After Elon Musk put 1.5 billion of Tesla treasury in bitcoin, crypto assets are now officially an asset class.
Many of our clients have been following the space for much longer and have friends, family and close contacts asking them to manage an initial pool of capital on their behalf, together with proprietary capital.
Other clients wish to establish an initial track record and/or test a strategy or algorithm using their own capital, with a view to raise more money from third-party investors further down the line.
Launch sizes are typically small compared to traditional hedge funds, with an average of around USD 1MM in seed. In this light, setup costs of more than 1% of the initial Assets Under Management (AUM) are difficult to justify.
In what follows, we provide a manual for budding managers, aiming to cover most aspects of setting up a private fund, from fees to redemptions to how profits and losses are allocated, using the legal documents as a guide.
You can download the template legals for your private fund here.
None of this is legal advice and you will be required to retain US counsel when you order your fund from Otonomos to sign-off on all your documents.
LLC vs LLP
Limited Liability Partnerships used to the vehicle of choice for the set up of private funds in te U.S.
More recently LLC's have gained prominence primarily on the basis of their ease of set up and general user friendliness.
This contribution is limited to the use of an LLC as the vehicle for a private fund and focuses specifically on its operating agreement which is the “legal software” for everything related to your fund.
It's best organized in the state of Delaware because of its high degree of legal certainty: most corporate law issues have already been decided in the courts of Delaware, hence your investors will be more comfortable with a fund domiciled there.
The Investment Advisor LLC
Clients often overlook that there is also a need for a second LLC which will function as the Manager to the first LLC. This LLC is typically incorporated in the State where the managers i.e. the persons who lend their brain to the fund and will make the investment decisions, are located.
It is also the entity that may be renting office space, incur overheads, pay salaries etc and to cover these expenses will receive the management fee out of the fund and possibly also part of the performance fee.
This Manager then enters into the operating agreement as the first (and typically only) Member of the fund LLC. Hence, you will need to incorporate the manager first before you can set up the actual fund.
It may be tempting to subscribe in personal name as first member to the LLC. However, for a number of reasons this is not a good idea, first and foremost because as manager of an investment pool you’re taking risks and it is always better to put a limited liability shield in between you and whatever risk you take.
Also, if not from the get go, depending on your seed size your Manager will eventually need a license and an Investment Advisor and it makes sense you get your entity licensed rather than taking the license in personal name.
Otonomos as such doesn't help with applying for this license however depending on a number of factors, including the State in which you are based, on whose behalf you are managing the pool and what your initial AUM is, the investment advisor would not need an immediate license. However you do need to take independent advice on this since advising on investments is a regulated activity in the U.S.
A limited number of variables
Regards to the fund setup itself, this has been done many times before and using a template you will just need to decide on a number of key variables.
- Obviously you need to choose a name that sticks and make sure the name is not already taken. We set up an LLC on your behalf, we make sure we do a name check so you would not have any IP or trademark infringement issues.
- Or substantially you will have to decide on the purpose of the LLC which in the case of a fund means specifying the investment strategy (Section 1.4).
- Section 1.5 ask you to choose a place of business for your LLC, Delaware LLCs typically do not operate out of Delaware so you may want to choose a business address for your fund. Section 1.6. would be Otonomos and its Agents as your Registered Agent in Delaware if you set up the private fund with us.
- What follows are a number of household-type sections and the Definitions in Clause 1.11. Key to an understanding of how a private fund LLC works is the concept of “Capital Account” (1.11(h)) which is basically the scoreboard of how much capital each Member in the LLC has, taking account of Contributions made and various adjustments.
- Linked to each Member’s “score” is the Net Asset Value (NAV) of the LLC (Section 1.11(x)) which is essentially the basis upon which each Member’s interest value will be calculated by multiplying the NAV with the % Membership interest each Member has in the LLC.
- Definition (cc) of Section 1.11 then defines the mechanics of how Profits and Losses are calculated. There is a lot of detail there but the mechanics reflect established practice. The more important clause on profits and losses is Article III.1 which deals with how profits and losses are allocated (see below).
The mechanics of subscribing to the fund
Subsection (gg) of Definition Section 1.11 makes reference to the “Subscription Agreement” which is the key document that investors will execute in order to purchase a Membership Interest in the LLC.
This “Sub Agreement” is attached to a Private Placement Memorandum, which is the third key document in your LLC setup and which governs the sale of the Membership Interests under applicable securities laws.
Private placements benefit from a “safe harbor” and are exempt from the offering rules that apply to public offerings of securities. In practice - and in hugely simplified terms - it means you should only approach pre-established contacts to become a Member in your LLC and have them accredit themselves as accredited investors under applicable regulations (see Article II, Section 2).
