Feeder fund

Think of a master-feeder structure like tributaries flowing into a main river. In this arrangement, multiple smaller funds (the "feeder funds") channel money from different types of investors into one large central fund (the "master fund").

When investors put money into a feeder fund, that feeder fund takes the investment and contributes it to the master fund in exchange for ownership shares. Each feeder fund owns a percentage of the master fund based on how much money it has contributed. This means that while investors technically own shares in their specific feeder fund, they indirectly participate in all the investments made by the master fund.

Most master-feeder structures follow a standard pattern. The master fund is typically set up as a partnership located outside the United States, often structured to take advantage of favorable tax treatment. This master fund serves as the central investment vehicle where all the actual trading and investment decisions happen.

The structure usually includes two main feeder funds. The domestic fund Domestic fund A domestic fund is a hedge fund organized under U.S. law—typically as a Delaware limited partnership or limited liability company—that serves as the primary investment structure for U.S. taxable investors. is organized as a Delaware limited partnership and serves U.S. taxpayers and certain U.S. tax-exempt investors like pension funds. The offshore fund is typically incorporated in the Cayman Islands and accommodates non-U.S. investors and U.S. tax-exempt organizations.

The offshore structure is particularly important because it helps non-U.S. investors avoid becoming subject to U.S. tax obligations. When structured properly, any U.S.-sourced income is taxed at the fund level rather than being passed through to the foreign investors, which could otherwise require them to file U.S. tax returns.

From a practical standpoint, the master-feeder structure creates significant operational efficiencies. The investment manager only needs to implement one investment strategy through the master fund, rather than managing separate portfolios for different investor groups. Each feeder fund automatically participates in the master fund's trading activities in proportion to its ownership stake.

This centralized approach eliminates several common problems. The investment manager doesn't need to execute the same trades multiple times across different funds, which would create unnecessary transaction costs and administrative complexity. There's also no need to constantly rebalance different portfolios to maintain similar investment positions.

Because all trading happens through one entity, the investment manager can focus on investment decisions rather than operational coordination. This typically results in lower trading costs and reduced administrative burdens, benefits that can ultimately improve returns for investors.

One of the key advantages of master-feeder structures is their flexibility for future growth. Adding new feeder funds to an existing structure is relatively straightforward. If the investment manager wants to accommodate a new type of investor or if a large investor requests its own dedicated feeder fund, this can be accomplished without disrupting the existing structure.

This flexibility contrasts with side-by-side structure, where separate funds operate independently. In a master-feeder setup, all investors share the same trading results since substantially all investment activity occurs at the master fund level. This eliminates potential conflicts that could arise if different funds achieved different performance results.

The structure also creates a larger pool of combined assets, which can provide additional benefits. Larger asset pools may allow the master fund to negotiate better financing terms with banks and prime brokersA financial institution that provides comprehensive services to hedge funds including trade execution, custody, securities lending, margin financing, and capital introduction.. Some institutional investors also prefer or are required to invest only in funds above a certain size threshold, making the combined pool more attractive to these investors.

Despite these advantages, master-feeder structures can create competing interests among different investor groups. Tax considerations provide a clear example of this challenge. U.S. individual investors might benefit from investments that generate dividend income, which receives favorable tax treatment. However, the same dividend income could result in a 30% withholding taxTaxes deducted from payments at the source, particularly relevant for foreign investors or entities receiving U.S.-sourced income. for the offshore feeder fund, effectively reducing returns for foreign investors.

These conflicting tax impacts can create difficult decisions for investment managers. They must balance the interests of different investor groups when making investment choices, which can sometimes limit their flexibility in implementing their preferred investment strategy.

The structure also creates complex administrative requirements. All gains, losses, and expenses from the master fund must be properly allocated back to each feeder fund based on their ownership percentages. These allocations must then be further distributed to the individual investors in each feeder fund according to their specific investment terms.

Additionally, the mechanics of investor subscriptions and redemptions become more complex. When investors add money to or withdraw money from a feeder fund, the feeder fund must make corresponding changes to its investment in the master fund. This requires careful coordination to ensure all allocations remain accurate.

The master-feeder structure can create additional regulatory complications, particularly when dealing with specialized investment rules. For example, certain new issues securities regulations restrict who can receive income from newly issued stocks. Investment managers must track which investors in each feeder fund are subject to these restrictions and limit the master fund's allocation of new issue income accordingly.

This requires looking through the feeder fund structure to analyze the underlying investors and their specific regulatory status. Such requirements can create significant administrative overhead and may limit the master fund's investment flexibility.

Establishing a master-feeder structure requires additional legal documentation and setup costs compared to a single fund. Each fund in the structure needs its own governing documents, regulatory filings, and ongoing compliance procedures.

Investment managers must also ensure that both the master fund and each feeder fund maintain their exemptions under federal securities laws. Typically, funds rely on exemptions that limit the number and types of investors they can accept. Under certain circumstances, particularly when feeder funds invest solely in the master fund, regulators may require the master fund to count all underlying U.S. investors in the feeder funds when determining whether it meets exemption requirements.

This "look-through" requirement means that even though investors directly own shares in feeder funds, they may be considered beneficial ownersInvestors who have economic ownership in a fund, counted for purposes of the Section 3(c)(1) exemption's 100-investor limit. of the master fund for regulatory purposes. Investment managers must carefully monitor these calculations to ensure continued compliance with securities law exemptions.