Crypto Asset Management: Expansion Roadmap for Managers and Investors (Part 1)

Asset managers who invest in crypto assets are expanding their footprint as managers of capital for investors. Investors are increasingly seeking out asset managers that have expertise in crypto assets. Likewise, crypto asset managers may seek to monetize a part of their revenue streams by partnering with established financial institutions or third parties seeking broader product offerings.

These partnerships can take numerous different forms—among them, acquisitions, minority investments, and revenue sharing agreements. Regardless of the form they take, a major focus of those discussions will be the valuation of the crypto asset management business itself. Unlike more traditional asset-management businesses catering to institutional or high-net-worth individuals, however, digital asset-intensive asset management firms will face a number of unique risks and valuation challenges.

In Part 1 of our series on deals in crypto asset management, we’ll take a look at these challenges and potential paths to managing them.

Valuation Challenges on Deal Structure and Terms

In any M&A transaction, valuing the target business and its expected revenues (or growth opportunities or synergies) is a primary focus. Acquirors and investment banks typically use models or market comparables to develop a price range as the starting point of any negotiation. In transactions involving digital asset managers, however, there are additional complications unique to this asset class.

Volatile Asset Values

Crypto asset prices – or more specifically, crypto-asset-to-fiat exchange rates – are inherently volatile. Sharp fluctuations in prices in short periods of time are common, and as a result, a snapshot of a portfolio valuation at any given time is unlikely to accurately reflect a manager’s long-term performance or the trends in the manager’s assets under management. Crypto asset prices can be highly sensitive to market events and regulatory developments or even political cycles, any of which can exacerbate the difficulties in developing pricing models for this asset class.

Valuation of Illiquid Assets

Aside from the volatility in crypto asset markets, asset managers investing in illiquid crypto assets will face challenges in determining asset valuations that will be agreeable to both parties. Due to lack of depth for certain crypto asset markets, it may not be possible to use a benchmark or market comparable to determine valuations. Unlike traditional securities markets, crypto assets do not have a sufficiently long track record where a model for asset values can be used as a proxy.

Client Withdrawals and Redemptions

Many firms managing portfolios of liquid crypto assets have faced—or may face—higher-than-usual rates of withdrawals, as some investors respond to global events or market news. Additionally, some asset managers of open-end private funds dealing with the challenges of valuing illiquid assets in the current environment have resorted to imposing gates or suspensions for redemptions. In those cases, large redemption queues may accumulate during periods where redemptions are limited or suspended, which could lead to eventual asset outflows that may also damage long-term relationships with investors and contribute to lack of confidence in the manager or the asset class.

These issues highlight the inherent challenges in assigning a value to crypto-focused asset management business. For example, asset managers that charge fees based on assets under management may have difficulties valuing crypto assets when calculating their fees. This in turn will make it challenging for a buyer to determine the revenue potential of a target business and to assess the risks associated with handling subscriptions and redemptions from clients and investors where the price is based on such valuations. For closed-ended funds that rely on exits, the volatility of crypto prices may make it difficult to predict the life cycle for realizing carried interest on long-dated investments. Similarly, the volatility of the asset class could make it harder to assess the growth potential of a particular asset manager’s business.

Potential Tools for Managing the Valuation Challenges in Deals

These issues are likely to ripple through structures and deal terms for investments in, or acquisitions of, crypto-asset managers in the near future. Below, we summarize how traditional tools can be used by buyers and sellers to address the above challenges during the negotiation phase of the deal, as well as on a post-closing basis.

Earn-outs

Deferring some portion of the deal consideration through an earn-out—tied to certain performance metrics for the target business post-closing—is common practice in asset manager acquisitions. Depending on the nature of the target business, and the type of assets its clients or funds are invested in, earn-outs tend to be tied to changes over a certain time period after closing, using metrics such as AUM, run-rate revenues (“RRR”), profitability, or a combination of these factors. These metrics, in turn, are often based on complex calculations which may or may not account for factors such as client in-flows and outflows, market movements, or other changes in underlying asset values, or which may contemplate thresholds above or below which certain changes will not be taken into account. Considerations for earn-outs in crypto-asset management deals include:

• Deals may allocate more deal consideration to the earn-out than to an up-front payment. In addition, given the inherent volatility and lack of visibility in crypto asset markets, parties may be inclined to delay earn-outs over a longer period of time following the closing.
• At the same time, parties should be careful about the extent to which earn-out payments are tied to changes in asset values. Given the volatility in crypto asset prices—and the potential uncertainty in the values of illiquid crypto assets—metrics tied to client retention or flows, or RRR metrics that disregard changes in AUM based on market movements, may be preferable.
• Parties should be cautious when using metrics that take into account client out-flows if a manager has imposed limitations on withdrawals or redemptions. In those situations, any historical withdrawal/redemption rate may not reflect what may come when these restrictions are lifted.
• Parties should continue to focus on post-closing buyer covenants intended to support achievement of the earn-out metrics. Sellers will likely push for more control over decisions on matters such as rate changes or personnel moves that could affect the business given their increased “skin in the game.” At the same time, uncertainty about the future will likely compel buyers to insist on flexibility to manage the business as they deem appropriate as circumstances change.

Purchase Price Adjustments

Many of the issues likely to affect earn-out structuring may also come into play in negotiating purchase price adjustments. Purchase price adjustments in asset management transactions are often tied to, among other things, changes in the same kinds of metrics that are used to calculate earn-outs. Parties should be cautious about tying adjustments to calculations that will be overly influenced by changes in asset values. Changes in AUM, based on the significant volatility of liquid assets in the current environment, could give rise to surprises. In cases of businesses managing client accounts or assets invested in illiquid assets, the parties should be as prescriptive as possible about how those assets will be valued for purposes of the purchase price calculation, to the extent variations will be taken into account. Detailed methodologies, use of third-party valuation agents, and agreed-upon illustrative examples of their application will help avoid disputes.

Value-Based Closing Conditions

The challenges relating to asset-valuation and volatility and unpredictable client behavior in the current environment are likely to also lead parties to focus on closing conditions tied to financial metrics and client retention. These kinds of closing conditions often interrelate with purchase price adjustments. For example, a purchase price adjustment may have a limit or a collar, but the buyer may be able to invoke a closing condition that’s tied to a deterioration not captured by the purchase price adjustment in order to walk away from the deal. As with the considerations for earn-outs and purchase price adjustments, in the near term, parties may favor closing conditions tied to client retention and inflows or outflows, or to RRR or AUM metrics that disregard changes based on market movements or underlying asset values.

Wrapping Up

Bridging valuation gaps between buyers and sellers in deals is always one of the most challenging parts of a transaction. The tools outlined above can be valuable ways to narrow those gaps and help parties reach a mutually acceptable outcome.