Crypto GP, how to exit?

This article is sourced from Medium, authored by Hutt Capital, and compiled by the Suyuan Yuxin team.

Like this waterbird standing by the waterfall, Crypto VCs may also need to think about how to handle the surging liquid assets.

Compared to Crypto VCs, traditional VCs have a simpler portfolio management process. The decisions that GPs need to make basically revolve around how many deals each fund has, the initial check size, follow-on investments, and reserve strategies. For early-stage venture funds holding IPO projects, GPs also need to formulate strategies to see how to realize value when selling stocks in the public market after the IPO lock-up period (the period during which original shareholders must hold their stocks after the IPO).

After the IPO, GPs will consider four factors: the liquidity of the stocks, the number of shares held, the company's performance and valuation, and the fund's investment return rate. Some funds may occasionally buy more shares at or after the IPO, but the main focus is still on when and how to sell. Additionally, a listed company often hopes that its venture capitalists will gradually liquidate their original holdings after the IPO. This is because, by this time, the fund has likely held this company for several years, and not exiting will not create more value.

Making sound decisions regarding publicly held shares for early-stage funds is an essential cornerstone on the path to GP success. This is because an IPO usually signifies that a company has successfully borne fruit, while also indicating a substantial position. However, for a specific fund, the work GPs need to do regarding the number of shares held in the secondary market (if any) is relatively minimal. Generally, the only decision GPs need to make is the timing of the sale. At this point, there is no further need for reserve capital after the IPO. Therefore, managing listed positions is relatively straightforward, although sometimes fund performance may be affected.

For Crypto VCs, the benefits of revitalizing funds with poor liquidity through investments in crypto assets are evident, but portfolio management may also be more intricate. If the liquid assets held by Crypto VCs are essentially intertwined with various "early-stage" situations, the complexity increases. In such cases, Crypto VCs may encounter the following challenges and questions:

1. If Crypto VCs have achieved substantial returns on liquid assets but are still in the early stages, when should they start selling? How much should they sell?

• Should Crypto VCs maintain a buy-and-hold strategy, or manage liquid assets more actively during the holding period?
• If Crypto VCs sell early assets in the public market, will they face significant risks?

2. Should Crypto VCs liquidate underperforming early-stage crypto assets and reinvest in more promising opportunities?

3. How should Crypto VCs manage reserve capital?

4. Compared to traditional venture capital funds, the market for crypto assets changes more rapidly. Should the LPA (Limited Partnership Agreement) stipulate that Crypto VCs need to enhance their ability to recover distributions and reinvest capital?

5. If Crypto VCs primarily invest in crypto assets, should they shorten the fund's duration?

6. As long-term capital gains diminish, will the alignment between Crypto VCs and LPs be affected by carry taxation (mainly referring to the U.S.)?

1. When to sell? How much to sell?

GPs holding liquid assets should always be on high alert regarding how to help LPs realize value and when to do so. Some GPs have publicly stated that they have never sold any crypto assets in their funds. This may be to demonstrate their "contribution" to the overall market, or more likely to show that they can remain patient, unlike those who sell as soon as a token can be liquidated. Regardless, while some may appreciate their stance, if GPs are merely holding for the sake of holding, it is not a performance worth boasting about.

As we previously mentioned, "playing a long game in the venture capital world," Crypto VCs cannot focus solely on short-term profits in investment decisions while neglecting long-term impacts, whether for investment strategy or the fund's reputation.

There are two key points to consider regarding this issue: How should Crypto VCs handle the substantial returns they have already achieved on liquid assets that are still in the early stages: 1) derive the future risk/return profile of this investment from its current valuation, and 2) develop a long-term strategy that both LPs and founders will expect.

First, it is not difficult for Crypto VCs to make investment decisions based on risk/return profiles. Theoretically, GPs should decide whether to sell or continue holding based on future potential upside, risk conditions, and their conviction in the investment. From an investment outcome perspective, selling a portion in certain cases makes sense, as it can both reduce risk and retain future upside potential.

However, investment decisions must also be made in the appropriate context, so Crypto VCs need to consider the shared interests of long-term partners such as LPs and entrepreneurs.

LPs invest money with GPs, especially in emerging categories like cryptocurrencies and blockchain, primarily hoping for substantial returns over the long holding period. Such returns should far exceed the LPs' inherent benchmarks (usually public market equivalents or fixed annual target returns). LPs do not want their venture capital funds to become frequent short-term traders; instead, they hope to build a monument of venture capital returns, like funds that invested in Facebook, Uber, or Airbnb, bringing high net worth multiples to LPs.

