Revisiting The “Crypto Investment Opportunity” — Liquid Hedge Funds Provide Compelling Exposure to the Sector

In late 2022, we published a white paper on the “Crypto Investment Opportunity” and proposed a multi-strategy liquid approach. We highlighted the opportunity to gain exposure to the development of a new and potentially disruptive early stage technology through publicly traded tokens in liquid and transparent digital asset markets. Investors could gain exposure to venture stage technology without having to lock up capital for 10+ years in illiquid traditional private investment vehicles.

These points remain valid today.

The transformative potential of blockchain-based technologies on global finance and commerce has only gotten stronger and more likely over the last couple of years. Development continued apace during the 2022–23 bear market and technological breakthroughs have enhanced the scalability, speed and security of blockchain technologies. There remains an asymmetric opportunity to invest in a technology with a myriad of disruptive use cases across large addressable markets.

Still, commercial applicability and implementation remains relatively slow and difficult to predict. Accordingly, we wanted to re-evaluate the most effective way to gain exposure given that early stage of technological development.

We think an investment allocation to the digital assets sector is rooted in the following simple equation:

We think that investors are best able to gain exposure to such an attractive investment opportunity in the digital assets sector through hedge funds that avail themselves of short and medium term opportunities. Hedge funds that trade in liquid digital asset markets are able to invest in the progress of blockchain without having to pick ultimate “winners”. They can apply investment and trading strategies, from long-biased fundamental-driven investing to arbitrage and quantitative-based trading strategies, to provide exposure to the sector without having to make long term bets on exactly how the technology may ultimately be deployed.

We wanted to use this short paper to elaborate some on that conclusion.

Early Tech with “Legs” — The Basic Case for Blockchain/”Crypto”

We start with the proposition that there is no investment case for seeking exposure to the digital asset and blockchain sector without the technology itself being potentially commercially viable and disruptive.

Blockchain is the enabling technology facilitating the shift to digital commerce and finance from earlier analog and electronic phases. Across numerous and massive addressable markets, “crypto” technology has the potential to allow people and businesses to engage with one another in more cost-effective, decentralized, transparent and inclusive manners.

Through the bear market of 2022–23, innovation continued. Significant advances have been made in the development of the computing infrastructure that will allow safe, quick, peer-to-peer commercial and financial exchange.

For example, the Ethereum ecosystem, and Layer 1 blockchain challengers like Solana, continue to improve upon speed and scalability for commercial transaction activity comparable to existing networks (e.g., Visa, Mastercard, ACH) while maintaining security. Real world assets such as US Treasury bonds, commercial real estate, private credit and private equity are being digitized and fractionalized onto digital ledgers that allow for 24/7 trading without the need for a third party intermediary. Decentralized Physical Infrastructure Networks (DePin) use blockchain-based incentives to coordinate the buildout and operation of critical physical infrastructure, such as the wireless network created by Helium using excess bandwidth from home routers.

More than half of Fortune 100 companies have pursued crypto, blockchain or web3 initiatives since the start of 2020. Franklin Templeton CEO Jenny Johnson called blockchain technology “the greatest disruption to financial services”. Blackrock CEO Larry Fink stated “I think ETFs are step one in the technological revolution in the financial markets. Step two is going to be the tokenization of every financial asset…”

Forbes recognized the same in the preamble to its “Blockchain 50 2023”: “Despite it all [the events and drawdown of 2022], dozens of enterprises around the world are still quietly investing in blockchain, the distributed-database technology that underpins the entire sector. These mostly big, mostly smart firms aren’t throwing good money after bad. They’re doing it because blockchain helps their businesses operate better, faster or cheaper.”

We think it is safe to say that digital assets and blockchain are potentially commercially relevant if not massively disruptive technologies worthy of investment consideration.

Liquid Public Markets — $2T Market Cap of Liquid Digital Assets

One of the most attractive facets of the digital assets and blockchain sector is a liquid and transparent marketplace that permits investment in these early stage technology projects by public market investors.

Blockchain technology companies, projects and protocols often have publicly traded interests at or shortly after the seed stage of fundraising. These “tokens” are a form of equity in the digital asset ecosystem. While not uniform in the rights and interests conferred on holders, they provide an interest in the development and progress of these early stage technologies. Investors are ostensibly able to buy and sell publicly traded interests in Seed/Series A through Series E stage companies.

Importantly, public liquid markets allow investors to trade these interests as the technology, network effect and pricing develop. One can buy a token in a Series A stage company, participate in the growth to a Series C level of fundraising and be able to trade the digital asset if the valuation gets ahead of itself or buy more if the valuation has yet to catch up to the technological and/or commercial progress. These markets provide more flexibility and capital efficiency for investors as they can exit positions that do not become core or reach interim price targets and recycle that capital into more shots on goal. And this all comes with pricing transparency into the value of underlying investments.

We cannot understate the opportunity for public market investors to invest in early stage blockchain technologies through the digital asset markets, a realm once limited to specialized private market investors and the illiquidity and lack of transparency that came with it. This opportunity can be illustrated by looking at the public and private market returns of two different actors in the digital asset sector — Coinbase (the leading US-based digital asset exchange; ~$53.7Bn market cap) and Polygon (a blockchain scaling solution for the Ethereum network; ~$11.2Bn market cap).

