Master-feeder structure

In a master-feeder structure, multiple smaller funds (called "feeder funds") channel money from different types of investors into one large central fund (called the "master fund"). The master fund is typically an offshore corporation or limited partnership established in the same jurisdiction as the offshore feeder fund.

When investors put money into the feeder funds, those feeder funds transfer the investment proceeds to the master fund. In return, each feeder fund receives ownership interests in the master fund. The percentage of the master fund that each feeder fund owns directly matches the amount of capital it contributed.

The master-feeder structure is one of the most common hedge fund designs. It efficiently serves different investor types under a single investment program. The structure works like this:

• A master fund (typically an offshore entity treated as a partnership for U.S. tax purposes) holds all investments and conducts all trading
• A domestic feeder fund (usually a Delaware limited partnership) channels investments from U.S. taxable investors
• An offshore feeder fund (typically a Cayman Islands corporation) serves non-U.S. investors and U.S. tax-exempt entities

A typical master-feeder arrangement includes a master fund structured as a non-U.S. partnership. Alternatively, it may be a non-U.S. corporation that elects to be treated as a partnership for tax purposes. The structure combines both offshore and domestic feeder funds.

These master funds and offshore feeder funds are typically organized in low-tax jurisdictions. Popular locations include the Cayman Islands and Bermuda.

Offshore master funds are generally preferable to U.S. master funds for regulatory reasons. U.S. master funds must look through to underlying investors in offshore feeder funds. This requires all such investors to meet accredited investor Accredited investor An accredited investor refers to an individual or entity that meets specific financial thresholds set by securities regulations, qualifying them to invest in unregistered securities offerings such as hedge funds, with standards including minimum income or net worth requirements. standards and potentially qualified purchaser Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. requirements, depending on the master fund's Investment Company Act Investment Company Act of 1940 The Investment Company Act of 1940 is a U.S. law that regulates companies whose main business involves investing in securities. Hedge funds typically use special exemptions under Sections 3(c)(1) or 3(c)(7) to avoid having to register under this law, which allows them to maintain the flexibility they need for their investment strategies and fee structures. exemption. These requirements are uncommon for typical offshore hedge fund investors.

Master-feeder structures are popular among investment managers for several reasons. The most important reason is that the investment manager can manage only one portfolio and conduct all or substantially all trading through one entity.

This approach eliminates duplicative trading. It also removes the need to rebalance each hedge fund's portfolio separately. Trading through only the master fund can reduce administrative burdens and lower trading costs.

The structure also benefits service providers. Certain service providers, such as custodians, only have to deal with one large hedge fund rather than two separate smaller hedge funds. A master-feeder structure can also reduce certain documentation requirements, such as the number of brokerage agreements needed.

The master-feeder structure allows for easy addition of new feeder funds. If an investment manager wants to form a new feeder fund, or if an investor requests its own single-investor fundInvestment funds with only one investor, which may be subject to enhanced regulatory scrutiny to ensure they serve genuine pooled investment purposes., a new feeder fund can be added to the pre-existing master-feeder structure with relative ease.

Unlike a side-by-side structure Side-by-side structure A side-by-side structure refers to the parallel operation of multiple hedge funds with the same investment strategy but different legal structures (typically domestic and offshore funds) that invest independently rather than through a master-feeder arrangement. , a master-feeder structure provides one set of trading results. This happens because all or substantially all trading is generally done by one entity—the master fund.

The structure avoids problems that can occur in side-by-side arrangements. In those arrangements, variations in trading or disproportionate redemptions between hedge funds can result in the sale of significant assets by only one fund. This issue does not arise in the master-feeder context.

Master-feeders also create a larger pool of aggregated assets. This larger pool may allow the investment adviser to obtain better financing at the master fund level or through a subsidiary. It may also attract investors who are more comfortable with, or are required to invest in, larger pools.

The investment manager runs a unified investment program through the master fund. Feeder funds may keep some flexibility to make separate investments when this benefits them for tax or regulatory reasons. However, this flexibility depends on whether the structure requires all investments to flow through the master fund.

Each feeder fund shares proportionally in the master fund's trading activities through its ownership stake. Investment managers typically oversee both the master fund and individual feeder funds. The compensation arrangements can be structured at either the master fund level or individual feeder fund level, depending on specific circumstances.

Master-feeder structures create complex allocation and tracking requirements. Investment gains and losses from master fund trading activities must be precisely allocated to each feeder fund and subsequently to underlying investors. Various master fund expenses also require precise allocation.