Once a fund has liquidity, if it can achieve a 20x return on a crypto investment within 2 to 3 years, it would be considered a success. If further substantial appreciation seems unlikely, from a portfolio management perspective, it is also appropriate to realize some investments, but this alone does not lead to massive returns for the fund.

However, if GPs are highly confident in an investment, believing it has the potential to escalate from a 20x return to 100x or 1000x over the next 5 years or more, such outcomes can truly benefit the fund in the long run. LPs want GPs to invest in genuinely valuable opportunities, hitting a home run that brings 5-10x net capital returns for LPs.

All of this illustrates that if a venture capital fund holds liquid early-stage crypto assets and has already achieved substantial returns, it should be cautious not to sell too much of what will be more valuable in the future—for the best outcomes, LPs are willing to wait.

When deciding how to sell early liquid crypto assets, Crypto VCs also need to consider the entrepreneurs. Similar to traditional venture capital, entrepreneurs in the crypto industry hope to establish long-term partnerships with their venture capitalists, working together to create future visions.

If a traditional venture capital fund rushes to sell its equity in a startup after three to five years instead of waiting eight to ten years to exit, the fund's reputation as a business partner may suffer, affecting its ability to secure promising deals in the future. This is particularly evident when leading investors write large checks; in contrast, smaller funds that have not led rounds and only write small checks may be more flexible.

LPs investing in blockchain and Crypto VCs should also adhere to this principle and not sell prematurely just because they can. If Crypto VCs decide to sell their holdings immediately after the lock-up period, even if this investment decision may be made out of caution, they must not overlook the reputation within their own entrepreneurial circles and the impact on their ability to continuously generate returns across multiple funds.

2. If investments are poor, timely loss-cutting is necessary.

Venture capitalists often say that they spend too much time on struggling portfolios compared to the contributions of certain star projects to fund returns. This is natural, as once the best companies enter a rapid growth trajectory, they typically do not require much of the GP's time. However, if Crypto VCs could bypass this dilemma by selling underperforming assets, what would happen? If there seems to be no future for these underperforming assets, what if they invest time and funds elsewhere, such as putting a little money into the most promising projects in another fund?

From a purely investment perspective, doing so may be reasonable in certain cases, and funds holding liquid crypto assets should consider this, even if they are still in relatively early stages. However, as mentioned earlier, Crypto VCs must ensure that this aligns with the fund strategy agreed upon with LPs from the outset and does not damage their reputation among entrepreneurs, thereby affecting future deal flow and opportunities to access good projects.

LPs may not have much to say about this. According to Peter Thiel, the leader of the "PayPal Mafia," doubling down on the best companies is a prudent strategy aimed at maximizing long-term returns.

As for entrepreneurs, Crypto VCs will likely assess whether a quick sale would impact their reputation based on specific circumstances. But at least in some cases, Crypto VCs may be able to exit underperforming assets in a way that does not harm other values. If they were good partners and had low expectations for the investment, other entrepreneurs would not blame Crypto VCs for selling too early; if everyone likes this venture capital fund, it would have even less impact.

Thus, venture capital funds holding liquid crypto assets can consider selling those early assets they do not have high hopes for and reinvesting in other highly promising portfolio companies. This is not always the right approach, but at least it is worth considering.

To ensure investments are not harmed, GPs must learn to timely recover funds from failing crypto assets and double down on successful crypto assets to stand out in the competitive crypto investment market (this is easier said than done; Suyuan has already noted many successful practices, timely loss-cutting, aiming for hundredfold returns).

3. How should Crypto VCs manage reserve capital?

The concept of holding reserve capital is related to traditional financing methods for startups, where existing investors can continue to invest (entrepreneurs also hope that investors will continue to inject capital). Therefore, if you invest in Series A, you need to prepare a reserve fund in case you want or need to invest in Series B, C, and other subsequent rounds.

Generally speaking, venture capital firms may allocate 50% of their funds for initial investments and 50% for follow-on investments. Some investment firms do not raise additional funds, so for those that genuinely need reserve capital, subsequent investment amounts will generally exceed the initial investment amount.

For private crypto asset investments, there may be many private token trades before an asset can be publicly traded on an exchange, but the number of trades generally does not correspond to the number of financing rounds requiring reserve capital for the fund. Therefore, while future private trades may require some reserve capital, the reserve capital for Crypto VCs is no longer meant to support follow-on investments but to maximize the pure returns of the fund.

