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The Global Dream: The Use of Master-Feeder Fund Structures by Asian-based Hedge Fund Managers
Effie Vasilopoulos, Partner
Katherine Abrat, Associate
Sidley Austin Brown & Wood (Hong Kong)
November 2005


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 stomping ground.

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.
US feeder funds are often domiciled in the US since the use of onshore structures is most familiar to US investors. However, it is also possible for the US feeder fund to be established in a tax-neutral jurisdiction such as the Cayman Islands and structured as a limited partnership (which, as a partnership, is a pass-through vehicle for US federal taxation purposes) or as a corporation that through a simple 'check the box' filing may elect to be treated as a pass-through vehicle for US federal taxation purposes.

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 tax-exempt investors.

  • 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' structures.

  • 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 vehicle.

  • 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 trading vehicle.

  • 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.
Key Issues for Asian-based Hedge Fund Managers to Consider in Structuring Master-Feeder Arrangements

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.
Notwithstanding registration by a non-US based hedge fund manager as an investment adviser, once registered, a non-US based hedge fund manager whose only nexus with the US is that the offshore domiciled private funds that it advises admit US investors, will not be subject to the full range of compliance obligations applicable to US-based registered investment advisers under the IA Act. Instead, the Rules provide that only certain of the IA Acts provisions will apply to such non-US advisers (which provisions include the anti-fraud, certain record keeping and compliance programme provisions).

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.
Conclusion

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



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