Let’s be honest, operational due diligence (ODD) is not known to be the first thing fund managers think of when meeting with a potential investor. It’s often not the initial points of conversation, such as strategy or portfolio performance, and stands behind sending marketing materials and an introductory call.
But wherever ODD arises, it is almost always a core step of any institutional investor's process before completing subscription documents and sending capital to a fund… And particularly, a necessary step for investing in a crypto hedge fund.
Operational Risks in Crypto Hedge Funds
From the perspective of a sophisticated investor, crypto hedge funds often come with the following operational risks which either require the investor to conduct ODD themselves or by employing a third-party consultant:
- Emerging Nature of Crypto Managers. A vast majority of crypto funds are managed by emerging firms with little operational history, or often are reliant upon scaling their assets under management (AUM) as quickly as possible in order to achieve a breakeven AUM that affords covering the expenses of running an investment manager.
- Trading and Execution Risks. Crypto funds come with their own nuanced trading risks, either due to effectiveness of trade execution, often due to changing and volatile market dynamics, and typically work with counterparties which are not as transparent as their traditional peers, or themselves have going concern risk, as most are privately owned.
- Custody Oversight. Who is managing those crypto wallets and keys? Not all crypto assets are able to be held through an independent third-party. In such instances, fund managers need to demonstrate, through detailed process and documentation, that the assets of a fund are being safeguarded in such a way as to reduce the risk of internal fraud or external compromise.
- Administrative Challenges. The daily administration of crypto funds is still a work in progress, either due to an investment manager not having detailed and institutional controls, or service providers still catching up to the specifics of crypto accounting and audit. Lastly, and for those managing comingled, open-ended funds; Do the terms of the fund offering work best for the manager or its investors?
The Evolution of Due Diligence Standards
Traditional hedge funds getting started nearly 30 years ago did not have the industry standards, volume of due diligence requests, nor the capital expenditures required of emerging funds of today. It is an easy deflection to determine that all of these hurdles for institutional capital can be resolved over time due to either strong investment performance or the often illusive co-GP investor who may help support a business in its infancy.
However, the reality for many managers is that it takes being consistent with good standards and a responsiveness that brings many to the final stages of an institutional due diligence process.
Meeting Institutional Investor Expectations
Some ways to “check” the right boxes of most sophisticated clients’ ODD includes basic, but often overlooked areas, such as well documented cash (fiat) and crypto asset control policies, a detailed digital asset valuation policy to be the back up for fund administration position pricing and clean audited financial statements, a thorough and dynamic counterparty risk management policy, and for certain domiciles, an often updated and reviewed compliance policy.
A vast majority of emerging crypto funds are not spending their time comparing notes on operational standards and client feedback because managing and keeping an eye on complicated crypto markets is hard enough. The daily requirements of managing a crypto portfolio for institutional constituents often leaves little time for firms with limited hours to make robust due diligence questionnaires, spend precious hours with full-throated client advocates (i.e., an allocator's investment or operational research analyst), and ensuring errors (be it trading or accounting) are reduced to an absolute minimum.
The Path Forward for Crypto Fund Managers
The reality is that it is not enough for crypto managers to rely on just investor conversations or speaking to peers to transform their firms into institutional organizations. Many investors predominantly taking interest in the current buy-side crypto space are either high net worth individuals or family offices that are in a position to assume a higher degree of operational risk due to the nature of their investment philosophies. Crypto managers seeking to elevate their operations and meet the benchmarks of sophisticated allocators—sovereign wealth funds, funds of funds, pensions and endowments, insurers, and private‑banking platforms—must address these requirements proactively from day one.
There are options available to crypto managers of all sizes and experience, some of which include conducting an operational gap-analysis with an experienced crypto due diligence expert, undergoing an independent ODD review, or working closely with investors and their due diligence teams (either internal or external).
CIG's Commitment to Supporting Operational Readiness
We often speak with fund managers who are simply unaware of what the minimum operational standards are to move to more advanced phases of investor due diligence. CIG’s mission is to support the institutional growth of the digital asset space. While our platform helps identify, diligence, and monitor funds, we are also guiding funds and institutions in their operational diligence readiness.
If you are a crypto fund manager who wants to improve your operational readiness, or if you are an institutional investor seeking crypto funds which meet your criteria for investment, we want to support you.
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