Mini-master structure

The mini-master structure combines features from two other common hedge fund arrangements: side-by-side structures 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. and master-feeder structures Master-feeder structure A master-feeder structure is a fund arrangement where multiple feeder funds (typically designed for different investor types) invest into a single master fund that makes all investments, creating operational efficiency while accommodating diverse investor needs. . Here's how it works: an offshore fund Offshore fund An offshore fund is a hedge fund established outside the United States, typically in low-tax jurisdictions like the Cayman Islands or British Virgin Islands. These funds primarily serve non-U.S. investors and U.S. tax-exempt organizations by offering tax advantages and greater regulatory flexibility than domestic fund structures. puts all of its investment money into a separate entity that the IRS treats as a partnership for tax purposes. This offshore fund then operates alongside a 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. that has the same investment manager.

When there is no master fund managing the domestic hedge fund, the domestic fund works directly alongside the offshore fund's subsidiary entity. Industry professionals typically call this subsidiary entity a "mini-master fund."

This structure developed mainly because of Section 457ATax provision requiring immediate income recognition of deferred compensation from nonqualified entities when no longer subject to substantial risk of forfeiture. of the Internal Revenue Code. This tax rule contains anti-deferral provisionsTax code provisions that require immediate income recognition of deferred compensation when no longer subject to substantial risk of forfeiture. that make it difficult for fund managers to structure complex compensation arrangements in a tax-efficient way.

After Section 457A took effect in 2009, investment managers found it generally impractical to delay paying taxes on incentive compensationPerformance-based pay structures that reward fund managers based on the fund's returns or achievement of specific targets. when that compensation was structured as fees. To solve this problem, many managers of offshore funds now structure their incentive compensation as profit allocations instead of fees. This approach allows them to get similar tax treatment to the compensation they receive from their domestic funds.

To get the tax benefits they want, offshore corporations typically invest their money through a subsidiary mini-master fund. This subsidiary chooses to be classified as a partnership for U.S. tax purposes. It then issues special ownership interests to the general partner or a related company.

These special ownership interests receive two types of returns. First, they get a proportionate return based on the capital investment. Second, they receive an 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. , which works similarly to how general partners receive performance-based compensation in domestic partnerships or limited liability companies.

Within these structures, the mini-master fund allocates performance compensation to an investment manager affiliate. This affiliate is typically the domestic hedge fund's general partner. The compensation relates specifically to the offshore fund's assets.

Since the mini-master fund operates as a partnership for U.S. federal tax purposes, the performance compensation flows through as a partnership allocation. This means the general partner entity receives pass-through tax treatmentTax treatment where business income and tax attributes flow directly to investors rather than being taxed at the entity level. on this income, which is generally more favorable than being taxed as regular fee income.

An offshore fund can operate as the only feeder in a mini-master structure when there is no domestic feeder fund Feeder fund A feeder fund is a type of investment fund that collects money from investors and then invests nearly all of that money into a larger "master fund." This structure allows different types of investors—such as U.S. taxpayers, tax-exempt organizations, and foreign investors—to all participate in the same investment strategy while using the fund structure that works best for their specific tax and regulatory needs. involved. Alternatively, both the mini-master fund and a domestic feeder fund can feed into a master fundThe central investment vehicle in a master-feeder structure where multiple feeder funds pool their capital for consolidated investment management.. In this second scenario, practitioners often call the mini-master fund an "intermediate fund."

This structure gives the manager flexibility in how they structure incentive compensation. Instead of treating compensation related to the offshore fund as a fee, they can structure it as an allocation of profits at the mini-master level.

From the manager's perspective, investors in an offshore fund typically don't care from a tax standpoint whether the fund pays performance-based allocations or performance-based fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. . However, managers often prefer structuring incentive compensation as profit allocations for their own tax purposes.

This preference stems from anti-deferral provisions in the Internal Revenue Code that apply specifically to fees. These provisions become particularly important when incentive compensation terms are complex, such as arrangements that span multiple years.

There is one potential drawback for managers to consider. If the incentive allocation comes from a fund that operates as an "investor" rather than a "trader," the resulting income may not be usable by the manager's partners to offset business expenses that the management company Management company The management company is the entity that employs the investment professionals and staff operating a hedge fund, receives management fees and often incentive compensation, and bears the operational expenses of running the investment management business. allocates to them.

The structure does add operational complexity compared to simpler arrangements. However, it can provide meaningful tax advantages for fund managers while addressing the different needs of various investor categories.

The mini-master structure differs from a full master-feeder structure in an important way. In a master-feeder structure, all investments flow through a single master fund. In contrast, the mini-master structure maintains some separation between the domestic and offshore vehicles.

This separation potentially allows for greater flexibility in adapting to the different needs of various investor types. Most offshore funds operate as entities that the IRS treats as corporations for U.S. tax purposes. This corporate treatment ensures that non-U.S. investors and tax-exempt U.S. investors avoid complications related to "effectively connected income Effectively connected income (ECI) Income earned by foreign individuals and companies that has a strong enough connection to a U.S. trade or business to be taxed like domestic income. Instead of paying a simple flat withholding tax, foreign persons with ECI must pay regular U.S. income tax at graduated rates and can claim deductions, just like U.S. taxpayers. " or "unrelated business taxable income Unrelated business taxable income (UBTI) Unrelated business taxable income (UBTI) is income that tax-exempt organizations earn from business activities unrelated to their exempt purpose. When tax-exempt organizations invest in hedge funds, certain fund activities can create UBTI, making these otherwise tax-exempt investors subject to taxation. ."