With the hedge fund industry booming
worldwide, Asian-based hedge fund managers
are exploring ways to access the huge
pool of potential investors in the United
States and other key financial centres
around the world. Largely driven by this
growing momentum, Asian-based hedge fund
managers are increasingly utilising master-feeder
structures to establish a product that
is attractive to international investors,
thereby significantly widening their target
investor base beyond the traditional Asian
What is a Master-Feeder Fund Structure?
A master-feeder fund structure is commonly used to pool investments by US taxable, US tax-exempt and non-US investors into one central vehicle – the master fund – in order to enhance the critical mass of tradable assets, improve the economies of scale under which the fund operates and invests and enhance operational efficiencies. The use of a master-feeder fund structure has the benefit of providing a familiar investment vehicle for each class of investor in the fund while at the same time providing for the aggregation at the master-fund level of the funds invested, thereby increasing scale and reducing costs.
A typical master-feeder fund structure involves the use of a master fund company, limited partnership or unit trust that is established in a tax-neutral offshore jurisdiction such as the Cayman Islands or Bermuda. Separate and distinct 'feeder' funds invest in the master fund. Each feeder fund is established to facilitate tax effective treatment for the various classes of investor who will invest in the fund.
US taxable investors can take advantage of investing in a feeder fund that is treated as a 'pass-through' vehicle for US federal taxation purposes (ie no tax is levied at the entity level) and is therefore tax effective for such US taxable investors for the following key reasons:
- It enables a pass-through of capital
gains and losses, allowing individuals
to enjoy more favourable rates of tax
on any capital gains.
- The arrangement can be structured to
ensure that there are no tax reporting
obligations in non-US jurisdictions.
- Any exposure to 'phantom' income can
be minimised. This relates to the potential
allocation of profits to an investor that
is required to be included in the investor's
taxable income notwithstanding that cash
has not been received.
- The arrangement can be structured to
ensure that there is no tax on gains in
non-US jurisdictions. If such taxes are
incurred, the investor should be able
to credit these taxes against any US tax
on the gain.
Non-US and US tax-exempt investors subscribe via a separate offshore feeder company that acts as a blocker for US tax purposes. This has the advantage of ensuring that such investors avoid coming directly within the US tax regulatory net applicable to US taxable investors.
The Key Tax Advantages of a Master-Feeder Fund Structure
By using separate feeder funds that have a particular characterisation for US federal tax purposes, the tax impact of an investment in the fund for US taxable investors, non-US and US tax-exempt investors is minimised, without the presence of one class of investor prejudicing the tax status of other classes of investor in the fund.
In a typical master-feeder fund structure, if the master fund is structured as a limited partnership or a unit trust, it will be treated as a partnership (and therefore as a pass-through vehicle) for US tax purposes. However, the structure provides the flexibility to structure the master fund as an offshore corporation that may elect to be treated as a partnership for US federal tax purposes by making what is commonly referred to as a 'check the box' election by way of a simple filing with the US Inland Revenue Service.
US taxable investors elect to invest in a feeder fund that is a pass-through vehicle because it is taxable as a partnership and avoids their investment being considered, for US tax purposes, as an investment in a passive foreign investment company (PFIC). Investors in PFICs are subject to a significantly more onerous tax regime under US law, and therefore, investments that are structured as PFICs are largely unattractive to US taxable investors.
US tax-exempt investors and non-US investors will ideally elect to invest through an offshore feeder fund that is not liable to US tax. US tax-exempt investors often prefer to structure their investment through an offshore corporation compared with an offshore limited partnership. This is because the latter may cause such investors to be liable to unrelated business taxable income (UBTI) that may be passed through a vehicle that is taxed for US purposes as a partnership (such as the master fund or US feeder fund) to the tax-exempt investor in certain circumstances. Liability to UBTI is of particular concern to US tax-exempt investors, where the investment strategy of the fund involves the use of leverage, since the definition of UBTI includes income received from 'debt-financed property', which may in turn lead to an adverse tax result for the particular investor.
A significant advantage of a master-feeder fund structure is that additional feeder funds may easily be added to invest through the master fund. These may be structured to facilitate investment by investors in other jurisdictions that the fund manager may wish to target. For example, Japanese investors are very familiar with, and obtain an optimal Japanese tax and regulatory result from, investment funds structured as unit trusts. Accordingly, a unit trust domiciled in a tax-neutral jurisdiction such as the Cayman Islands may be established as a feeder fund for Japanese investors.
The feeder funds invest all of their assets (which essentially comprise investors' funds less the operating and administrative costs of the feeder fund) in the master fund, which in turn conducts all trading activity. Through their investments in the master fund, the feeder funds participate in the profits of the master fund on a pro-rata basis, in proportion to the amount invested in the master fund.
Management and performance fees may be paid at either the level of the feeder funds or the master fund, providing a further element of flexibility for fund managers in the structure.
Ten Good Reasons to use a Master-Feeder Fund Structure
- The principal advantage of adopting
a master-feeder fund structure for a hedge
fund is that it allows US taxable investors
to invest in an offshore hedge fund in
a tax-efficient manner that does not compromise
the tax position of other non-US or US
- A hedge fund manager will also be much
better placed to increase the critical
mass of funds under management and thereby
obtain and maintain credit lines and enhance
the fund's ability to meet asset size-based
investment qualifying tests.
- By adopting a structure that can target
a much broader investor base and increase
the tradable scale of assets under management,
the hedge fund manager can generally increase
its fees (which are typically charged
on an annual basis as a percentage of
the net asset value of the fund or of
the net capital gain of the fund).
- A master-feeder fund structure assists
in eliminating performance differences
between the various feeder funds by pooling
assets from the different classes of investors
into the same master fund for investment.
