Digital Assets Discussion: Crypto Special Situations and Dislocation Funds

In a follow-up to our recent podcast regarding stablecoins, in this Ropes & Gray podcast, asset management attorneys Melissa Bender, Glen Chen and Charlie Humphreville discuss what is happening more broadly in the crypto markets, including the decline in the price of bitcoin and other tokens, and the consequences of these trends on fundraising for crypto funds.

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Transcript:

Charlie: Welcome to this podcast in the Ropes & Gray crypto and blockchain series. Following up on our recent podcast discussing stablecoins, we thought it would make sense to talk a bit more about what is happening more broadly in the crypto markets. It been a tumultuous few weeks and as of the date of this recording the price of bitcoin has fallen below $20,000 for the first time since December of 2020. The decline in the price of bitcoin and other tokens has put increasing pressure on other parts of the market as well.  In today’s podcast, we’ll explore the consequences of these trends on fundraising for crypto funds. I’m Charlie Humphreville, a counsel affiliated with the firm’s Boston office. I’m joined by Glen Chen, counsel in our LA office, and Melissa Bender, a partner in San Francisco. We’re all members of the firm’s asset management practice and work in the crypto and blockchain space. Glen, do you want to kick things off by providing a bit more color about what’s been happening in the market more broadly?

Glen: In particular, bitcoin miners that took out large loans to purchase new mining hardware are feeling squeezed in terms of their ability to obtain sufficient returns from their mining activities to service the debt. Similarly, crypto exchanges have been under pressure as retail and other investors take a giant step away from digital assets. Declining trading activities have translated into severe contraction of these businesses, as evidenced by Coinbase’s recent determination to lay off nearly a fifth of its workforce. Similarly, Celsius – a platform that offers products which allow customers to earn interest on cryptocurrency deposits similar to a bank – has been plagued by the inability to meet withdrawals due to liquidity constraints associated with its underlying investments. Celsius has retained advisers to assist with a workout. BlockFi, a similarly embattled platform offering yields on crypto, has turned to crypto exchange FTX for emergency financing in a market where other more traditional liquidity sources are severely limited. Some asset managers are also experiencing distress, such as crypto hedge fund Three Arrows, which had significant exposure to Terra. Three Arrows was recently forced into liquidation by courts in the British Virgin Islands. There is increasing concern that the Terra, Celsius, BlockFi and Three Arrows events may lead to broader market contagion.

Melissa: Notwithstanding that the future outlook has been dubbed a “crypto winter,” it’s not all doom and gloom. Investors in the crypto and blockchain space see opportunities in the midst of this turmoil and we’ve been fielding increasing inbound interest in putting together pools of capital to take advantage of the opportunities that are developing out of this turmoil. We thought we’d take a few minutes today to talk about special situation and dislocation funds and ways in which they may make an appearance in this market. As a starting point, it may be useful to provide some background about private funds that invest in crypto and what their structures have been to date. Charlie, would you mind providing a bit of context on this front?

Charlie: Sure. In general, digital assets-focused funds tend to be either closed-end, venture style funds with a fixed investment period and fund term or open-end, hedge fund-style funds permitting redemptions. One notable feature of closed-end crypto funds is that they tend to permit distributions in kind of liquid tokens in the same way that marketable securities may be distributed in a traditional venture-end fund. For open-end funds, unless the fund is going to be targeting exclusively highly liquid tokens, we often see fairly broad limitations on redemptions, including lock-ups, gates and side pockets. We’ve also seen increasing popularity of so-called “rolling” funds in the crypto space, which are closed-end funds that raise new pools of capital for investment on a quarterly basis. Crypto funds also tend to vary widely in their mandates, with some funds targeting a broad range of digital assets and investments in companies in the blockchain ecosystem while others are more targeted and may, for example, invest only in a single type of digital asset such as NFTs.

Glen: Great – thanks, Charlie. It’s worth noting that what we haven’t really seen to date, though, are funds that have been designed to invest in crypto and related assets where there are market events such as what we are seeing now. Many listeners may be familiar with traditional special situations or opportunities funds designed to capitalize on troubled industries and credit-constrained companies. These funds are often similar in structure to traditional or private equity or credits funds and have fixed investment periods and terms. In some cases they may have evergreen or hybrid structures, although this is relatively uncommon. Another, more recent, trend is contingent dislocation – or “trigger” – funds. These funds garnered particular attention during the 2020 market crisis brought on by the initial spread of COVID. A contingent dislocation fund fundraises in anticipation of a market event, which may be defined in different ways depending on the strategy. The fund is then “triggered” and the capital deployed when the market event occurs.

Melissa: It will be really interesting to see how these more traditional structures may be reinvented in the crypto and digital assets space. In many ways, the terms of the particular fund will be dictated by the underlying assets to be acquired. Managers that see opportunities in the depressed value of tokens may decide to structure a fund with more hedge fund-like terms and offering liquidity subject to gates or side pockets after an initial lock-up period. For truly distressed assets, though, managers may need to hold the asset for a period of years for the market to fully recover and will likely be better served by a closed-end structure with an investment period and fixed duration. Managers may even want to consider hybrid structures given that the assets acquired could vary so significantly and may consist of a mix of debt, equity and tokens. Another interesting wrinkle will be types of rights that managers are negotiating for when making investments in distressed assets in the crypto sector as there is no established market practice here. To the extent new debt is issued or existing debt is restructured, what features will it have? What will the security consist of with such an unusual asset base? There are particularly interesting issues arising from the fact that a significant portion of the crypto crisis involves assets that are subject to smart contracts where – by definition – the operation of those contracts may be difficult, if not impossible, to modify. Furthermore, with a decentralized asset there is no counterparty to negotiate with. No doubt the answer to these questions will also affect the terms of the funds being raised.

Glen: Thanks, Melissa. We’ll also plan to dig into some of these questions you’ve raised in another installment of this podcast series. That brings us to the end of the podcast. Charlie, Melissa and I appreciate you tuning in to this series. For more information on the topics that we’ve discussed today, other topics related to digital assets, or other similar topics of interest, please visit our Ropes & Gray website at ropesgray.com/cryptocurrency, where we have links to additional materials.

Charlie: And don’t hesitate to get in touch with one of us or whomever you have a working relationship with at Ropes & Gray. Finally, you can subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.