(Bloomberg) -- Judging by a record Bitcoin rally that fueled a $1 trillion jump in the digital-asset market this year, crypto fever is back. But look beneath the surface to trends in venture capital and a far more sober picture emerges. 

While venture funds are rushing to try and raise cash, the limited partners they tap for money are wary of hype and mindful of the lessons of 2022. Back then, valuations collapsed alongside the implosion of crypto outfits such as hedge fund Three Arrows Capital and Sam Bankman-Fried’s fraudulent FTX exchange.

The shake out destroyed a big chunk of capital, and limited partners indicated in interviews that a slew of surviving venture investments have yet to pay out any gains even if valuations are improving on paper. Such a backdrop puts the onus on funds seeking fresh money to show why this time will be different.

“The toilet isn’t quite done flushing here in the crypto industry,” said Adam Jackson, co-founder of decentralized talent network Braintrust and an investor in over a dozen crypto funds. It’s “a bit of a struggle still” for digital-asset venture capital funds to raise money.

Funding Challenge

The challenging conditions for crypto venture capital are evident in data tracked by digital-asset financial services firm Galaxy Digital. Fundraising slid to $5.8 billion last year from $38 billion in 2022 and over $20 billion the year before.

The figures also show the significance of startup funding. Crypto venture capital firms had about $72 billion in assets under management at the end of 2023 — or over half of the money in all digital-asset portfolios. The percentage may have eased this year due to the assets amassed by US Bitcoin exchange-traded funds.

The successful debut of the ETFs and Bitcoin’s recent all-time high are only a sample of the developments the crypto industry is currently celebrating. The Berachain blockchain platform — whose pseudonymous founders have cartoon-bear avatars — just achieved a $69 million funding round that valued it at $1.5 billion. New York-based Hack VC is raising at least $100 million for a startup fund, having already brought in $150 million in February.

For all these isolated signs of success, the wider mood music among limited partners suggests crypto venture capital funds face a tough sell. Tim Grant, chief executive officer at Deus X Capital, a limited partner in four crypto funds, said the market appears “crowded” and that “differentiation is harder.”  

‘High’ Competition

Ray Hindi, managing partner at crypto venture capital company L1 Digital AG in Zurich, echoed the sentiment. L1 Digital manages $600 million across direct venture investments, a fund-of-funds and an open-ended fund-of-funds.

“Too many venture capital firms in the space are raising at the moment and the competition is really high, but the demand isn’t as strong as it once was, so they are struggling,” Hindi said.

Since venture funds often invest in both the equity and digital coins issued by startups, paper returns are looking much rosier courtesy of the latest digital-asset rally. Yet few have produced much in the way of actual payouts, which is increasingly a sticking point for limited partners.

A key metric for tracking payouts is distributed to paid-in capital or DPI, which tracks how much money limited partners get back from managers. This ratio for most of the funds set up in 2021 is sitting at zero, according to Saison Capital’s Chief of Staff Sharvin Baindur. The venture arm of Japan’s Credit Saison recently benchmarked the performance of such funds. Saison Capital has backed more than 20 funds, though not all are crypto-focused.

Fallout From 2021

“Your entry point here matters quite a lot,” said Braintrust’s Jackson, citing an investment in Polychain Capital from 2017 that’s now “way up.” But “if you allocated in 2021 and did your capital calls then, you’re not way up — you’re way down,” he said, referring to the peak of the pandemic-era crypto bull run.

Hindi’s L1 Digital has invested in 11 crypto funds, of which two have distributed capital. The first was set up in 2019 and has a DPI of 2.5, while the other from 2021 is at about 1.5. Hindi also stressed the vintage of a fund is a key factor, and that portfolios overweight in equity tend to take longer to return capital.

These days the pressure to produce tangible returns is mounting, according to Nicole Zhang, a partner at Lingfeng Innovation Fund, which set up a crypto fund in October 2022. “Our LPs expect us to deliver DPI by year-end,” Zhang said. 

The focus on payouts has put greater attention on liquid token funds, which also tap into crypto projects but via digital coins already trading on exchanges. Liquid funds are easier for investors to buy and sell, whereas venture funds have more illiquid holdings and are subject to lock-ups and vesting periods.

Galaxy Digital categorizes liquid token funds under a category called HF Fundamental, which accounted for $11.5 billion or about 8% of all the assets under management in digital-asset funds. Liquid funds overlap somewhat with crypto hedge funds, whose 76% gain over the past 12 months leads all hedge fund investment styles, based on the Bloomberg Hedge Fund Indices.

Hindi from L1 Digital is convinced that institutional investors are increasingly alive to the benefits of liquid — or open-ended — funds. “While the demand for open-ended structure is still somewhat timid, it will accelerate as investors start embracing the benefits of liquidity,” said Hindi. He also expects distributions by crypto venture funds to pick up to satisfy the demands of limited partners.

©2024 Bloomberg L.P.