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Is it Time to Revisit Your Hedge Fund Structure?

A typical “master-feeder” private investment funds structure uses a combination of corporate entities, including companies, limited partnerships and/or limited liability companies. Investment managers should consider the consequences associated with choosing one form instead of another early in the structuring process.

This article contemplates a structure that involves both US and Cayman Islands-domiciled “feeder funds” and suggests that, because of the enhanced complexity of Cayman Islands companies, it may be a good time to consider structuring a “master-feeder” fund solely using limited partnerships. Fur­thermore, this article will:

  • describe a typical “master-feeder” structure;
  • discuss the role of directors in Cayman Islands com­panies, which are frequently used as offshore feeder funds in “master-feeder” structures;
  • briefly discuss increased scrutiny and potential regula­tion of directors; and
  • suggest some advantages of a “master-feeder” struc­ture that does not employ directors.

Basic hedge fund structures

A “master-feeder” structure is used primarily by hedge fund managers to address investor tax and regulatory concerns, some of which are discussed below. In a typical structure, a master fund will be formed in a tax-efficient jurisdiction to serve as the primary trading vehicle. Investors invest in the master fund indirectly through a feeder fund that contributes all or substantially all of its assets to the master fund.

A few of the well-known advantages of a typical “master-feeder” structure include the following:

  • ease of trading — all investment assets and most counter-party and service agreements are held in and with one entity (i.e., the master fund);
  • fundraising flexibility — multiple feeder funds can be added to the structure to accommodate future inves­tors with different terms and conditions; and
  • tax and regulatory flexibility — multiple feeders can be added to accommodate the tax requirements of differ­ent classes of investors.

Potential disadvantages can include the cost of estab­lishing the entire structure, especially in the case of smaller hedge funds seeking a cost-efficient structure, as well as the accounting and administrative complexity involved in admin­istering a master fund with multiple feeders.

The choice of fund entities and jurisdictions is largely driven by regulatory and tax considerations (and investment managers should consult tax counsel early in the structuring process):

  • US Taxable Investors: Feeder funds established in the United States, or for investors that are already subject to the US federal income tax regime, typically will be established as entities that provide “flow-through” income tax treatment for US federal income tax purposes. In such case, both the US feeder fund and the master fund will not be subject to US federal income tax and each investor will be allocated its allo­cable share of the master fund’s gains, losses, income, deduc­tions and credit. The US feeder fund would typically be struc­tured as a Delaware limited partnership or Delaware limited liability company because each of these entities is treated as a “flow-through” entity for US federal income tax purposes (unless elected otherwise) and Delaware has proven itself to be a stable jurisdiction in which to conduct business.
  • Non-US Investors and US Tax-Exempt Investors: Non-US investors (to the extent they are not already subject to the US tax regime) typically will seek to avoid being subjected to US federal income tax on income that is “effectively connected” with the conduct of a trade or business in the United States and US tax-exempt investors typically will seek to avoid the potential US federal income tax consequences of recognizing “unrelated business taxable income”. Feeder funds offered primarily to these investors typically will be established in a non-US jurisdiction as an entity that is taxed (or elects to be taxed) as a corporation for US federal income tax purposes (where limiting the activities of the master fund to alleviate these concerns is not ideal or practical).

The Cayman Islands is a popular jurisdiction in which to establish both offshore feeder funds and offshore master funds, in part for a number of reasons:

  • entities formed in the Cayman Islands are generally not subject to Cayman Islands tax;
  • as with Delaware, the Cayman Islands is generally con­sidered to be a stable jurisdiction in which to conduct business and is familiar to both investors and to invest­ment managers; and
  • the jurisdiction boasts a robust network of service providers thereby facilitating fund establishment, ac­counting and administration.

