The recent rapid growth of the hedge fund industry in Asia
has prompted an increasing number of Asian-based hedge fund
managers to explore other options for structuring their funds
that will afford tax efficient access to the U.S. and European
capital markets. Establishing a new fund, or restructuring
an existing offshore fund to incorporate a master-feeder structure,
is one way in which this objective can be achieved.
What is a Master-Feeder Fund Structure?
A master-feeder fund structure is commonly used to accumulate
funds raised from both U.S. taxable, U.S. tax-exempt and non-U.S.
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 arrangements operate
and enhance operational efficiencies, thereby reducing costs.
The structure generally involves the use of a master fund
company (incorporated in a tax-neutral offshore jurisdiction
such as the Cayman Islands or Bermuda) into which separate
and distinct "hub" or feeder funds invest. U.S.
taxable investors take advantage of investing in a U.S. limited
partnership feeder fund, which through certain elections made
at the time the structure is established, is tax effective
for such U.S. taxable investors. Non-U.S. and U.S. tax-exempt
investors subscribe via a separate offshore feeder company
so as to avoid coming directly within the U.S. tax regulatory
net applicable to U.S. taxable investors.
In this way, the tax impact of an investment in the fund
for U.S. taxable investors and non-U.S. or U.S. tax-exempt
investors, respectively, is minimised without the presence
of one class of investor prejudicing the tax status of other
classes of investor in the fund.
A typical master-feeder fund structure is as follows:
The feeder funds invest all of their assets 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 are usually payable at the
level of the feeder funds.
How to transition to a Master-Feeder Structure
Master-feeder fund structures have long been used by U.S.-based
hedge fund managers for their funds as a means of implementing
a tax effective structure for both U.S taxable and non-U.S.
or U.S. tax-exempt investors. In Asia, the use of master-feeder
fund structures is not as widespread. However, there has been
an increased interest recently among Asian-based hedge fund
managers in sourcing investors from the U.S., and a correspondingly
increased interest in establishing master-feeder fund structures
or restructuring existing hedge funds, through which U.S.
taxable investors may invest in a tax efficient manner.
Restructuring an existing hedge fund that accepts investment
from non-U.S. or U.S. tax-exempt investors to incorporate
a master-feeder structure generally involves the following
- establishing a new offshore-domiciled company (in
a tax-neutral jurisdiction such as the Cayman Islands or Bermuda)
which will act as the master fund - this fund will not accept
direct investment except through use of a feeder structure;
- restructuring the existing fund entity to become the
feeder fund that will accept U.S. tax-exempt and non-U.S.
investors. The feeder company's sole investment is in shares
in the master fund;
- establishing a U.S. limited partnership which acts
as the feeder fund for U.S. taxable investors and which holds
shares in the master fund as its sole investment; and
- assisting the feeder and master fund structures to
make the necessary tax elections under U.S. Federal tax law
required to achieve optimal tax efficiency for all investors.
There are variations to the above method for restructuring
an existing fund, but the aim is to ensure that a structure
is achieved in which the master fund holds all of the underlying
fund investments and investors hold interests only in the
Implementing Effective Tax Planning
In a typical master-feeder fund structure, the master fund
will make what is commonly referred to as a "check the
box" election to be treated as a partnership for U.S.
U.S. taxable investors elect to invest in the master fund
because it is taxable as a partnership in order to avoid having
their investment considered, for U.S. tax purposes, to be
an investment in a foreign passive investment company ("PFIC").
Investors in PFICs are subject to a significantly more onerous
tax regime under U.S. law, and therefore, investments that
are structured as PFICs are largely unattractive to U.S. taxable
U.S. tax-exempt investors and non-U.S. investors will ideally
elect to invest through an offshore feeder fund which is not
liable to U.S. tax. U.S. tax-exempt investors often prefer
to structure their investment through an offshore corporation
as compared to 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 an offshore partnership to the tax-exempt
investor in certain circumstances. Liability to UBTI is of
particular concern to U.S. tax-exempt investors where the
investment strategy of the partnership involves the use of
leverage, since the definition of what constitutes "UBTI"
includes income received from "debt-financed property"
which may, in turn, lead to an adverse tax result for the
Why use a Master-Feeder Fund Structure
The principal advantage of utilising a master-feeder structure
is that it allows U.S. taxable investors to invest in an offshore
hedge fund in a tax efficient manner that does not compromise
the tax position of other non-U.S. or U.S. tax-exempt investors.
This enables a hedge fund manager 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. This aspect of the
structure also assists the hedge fund manager to 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 can also assist in eliminating
performance differences between the two 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 engages in
"re-balancing" trades as between parallel or "side-by-side"
structures. It also eliminates the need to enter into duplicated
agreements with counterparties, which reduces costs in the
Similarly, the pooling of assets at the master fund level
creates greater economies of scale for the purposes of 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. Flexibility is also maximised at the
investor level, since multiple "hub" or feeder arrangements
can be introduced to feed into the master fund, catering for
different classes of investors which adopt different currency,
subscription and fee structures.
Significant opportunities exist for Asian-based managers
to access the U.S. and European capital markets in a regulatory
and tax efficient manner, provided that appropriate structures
are planned and implemented. Adopting a master-feeder fund
structure can afford hedge fund managers with access to both
U.S. taxable and non-U.S. investors, while allowing a high
degree of flexibility and efficiency in the management and
operation of the fund. 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.