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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