Fair value– the term used by accountants to refer to the correct valuation of assets for financial reporting purposes — shouldn’t be taken at face value by fund managers or investors when comes to cryptoassets.
Anyone who comes to the table unprepared for a potential dispute is foolish as shown in a recent lawsuit involving Polychain Capital, the US’ largest cryptofund manager. Despite making a killing on his investment, an investor sued Polychain asking for more information on the grounds that some of the assets were not valued correctly. Polychain did win the case, but only after a year of litigation.
Although nothing prevents disgruntled investors from suing a mutual fund complex on similar grounds, the risk is far higher for cryptoassets because of their huge liquidity, potential illiquidity, and lack of established valuation standards. Accounting experts compare the task to sticking a square through a round hole. How easy it will be all depends on the size of each. The more illiquid the cryptoasset the more subjectivity comes into play and the higher the potential for a disagreement between the fund and the investor and potential litigation.
“Investors can’t be certain fund managers are valung their assets correctly and fund managers can’t be certain investors will be satisfied with their efforts,” says Gregory Ewing, a partner with CKR Law in Washington DC specializing in cryptoasset regulation. “These [cryptoassets] are entirely new asset classes that require fund managers and investors to apply old rules in new ways or to collaborate in new ways to find new rules that work better.
Although there are numerous theories for how cryptoassets must be valued, they are focused on when or whether an investor should buy a cryptocurrency or other asset. When it comes to financial reporting requirements, fair value accounting standards must be applied to cryptoassets even if they don’t appear to always meet the strict definition of a financial instrument.
The term fair value is defined as the “exit” price or the investor could receive at the time of sale in an orderly market. How accountants determine that valuation depends on which one of of three classes the asset falls under — Level One, Level Two and Level Three. As a rule of thumb, liquid exchange-traded assets fall under Level One because they have reliable observable inputs. Semi-liquid or illiquid assets fall either under Level Two or Level Three. Using the Level Two categorization allows a fund manager to extrapolate a price based on comparable assets, while Level Three requires working with proprietary pricing models because there is either little to no liquidity and no comparisons to similar assets can be drawn.
Cryptocurrencies such as Bitcoin, would likely fall under Level One assets while security tokens fall under Level Two or even three. Yet despite their liquidity, cryptocurrencies aren’t all that easy to price. “Fund managers can’t simply take the closing price at an exchange, because there is no single exchange and no closing price,” says John Ward, managing director and head of operational due diligence in New York for Duff & Phelps, a global financial services consultancy.
Cryptomarkets are highly fragmented with cryptocurencies trading on hundreds of exchanges that are open 24-by-7. Such a scenario leaves fund managers to use varying methodologies. “Fund managers might rely on the average price at a given time using a crypto-industry accepted pricing service,” says Ashok Goyal, audit partner at Berkower LLC, an accounting firm in Iselin, New Jersey specializing in cryptofund managers. “Alternatively, in certain limited circumstances, fund managers might use a single price on the exchange on which they do the most trading.” CoinMarketCap appears to be the predominant source of cryptocurrency prices relying on a volume-weighted average price based on real-time prices from multiple crypto-exchanges.
Which approach is right is anyone’s guess. “The difference between using an average price and a single price depends on the market’s volatility,” says Ignacio Griego, audit partner specializing in alternative investment funds for global financial services consultancy BDO US in San Francisco. “There could be a minimal or a major discrepancy between an average price or a single exchange price.”
Lukka, a New York-based middle and back office technology provider for cryptofunds formerly known as Libra Tech, says that it has come up with a proprietary methodology for valuing cryptoassets that is far better than relying on an average price, the most common approach. Instead, Lukka’s new pricing feed Lukka Prime, will rely on identifying the principal market on which cryptocurrency trades — a stance which it says allows the fund manager to meet fair value acounting requirements. “Average pricing does not meet the US’ Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS), primarily because one cannot actually trade at that price,” says Jake Benson, chief executive of Lukka. US and global accounting standards have been converging for over a decade to become comparable in many instances.