Helpfully, the definition of who qualifies as an Accredited Investor in the United States has recently been broadened in scope and now includes people who have certain professional qualifications or obtained certain higher education degrees.
Equally helpful is that in the United States investors can self accredit which in practice means that they could just tick a box in which they represent to you that they are accredited, without you having to perform checks as to the veracity of their representation.
This contrast with certain jurisdictions where investors cannot self-accredit, for instance Singapore, placing the burden on you as the Manager to effectively corroborate their financial position to see if it meets the minimum income or asset requirements.
Practically, self-accreditation makes it possible to conduct your sale entirely online making sure that subscribers execute the subscription agreement via a digital signature or a mere online digital consent, combined with a pop-up that requires them to self-accredit before they can proceed.
Once they do proceed, they will then be presented with your bank account details where they can send their Contribution.
Capital Contributions
These Capital Contributions are dealt with in Article II of our Operating Agreement template.
Section II.1 mentions ”a bank check, cash or otherwise immediately available funds” as a way for Members to make their Capital Contribution. Typically a minimum contribution is set and Crypto can be used as a means of making the Capital Contributions.
Practically, if you are going to use crypto as a means of accepting Capital Contributions, but your fund is denominated in US dollar, may make sense to limit yourself to only stablecoin subscriptions (in addition to fiat itself).
However you will also take other forms off Crypto you may look into a solution that automatically converts the US dollar value of the Capital Contribution into the corresponding crypto currency for instance by using a Coinpayments.net link.
This will work a lot better than you just pasting your public wallet address into the Subscription Agreement which leaves it to your investors to calculate the exchange rate at which they contribute in crypto and will inevitably result in discrepancies.
Section 3 (a) to (k) of Article II then deals with a raft of Members’ Representations and Warranties which are essentially in there for your own protection as the Manager.
Skin in the game
As Manager, you can invest on the same terms other Members and effectively become a Member together with them (Article II, Section 4).
In fact, investors would expect you to have “skin in the game” by having put some of your own capital into the LLC, and they will ask!
Also, you do not need outside investors: you can perfectly use the Operating Agreement as it is even if you only invest proprietary capital. In this scenario, you just become the Single Member owning 100% of the Membership Interests and making all of the Capital Contributions.
You will then also allocate all the Profits and Losses to your own Capital Account.
If there is more than 1 Member, Article III.1 deals with how such profits and losses are allocated across all Members. It is a cornerstone section of the Operating Agreement and you should carefully reflect on what profit and loss allocation mechanism you want to use:
What fees will apply?
When will they kick in?
High-watermarks may seem fair to investors but as a Manager you risk shooting yourself in the foot, especially when managing crypto assets with high volatility. Essentially, a high-watermark means that you need to do better than your previous highest NAV (over a defined period of time, e.g. a 12-month period) before you get a cut of your outperformance. Some Managers have gone through an 11-month dry spell without fees as a result!
Instead of a high-watermark, we typically recommend Managers to use a hurdle rate which they first need to obtain before they can start charging a performance fee. Such hurdle could for instance be the return from passively holding bitcoin or a basket of major cryptocurrencies. In such fee structure, only when you outperform this benchmark will you be able to charge performance fees.
Article III.1(b) then reflects a mechanism for dealing with the allocation of Profits and Losses in the case the percentage interest of any member changes during any calendar month or given period of time. This mechanism too needs careful study and is linked to Redemptions (typically referred to as Withdrawals) and how they are “equalized” across the remaining Members after one or more Members redeemed their Membership Interest.
Withdrawals
Article V deals with such Withdrawals in detail. The key section is Section 4, which deals with Voluntary Withdrawals. In laymen terms, this section governs how you can come out of the fund and together with the variables on fees and how they are applied (see above), this second set of variables related to Withdrawals constitute some of the key operative mechanisms of any fund setup.
Get these wrong and it may mean life or dead for your fund:
- How long will new Capital Contributions be locked up for? As a Manager, you want to get away with the longest possible lock-up, since a stable capital base is preferable over how money that leaves during the slightest market turbulence. However as an investor you want to make this lock-up as short as possible, if not waived in its entirety. Our template has 90 days but we’ve seen some managers get away with 6 months, even a year.
- Equally important is the Withdrawal Notice, which we standard put at 30 days but which again you may want to try to make as long as you can get away with. Practically a 30 day Withdrawal Notice means that if a member wants to come out say by the end of March, his or her notice needs to be in by the end of February at the latest. This may seem a reasonable time however, if you are in a profitable position it may mean that you will have to sell good assets within a relatively short period of time in order to meet withdrawal requests.
