 tokens would be burned, leaving the other nine members with an aggregate 900k mirror tokens over US$1,080,000 in assets post-redemption, or US$1.2 per token.

So far, expect for the frequency at which the NAV per share is calculated, this is not any different from the mechanics of a traditional fund.

Where the models starts to diverge is how fees are applied.

In a traditional fund approach, the manager fees are taken out of the fund’s pool. Fees (typically a 2% management fee and a 20% performance fee) are paid to the managers out of the assets of the fund who then decide whether they keep them or reinvest them or any combination of both.

In our model, the smart contract would automatically issue more mirror tokens to remunerate the “manager” smart contract for its performance.

Whilst the net result is the same, the formula is different.

In our above example in which members of an investment club agreed that the “manager” smart contract could keep 20% of all outperformance (the difference between the end NAV and start NAV over the period, or US$200k in our example), this would mean an additional 40,000 mirror tokens would be mined at the end of the period (20% of 200k), effectively diluting existing mirror token holders.

With 1,040,000 tokens now outstanding and US$1.2MM in total value in the pool, the price per token is now US$1.15 per token instead of the US$1.2 per token, reflecting the “carry” in tokens issued to the “manager” smart contract.

Redemptions and new subscriptions (members leaving and new members coming in during the lifetime of the pool) do complexify the NAV calculation but not significantly so, and here too the smart contract would keep score without the need for centralized calculations by a trusted third party fund admin.

Community Request for Proposal

It is on the legals and regulatory rather than the technology and fund admin that we see the bigger challenges.

In our analysis, all that is happening here is that an investment algorithm has been collectively deployed by the members of a Decentralized Investment Pool to look after their funds, and gets paid in kind when it grows the assets in the pool.

The key question remains if this could be considered a “carry” and therefore turn the club into a fund?

To get this conclusively resolved, we’re appealing to anybody in the community who can help with the legal analysis and test our thesis, in return for a grant from the OtoCo Foundation - our first!

Conclusion

Our thesis is that a smart contract that receives native tokens to account for its contribution to the growth of assets in a decentralized pool is very different from a group of appointed managers who actively manage a club’s assets and receive a cash carry, even if ultimately the developers of the algorithm are then ones that benefit from the extra token allocation.

In our view, as long as the DIP’s governance rules allow for all members to participate in the decision to deploy the smart contract, we do not see how this leads to any sort of paid investment advisory specialization akin to a General Partner/Limited Partner-type relationship between the managers and investors in a traditional fund.

Such member participation could be guaranteed by adding governance rights to the mirror tokens and make all major decisions related to the DIP subject to an onchain vote, thereby preserving the key characteristics of what sets a club apart from a fund.

From discussions with Weezi, this could even lead to assets in a DIP being bucketed in lower-risk, medium-risk and higher risk strategies.

From a legal point of view, any ownership and governance rights contributors would expect to see protected can be documented, however this would require a radical overhaul of the templates lawyers currently work off - a big ask!

Once our thesis is confirmed, we would then source community funds to hire counsel to put the legal foundation under an onchain setup which we believe could lead to a whole new way of investing: decentralized investment pools that have club-type governance whose members collectively decide to delegate the management of their assets to a smart contract that can earn tokens depending on how well it performs.

Here’s to tokenized crypto ETFs open to everybody!

> Please contact us here if you wish to receive more details of the grant and apply.