Coinbase was a startup company that raised capital and grew through the traditional private venture capital model. Coinbase raised its Series A round at $0.20 per share in May 2013. It ultimately went public on the NASDAQ in April 2021 in a direct listing at $381 per share. Series A investors made a more than a 1,905x return in the private markets upon the offering to the public. Public market investors were down 47% from the IPO price as of March 1, 2024.

Compare the private-public disparity to that of Polygon (MATIC). Polygon raised its private Series A round at $0.00263/token in April 2019. MATIC began to publicly trade shortly thereafter in April 2019, with the first trade at $0.00582. This amounted to a 2.2x return to the private market holders. MATIC traded at ~$1.00 on March 1, 2024, providing public market investors with a cumulative return of more than 17,082%. Public market investors had the opportunity to participate in and capture any and all of that return.

Moreover, there is a vast market for public investors to participate in. The market capitalization of the publicly traded digital assets is approximately $2.46T. Bitcoin has a market cap of ~$1.30T. The market capitalization of the 100th largest token is ~$1.02Bn. There are more than $143Bn of stablecoins that facilitate access to digital asset markets. Daily digital asset trading volumes exceed $100Bn/day.

We think it safe to say that there is a robust liquid trading market facilitating liquid and public exposure to a wide variety of digital assets.

Investment Strategies Not Dependent On Ultimate Winners — Liquid Hedge Funds with Domain Expertise Can Take Advantage of Short and Medium Term Opportunities

Traditionally, investments in early stage technology were the exclusive purview of closed-end venture capital funds. These venture capitalist funds are only successful when a number of portfolio companies emerge as commercially viable public companies or have an alternative exit like a merger or acquisition. Talented venture capitalists must pick some of the ultimate winners.

There are a number of venture capitalists who are able to do so. However, we think that we are in a relatively early stage of the development of commercially viable blockchain-based businesses. At such an early stage, we think it is even more difficult to pick winners and do so within a reasonable time horizon. Development is slow. It will take time before large swaths of the economy become digitized on blockchain rails.

And in that time, these early stage companies will have to advance from a seed stage, though a number of rounds of private financings and then have to cross the proverbial startup “valley of death” in order to emerge as a commercially viable entity. Most will fail. A few will emerge from the valley of death with technologies or products that are commercially viable and deployable on mass scale. These few will reap tremendous returns as they engage in capital market transactions to realize that value, be it public offerings or other capital market exits.

Hedge funds that trade liquid tokens across a spectrum of investment strategies are able to provide exposure to the digital asset and blockchain sector without having to pick the few winners that emerge as the standard bearers for the sector.

To be clear, these hedge fund managers must still be research-focused and immersed in early stage blockchain technologies. Fundamental-driven managers will use bottom-up research and on- and off-chain analysis as well as top down secular, macro and regulatory analysis to find high growth projects. But they can invest in attractive technologies at early stages and reap the rewards from asset appreciation without having to remain in the trade until it reaches exit velocity. Actively managed hedge fund vehicles can improve upon the normalized venture capital distribution of returns by trading in and out of companies at varying stages of maturity and development.

Additionally, trading-driven hedge fund managers can take advantage of structural inefficiencies in the digital asset markets and enhance the risk-adjusted returns of a diversified portfolio. The digital asset markets are at an early stage of development. The market structure is developing in real time. Investors face fragmented liquidity across exchanges, counterparty management challenges and custody constraints. Speculative capital flows create wider trading spreads and arbitrage opportunities.

We think that managers who port arbitrage and trading strategies from traditional financial markets to the nascent and inefficient digital asset markets offer investors additional avenues for investment return. Arbitrage, trend following and other quantitative strategies allow investors to blend the risk profile of their investments and shift away from long-biased strategies during market downturns to protect capital in bear markets.

We think that hedge funds offer investment strategies that can prove successful without having to pick the technologies, protocols and companies that will ultimately run digital commerce and finance, offering attractive risk-adjusted exposure to the opportunity in digital assets and blockchain technology .

Attractive Investment Opportunity — Liquid Hedge Fund Exposure to “Crypto Investment Opportunity”

In sum, we remain bullish across the entire spectrum of investments in the digital asset and blockchain sector. We want to highlight the attractiveness of gaining exposure to the sector through actively managed hedge fund vehicles. Such managers offer investment opportunities driven by the underlying technological innovation though in a transparent, liquid and capital efficient manner that does not demand picking the ultimate winners in the crypto arms race — only the interim winners and losers. Hedge fund managers can also offer investment opportunities driven by the structural inefficiencies embedded in nascent and emerging markets in order to gain diversified exposure to the sector and use the liquidity of public markets to protect capital in downturns.

We think “zero” is the wrong allocation to the digital asset sector. A multi-strategy fund of hedge funds provides a single, simplified vehicle to gain diversified actively managed liquid exposure to the digital asset and blockchain sector and avail oneself of secular upside on the promise of a digital world.