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.
