Key considerations when establishing a VC digital asset fund
Establishing a venture capital (VC) digital asset fund can involve navigating a complex landscape of regulatory, operational and strategic considerations. As the digital asset market continues to evolve in the United Arab Emirates (UAE) and globally, fund managers must address key areas to ensure a successful fund launch. This article provides an overview of the key regulatory, legal and operational considerations for MENA-based fund managers seeking to establish their first VC digital asset fund1.
What is a VC digital asset fund?
A VC digital asset fund typically focuses on investments that have the potential for high growth within the digital asset and blockchain ecosystem.
The asset class is broad, and includes:
start-ups developing solutions relating to blockchain technologies or applications
decentralised finance (DeFi) services
NFTs (including digital art platforms and gaming apps)
digital exchanges
asset tokenisation
custody
Web3 projects
digital asset payments
compliance solutions
research and analytics.
A VC digital asset fund may invest in the equity shares alone of a target company, but an investment in the tokens of a target company or a related project is often also part of the total investment. Like other VC funds, VC digital asset funds typically look for businesses with strong teams, innovative technology, and a clear path to scalability and profitability.
In Q1 2024, venture capitalists invested USD2.49 billion (+29% QoQ) into cryptocurrency and blockchain-focused companies across 603 deals (+68% QoQ). About 80% of the capital was invested in early-stage companies, while 20% was invested into later-stage companies.
Key regulatory and legal considerations
Domicile
Several countries are actively competing to attract VC digital asset funds by creating flexible regulatory environments, offering tax incentives, and promoting innovation in the digital asset and technology sectors. Some of the main countries include the UAE, Singapore, Switzerland, the Cayman Islands, the Bahamas and Malta.
Choosing a domicile that offers favourable fund and digital assets regulations, tax neutrality and a stable political and legal environment is important, but investor preference is also critical. Some investors may prefer, or are required to invest in, funds domiciled in jurisdictions with a robust regulatory framework that provides additional transparency and investor protection, while other investors may prefer more flexible regulatory environments that enable the fund manager to adopt a wide range of investment strategies.
In the MENA region, the Dubai International Financial Centre (DIFC) and the Abu Dhabi Global Market (ADGM) have enacted regulatory frameworks to attract VC and digital asset funds. Both jurisdictions have their own independent legal systems and courts that are based on English common law. In the case of the ADGM, English common law is directly applicable.
The domicile of the fund can influence the ability to market and distribute the fund to different investor classes across jurisdictions. Although jurisdictions like the Cayman Islands and Singapore are very well established, ADGM and DIFC fund managers should note that only DIFC, ADGM and onshore UAE Securities and Commodities Authority (SCA) domiciled funds are eligible for registration under the UAE funds passporting framework allowing wider access to UAE professional investors on a private offering basis.
Regulatory compliance
One of the foremost considerations for a fund manager of a VC digital asset fund is regulatory compliance. Key considerations include matching the regulatory fund classification with the investment strategy of the fund and ensuring that any specific digital asset investment is acceptable to the regulator.
At the fund structuring stage, the fund manager must identify the core investment focus of the fund, risk management strategies and liquidity considerations. Will the fund only invest in equity and equity-like instruments of start-ups, or will it also invest in digital assets? If direct investments in digital assets form part of the investment strategy, will these assets only be a smaller component tangentially attached to the equity securities or constitute one of the main investment strategies of the fund? For example, gaming tokens may be attached to principal equity investments of a gaming fund and as such, may only be an incidental investment of the fund.
As mentioned above, the fund may pursue a combination of equity and digital asset investments. A DIFC or ADGM fund investing in start-ups may be, but is not required to be, classified as a VC fund. Both jurisdictions offer lighter touch regulatory regimes for VC funds compared to other types of investment funds and generally allow VC funds to invest in equity securities and investment tokens.
However, a right to receive utility tokens or payment tokens issued by a start-up, which don't provide equity participation in the profits and assets of the business, won't generally be a permissible investment for a DIFC or ADGM VC-classified fund. Where a VC fund classification doesn't allow the fund manager to implement the proposed investment strategy of the fund, the manager and legal counsel will consider an alternative fund classification.
To the extent that the fund’s investment strategy will include investing directly in digital assets, the fund manager should also note differences in regulatory approaches. For example, a DIFC fund can only invest in ‘recognised crypto tokens‘ which can be found on a list (which currently includes Bitcoin, Ethereum, Litecoin, Toncoin and Ripple) maintained by the Dubai Financial Services Authority (DFSA) on its website. This is unless the fund is a ‘Qualified Investor Fund’, in which case it may invest up to 30% of the gross asset value of the fund in crypto tokens that are not recognised crypto tokens, subject to complying with certain conditions.
In the ADGM, the Financial Services Regulatory Authority (FSRA) has a general power to determine virtual assets (including non-fiat virtual currencies) that will be permitted to be invested in by an ADGM fund. The ADGM Guidance – ‘Regulation of Virtual Asset Activities’ provides a list of key factors that the FSRA will consider in determining if a virtual asset meets the requirements of being an ‘accepted virtual asset’. Both the DFSA and FSRA wish to adopt a forward-thinking approach to regulation. Before the launch of a VC digital asset fund, we encourage the fund manager to meet with the regulator to provide an overview of the investment strategy of the fund.
