OK, You Blew Up Your Crypto Fund. What Do You Tell Your LPs?
The sudden “radio silence” from typically forthright crypto traders has been driving their investors “all but mad”
Dall-E
The moat has been breached, and the sky is all but falling.
Even blue-chip crypto traders running serious institutional money have booked eye-popping losses in just weeks. For their investors, the full extent of the damage is still anyone’s guess — a seeming eternity after FTX’s abrupt bankruptcy — as investor relations professionals hide behind pending mark-to-market valuations for startup stakes and early-stage tokens.
And that’s not to mention the scores of asset managers who have battened down the hatches as they’ve tried to trade their way out of historic holes, before their monthly performance updates are due, any day now, to their limited partners, industry participants told Blockworks.
One institutional crypto fund allocator, who has written checks to more than a dozen such operations, said the abrupt radio silence has been all but “maddening” — drawing a direct parallel to TradFi traders running for any kind of cover during the 2008 financial crisis.
“We’re all in the dark,” the source said. “I gave you my money. Why are you not answering my calls?”
Not that they’ve all beat feet to desert islands with no cell service. Case in point: Multicoin Capital.
The veteran cryptoasset manager’s flagship liquid hedge fund plummeted 55% in approximately two weeks in November. The firm’s investors, of course, were not pleased.
But three sources close to the firm told Blockworks they took some solace in the fact that Multicoin executives didn’t hem and haw on a recent call explaining what happened — and at least tried to walk them through why.
One of the sources provided a detailed account of the call, which was open exclusively to limited partners. A Multicoin spokesperson declined to comment.
“The market is down a lot this year,” an executive said on the call. “And we’re down more than that. There’s no sugarcoating that. Making matters worse, we got hit while [we were] down. We strongly and publicly endorsed [FTX Founder] Sam Bankman-Fried and FTX. And they turned out to be frauds.”
Indeed, Managing Partner Kyle Samani led the charge to back FTX US with an unspecified amount in January 2022, when he told Coindesk that the affiliate of FTX proper was “laying the groundwork to become the dominant trading platform in the United States for all things crypto.”
FTX US had raised $400 million at a valuation of $8 billion. Bankman-Fried, ironically, has recently scrambled to come up with $8 billion to bail out his flailing businesses. Samani’s fund has also gone in alongside Bankman-Fried in backing a number of startups, an indicator of the venture business more broadly, wherein portfolio managers typically rely on one another for deal flow and due diligence.
Multicoin execs — pointing out internal capital accounts for, collectively, the largest chunk of the flagship — said they had no intention of shuttering the vehicle or, worse, the firm. Nor would they entertain converting to a proprietary trading shop, an increasingly enticing route for those with the stomach to place riskier wagers in a bid to print big profits from staggering market dislocations, especially arbitrage opportunities.
Axios, The Block, CNBC and Fortune have reported aspects of Multicoin’s recent dealings. This story contains unreported details and provides the first account of the firm’s investor call.
Due diligence can avert a disaster
Scheduling an impromptu mid-month call is easy when you’re crushing your benchmark and want to put uneasy, information-starved investors at ease. But precious few digital assets-focused hedge and venture capital firms have been in that fortunate position lately.
They’re facing, instead, the onerous, come-to-Jesus undertaking of owning up to many, many errors: disproportionately relying on FTX custody, employing far too much leverage and doubling down on bets — that would turn out to be disastrous — in round after round.
It doesn’t have to be this way, though.
It doesn’t, that is, if asset managers do their homework. If they establish ironclad due diligence standards, put in place appropriate risk parameters and stay in near-constant communication with their investors all the while, a due diligence professional told Blockworks.
And it needs to be communicated in writing, according to James Newman, co-founder of London-based perfORM Due Diligence.
The startup specializes in deep dives on digital asset buy-side players and their service providers. Newman declined to specifically discuss Multicoin, or perfORM customers, citing client confidentiality.
“So, it’s one thing, verbalizing it,” Newman said. “The next step is actually to write that down in a policy that is then made available to investors. So, that’s part of assuring investors that there is an actual procedure and policy in place.”
Simply putting all that in place to begin with isn’t enough, Newman said. There needs to be a real commitment to a schedule of conducting due diligence check-ins with counterparties, as well as communicating the results, and, especially, any material changes, to investors.
