Pranav Kanade is a member of the Digital Assets investment team at VanEck. He serves as portfolio manager for the VanEck Digital Assets Alpha strategy.
Russ Alan Prince: What are some similarities and differences between liquid tokens and public equities?
Pranav Kanade: There are many types of tokens, so it is helpful to narrow down the focus to the ones that derive their intrinsic value from fees and cash flows. In that regard, these subsets of cash-flowing tokens are multi-purpose assets.
Like equities, they are a capital formation tool. While equities represent ownership in a business, these tokens represent ownership in decentralized networks and protocols. This ownership provides the token holder with a claim on future cash flows. While stocks only offer ownership, tokens are programmable to have utility. Often, this utility is designed to reward customers in novel ways to accelerate adoption, create loyalty, and increase engagement. Well-designed tokens blur the lines between owner and customer.
Prince: How do you value liquid tokens?
Kanade: We focus on two primary characteristics for the liquid token subset. First, they need to solve some critical problems for end-users who pay fees to use the product. Second, the fees generated should flow to the token holders with minimal value leakage. The most common way cash flows back to the token holders are via a staking/token supply burn process.
Let’s use Ethereum as an example. End users pay gas fees to use applications built on the Ethereum blockchain. Most of this fee is then used to burn the outstanding supply of Ethereum. In the month of October 2022, the Ethereum network generated about $95 million in fees. $75m of this $95m was used to burn the outstanding supply of Ethereum, while the remaining $20m was distributed to stakers who are those who agree to lock up their Ethereum tokens to secure the network. This burn component is similar to a share-buyback in the traditional equities world.
Our primary focus in this example would be to find a reasonable way to forecast future fees, as this will determine the amount of future Ethereum burned. We can then apply traditional valuation methodologies like a discounted cash flow analysis or multiple free cash flow to arrive at appropriate price targets for the underlying liquid token asset.
Like traditional equities, the underlying drivers of fees—revenue—vary based on the project. Similar to how the drivers of revenue growth for a healthcare stock differ from an oil and gas stock, the same holds true for tokens. We spend a lot of time understanding the true drivers of fees/revenue and finding good ways to query the blockchain to collect relevant data.
Companies file a 10-K and 10-Q periodically to disclose financials in the equities world. That doesn’t apply in the token world, as all this data is easily available on a live basis by querying the blockchain. We have a set of tools and internal resources that help us gather this relevant data. The result is a financial model where we forecast these drivers 5 to 7 years into the future and then apply a DCF-like analysis. We typically forecast three distinct scenarios: a downside case, a base case, and an upside case. We apply probabilities to these scenarios and arrive at an expected value. Tokens with the largest price vs. expected value deviations are where we develop most of our convicted views.
Prince: What are some benefits of allocating capital in the liquid token market vs. crypto venture capital?
Kanade: Unlike traditional markets where projects go from seed round which is illiquid to IPO which is liquid in about 6 years, token projects become liquid and tradeable in less than two years. Broadly speaking, there are two types of investment strategies within digital assets that focus on the illiquid/liquid life cycle. First are closed-end venture funds that primarily invest in illiquid seed and Series-A deals. The second is open-end liquid token strategies that invest in tradeable tokens.
Given the early-stage nature of liquid token assets, they exhibit high levels of price volatility when compared to public equities. As institutional investors have entered the digital assets space, they have been over-allocating to closed-end venture funds as a way to shy away from the market-to-market nature of liquid tokens. We believe this has reached extremes. According to Pitchbook, the median pre-money valuation for seed deals in the crypto space continued to rise through the first half of 2022 despite liquid token valuations correcting 80% to 90%. Liquid token valuations often set the exit valuations for these seed rounds. We need to see a meaningful appreciation in liquid token valuations to see good performance from these closed-end venture funds.
RUSS ALAN PRINCE is the Executive Director of Private Wealth magazine (pw-mag.com) and Chief Content Officer for High-Net-Worth Genius (hnwgenius.com). He consults with family offices, the wealthy, fast-tracking entrepreneurs, and select professionals.