- Finally, a Manager needs to define the frequency with which Withdrawals can be made. This withdrawal frequency does not necessarily have to coincide with the length of the withdrawal notice: a fund can be open for say quarterly withdrawals as long as Members give 30 days’ notice of their desire to do so. Our template caters for monthly withdrawals with a 30 days’ Withdrawal Notice which in liquid markets and especially crypto markets seems to be the default.
- A last paragraph of Article 4 deals with the period within which Withdrawal Proceeds need to be wired out, and specifies how. Here too, 30 days is standard but it the case crypto is sent back you may want to consider doing this sooner.
- V.6 too merits attention since it allows Managers to “gate” withdrawals in special circumstances, for instance when the markets are frozen or valuations for the underlying assets become difficult or impossible. Such gating is entirely self-serving from a Manager’s perspective, but risks causing a lot of protest from investors who may effectively be barred from coming out of a fund during the worst possible market conditions when their need for liquidity is highest.
The Management of the LLC
Article VI of the Operating Agreement deals with governance generally and the powers of the Manager of the LLC specifically.
As a general rule, the Manager is giving very wide discretion in how the company is managed.
Investors will however want to see specific transactions that are permitted under the investment strategy and these will need to be carefully defined by the Manager (See Article VI.2(a)).
Article VI.3 prevents the Manager from “[engaging] in any activity that is not consistent with the purposes of the Company” and places further restrictions on the Manager’s powers. Article VI.5 then lists specific Duties and Obligations of the Manager.
Taken together, these clauses show that managing money on behalf of third parties is not trivial and does come with significant responsibilities. It is one more reason why a Manager should wrap their activities in limited liability by having a separate legal entity act as Manager rather than be appointed in personal name (see above).
Getting paid
Obviously, the Manager will want to get paid to assume the Management responsabilities.
Article VI.7 reflects a management fee of 2% of the fund’ Net Assets per annual, calculated and paid on a monthly basis. There is some devil in the detail of how these fees are applied on a monthly basis which Managers need to be aware of.
However as mentioned earlier, the juice from successfully managing assets comes from the Performance fees, which are determined in Article III.1 (see above).
In both cases, if the Management and Performance fees are paid to the Managing LLC, such income will be passed on to the ultimate member of the managing LLC. If this member is based in the United States, this would mean that all fee income from managing the fund will have to be reported on his or her personal tax return.
Upfront costs
Setting up a fund comes with a significant upfront cost which are typically born by the sponsor i.e. the manager of the Fund.
By the time everything is set and done, the dual LLC setup and associated legal expenses will add up to around USD 10,000 (though the legal cost can be halved if you use our template and have our US counsel do a safety check on the variables you set).
The good news is that such organizational expenses incurred by the Manager can be reimbursed out of the NAV of the fund. To prevent these costs from hitting the NAV all at once, they are typically amortized over a period of 12 months.
VI.8(xi) deals asks the Manager to make an estimate of this total costs, which include the legal expenses and the cost of formation of the fund itself. As long as these costs are reasonable, you should not get pushback on this from your investors.
The remainder of our Operating Agreement template deals with operational and miscellaneous matters.
As a general principle, any wording that deviates from precedent will add to your legal cost, and may trigger flags with investors who are used to look at pretty much the same terms and don’t like legal ambushes.
Run on a spreadsheet?
In Annex to the 25-page Operating Agreement is a 1-page signature page to be signed by the Member.
It simply states the amount of Capital Contribution and the number of LLC interests.
The latter is a % of the total LLC interest corresponding to that particular Member’s Capital Contribution as a portion of the overall fund assets.
Smaller funds who do not (yet) have an outside fund administrator will typically keep a spreadsheet that helps keeping track of Members and their corresponding Capital Contributions.
Such spreadsheet could in theory be replaced by blockchains as ledgers of Membership and Contributions, however ultimately the scope for innovation in this field quickly bumps up agains the limitations of the legacy, analog world: the best blockchains may ever achieve here is to duplicate analog processes, rather than replace them.
We see much bigger scope for innovation when the fund units (or LLC Membership Interests) themselves are tokenized and can be purchased by simply sending crypto to a smart contract.
However, private placement rules and investor accreditation would still apply, given that the tokens representing Membership in an LLC are likely securities (though there are two schools on this).
A much more radical approach to how fund setup and fund management generally could be re-engineered would be to raise capital first and deal with investor qualification and sales restrictions later.
We describe this idea in our Launch Pool piece in this issue of The Otonomist. However for a more traditional investor base, recognizable terms and legal documents may still win over smart contract code, and we will be happy to help you put with such a battle-tested setup.
Schedule a FREE 30 mins call today to see how we can help.