To adjust for the relatively low required reserve capital, Crypto VCs can consider three main approaches: 1) increase the initial check size and reduce reserve capital, 2) make more deals with the same initial check size and less reserve capital, or 3) maintain traditional reserve capital strategies. This is because GPs have the opportunity to use liquid assets to increase positions in certain crypto assets at attractive prices.

Option 3 may be a good choice. A smaller initial check size can reduce risk and prevent large checks from being wasted on companies that may not last long. Therefore, under the same conditions, issuing a larger initial check size is not advisable. Funds should not start making more deals just because they currently have the capacity to increase deal numbers. This could lead to excessive diversification in the portfolio, potentially reducing investment returns and diluting the impact of successful projects.

Overall, lower reserve capital will prevent venture capital funds from continuing to invest significantly in their best investments. In the future, Crypto VCs will have the opportunity to increase their holdings in early liquid assets through the public market, and if this is successful, it will bring higher returns to LPs.

So, one unresolved question is whether if venture capital funds liquidate certain early liquid crypto assets (whether fully or partially) and then recycle those funds into other investment opportunities, it would reduce the need for reserve capital to some extent? It is certainly possible, but ultimately, it cannot be guaranteed that crypto assets can be liquidated in the early stages, so Crypto VCs will still proceed with caution.

4. The ability to enhance recovery distributions and reinvest capital needs to be improved.

Regardless of the fund's intentions, the safest approach is to maintain maximum flexibility and not force GPs into more aggressive and energy-consuming portfolio management methods. Traditional venture capital funds can typically invest up to 110-120% of committed capital (by recovering already realized returns), while Crypto VCs need to continuously experiment to find the recovery ratio of realized returns that best matches their investment strategy.

For a fund that invests 100% in crypto assets, it can increase the reinvestment cap by an additional 20% (meaning if a fund has 50% invested in crypto assets, it can add another 10% to the reinvestment cap).

5. The fund's duration should not be shortened.

Even if Crypto VCs primarily invest in crypto assets, they should not shorten the fund's duration. Four to six years (assuming a two-year investment period within a six-year fund duration) is unlikely to provide sufficient time for seed and early-stage investments to mature fully, thereby continuously maximizing value and obtaining risk returns. Even if some investments can be liquidated, it does not mean GPs should sell at that time. Therefore, funds that shorten their duration due to investing in crypto assets will either exceed the initially stipulated timeframe or, in some cases, sell too early, leaving LPs with nothing to show for their money.

6. Will the extension of the holding period affect the consistency between LPs and GPs regarding carry?

In January 2018, the U.S. enacted a law requiring venture capital funds to hold investments for at least three years before GPs can receive carry. This means GPs must hold an investment for three years to earn carry. Previously, the holding period was one year.

This law clearly encourages various venture capital funds to hold assets for at least three years to facilitate the receipt of carry. For traditional venture capital funds, this change has little impact, as most investments—especially those that perform well and generate most of the carry—will require a holding period of over three years regardless.

However, for Crypto VCs, the ideal time to sell assets that can be liquidated more quickly may be shorter than three years, including those investments that bring substantial carry to GPs. In this case, GPs may be driven by tax considerations to hold assets longer than LPs. This also means that GPs may not actively manage liquid crypto assets unless the assets generating excess returns can bring in more carry, at least to offset tax changes. On the positive side, this should prevent Crypto VCs from frequently entering and exiting or wavering between various new liquid crypto assets.

In some cases, the lack of consistency between LPs and GPs may be an unsolvable issue, and Crypto VCs are likely well aware of how their carry will be taxed in various situations. LPs certainly hope that GPs will prioritize their interests, but LPs also need to think deeply to ensure that Crypto VCs recognize their interest alignment and do not let tax factors affect their investment pace, allowing GPs to manage the portfolio effectively and optimize returns.

7. Conclusion

In an era where the liquidity of crypto assets is continuously strong, there will not be a one-size-fits-all golden rule for portfolio management among Crypto VCs.

Gradually, some excellent specific practices will be uncovered, and those Crypto VCs that actively seek to leverage crypto asset liquidity to double their interests alongside LPs will achieve excess returns in the process.

In the traditional venture capital field, newly established funds often make portfolio management mistakes. Without foresight, many GPs in the blockchain and crypto world may stumble here and learn from the experience. It is crucial for Crypto VCs to consider these issues when establishing their funds. To ensure a sound fund structure and that GPs are thoughtful in their portfolio management methods, LPs should also cover these topics in their due diligence work.