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The Benefits of Master-Feeder Fund Structures for Asian-based Hedge Fund Managers
Effie Vasilopoulos & Katherine Abrat, Sidley Austin Brown & Wood (Hong Kong)

April 2004

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:

Click to view larger image

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 key steps:

  • 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 feeder funds.

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. tax purposes.

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 investors.

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 particular investor.

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 longer term.

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.

Conclusion

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.


If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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