To determine the principal market on which a cryptocurrency trades, Lukka blends qualitative and quantitative criteria in a complex mathematical formula. The firm then uses the last price from the principal market. The quantitative factors include the exchange’s jurisdiction, level of regulation, whether it has anti-manipulation procedures in place and whether it has robust anti-money laundering and know your customer procedures. The quantitative criteria include at volume, liquidity, and average bid-ask spread. (A full explanation of Lukka’s five step methodology can be found in its white paper entitled “Cryptocurrency Pricing for Financial and Tax Reporting”).
It has yet to be determined how popular the proprietary methodology, now in preview mode, will be. A fund administrator could decide using such a methodology will be a competitive selling point or it might want to eliminate all legal liability for any errors by taking the easy way out. Truly independent pricing comes with some risk.
“It’s in the fund manager’s best interest to hire fund administrators to reassure investors they have an idependent source, but fund administrators might decide to use the fund manager’s price to strike the NAV or follow the fund manager’s methodology rather than do their own work,” says Wulf Kaal, a cyberfinance and alternative funds professor at the University of St. Thomas Law School in Minneapolis. Several cryptofund administrators contacted by FinOps Report either did not respond to calls seeking comment or would not discuss their methodologies. Attorneys specializing in cryptofunds say they either don’t know or can’t disclose how specific fund administrators operate.
Polychain Capital found out the hard way that using both a fund administrator and an audit didn’t make it immune to investor gripes. Neither did generating good performance. One of its investors Harry Greenhouse earned over a 2,000 percent return on his investment when he redeemed in January 2018, but that apparently wasn’t good enough for him. In March 2018 he sued in Delaware Chancery Court to access the records on Polychain’s holdings, expenses and methods for valuation alleging that some assets had been improperly valued. The non-jury trial court decides on administrative law cases involving Delaware incorporated firms. Polychain is incorporated in Delaware.
Although the Delaware Chancery Court ruled against Greenhouse earlier this year, it was only on the grounds that he had cashed out. Hence, he had no legal standing to ask for further information. The court denied Greenhouse’s claim that because of the Polychain fund’s five percent audit holdback he remained a partner. Instead, it said he had rights only as a creditor.
Here is Greenhouse’s account of events which cannot be independently verified and is disputed by Polychain. According to Greenhouse, an employee of Polychain told him that 15 percent of the fund’s assets were illiquid and could be valued at cost upon redemption. Yet another employee subsequently informed Greenhouse that the firm had achieved sufficient investor consent to create a side pocket with illiquid assets to be excluded from redemptions until they became more liquid leading to a higher valuation. Those illiquid assets, which took up a significant component of the portfolio, included SAFTs, or Simple Agreements for Future Tokens. Founded by Olaf Carlson-Wee, the first employee of Coinbase, Polychain is considered to be along the earliest funds to invest in crypto-tokens back in 2016.i
When Greenhouse asked to redeem his stake he was told that he would receive a valuation at cost and would not benefit from the potential higher valuation. Greenhouse then asked to suspend his redemption and demanded further information on the composition of the portfolio including the valuation policies. He was denied both. Polychain argued he wasn’t entitled to more data because it was highly confidential and he could use the information for a competing investment fund he created. What’s more, countered Polychain, Greenhouse had already received a detailed auditor’s report for the year in question produced by Cleveland- headquartered Cohen & Co. which “independently” verified Polychain’ valuation and methodology. The fund also used Denver-headquartered MG Stover as its “independent” fund administrator.
Neither Cohen & Co, nor MG Stover were named as a defendant in the Greenhouse’s suit. Cohen & Co’s website indicates that the firm offers auditing services for over 100 cryptocurrency funds, while MG Stover’s webite says it is a full-service fund administrator specializing in alternative investments.
Unlike Bitcoins or other cryptocurrencies which trade on exchanges, SAFTs don’t. They are hard to price illiquid assets because there is no certainly over whether a company will actually issue the tokens. They allow a company to presell tokens before they are issued to develop blockchain applications or products and deliver the tokens at a future date.
Given the difficulty of pricing such illiquid cryptoassets traders tell FinOps Report that it is unclear how much of their own work either Cohen & Co or MG Stover did to confirm Polychain’s valuation. Cohen & Co declined to comment and MG Stover did not return calls seeking comment. Some cryptofund auditors tell FinOps Report that they typically do reprice liquid cryptoassets– such as cryptocurrencies– on their own. However, when it comes to semi-liquid or illiquid assets they might simply review the valuation memos and assess whether the methodology provided by the underlying fund manager is reasonable.