For these and other reasons, hedge fund managers may prefer to use a Cayman Islands exempted company (which is governed by the Companies Law (2012 revision), a Company) as the offshore feeder fund in a “master-feeder” structure and a Cayman Islands exempted limited partnership (which is governed by the Exempted Limited Partnership Law (2012 revision), a Partnership) as the master fund. Note that, for off­shore funds, some managers may use Companies as master funds and Partnerships as offshore feeder funds. Other off­shore entities, such as trusts, are sometimes used but are con­sidered by many to be too expensive or legally rigid.

Under US federal income tax law, a Cayman Islands Part­nership (as well as many other types of non-US entities that are treated as “flow-through” entities for US federal income tax purposes) may file an election with the US Internal Revenue Service (a so-called “check-the-box” election) elect­ing to be treated as a corporation for US federal income tax purposes. A Cayman Islands Partnership that is treated as a corporation for US federal income tax purposes (i.e., by filing a “check-the-box” election) may prove, in certain situations, to be more efficient to use as an offshore feeder fund than a Cayman Islands Company. Alternatively, the investment manager may use Cayman Islands Partnerships (with no “check-the-box” elections) as the offshore master fund and offshore feeder fund and interpose an entity that is treated as a corporation for US federal income tax purposes between the offshore feeder fund and the master fund.

The role of Company Directors in a “master-feeder” structure

Companies are required to have directors (each, a Director) but investment managers, and indeed some Directors, may not understand the various legal obligations and duties associat­ed with the position. An affiliate of the investment manager typically holds the “management shares” of a Company used in a “master-feeder” structure; “management shares” gener­ally hold the power to appoint the Directors. Those Directors have a number of statutory duties (maintaining registers, certain reports and books of account, among others) and must approve certain actions taken by the Company. Direc­tors (in their role as Directors) do not manage the business or make investment decisions. This is because, in the context of a Company used in a hedge fund structure, the Company hires the investment manager to run the investment program and, in the management agreement with the investment manager, the Directors delegate to the investment manager all powers permissible under governing law.

The legal role of Directors is not ministerial, however, which investment managers should consider when appoint­ing them. Not all Director duties can be delegated to the in­vestment manager and Directors are subject to personal li­ability for a breach of certain fiduciary duties, which will be discussed below. Cayman Islands case law has established a number of principles relating to Directors’ fiduciary duties, perhaps the most pertinent of which is that Directors must act in what they bona fide consider to be the best interests of the Company.

This duty is owed to the Company itself, i.e. the offshore feeder fund, and not to subsidiary or affiliated entities and not necessarily to investors. In the context of a “master-feed­er” structure this means that Directors primarily consider the interests of the offshore feeder fund, when structured as a Company, and not those of the master fund or any other feeder fund. If the “master-feeder” structure uses a Company for both the offshore feeder fund and the master fund, then the master fund will have Directors whose duties are owed to it and not to the offshore feeder fund. Some fund com­plexes use the same Directors for the offshore feeder fund and the master fund, which may give rise to irreconcilable conflicts of interest.

In the case of hedge funds, Directors are typically one of two types: “insiders” (employees of or entities controlled by the investment manager); or professional Directors that are not affiliated with or otherwise employed by the investment manager (Independent Directors). Independent Directors generally either work for a financial services company, which may perform separate administrative services to the fund complex, or work independently.

There may be costs involved in employing Directors. In­dependent Directors, and some insiders, are typically paid a salary for their work that is not tied to the fund’s investment performance. Directors’ compensation and other fees are generally paid out of the assets of the Company itself.

Increased demand for the use of Independent Directors

In the past it was fairly common for all of the Directors of a Company used in a hedge fund structure to be insiders, which is efficient because they are known to the investment manager and generally share the investment manager’s views. However, investor demand for Independent Directors has increased since the financial crisis as investors seem to as­sociate them with added security in that an Independent Di­rector may look more carefully into the investment manager’s business practices than an inside Director.

