It is hard to overstate the ingenuity and volatility experienced through the digital markets since the first cryptocurrency, Bitcoin, was created in 2009. That volatility, and possibly the limited investor base, has created a unique situation for investment companies holding digital assets — a mixed portfolio of both liquid and illiquid investments.
Along with this unique situation comes equally unique complexities in determining incentive and performance fee (incentive) calculations. As a fund manager, this is an important area to understand and address.
Illiquid vs. Liquid Investments and the Side Pocket
Determining whether an investment is illiquid can be simple in the case of certain Initial Coin Offerings (ICOs), Simple Agreements for Future Tokens (SAFTs), etc. However, for many freely tradable digital assets, liquidity can be frequently in flux depending on the assets held and the size of the position.
For example, some assets may be so thinly traded compared to an entity’s holdings that even transacting a fraction of its assets can move the markets significantly. Given U.S. Generally Accepted Accounting Principles’ (GAAP’s) disallowance of blockage discounts in determining fair value of investments, there may be discrepancies in what investors would receive if all investments were liquidated on a measurement date and what should be reported as fair value under GAAP.
A lot of recommendations have been made to move illiquid investments into side pockets, a strategy not typically seen in a traditional hedge fund, as historically liquid and illiquid investments would not be commingled in the same fund or portfolio. While this solution alleviates the challenge of treating investors equitably, by attributing gains/losses on illiquid investments solely to investors that put up value at risk by being in the fund when the investments were made, the use of side pockets still leaves unique complexities on incentive and performance fee (incentive) calculations.
In accordance with common practice in applying GAAP, if a nonregistered investment partnership reports capital by investor class, the accrued incentive should be reflected in the equity balances of each class of shareholder or partner at the measurement date, as if the investment company had realized all assets and settled all liabilities at the fair values reported in the financial statements. The calculation to determine accrued incentive is generally not overly complex. However, the determination of when incentive fees should be crystallized — or how they should be calculated and actually charged to an investor — is subject to greater complexity and is driven more by the fund’s governing documents and less by GAAP standards.
What Fund Managers Should Consider
As a fund manager, it’s imperative that you ensure your documents clearly define the methodology for incentive crystallization. Some key considerations to address include:
- Are unrealized gains within a side pocket subject to incentive crystallization at the fund’s standard crystallization date (typically year-end)?
- Are realized gains within a side pocket subject to incentive crystallization at the date the gains are realized, or are they moved into the investor’s liquid portfolio balance where they will be included with gains and offset against losses within the liquid portfolio at the fund’s standard crystallization date?
- Should a fully redeemed investor (with respect to its liquid portfolio balance) surrender the benefit of any liquid loss carryforward, or is it maintained to offset any future gains from side pocketed investments?
While there will be diversity in practice across funds, it is critical to understand the accounting complexities created by your fund’s portfolio, develop the appropriate policies and procedures to address them, and ensure you properly disclose them to investors. As the investable universe of digital assets continues to evolve, there is likely more to come on the question of performance and fee calculations in a mixed portfolio.
Contact Jeff Megaro at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.