Cryptonetwork founders, unlike those starting traditional equity businesses, now have to think about the fund structures of their investors. This is because the liquidity of cryptoassets brought the hedge fund model, which carries an active trading bias, to early-stage tech investing, a field historically dominated by venture capital. If you’re raising money for a cryptonetwork, each model has pros and cons depending on your goals, but understanding how they operate is key to making good decisions about how to structure financings.
Hedge funds tend to use “liquid” fund structures, meaning investors in the fund (called limited partners, or LPs) have a right to withdraw their capital after a certain “lockup” period. For example, LPs in a hedge fund with quarterly redemptions and a 1-year lockup can withdraw parts or all of their capital once a quarter, after a year has passed since their initial investment. It’s also common for hedge fund managers to have the right to accept additional capital into the fund at a similar cadence. As a result, the assets under management of a hedge fund fluctuate over time as people subscribe and redeem their investments – and there is always the risk of mass withdrawals forcing the fund’s managers to dump assets on the market in order to meet their obligations.
Venture capital funds, like Placeholder, use a “committed capital” structure, which means LPs commit a certain amount of money that is “called” over a period of time (10 years in our case). Within that period, the managers of the fund (general partners) request capital from LPs as they deploy the fund, and LPs are obligated to provide it. In contrast with hedge funds, LPs in venture capital funds cannot redeem their investments at will – instead, capital is distributed back to them when the general partners realize the profits of an investment. This structure is designed to provide a stable, long-term supply of capital to risky ventures, which is why it is well-suited for startup investing.
Another important difference is how hedge fund and venture capital managers are compensated. Both types of funds employ some variant of the “2 and 20” payment structure, which stands for 2% annual management fee, and 20% carried interest. The management fee pays for the operating expenses of the fund (employee salaries, office, travel, marketing, etc.), while carried interest is the percentage of the profits paid to the managers when they invest successfully.
While similar in nature, this payment structure works differently for each type of fund. In a hedge fund, the management fee is calculated off the total value of its assets under management on a quarterly basis, which means it fluctuates depending on the performance of the fund. If the portfolio gets cut in half, for instance, so does income for the quarter or year. In a venture fund, by contrast, management fees come off the total amount of committed capital, and not the current value of the portfolio, which guarantees a stable source of operating income for the managers independent of market conditions.
When it comes to carried interest (or carry), hedge fund managers are typically paid yearly based on the paper profits of that year (but usually only if the profits are higher than the previous year’s), while VCs are only paid when they distribute capital back to LPs. This means that hedge fund managers get compensated well for every year or quarter that the fund does well, but less so when it doesn’t, while VCs only get carry when they produce real profits for their investors.
The effect of these differences is that hedge fund managers have a greater incentive to maximize short-term profits, as they can be severely affected if the fund underperforms in any given period, while VCs are incentivized to maximize long-term, realized value in order to increase their payout. And this is reflected in how each type seeks profits: in general, hedge funds will tend to trade around market fluctuations, while venture funds tend to build and hold investments to optimize for long-term value.
All of this matters for crypto founders because having the right balance between active market investors and long-term holders is important to bootstrap a healthy cryptoeconomic circle. Hedge funds’ active trading style can help with a token’s liquidity, but will provide more volatile capital, while venture funds can afford to hodl independent of market fluctuations, which is important for both early and long-term network capitalization.
While some hedge funds do invest with an eye towards long-term value, as a matter of structure a lot of things can get in the way of executing this strategy. Honoring redemptions, maintaining operating income through volatility, and maximizing end-of-year compensation all pressure hedge fund managers to sell assets on a regular basis. This can also drive them to act against the interest of a network by shorting in order to maximize their own value, which is something venture capitalists, by law, cannot do.
Meanwhile, venture funds are largely insulated from these concerns, and few things prevent them from investing (or divesting) in the market when it is suitable to do so, such as when it is necessary to provide liquidity for a token. And because venture funds don’t take carry on a recurring basis, the value of the portfolio can compound more effectively over time to everyone’s advantage.
That said, venture funds still need to fully exit their investments at some point. In our view, this should occur when a network develops to the point where it can sustain itself without venture capital hodlers, and in a manner that does not adversely affect the market for the token. Ultimately this can be good for the network, as it has the effect of distributing the token – and therefore its value – more broadly across the community. In that sense, done right, long-term investors can be helpful “placeholders” in the early development of a cryptonetwork.