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  • Writer's pictureMichael Schwartz

Hedge Funds Provide Compelling Exposure to Digital Assets Sector

Revisiting The "Crypto Investment Opportunity" – Liquid Hedge Funds Provide Compelling Exposure to the Sector


Michael Schwartz, CEO & Co-CIO, Arena Digital Capital Management, LLC

March 2024

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.


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