Private funds investing in digital assets have exploded in popularity—but pose unique legal risks
David Felsenthal, Steven F Gatti, Philip Angeloff, David Adams, Ashwini Habbu, and Jesse Overall are attorneys with Clifford Chance, LLP.
But a complaint filed in the Delaware Court of Chancery in Harry Greenhouse v. Polychain Fund I LP and Polychain 2030 LLC, Case No. 2018-0214 (Del. Ch. 2018), illustrates some of the issues and risks investors in such funds face, including: (1) complex fund structuring (e.g., early redemption); (2) valuation procedures; (3) fidelity to stated investment objectives; and (4) securing information rights and understanding the fund’s confidentiality policies.
In Greenhouse, an investor in a hedge fund (“Polychain Fund I”) with a portfolio of digital assets alleges that—despite the fund’s claim that the investor received a 2,300% return—the fund improperly undervalued certain assets, which diminished the value of his interests in the fund at redemption. The investor sought access to various records, including the fund’s portfolio composition and the manager’s valuation policy, neither of which had been disclosed to investors.
According to the complaint, an employee of the manager represented to the investor that (a) 15% of the fund’s assets were illiquid, (b) unlike many hedge funds, the fund did not hold such assets in “side pockets”, i.e. segregated accounts used to hold illiquid investments separately from the rest of the fund’s holdings, and (c) illiquid assets would be valued at cost upon redemption. Citing data from the futures market, the investor believed the manager’s valuation to be low and asked for valuation information from the manager to substantiate its figures—which was not provided.
Shortly thereafter, the fund sought investor consent to amend the fund’s documentation in order to allow it to hold illiquid investments like “SAFTs”—which had, according to the manager, become a “much more significant” component of its portfolio—in side pockets. SAFTs, or “Simple Agreements for Future Tokens”, are effectively physically settled forward contracts for blockchain tokens that allow a company (typically an early stage startup) to pre-sell tokens before they are issued, use the money to develop a blockchain app or product, and then deliver the tokens at a future date. The uncertainty over whether the startup will ever issue the tokens makes SAFT investments difficult to value, and—because they are considered securities—the SAFT contracts themselves usually are subject to legal restrictions on resale, rendering them illiquid, in contrast to established cryptocurrencies (e.g. Bitcoin, Ether) which trade freely and in high volumes on public cryptocurrency exchanges.
Following the solicitation of investor consent for the side pocket amendments, another employee of the fund manager represented that illiquid assets, like SAFTs, would now be placed in side pockets and excluded from redemptions until they became more liquid, which could lead to a higher valuation. According to the investor, in reliance on that understanding, he now requested to redeem his interest. However, the investor claims he was now told that his redemption was to be under the “old terms”, i.e., no side pockets coupled with valuation of illiquid assets at cost. In response, the investor asked the fund to suspend his redemption request, and to provide more information regarding its valuation policy—both of which the fund refused. In its answer to the investor’s suit, the manager claims that the investor’s motivation is not to better establish price for the fund interest—which, according to the manager, has been confirmed by independent sources—but rather, to gain inside information to launch a competing investment vehicle.
The Greenhouse complaint is instructive to both investment managers and investors in digital assets. First, a fund’s structure and terms must be aligned with the nature of its proposed investments. On its Form D filing with the Securities and Exchange Commission (the “SEC”), Polychain Fund I indicates that it is a hedge fund. A signature feature of hedge funds is their periodic redemption windows, which they can provide to investors because the underlying asset classes in which these funds typically invest are highly liquid (e.g., publicly traded securities) and easier to value. Yet according to the complaint, up to 30% of Polychain Fund I’s portfolio consisted of illiquid digital assets—which are difficult to value and complicate redemption mechanics.
Unlike hedge funds, private equity and venture capital funds, which often hold illiquid assets that are hard to value, generally do not permit early or periodic redemption rights and require investors to hold their investments for years. Polychain may have been able to avoid the current litigation if the rights it offered investors were better aligned with its investment strategy. Perhaps learning from its experience with Polychain Fund I, in January 2019 Polychain’s sponsor reportedly announced that its newest fund features a seven-year lockup period.
Potential investors should take heed from Greenhouse as well and ensure that they understand their information rights and establish effective oversight mechanisms to prevent “style drift”, over concentration, and other portfolio composition risks. Polychain Fund I’s purported admission that its investments in illiquid SAFTs had become “much more significant” raises the question of whether the substantial increase was inconsistent with the fund’s stated investment plan. The fund’s treatment of its portfolio composition as a trade secret may have hampered the ability of investors to monitor the fund’s fidelity to its stated investment objectives. The fund investors only learned of the increase in SAFT investments because the manager sought investor consent to the side pocket amendments.
Finally, Greenhouse brings into sharp relief the challenges of digital asset valuation. The SEC has addressed this issue in the context of SEC-registered funds, emphasizing that managers must develop and implement policies and procedures to value digital assets, accounting for differences among the various types. Digital assets are inherently difficult to value, but their accurate valuation is central to the management of a fund. Fund sponsors should amend their valuation policies to specifically address digital asset valuation..