by: Jeffrey Tunkel, Retired Partner
Investment managers seeking to start hedge funds, both domestic and offshore, have several options available to them in structuring the funds. The most common structures are side-by-side, master-feeder and mini-master.
In a side-by-side structure (see diagram A) there is both a domestic fund and an offshore fund whereby both funds make direct investments in accordance with the investment strategy and allocate the trades on a net asset value allocation.
The domestic fund structure is typically a limited partnership with the investment manager acting as the general partner. The offshore fund is an investment company organized outside the U.S. which offers their securities to non-U.S. investors and to U.S. tax exempt investors. The advantage of an offshore fund is that the investors would generally not be subject to U.S. taxation. The domestic fund’s gains and losses are passed on a pro rata basis to the investors. The offshore fund can be domiciled in the tax free jurisdictions which do not impose corporate level taxes on offshore hedge funds. Offshore funds are also attractive to U.S. tax exempt investors as a way to avoid Unrelated Business Taxable Income. This can be accomplished because if the offshore investment manager acquires securities on margin (leverage), an offshore fund which is set up as a corporation blocks the Unrelated Business Taxable Income that would otherwise be taxable to a United States tax exempt investor. A side-by-side structure would be used today more often in a fund of funds strategy because there are duplicative administrative costs associated with operating two funds.
The advantages of a side-by-side fund are as follows:
- Tax efficiency, long term holding periods have no effect on an offshore fund shareholder.
- The offshore fund can choose a fiscal year end other than December 31, thereby allowing the manager to postpone incentive fees or allocations to different tax years.
A master-feeder structure (see diagram B) is where the domestic fund and the offshore fund invest all of their assets into the master fund which in turn makes the investments on behalf of both the domestic fund and the offshore fund, collectively, the feeders.
Funds are invested into a master fund which serves as the investment entity in the master-feeder structure. There is a separation of the investment portfolio from the investors. A single portfolio is maintained in the master fund and its participants are the feeder funds, funds that house the investors and feed the capital to the master fund. The feeders are defined by the nature of the investors. A United States limited partnership feeder is for taxable domestic investors and an offshore corporation feeder is for non-United States investors and non-taxable United States investors. Tax-exempt U.S. investors (e.g., pension funds, charitable entities, etc.) and foreign investors generally do not invest in a U.S. fund in fear that the IRS may try to declare the income unrelated to their tax-exempt purpose (in the case of tax-exempt U.S. entities) or effectively connected to a U.S. trade or business (in the case of foreign investors). Either result could expose investors to U.S. income tax. For this reason, an offshore structure is generally chosen when the mix of investors includes foreign investors or tax-exempt U.S. entities. The master fund must make a “check the box” election to be taxed as a partnership for U.S. tax purposes. Prior to the Emergency Economic Stabilization Act of 2008 the benefit of having an offshore fund was the ability for the manager to have the option to defer receipt of fees, leaving them in the fund to compound at the fund’s pre tax rate of return until withdrawal at a later date (see mini master structure below).
The advantages of a master-feeder structure as opposed to a side-by-side structure is as follows:
- A single trading entity which does not require allocating individual trades on a net asset value
- An individual portfolio to manage
- One performance result, in that expense(s) can be different for each fund
- More leverage ability
As an outgrowth of the Emergency Economic Stabilization Act of 2008, the mini master structure was born.
The mini-master structure (see diagram C) is made up of two entities, an offshore feeder and the master fund. The offshore feeder is taxed as a corporation to benefit United States tax exempt investors and block Unrelated Business Taxable Income. The master fund can be structured as a partnership for tax purposes. So, the U.S. hedge fund manager would receive an incentive fee as an allocation from the master fund rather than as a fee and taxable as ordinary income and take any advantage to the long term capital gains generated by the master fund.
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Our conclusions are based on the facts and assumptions as stated and on authorities that are subject to change. To ensure compliance with requirements imposed by the IRS in Circular 230, any tax advice contained in this communication (including any attachment that does not explicitly state otherwise) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.