By John Buscema, President and founder of International Fund Administration (IFA) with offices in New
York and Bermuda. IFA provides administrative services to offshore and domestic private investment
companies and has been actively involved in assisting money management groups with the structure and
organization of investment vehicles. This article first appeared in the February 1996 issue of Hedge Fund News┐.
Today, most hedge fund managers wish to manage money for both US and Non-US investors. To accomplish this, the manager will typically set up a domestic US limited partnership for the US investors, and an offshore fund for the Non-US investors, so as to ensure preferable tax treatment for each of these groups. In doing so, there are certain inherent inefficiencies created. Namely, the manager now has two distinct portfolios to manage, is required to allocate trades amongst these portfolios and must attempt to maintain similar performance between the entities.
┐However, there is a structure commonly referred to as "master feeder" which can resolve these inefficiencies. The application of this structure to hedge fund groups (and indeed others) can produce many efficiencies which benefit both the manager and investors. A master feeder structure is comprised of three entities: one "master" company and two "feeders". Under this scenario the feeders would be set up as a limited partnership organized in the US, for US investors and an offshore corporation for Non-US investors. The sole investment of these two feeders would be an ownership interest in the third entity: the master. It is at the master company level that the actual portfolio investments would be made, thus consolidating all the trading activities into a single portfolio. This master company would typically be an offshore entity and be organized as a limited liability company to preserve the tax treatment of both the US and Non-US investors. The structure would look like the following:
The Benefits: simplicity and flexibility
┐Most managers are very excited about the prospect of a structure that can efficiently consolidate multiple portfolios into one. One portfolio eliminates the allocation of trades among multiple portfolios and simplifies reconciliations. Combining the assets also creates "critical mass". Critical mass may assist the manager in obtaining and maintaining requisite credit lines (most lenders will be more comfortable providing credit lines to one larger entity rather than to two separate smaller entities) and create a pool of assets large enough to effectively implement his strategy as well as reaching the break-even point with respect to organization and operational costs associated with the new entity. Finally, one common portfolio also ensures that the performance of the domestic and offshore entities mirror one another.
Also, with a master feeder structure in place, it is very easy to add another feeder as a "private label" fund for an institution, thereby eliminating the need for another portfolio, additional credit lines, etc., while providing critical mass. It should also be very attractive to the institution to begin their new product with a fully invested and diversified portfolio, thereby eliminating much of the start-up risk. This new private label feeder can also have an entirely different fee structure.
Additional special purpose feeders can be established to meet specific regulatory or tax requirements of different groups of investors. The US limited partnership is a good example of a special purpose entity, as it, in conjunction with a limited liability master, creates a flow through entity for the US investors, thereby eliminating the potentially negative tax implications of a PFIC, CFC or FPHC (Passive Foreign Investment Company, Controlled Foreign Corporation and Foreign Personal Holding Company respectively) which are commonly encountered when placing US investors into an offshore entity. When an investor
sells their interest in a PFIC, any gains will be treated as ordinary income, allocated ratably each day the investment was held, and be subject to an interest penalty on the taxes that would have been due over the period. In addition, upon death, an investor's shares would not have their cost basis stepped-up to the current market value for tax purposes as would normally be the case. Alternatively, the investor may be able to make a QEF election (Qualified Electing Fund), which would allow a pass through of ordinary earnings and net capital gain each taxable year. However, any net-losses will not flow through a QEF and may not be carried over or back by the QEF. In the case of an entity deemed to be a CFC or PFHC, income of the entity is attributed to the shareholder each year, whether or not it is actually distributed, and becomes taxable at such time.
A Word of Caution
The structure is typically more attractive when all the entities are newly organized, as opposed to utilizing an existing US limited partnership. To have an existing entity become a feeder into a master company, existing portfolios of securities are generally contributed to the master company in exchange for an ownership interest of equal value. However, under US tax law, domestic partnerships which contribute assets to a foreign entity are subject to an excise tax on the contribution. While the excise tax is not levied if the partnership makes an election to pay tax on any unrealized capital gains at the time the portfolio is being contributed, this may be a problem if the partnership has significant unrealized capital gains. One solution is to structure the master company as a US limited partnership which maintains its principal office offshore, as defined in Section 864 of the US Tax Code (the "Ten Commandments"). Such a contribution would therefore not be made to a foreign entity nor subject to the excise tax.
Additionally, one must be very careful to ensure that the structure is being properly accounted for. One area which must be focused upon is how fees are charged. The basic rule of thumb is to calculate and charge fixed and performance fees at the feeder level as opposed to the master level. There are many problems and inequities which can arise if these fees are charged at the master level. In addition, charging fees at the feeder level will provide greater flexibility if there are ever any feeders added which have different fee levels. The structure also requires a greater level of attention with respect to the interplay between the feeders and the master company. The feeders will regularly have capital contributions and withdrawals made by the investors. In addition, the feeders will have ongoing fees and expenses which have to be paid. These cash flows will typically require corresponding capital transactions between the feeders and the master company.
The principles of the master feeder open up a number of possibilities with respect to creating hybrid structures to optimize some of the efficiencies inherent to master feeder. One of the most intriguing possibilities is to combine the master feeder structure with an umbrella structure which employs multiple investment strategies under one legal entity. This is accomplished by designating different classes of shares within the entity, with each class devoted to a specific investment strategy. For example, class 'A' might be equity long-short and class 'B' fixed income arbitrage. If a master feeder were to be structured similarly, each of the feeders and the master would have corresponding classes. Class A of the domestic and offshore feeders would only own Class A of the master; Class B would own master Class B, and so on. Each of the classes of the master would have its own unique portfolio of securities.
This structure would be useful to groups that intend to offer multiple strategies and those that sponsor a number of managers. The benefits would come from efficiencies both in cost savings and the speed with which new strategies could be added. Ideally a template offering document would be created for each feeder covering all the common information. To this template would be added small supplements or inserts which highlight the specific strategy of each class, its liquidity, fee structure and any unique risk factors. Each time a new strategy was to be added, a new supplement is drafted and an additional class created. The time and cost involved should be significantly less than that required for organizing an entirely new entity (or entities) and drafting a full set of offering documents and articles for the entity. Umbrella structures and this variation have some inherent problems which can be overcome with some forethought. One major concern is that of cross collateralization in the event of a default on any borrowings. If one class were to experience such an occurrence, the other classes should not bear any of the associated risk. To prevent such an occurrence, multiple master companies could be utilized (each for a single class) or an entity below a class in the master could be added to isolate the risk inherent to a specific class. In either case, the recourse of creditors would be limited to a specific pool of assets within the entity in question. An alternative solution is to ensure that all loan or margin agreements specifically acknowledge that recourse is only to the assets of the class in question and no other classes.
Other interesting applications have involved master companies established as registered broker dealers, to legally increase the borrowing limits on equity based securities, and masters organized in specific jurisdictions to take advantage of specific tax treaties when investing into certain countries (i.e. Mauritius for investments into India). The applications and possibilities available with the structure are quite broad and can provide solutions to many different types of problems.u