Forming Special Purpose Entities to Gain Exposure to Private Cryptocurrency FundsBy: Peter F. Cifichiello and Kenneth R. Earley
October 06, 2021
With the expansion of cryptocurrency and the opportunities to capitalize on its growth, there has been a recent flurry of sponsors looking to raise capital in order to launch private funds primarily focused on cryptocurrency positions. With many large institutional investors often dissuaded by its volatility, still taking a very “wait and see” approach to the cryptocurrency market, the door may be open for certain smaller private investors. Often these smaller private investors are interested in pooling capital; creating special purpose entities (“SPEs”), such as a limited liability company (“LLC”), and collectively investing right alongside larger investors in cryptocurrency focused private funds. This presents a fantastic avenue for these smaller scale investors to gain exposure to cryptocurrency in a manner that is normally reserved for larger institutional investors and family offices. Many private funds and their sponsors are willing to accept these types of investments, provided that the SPEs and their investors comply with certain regulatory requirements under which such funds operate.
What these small private investors should understand is that many new U.S. based cryptocurrency private funds are operating under certain exemptions from registration under the Investment Company Act of 1940 (the “1940 Act”). One common exemption appears under Section 3(c)(1) of the 1940 Act.
Certain smaller investors looking to invest in a private cryptocurrency fund through an SPE, like an LLC, will likely be doing so through a private fund relying on the Section 3(c)(1) exemption and, therefore, will not be able to circumvent the 100-beneficial owner limit under Section 3(c)(1). Quite the contrary, because these SPEs are formed specifically for the purpose of investing in the private cryptocurrency fund, they will be subject to a “look through” requirement meaning that, for purposes of complying with the 100-beneficial owner limit of Section 3(c)(1), the private cryptocurrency fund must “look through” a potential SPE investor to count all its underlying investors towards the investor limit. As an example, a group of 8 business associates (all of whom are accredited investors) are interested in forming an LLC to use as an SPE, within which to pool $500,000 in investment capital. The SPE is being formed to serve as a limited partner investor in a private fund focused on cryptocurrency, structured as a limited partnership, and operating under the Section 3(c)(1) exemption. To comply with the 100-beneficial owner limit of Section 3(c)1, the private fund is required to “look through” the SPE and count each of its 8 investors as 8 direct investors in the private fund. This is important because many private funds have minimum investment thresholds (e.g., $500,000). Therefore, smaller investors considering pooling funds and forming an SPE for private fund investment reasons would be prudent to target potential co-investors that can commit a significant portion of funds. This serves to maximize investment while, minimizing the number of investor slots used for purposes of the 100-beneficial owner limit of the private fund. Under these circumstances, your business colleague who has $200,000 in cash to commit towards the SPE is more desirable than your Uncle Louie looking to park $10,000 after a successful Vegas vacation. Sorry Uncle Louie.
When structuring an SPE to invest in a private cryptocurrency fund, understanding the regulatory constraints on the fund, is essential to targeting your investor pool and creating a structure that works for your investors, while maintaining good will with the private fund; helping it comply with its regulatory constraints. The proper advice and knowledge is essential for raising funds, and creating effective governance policies within your investment vehicles.