Institutional investors, high net-worth individuals, family offices, offshore investors, or onshore entities with preferential tax treatment (pension funds, endowments, IRAs, 401(k)s, etc.), might consider forming a hedge fund vehicle in order to maximize capital contributions while maintaining multi-jurisdiction regulatory compliance.
The process of forming a hedge fund structure for bitcoin investments can be broadly broken down into three phases: structural and operational considerations, selection of the fund’s service providers, and optimizing the deliverables from each service provider.
Structural and Operational Considerations for Fund Construction
Open or Closed-End Fund?
Closed-end funds are intended to last for a fixed amount of time, typically between five and ten years. Investors are generally not permitted to make withdrawals during this term. Real Estate, Private Equity, and Venture Capital funds are often structured this way.
Open-end funds allow investors to make periodic redemptions and contributions (details would be specified in the fund’s offering documents). Generally, open-end funds invest primarily in liquid assets, like bitcoin.
Who Will Staff the Fund’s Board of Directors?
There are instances where start-up funds choose to staff the board with members of their sponsoring organization – while this is technically legal, some investors prefer boards staffed with independent members.
“40 Act” Fund Structure?
The Investment Company Act of 1940 is the regulatory structure for investment funds; hedge funds will often structure themselves to be exempt from this regulation under one of two exemptions:
- Section 3(c)(1) Funds are limited to 100 “accredited investors” (there may be exemptions on the total number of investors). In this context, accredited Investor refers to individuals with (i) a minimum net worth of $1m or (ii) $200,000 annual income; $300,000 if combined with a spouse. For entities and trusts, this means a minimum of $5 million net worth. Start-up funds are often structured like this because of the lower barrier to entry for investors
- Section 3(c)(7) Funds can technically have an unlimited number of investors. However, most will choose to keep their total number of investors under 2,000, so as to avoid registration under the Securities Exchange Act of 1934 as a publicly traded partnership. Investors must be “qualified purchasers, " meaning individuals with at least $5 million in net investments. Trusts or entities need at least $25 million in net investment in order to be deemed qualified purchasers.
Domestic or Offshore Fund?
This consideration can be distilled into two main questions:
- Are there expected capital contributions from offshore investors or entities?
- Is there an expectation that onshore tax-preferred entities will seek to invest in the fund?
If the answer to one, or both questions is “yes,” then structuring the fund with offshore components will likely prove to be beneficial. This does come at an additional cost, as more work will need to be done by the fund managers and service providers. However, it is of the utmost importance that a fund remains in compliance across any regulatory jurisdiction in which it operates.
Offshore Funds can take be structured in many ways, one of the most common is the “master-feeder” structure, wherein onshore investors are able to invest capital in the onshore feeder. Offshore entities and onshore tax-exempt entities invest capital through the offshore feeder, which is incorporated in an offshore domicile. Both vehicles “feed” into an offshore master fund, this entity handles the capital investment processes.
Generally, the Cayman Islands and the British Virgin Islands are considered the most robust options for offshore funds, as many fund services professionals and organizations operate in those jurisdictions.
Bermuda, Ireland, and the Netherlands Antilles are less frequently utilized, but still have relatively permissive regulatory climates and fund service infrastructure in place.
If it is the case that the fund is meant to serve U.S. citizens or U.S. taxable investors, the fund could be set up as a single U.S. hedge fund.
Typically, the fund is set up as a General Partnership, which provides investors and managers limited liability, plus the benefit of pass-through taxation, wherein all income is passed through to the partners and members. These advantages allow the fund to avoid double taxation, a characteristic of the corporate structure.
Domestic-only fund structures are often composed of a fund entity (Delaware LLC or LP) and an LLC (local to the fund sponsor) to serve as the Investment Manager and General Partner; this is the entity that would receive performance allocations and management fees.
If creating multiple funds, it is recommended that the fund sponsor establish two separate entities for the Investment Manager and General Partner This is to allow subsequent funds to maintain separate general partners for liability purposes.
Fund Service Providers and their Deliverables
Among the most important factors of a fund’s operational success are capable service providers who lend their expertise to help solve specific problems. While the performance of the fund will ultimately determine how much capital managers are able to secure, institutional and high-net-worth investors prefer to engage funds with credible service providers.
Please note that the following list is meant to be a general overview and is by no means exhaustive.
Skilled legal counsel is of paramount importance in ensuring that a fund is properly structured and that its offerings are compliant with the regulatory environments in which they are marketed. In addition to establishing all legal entities that compose a fund’s structure, legal counsel also drafts and maintains the fund’s Offering and Operating documents.
Within the context of a bitcoin-focused hedge fund, it is critical to select legal counsel with industry-specific (and potentially jurisdictionally-specific) securities law expertise. Offshore funds should also consider retaining legal counsel local to the offshore legal entity previously established.
Prime Brokerage Firm
A fund focused on bitcoin investments will be primarily concerned with sourcing bitcoin for their offerings, and potentially derivative/hedging products. Quality brokerage firms (bitcoin exchanges, in this case) provide trade execution, trade clearing/settling, portfolio and risk management tools, as well as comprehensive reporting.
Fund Administration Firm
Fund administrators specialize in providing accounting and record-keeping services for funds and money management organizations. Services include portfolio accounting and reporting, transaction recording, accounting for investor subscriptions and redemptions, invoicing, and general bookkeeping.
A bitcoin-focused fund might consider hiring a fund admin firm that is comfortable dealing with in-kind contributions (and potentially in-kind redemptions).
“In-kind” means that the investor’s contribution to (or withdrawal from) the fund is executed with the same asset that the fund invests in – bitcoin, in this case.
Custody Solutions Provider
In the legacy financial system, the chosen brokerage firm would typically also be responsible for the custody of a fund’s assets. In the case of a bitcoin-focused fund, custody is its own consideration.
Fortunately, because of the technological capabilities of the protocol, bitcoin can be secured using native “Multisig” locking script configurations in a manner that removes single points of failure.
Legacy Banking Services
It is likely that there will be certain investors or entities that wish to contribute to the fund on a fiat-denominated basis. Therefore, it is generally good practice to establish a fund-specific bank account with an institution that has demonstrated competency in working with bitcoin-focused fund structures.
Audit and Tax Services Firms
While submitting the fund to a yearly audit is not required by law (unless the manager is a registered investment advisor), many investors require such an audit for their due diligence processes.
If the fund is domiciled in multiple locations (i.e. Delaware and the Cayman Islands), the fund should consider two separate audits for the two different tax frameworks. Start-up funds will commonly schedule a first audit only after a full year of operations.