Multicoin competitor Arca, for one, has likewise recorded choppy performance in its flagship liquid hedge fund this year, despite not having significant FTX exposure. The firm, led by CEO Rayne Steinberg, has rejigged a number of internal guidelines since.
The market’s turn for the worse has forced Steinberg’s hand in shifting the capital-raising strategy for the firm’s ongoing Series B raise — with capital already earmarked, in part, to bolster regulatory and compliance safeguards.
Are third-party crypto custodians still a necessary evil?
In Multicoin’s case, “what happened?” has been the question de jour.
The short version: Outstanding financial instruments under FTX custody and related derivatives, as well as a position in the startup Serum and a bullish thesis on SOL, were to blame. Both Serum and SOL, Solana’s native token, have lost immense value, partially because of their longtime ties to Bankman-Fried. The former has been placed in a side-pocket since the 2020 investment.
Traders are required to keep collateral with market-markers before open derivatives are settled.
On the custody front, Multicoin entrusted FTX with unspecified cash and FTT, the exchange’s native token that is also now underwater — plus relatively small sums of tokens only FTX US would custody, including Solana-based Mango (MNGO). Multicoin also has an equity stake in FTX, one which it will, presumably, have to write down, too — to zero.
The firm, as of mid-November, had successfully withdrawn about a quarter of its locked assets — resulting in a total fund exposure of about 10% — and had been planning to whip up a side-pocket to protect potential incoming limited partners.
Multicoin had one other main trading counterparty: the now-defunct Genesis. But its team “closed out that exposure immediately” after FTX stopped withdrawals. The firm also has exposure to Coinbase’s custodial solutions. It it, however, moving certain outstanding assets to non-custodial, multi-signature solutions.
With centralized custodians, as keepers of clients’ private keys, there’s always an element of risk, according to Nick Neuman, chief executive of Casa, which helps individuals and entities set up their own cold storage solutions. Neuman declined to specifically discuss Multicoin or any Casa clients.
Complicating matters: It’s tricky for active crypto traders to rely much on cold storage, Neuman told Blockworks, because of the time and logistics involved in transferring assets in an alpha-driven game where mere milliseconds matter.
Relying on third-party custodians — however reputable — “inherently requires trust” in potential bad actors, Neuman told Blockworks, the “exact type of thing our industry is trying to eliminate.”
The Casa head said the problem calls for a “mix of solutions.”
“One thing I know is that we have seen repeatedly […] in our industry, problems with bad actors — since the beginning, with Mount Gox [being the] earliest and largest,” he said.
Multicoin: What to do, what to do?
Multicoin is in the process of onboarding Anchorage as an additional custodian in an effort to reduce its counterparty exposures, one of the sources said. A spokesperson for Anchorage declined to comment.
Multicoin has one big, quick fix. The firm — in addition to conducting due diligence on a number of other potential custodians, as well as other types of service providers — said it has already moved to keep its assets on any exchange for no more than 48 hours at a time. A number of other high-profile competitors have historically entrusted tokens to counterparties on a near-indefinite basis.
Its traders are also in the process of reducing collateral it pledges to market-makers. The upside is that the move reduces the tail risk of another liquidity crunch. The downside is that it significantly increases the risk of margin calls.
The “more tightly knit” the collateral, the firm said, the “greater the risk” of abrupt liquidation, adding that new mitigating risk controls are in the works. Some of those incoming, tightened controls have been about four months in the making. Multicoin is also implementing fresh restrictions on staking, aiming to minimize exposures of locked-up tokens “in order to maintain flexibility and optionality during times of crisis.”
At least one thing is clear: the toll nefarious actors have taken — and, by all appearances, are continuing to take — on all of crypto, is mounting. And it has real-world consequences for the investors who entrust their capital to the traders who increasingly encounter them.
The firm told limited-partners it was not yet “sure” how its administrators and auditors would value frozen assets under GAAP accounting standards.
“But in our view, they should be marked to zero,” an executive said. “There is some chance of a partial recovery. And, you know, it’s maybe a smaller, much smaller chance of a larger recovery. But we believe that the conservative thing to do is to value them at zero for the time being.”
Multicoin had $8.9 billion of gross assets under management as of year end 2021, the latest data available.
How much is left?
Updated Dec. 2, 2022 at 2:53 pm ET: Clarifies the process and rationale behind Multicoin’s move to reduce the collateral it posts with market-makers.
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