A master-feeder structure is a strategic arrangement commonly utilized by hedge funds to amalgamate both taxable and tax-exempt capital from U.S. and international investors into a singular, master fund. This structure involves creating separate investment vehicles—known as feeders—for different groups of investors.
Investors infuse capital into these respective feeder funds, which then channel assets into a centralized entity known as the master fund. The master fund is responsible for all portfolio investments and trading activities. Fees related to management and performance are incurred at the feeder-fund level.
Key Takeaways
- In a master-feeder structure, investment funds originate from investor capital; these feeder funds subsequently invest in a centralized master fund.
- Hedge funds frequently use master-feeder structures to cater to both U.S. and non-U.S. investors.
- This structure allows funds to leverage economies of scale and beneficial “pass-through” tax treatment.
How the Master-Feeder Structure Works
The process initiates with investors depositing capital into the feeder fund. The feeder fund, containing all the limited partnership/shareholder capital, then purchases shares of the master fund similar to buying shares of a company’s stock. The significant distinction is that by buying into the master fund, the feeder fund acquires all the master fund’s income attributes, including interest, gains, tax adjustments, and dividends.
Although this two-tiered structure can manifest in various forms like funds of funds mutual funds, it is particularly prevalent among hedge funds that cater to both U.S. and offshore investors. The master-feeder fund structure benefits asset managers by providing a sizable capital pool while enabling the design of niche investment funds.
Composition of Master-Feeders
Typically, a master-feeder structure involves one offshore master fund alongside one onshore feeder and one offshore feeder. Feeder funds investing in the same master fund have diverse options. They may differ in terms of investor type, fee structures, investment minimums, net asset values, and operational attributes.
Consequently, feeder funds can operate as independent entities with the ability to invest in various master funds, without strictly adhering to one master fund. For instance, if feeder fund A contributes $100 and feeder fund B contributes $200 to the master fund, fund A would receive one-third of the master fund returns, while fund B would receive two-thirds of the returns.
Advantages of the Master-Feeder Structure
One notable advantage of the master-feeder structure is the consolidation of multiple portfolios into one entity. This consolidation facilitates reduced operational and trading costs. A larger portfolio enjoys the benefits of economies of scale, access to better services, and favorable terms offered by prime brokers and other institutions.
Pros
- Economies of scale
- Tax-advantaged partnership status
- Convenient for both domestic and international investors
Cons
- Dividends may be subject to withholding tax (if offshore)
- Challenges in formulating a universal investment strategy
Disadvantages of the Master-Feeder Structure
The main drawback is that funds held offshore generally face a 30% withholding tax on U.S. dividends. Additionally, combining investors with different characteristics and investment priorities can be challenging. Frequently, finding a middle ground is difficult, as strategies suitable for one type of investor may be unsuitable for another.
Real-World Example of Master-Feeder Structure
Relationships between a master fund and its feeders can be intricate. A noteworthy example is a 2018 case involving the Ardon Maroon Asia Dragon Feeder Fund and the Ardon Maroon Asia Master Fund. The case revolved around how redemption requests by a feeder fund were treated during liquidation.
In 2014, a feeder fund investor submitted a redemption notice. The feeder fund, anticipating automatic satisfaction of the request by the master fund, assumed a “back-to-back redemption.” However, both funds went into liquidation afterward. The investor’s debt claim was rejected by the master fund’s liquidators because the feeder fund had not formally submitted a separate redemption request.
A lawsuit was filed in the Cayman Islands where the Grand Court ruled in favor of the master fund in mid-2018. Despite industry practice, the court noted that the documents required a written notice of redemption from the feeder funds, and thus Asia Dragon was remiss in not notifying the master fund separately.
Related Terms: feeder fund, master fund, asset management, offshore investments.
References
- Advent. “Understanding Master-feeder Accounting”. Pages 3-5.
- Advent. “Understanding Master-feeder Accounting”. Page 5.
