How to make an awful tokenized fund that nobody will buy

You might think that being a fund manager is great work if you can get it. Managers that successfully raise funds from investors have the potential to make a lot of money, and also collect steady fees, without ever putting their Lambo payments at risk. However, insiders know that it’s a lot of work. So, it’s clever that most tokenized fund managers are making terrible offers that fail to attract investors. Read this article to learn the key points of offering bad funds that nobody will buy.

Don’t give the money back

The number one reason for making an investment is to get money back, in some sort of cash. That’s why professional PE investors tell their funds to return money to investors when they sell an asset. Their managers can’t hold on to money and earn fees for an unlimited number of years. That’s why retail investors buy mutual funds and ETFs and REITs, which all have requirements to distribute profits or redeem shares. Equity investments are perpetual, but they also come with governance that allows shareholders to apply pressure to distribute dividends or sell the company. In theory, if you never get money back, the value of the investment is zero. In practice, there are funds that are “closed end”, which don’t provide a normal way to redeem shares for cash, and these funds generally sell at a discount to their underlying asset value.

So, it’s inspiring to see that many tokenized funds start out by promising NOT to give money back. A winner in this category is Eviraesium, which advertises itself throughout as a “perpetual” real estate fund. “Perpetual” means that they don’t give money back. They draw inspiration from a long series of funds that were offered as “evergreen”, which means they don’t give money back, or what I would define as half-evergreen — they give back 50% of the money from each exit. Most of these funds also say that giving back money is optional. A typical clause says that they have a policy to pay dividends or buy back tokens, but only if the manager wants to.

Expect these funds to be worth less than their asset value

Charge high costs to your initial investors

When you collect money from the initial buyer of a fund, you often end up charging some direct costs. Selling an offer can cost 6% or more, so investors that put in $100 only get $94 worth of assets. There are also indirect costs that investors get stuck with. Closed end real estate funds typically trade at a 5% discount to underlying value (see the note above about discounts), so that’s another $5 in losses. Then, you hold investor money in a bank account earning 2% while you shop around for that juicy 10% yielding investment. Investors will probably lose another $4 in expected return while you do that.

Yo might also take a management share of 8% to 15%. In theory, this does not change the cost of the fund over the long term. You say that you will give up fees (such as 2% per year and 20% of profits) and trade it for the management share.

In practice, it gives buyers an excellent reason to dodge the initial offering, because initial offering buyers take an immediate hit to the value of their investment, and it can take years of returns to get back to breakeven.

Congratulations. These costs provide great reasons for investors to avoid buying your initial offering. Nobody wants to pay $100 to get $85.

Remove the investor’s legal rights

If investors are tired of watching a manager collect fees with no intention of giving any money back, they can often threaten legal action. That doesn’t need to be true in the tokenized world. In the tokenized world, you can attempt to sell tokens with very few legal rights, and you can try to sell tokens from a shell company that isn’t vulnerable to legal action. The Oscar in this category goes to Andra. They formed a VC fund in the Cayman Islands, which is a pretty good jurisdiction for investors. However, they tried to sell their token from a shell company in the British Virgin Islands. The sole purpose of this company was apparently to deposit the money in the Caymans, and disappear. Good job!

Make a tokenized investment that is worse than the underlying investment

I’ll give credit to Citivest.io for their comprehensive plan to degrade the value of a good real estate investment. If you look at their sister site, Citivest.com, you will find that they are offering to place investments into “real estate PE funds”. These are often good investments, and it looks like Citivest is doing a nice job for their direct investors, at a very reasonable cost. Naughty! They make up for this mistake over at Citivest.io, where they are pitching a token that strips away the attractive features of their direct fund investments. The token goes to a fund of funds, so investors would pay two levels of management fees. They don’t get the depreciation tax deductions of a real estate investment. And where the real estate PE funds pay investors when they get exits, the token buyers don’t get money back.

Bonuses for early investors

If you really want to tie yourself in knots, you can offer to give bonuses or discounts to early investors. Then, you have to persuade later investors to pay for these bonuses. For example, consider the initial design of the offer from VC fund BlueOcean. The game theory on this offer is amazingly bad. They proposed to sell the first 5M units with a 60% bonus, then the next 20M units with a 30% bonus, and then 75M more units. In this scenario, the first $1 invested with no bonus is only worth $0.70. The other 30% goes to pay off the bonus rounds. No rational investor will buy that unit. Even if there are 75M irrational investors, the non-bonus investors will get a maximum of $0.87 (after sales costs). Trust me, I have an applied math degree from Harvard. In a rational world, this round is capped at 25M units, with nobody to pay for bonuses. Those professional VC’s did a good job at making their round harder to close.

Fund managers will often argue that early investors are taking a risk and should get some compensation. That’s true for equity investments, but the opposite is true for funds. Early investors in a small fund get access to the best deals, and their returns can be degraded when the fund gets bigger and has to invest in riskier deals. It’s the MANAGER that benefits from getting the round started, and then adding more investment. Therefore, in a rational world, early investors would not get bonuses that are stolen from later investors. They would get rewarded with shares in the management company, or a share of management fees.

Create tax problems for your buyers

I have seen a number of funds that are set up as non-US companies (for example in the Caymans, or the UK). This is good for non-US investors, but it creates a major tax problem for US taxpayers. The tokens they sell can be classified by the IRS as a investments in a PFIC (Passive Foreign Investment Company). This can trigger very expensive extra taxes. Commendably, the funds don’t warn investors about this problem, and they often don’t intend to send annual P&L statements, which would allow PFIC buyers to avoid tax penalties. It’s great that they are helping their investors pay off the US deficit.

I’m sure you can think of more ways to shortchange your investors and make your fund unbuyable. Get creative! We might have to wait a long time before someone comes along and offers a good tokenized fund. Stay tuned for our ETF proposal, which fixes most of these problems.