A 2011 case in the Cayman Islands, Weavering Macro Fixed Income Fund Limited (In Liquidation) v. Stefan Peterson and Hans Ekstrom, received wide attention from lawyers and investment professionals. The court found the directors of the fund guilty of a violation of their fiduciary duties as a result of their failure to supervise the fund’s investment manager and to exercise independent judgment leading to Weavering’s collapse. It has been noted that Weavering simply applied ex­isting law and did not create new duties, but the amount of the fine (over US$100 million for each Weavering director) re­minded Directors of the need to abide by the legal duties in satisfying their roles as Directors. The particularly bad behav­ior that led to the collapse of the Weavering fund also alerted investors to the supervisory role that Directors should play and, in particular, seemed to increase the demand for Inde­pendent Directors (both Weavering directors were close rela­tives of the fund’s investment manager).

Certain statistics suggest that the use of Independent Directors by private funds is increasing. A survey conducted by a Cayman Islands law firm suggested that, one year after Weavering, roughly 72 percent of private funds used Indepen­dent Directors, an increase of 64 percent from the prior year. In addition, that same survey revealed that of those funds employing Independent Directors, 49 percent used a major­ity of Independent Directors for their board and 37 percent exclusively used Independent Directors. As noted above, the role of a Director is generally supervisory and they do not run the day-to-day business of the Company.

Increased use of Independent Directors has raised other fears, however. As demand for Independent Directors has in­creased so too has the concern that certain Independent Di­rectors hold so many board seats that they lack the requisite time to effectively fulfill their duties. It has been noted that a small group of Cayman Islands “jumbo directors” are sitting on the boards of hundreds of hedge funds.

Increased CIMA attention to Directors

The Cayman Islands Monetary Authority, the governing body for Cayman Islands’ private investment funds and others (CIMA), recently issued a consultation paper—which often precedes rulemaking—seeking comments on several propos­als being considered, including the following:

  • requiring Directors to register with CIMA, including the provision of personal contact details, information re­garding the Director’s role, experience and knowledge of the sector in which the Director serves, and any infor­mation regarding previous or ongoing regulatory, legal or judicial enforcement action against the Director; and
  • establishing certain qualifications and other require­ments, including a possible limit on the number of di­rectorships that one person can hold and establishing minimum fitness and other qualifications.

The responses to the proposals (including from hedge fund managers and Directors) have generally supported the increased scrutiny of Directors, while expressing concern that too much regulation could create a shortage of available Directors. Although the timing and content of final rules by CIMA, if any, is not currently known, investment managers should expect increased scrutiny of Directors and possible disclosure obligations for funds that use Directors.

Potential advantages of not using Directors

Partnerships allow the investment manager to avoid em­ploying Directors, who face increased scrutiny, regulation and cost. As noted above, Partnerships may also allow the investment manager to provide the tax benefits that drive certain investors to invest in feeder funds structured as Com­panies. While some non-US investors may choose to invest only in a Company, this can often be addressed in negotia­tions and, if necessary, the investment manager can inter­pose a Company into the “master-feeder” structure or form another suitable vehicle for that investor.

A structure solely comprised of limited partnerships can also simplify marketing and governing documents. Most in­vestment managers will prepare separate confidential private offering memoranda (the “PPM”) for the US feeder fund and the offshore feeder fund (in the case where the offshore feeder fund is a Company) because of the entities’ different corporate forms and governance mechanics. For example, limited partnerships require detailed provisions describing partnership capital accounts and withdrawals, whereas cor­porate entities require provisions describing the issuance and “roll-up” of various share classes and computation of net asset value. For a structure comprised entirely of limited partner­ships, the PPM disclosure will be virtually identical for each feeder fund, and it is common to market all feeder funds with one PPM. A combined PPM should reduce legal costs and sim­plify the marketing process. Similarly, the partnership agree­ments of each feeder fund can be based on a single model and directly compared by the investment manager, counsel and investors.

Sean Dailey is a counsel in the New York office of Chadbourne & Park LLP.

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