It is also unclear how much information Polychain disclosed on its pricing methodology. The firm insists it provides lengthy descriptions of its valuation methodologies including a breakdown of different valuation approaches to its digital asset classes. Presumably, Polychain also provides plenty of wording indicating the high risk of investing in cryptofunds.
Whether Polychain would have won its case had Greenhouse not redeemed his stake in its fund is debatable. Polychain would ikely made the same arguments. What could Polychain have done differently? The firm would likely say nothing based on its account of events. Of course, such an explanation makes Greenhouse sound like nothing more than a greedy litigious investor.
Was he? At the very least Greenhouse was disgruntled enough to take his allegations to court, so the case does highlight another challenge involved for fund managers and clients invested in digital assets. So far institutional investors appear to have focused their hesitancy in investing in cryptoassets on whether a cottage industry of new relatively untested service providers meet the US Securities and Exchange Commission’s definition of qualified custodian for registered investment advisors. If so, can they really keep the cryptoassets safe from theft or loss and what happens if they don’t?
At the very least Greenhouse’s lawsuit should prompt both fund managers and investors in cryptoassets should pay just as much attention to valuation risks as they do custodial. For starters, valuation depends on liquidity which can vary depending on when a redemption is made. “Polychain might have been wiser in relying on a redemption policy which matched its portfolio composition,” says David Felsenthal, a partner in the law firm of Clifford Chance in New York. “On its Schedule D form with the SEC Polychain listed its fund Polychain Fund 1 as a hedge fund, but its portfolio composition — with 30 percent of assets in SAFTs — would make it more aligned with a venture capital fund which would customarily impose longer hold periods for investors.”
Investors also need to know how far they can go in asking for more information. Fund managers may want to raise their assets under management, particularly from institutional investors, but might not be too eager to give away the shop in return. “Investors need to understand their information rights and establish effective oversight to prevent style drift, over concentration and portfolio composition risks,” says Felsenthal. “Although not raised in Greenhouse’s complaint, Polychain’s admission that its investments in illiquid SAFTs had become much more significant raises the question of whether the substantial increase was consistent with the firm’s investment plan.”
According to Felsenthal, Polychain’s treatment of its porfolio composition as a trade secret may have hampered the ability of investors to monitor the fund’s fidelity to its investment objective. The fund’s investors only learned of the increase in the SAFT investments, because Polychain sought investor consent to create a side pocket.
If investors don’t cause trouble for cryptofund managers who don’t handle their valuations correctly, the SEC might. The agency has already given fair warning that fund managers must develop and implement policies and procedures to value digital assets, the same as they would for traditional. “Fund managers should amend their valuation pollcies to address digital asset valuation,” says Felsenthal.
That means cryptofund managers need to ensure they are clear about their valuation policies by asset class and present plenty of risk-based caveats for investors. The clearer they are — meaning the more information they provide–the more likely the investor is to fail in court when arguing it didn’t understand the pricing methodology.
“Following one’s written policies and procedures also helps,” says Duff & Phelps’ Ward. “So does having a valuation committee representing a cross-section of the portfolio manager, chief executive, traders, and third party fund administrators and auditors.”
How likely is a cryptofund manager to apply such rigorous valuation standards? It all depends. “There are plenty of cryptofunds run by former technologists or active traders who have no experience operating an actual business,” says Kaal. The SEC is also far less likely to catch a small cryptofund manager operating outside its radar if its size makes it exempt from registration. Most cryptofund managers aren’t registered. Therefore, it pays for investors to ask about just who else is on the operating team and their qualifications.
Ultimately, Investors need to do a bit more soul-searching before they invest in cryptofunds. “They must ask themselves whether they want to accept not only the potential price volatility, but also the fund manager’s explanation of how it values the assets and the exact roles of the administrator and auditor,” says Kaal. “It is unlikely the fund manager will show the terms of the third-party contracts, but it should be able to disclose what methodologies the administrator and auditor are using, if any, to value the assets themselves.” They could simply be accepting the fund manager’s prices or verifying it followed its methodology. That doesn’t mean the prices are accurate.
As is the case with all asset allocations, if an investor doesn’t think it is receiving a sufficient amount of information or is uncomfortable with the information it is receiving from a fund manager, it’s time to make another investment.