The structure demands sophisticated systems to monitor subscriptions and redemptions at the feeder fund level. These transactions trigger corresponding transactions at the master fund level. Additional operational complexities arise from accommodating diverse feeder fund investor types, particularly regarding regulatory compliance matters.

For master funds that trade in "new issues New issues New issues (or IPOs) refers to initial public offerings of equity securities, subject to FINRA Rules 5130 and 5131 that restrict certain persons, including financial industry personnel and hedge fund investors, from participating in these offerings. ," as defined under FINRA rules, investment managers face additional requirements. They must calculate the appropriate allocation of new issues income to each feeder fund by examining the underlying investor composition of each feeder fund. This analysis determines what percentage consists of persons restricted from receiving such income under FINRA Rule 5130 FINRA Rule 5130 FINRA Rule 5130 (New Issue Rule) prevents brokerage firms from giving initial public offerings (IPOs) to accounts owned by industry insiders. This rule stops people who work in finance from getting special access to new stock offerings that might be underpriced and profitable. and FINRA Rule 5131 FINRA Rule 5131 FINRA Rule 5131 (Anti-Spinning Rule) prohibits broker-dealers from allocating new issues to executive officers and directors of public companies and certain covered non-public companies as a reward for investment banking business, a practice known as "spinning." .

Current regulations continue to apply, though recent updates have exempted certain business development companiesA type of closed-end investment company that invests in small and mid-sized businesses, subject to specific regulatory requirements under the Investment Company Act. from the restrictions.

Master-feeder structures can create conflicting tax outcomes for investors across different feeder funds. For example, U.S. individual taxable investors may benefit from preferential tax rates on qualifying dividend income. Meanwhile, offshore funds typically face withholding taxesTaxes deducted from payments at the source, particularly relevant for foreign investors or entities receiving U.S.-sourced income. on U.S. corporate dividends.

This situation may create conflicts of interest for investment managers. They must decide whether to invest in dividend-paying U.S. securities or to exit positions before dividend dates. Side-by-side structures allow for differentiated decision-making to optimize after-tax returns for each fund's investor base.

Other potential drawbacks of a master-feeder structure result from the complexity of the structure itself. The master fund and any additional 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 3(c)(1) Section 3(c)(1) Section 3(c)(1) of the Investment Company Act of 1940 exempts private funds with no more than 100 beneficial owners from registration as investment companies. This exemption allows hedge funds to operate with greater flexibility. However, it also restricts their investor base to a smaller number of participants. or 3(c)(7) Section 3(c)(7) Section 3(c)(7) of the Investment Company Act of 1940 exempts private funds from registration as investment companies if they limit investors exclusively to "qualified purchasers" and do not make public offerings. This allows hedge funds to accept unlimited investors who meet high wealth thresholds. exemptions under the Investment Company Act. Under certain circumstances, including when a feeder fund invests solely in a master fund, the master fund must look throughA regulatory approach that evaluates the characteristics of underlying investors rather than treating the fund entity itself as the relevant party for compliance purposes. its feeder funds and treat all underlying U.S. investors as 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 purposes of the master fund's own Investment Company Act exemption.

Current regulations allow qualifying venture capital funds under 3(c)(1) to have up to 250 beneficial owners with aggregate capital contributions and uncalled committed capital not exceeding $12 million, which represents an increase from the previous $10 million threshold.

Some sponsors want to replicate the incentive allocation Incentive allocation Incentive allocation is the performance-based compensation structure in domestic hedge funds where the general partner receives a percentage (typically 20%) of the fund's net profits as an allocation of partnership income, subject to high-water marks and potentially hurdle rates or clawback provisions. structure that they use with their domestic hedge funds in the offshore hedge fund setting. However, since the offshore hedge fund is generally a corporation for U.S. federal tax purposes, it cannot use a profits allocation.

Instead, the offshore hedge fund invests its assets through a subsidiary that is treated as a partnership for U.S. federal tax purposes. The performance compensation is taken at that subsidiary level. In a master-feeder structure, a subsidiary of the offshore feeder fund that invests all or a substantial portion of its assets into the master fund is typically called the "intermediate fund."

Master-feeder structures may prove inefficient under certain circumstances. They work poorly when managers intend to implement different investment approaches for domestic and offshore feeder funds based on specific tax considerations. They are also inefficient when managers plan to exclude certain feeder funds from particular investments that would create adverse tax consequences for their respective investor bases.