Feeder fund

In a master-feeder structure, domestic and offshore hedge funds feed into a master fund. When investors subscribe for interests in the feeder funds, the feeder funds contribute the subscription proceeds to the master fund in exchange for master fund interests. Each feeder fund holds an ownership percentage in the master fund based on the amount that it has contributed to the master fund.

A typical master-feeder structure consists of a master fund that is formed as a non-U.S. partnership or a non-U.S. corporation that has "checked the box" to be classified as a partnership for federal tax purposes, an , and a .

The domestic feeder fund is typically structured as a Delaware limited partnership designed to serve U.S. taxable investors and certain tax-exempt U.S. investors. The offshore feeder fund is usually organized as a Cayman Islands corporation to accommodate non-U.S. persons and tax-exempt U.S. organizations who benefit from the corporate structure because any from the offshore fund's activities is taxed to the fund and does not cause the non-U.S. investor to become a U.S. taxpayer or to file a U.S. tax return.

The investment manager implements one investment program through the master fund, although the feeder funds may have the ability to make investments on their own if desirable for tax or other reasons, unless the feeder funds are "" into the master fund. Each feeder fund participates pro rata in the master fund's trading through its interest in the master fund.

The master-feeder structure allows the investment manager to manage only one portfolio and conduct all or substantially all trading through one entity. The investment manager can eliminate duplicative trading and the need to rebalance each hedge fund's portfolio. Being able to trade only for the master fund can also ease administrative burdens and reduce trading costs.

The master-feeder structure allows the addition of new feeder funds with considerable ease. If an investment manager would like to form a new feeder fund, or if an investor requests its own single-investor fund, a new feeder fund can be added into the pre-existing master-feeder structure.

Unlike a , using a master-feeder structure provides one set of trading results since all or substantially all trading is generally done by one entity—the master fund. Master-feeders also create a larger pool of aggregated assets, which may allow the investment adviser to obtain better financing at the master fund level or attract investors who are more comfortable with, or are required to invest in, larger pools.

A master-feeder structure can create conflicting tax considerations for the investors in the feeder funds. For example, while noncorporate taxable U.S. investors may benefit from a lower tax rate on certain dividend income, the offshore hedge fund would generally lose 30% of a dividend paid by a U.S. corporation. Accordingly, the investment manager may face a conflict of interest in whether to trade in a U.S. corporation paying substantial dividends.

The master-feeder structure can also create complex allocation and tracking issues. Appreciation and depreciation resulting from trading at the master fund, as well as certain master fund expenses, must be properly allocated to the feeder funds and subsequently to the feeder fund investors. Mechanics must also be set up to track the subscriptions and redemptions at the feeder fund level, which will require corresponding subscriptions and redemptions at the master fund level.

Additional complexities may result from the various types of feeder fund investors, particularly with respect to regulatory issues. For master funds that trade in "," as defined under the Financial Industry Regulatory Authority rules, the investment manager must determine the amount of new issues income that each feeder fund can receive by looking through to the investors of the feeder funds and determining what percentage of the underlying investors are restricted from receiving such income.

The master fund and any extra feeder funds require additional fund documentation and set-up costs. The investment manager must also ensure that the master fund and each of its feeder funds preserve their or exemptions under the . Under certain circumstances, including when a feeder fund invests solely in a master fund, the master fund must look through its feeder funds and treat all underlying U.S. investors as of the master fund for purposes of the master fund's own exemption.