Ensuring the fund complies with anti-money laundering (AML) regulations and counter-terrorism financing (CFT) regulations is also critical. The appointment of a third-party fund administrator will assist with compliance obligations imposed on a VC digital asset fund. Selecting an administrator with digital asset expertise becomes critical where the fund accepts subscriptions in digital assets (in-kind subscriptions) because this adds additional AML/CFT and valuation considerations.
Institutional investors will normally conduct enhanced business, operational and legal due diligence when considering an investment in a private digital asset fund, due to such funds being classified as higher risk in their internal investment policies. The fund manager’s appointment of reputable and experienced service providers will give reassurance to these investors.
Legal structure
Choosing the appropriate legal structure for the fund mainly involves liquidity considerations (whether it’s an open-ended vs closed-ended fund), investor preference and tax considerations such as tax transparency. To the extent that the fund’s assets will be illiquid (such as investments in early-stage companies), a closed-ended structure allows the fund manager to better manage the timing of the sale of the fund’s investments by prohibiting investor redemptions until the end of the term of the fund.
A limited partnership structure (often referred to as a GP/LP structure) is preferred by fund managers and investors for several reasons, primarily related to governance and operational flexibility, and tax transparency. This structure, widely accepted for DIFC and ADGM VC and private equity funds, allows for a contractual framework between the limited partners and the general partner that balances management control and investor protection. The GP/LP structure typically simplifies tax reporting and compliance for funds with an international investor base, given that income generated by the fund is typically treated as pass-through income for tax purposes.
Tax considerations
Engaging with professional advisers who specialise in fund formation and investment tax law is essential to navigating tax complexities and ensuring compliance with relevant regulations while minimising tax exposure for both the VC digital asset fund and its investors.
As mentioned above, the domicile and structure of the fund will be the key factors under consideration. At this time in the UAE, generally, a fund established as a limited partnership with no legal personality should not be subject to corporate income tax if it’s properly structured, while a company structure meeting the conditions of a 'Qualifying Investment Fund' may be exempt from corporate tax, subject to satisfying certain requirements.
A fund manager looking to accommodate the tax requirements of global investors may consider a master-feeder fund structure. In such a structure, all investors invest in one main master fund via feeder funds.
The structure generally involves the use of a master fund established in, for example, the Cayman Islands, with feeder funds established in the DIFC or ADGM for MENA investors, the Cayman Islands for US tax-exempt and most Asian investors, and Delaware for US taxable investors. A feeder fund may also be established in Luxembourg or Ireland for European investors.
Proper tax planning can enhance the fund's attractiveness to potential investors and improve overall investment returns.
Choosing a domicile that offers favourable regulations, tax neutrality, and a stable political environment is important, but investor preference is also critical. Some prefer jurisdictions with robust frameworks for transparency and protection, while others lean toward more flexible environments enabling wider investment strategies.
Operational and strategic considerations
Valuation
Investments in fast-growing sectors like the digital asset sector could result in increased price fluctuation in the valuation of the digital assets due to the rapid pace of product change and the development and changes in government regulations. Digital assets, whether considered mature or immature, are particularly volatile. Factors such as shifts in sentiment, economic circumstances, or even a single comment on social media can lead to significant fluctuations in market values, causing them to rise or drop sharply.
The valuation policies of a VC digital asset fund may therefore differ from those of a standard VC equity fund due to several factors including the nature of the assets being invested in, the regulatory landscape, and the specific methodologies used. For example, a DFSA-regulated fund manager of an ‘external fund’ such as a Cayman fund must conduct daily valuations of the fund’s investments in crypto tokens. VC digital asset funds must establish dynamic but clear valuation policies to ensure consistency and transparency.
The DFSA and FSRA expect the offering documents of an investment fund to disclose a summary of the valuation policy of the fund, including the valuation process of any special asset classes such as digital assets. Generally, disclosure obligations are ongoing, and given the rapidly developing market for digital assets, the fund manager is required to ensure that the valuation policies of a VC digital asset fund are adequate and up to date.
Custody and security
Where the investments of a VC fund include digital assets, the custody and safeguarding of these digital assets is critical. This can be achieved as a start by selecting reliable custodians and implementing robust security measures (including adequate key management and storage) which are essential to protecting against theft and fraud risks. Not all custodians have the expertise to handle digital assets, so fund managers must carefully evaluate potential partners.
Furthermore, ensuring that the fund's operational infrastructure can support secure transactions and storage is crucial. Both the DFSA and the FSRA have implemented custody rules for digital assets, including the regulator’s approval of any custodian holding digital assets on behalf of a fund domiciled in the DIFC or ADGM, as applicable. These rules are designed to create a regulatory framework that ensures the safekeeping and management of digital assets and aim to provide security for investors.
Investor relations and reporting
Building and maintaining strong relationships with investors is key to any investment fund's success. This involves regular communication, often at least quarterly for a digital asset fund, and transparent reporting on fund performance and market conditions. Any changes to the investment strategy of the fund should require investor consent. Clear and consistent communication helps build trust and ensures that investors are informed about the fund's activities and performance.
Conclusion
Like digital assets themselves, the regulatory landscape for digital asset funds is continually evolving.
Setting up a VC digital asset fund requires careful planning and consideration of various legal, regulatory and operational factors. It's advisable to work with legal and other professionals who specialise in fund formation, tax and digital asset investments to navigate the complexities and ensure compliance with all applicable laws and regulations.