- The structure can also drive further
efficiencies in the manner in which investments
are made since only a single trading entity
(being the master fund) is used. This
avoids the need for the investment manager
to split tickets or engage in 're-balancing'
trades as between parallel or 'side-by-side'
- A master feeder structure eliminates
the need to enter into duplicated agreements
with counterparties, which reduces costs
in the longer term.
- Similarly, the pooling of assets at
the master fund level creates greater
economies of scale in the day-to-day management
and administration of the fund and its
portfolios, generally leading to lower
operational and transaction costs. For
example, only a single set of risk management
reports and other analyses need be undertaken
at the master fund level.
- Master-feeder fund structures can be
extremely flexible. The structure can
be employed equally for single-strategy
hedge funds as well as umbrella structures
employing multiple investment strategies.
The master fund may be incorporated offshore
as a segregated 'portfolio' or 'cell'
company in which the assets and liabilities
of each portfolio of the master fund are
legally segregated from other portfolios
thus facilitating a multi-strategy approach
through the use of a single master fund
- An alternative approach is to establish
separate special purpose trading vehicles
that are owned by the master fund, through
which the different investment strategies
may be traded, thus segregating the liabilities
associated with each separate class and
strategy of the master fund from others.
This structure also allows for the appointment
of sub-managers having specific expertise,
to manage the investments of each such
segregated portfolio or special purpose
- Flexibility is also maximised at the investor level, since multiple feeder funds, including feeder funds that may issue different classes of securities or interests to investors, can be introduced to feed into the master fund, catering for different classes of investors by adopting tailored operating currencies, fees, subscription terms and investment strategies.
From February 2006, a non-US-based hedge fund manager that advises 'private funds' having in total more than 14 investors that are US persons will need to register as an 'investment adviser' with the Securities and Exchange Commission (SEC) pursuant to new rules published by the SEC (Rules) under the US Investment Advisers Act of 1940 (IA Act).
The definition of private fund in the Rules includes non-US domiciled hedge funds that permit investors to redeem their interests in the funds within two years of purchasing such interests, and in which interests have been offered based on the investment advisory skills, ability and expertise of the relevant adviser. Accordingly, non-US based hedge fund managers that advise hedge funds that do not subject investors to a lock-in period of at least two years from the date of investment, and in which a total of more than 14 US investors invest, will be required to register as investment advisers under the IA Act.
The Rules require non-US based hedge fund managers to count the number of US investors that own interests in private funds that the fund manager manages, in order to determine the number of US clients the manager advises for investment adviser registration purposes. In this regard:
- A manager that manages individual accounts
directly must count these clients as well
as clients recognised through the look-through
approach for private funds.
- If the private fund is US based and
the manager is counting investors in the
fund, the fund itself will not be treated
as a client.
- The manager itself need not be counted when assessing the number of US clients.
If a non-US adviser has its principal office and place of business outside the US and the private funds it advises are organised or incorporated under the laws of a country other than the US, then the non-US adviser need not look through the funds to its ultimate investors for the purposes determining its compliance obligations under the IA Act. The limited compliance obligations imposed on a registered non-US adviser that advises only offshore funds are commonly referred to as the Compliance Light Regime.
It is unclear what the implications of the above Rule will be for a registered non-US adviser that advises a private fund that incorporates a complex master-feeder fund structure involving the use of an entity that is organised or incorporated under US law (such as a Delaware limited liability company or limited partnership). Both the Rules and the SEC's Guidance Notes issued in connection with the Rules are silent as to whether the use of a US domiciled feeder fund in a typical master-feeder fund structure will cause a registered non-US adviser to have to comply with the full range of regulations under the IA Act, on the basis that the US feeder fund is not organised or incorporated under the laws of a country other than the US. No further written guidance on this issue or clarification of the scope of the Rule has been issued by the SEC to date.
Asian-based hedge fund managers must therefore carefully consider the proposed domicile of any US feeder fund in a master-feeder fund structure in order to minimise the possibility that the manager, if proposing to register as an investment adviser with the SEC, could be subject to the full panoply of compliance obligations applicable to advisers that advise US-domiciled funds and clients.
Options that Asian-based hedge fund managers may consider include the following:
- If a US-domiciled feeder structure
is preferred, provide for management and
performance fees to be paid to the fund
manager at the master fund level and not
at the feeder fund level and amend the
terms of the US feeder fund to ensure
that such fund acts only as a feeder fund
to 'channel' investments into an offshore
master fund. All trading, and therefore
'advisory' activities would be conducted
only at the master fund level, and this
would ensure that the US feeder fund should
not be considered to be an advisory 'client'
of the non-US adviser for the purposes
of the Rules and the IA Act; or
- Establish the US feeder fund in a tax
neutral jurisdiction (such as the Cayman
Islands) as a vehicle that will be treated
as pass-through for US federal tax purposes.
The advantage of this approach is that
for the purposes of the Rules, the registered
non-US adviser manages only non-US "private
funds", and would therefore be subject
only to the Compliance Light Regime applicable
to offshore advisers.
Significant opportunities exist for Asian-based managers to access the global capital markets in a regulatory and tax efficient manner, provided that appropriate structures are planned and implemented with particular regard to the likely investor base the manager proposes to target for its funds. Adopting a master-feeder fund structure can afford hedge fund managers with access to both US taxable and non-US investors, a high degree of flexibility and efficiency in the management and operation of the fund, while minimising the compliance obligations of the manager under relevant investment advisory regulations in the US. While careful planning is required, the structure is ultimately designed to facilitate and maximise the potential for growth in assets under management in a manner than transcends regional regulatory barriers to facilitate access to the global capital markets.
Fig 1: TYPICAL MASTER
FEEDER FUND STRUCTURE