Introduction
Along with many of it's other features FundCount software has the necessary functionality to automate master feeder fund structures' operations in an effective way.
Please view the diagram of a sample structure that can be automated, by clicking here.
Gain/loss items can be passed through from the master fund down to feeders item by item - for US tax reporting.
Master Feeder Funds
A master-feeder fund structure is commonly used to accumulate funds raised from U.S. taxable, U.S. tax-exempt and non-U.S. investors into one central vehicle - the master fund - in order to enhance the critical mass of tradable assets, improve the economies of scale under which the fund arrangements operate and enhance operational efficiencies, thereby reducing costs.
The master feeder structure creates separate investment (i.e. feeder) vehicles for each investor group. Investors subscribe for shares or partnership interests in the appropriate feeder fund which in turn invests these proceeds in a single offshore trading (i.e. master) vehicle. It is at the master company level that the actual portfolio investments would be made. Profits and losses are apportioned pro-rata to the NAV of each feeder.
Feeder funds are not tied to a master fund. Feeders are their own legal entities and can invest in any number of master funds. A master fund is not tied to a feeder too and can accept investments from any number of feeders.
The U.S. taxable investor feeder is usually a domestic limited partnership. The non-U.S. investor feeder (which will often take U.S. tax-exempt investors seeking to avoid "UBTI" - unrelated business taxable income) is normally an offshore corporation. The master fund is either an offshore partnership or an offshore corporation which elects to "check-the-box" under U.S. tax law. Since the IRS "looks through" a feeder partnership to assess U.S. taxable investors on the gains in the underlying master fund, it is critical that the master fund not be classified as a "PFIC" (passive foreign investment corporation). The "check-the-box" election achieves this by allowing the master fund corporation to be viewed as a partnership for U.S. tax purposes.
U.S. taxable investors can subscribe directly into the offshore master fund. There is no tax disadvantage to U.S. investors although some lawyers feel more comfortable with the extra degree of legal separation afforded by a domestic feeder. In either case, non-U.S. investors and U.S. tax-exempt investors continue to subscribe through an offshore feeder.
A typical master feeder structure is comprised of:
* one master fund,
* two feeders set up as:
- Limited partnership organized in the U.S. (for U.S. investors),
- Offshore corporation (for non-U.S. and U.S. tax-exempt investors).
A typical master feeder fund structure with onshore and offshore feeders is shown below:
Advantages of a master feeder structure
- Consolidation of multiple portfolios into one.
- A larger entity is created making it easier to obtain and maintain credit lines and other financial benefits.
- Reduces trading, operational and transaction costs.
- Additional private label feeder funds can be added to an existing master fund, eliminating much of the start-up cost and risk.
- Fees can be charged at the feeder level, providing greater flexibility if new feeders are added with different fee levels.
- The general partner's performance fee will be able to maintain the underlying tax attributes from onshore feeders.
- Elimination of performance differences between the two feeder funds.
- Master feeder fund structures can be extremely flexible.
Disadvantages of a master feeder structure
- An offshore fund is generally subject to 30% withholding tax on U.S. dividends.
- All assets and liabilities of the master fund are cross-collateralized; that is, any asset is available to satisfy any liability in the event of liquidation. This can be a problem for investors where there is more than one share class (i.e. risk profile) being traded in a single master fund.
- Master-feeder structures address the problem of combining U.S. and non-U.S. investors. Investment strategies may not offer advantages to all investors at all times. Some investment types are not appropriate for offshore investors but can be appropriate for U.S. investors.
- 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.
- 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.
- Uneven allocation of profit and loss (e.g. hot issue vs. non-hot issue) and tax accounting can be cumbersome.
Such complicated cases as allocating hot issue profit and loss to the feeders, treatment of sidepocket investments and multiple portfolios are not illustrated in this article but can be handled by FundCount software.
Accounting Procedures for a Master Feeder
Deposits of capital start at the feeder funds where the U.S. taxable, U.S. tax-exempt and non-U.S. investors' capital resides. The feeder funds then decide to invest all or part in a master fund. So this deposit not only determines each investor's capital ownership percentage in the feeder, but also determines the feeder's capital ownership percentage in the master.
When the feeder invests in the master, it looks like capital coming into the master fund from one of the investors. At the master level the net capital flow of all investors is entered using which the master generates profit and loss.
After the master fund has recorded the net capital flows, it has a pooled trading account. All trading transactions (buys, sells, etc.) are at first accounted for at this level. Then profit and loss components are allocated to the feeder funds based on their capital percentages.
Feeders can decide to invest in a master fund as well as anything else if allowed by the partnership agreement. So there are often two sources of profit and loss for a feeder: profit and loss generated by the master and profit and loss related only to other things that the feeder invests in. Moreover, feeders carry certain expenses of their own. So, after the master profit and loss is distributed to its feeders, all the feeder-specific profit and loss is entered, and then allocation to investors takes place.
Management and performance fees are usually payable at the level of the feeder funds.
Conclusion
Adopting a master feeder fund structure can afford hedge fund manages with access to U.S. taxable, U.S. tax-exempt and non-U.S. investors, while allowing a high degree of flexibility and efficiency in the management and operation of the fund. While careful planning is required, the structure is ultimately designed to facilitate and maximize the potential for growth in assets under management.
Any fund manager looking to establish a master-feeder structure is advised to obtain legal counsel / tax advice beforehand as regulations are always subject to revision, and each situation must be assessed on the basis of its specific circumstances.
Before purchasing a partnership accounting system that handles master feeder structure, an in-depth systems analysis needs to be done.
