The first hedge funds were primarily national in nature. They served as a way for high net worth individuals and institutional investors to diversify their portfolio and exposure, by investing into funds deploying unique or contrarian strategies.
Over time, hedge funds grew from a regional phenomenon into a global alternative asset class. Hedge funds today are at the nexus of finance, law and regulation. In addition, their transnational nature entails complexities both in terms of structuring the fund itself, and the day-to-day operation of it.
A number of factors influence the choice of jurisdiction for hedge funds. This includes the type, profile and location of the investors, their expectations for governance-related matters and their familiarity and preference for specific jurisdictions.
Hedge funds that only onboard investors from the country that the management team is based in tend to use the same jurisdiction for the fund, for administrative and operational simplicity. The complexities lie in funds that have a broad investor base across multiple jurisdictions. We’ve written an article on why many fund managers decide to base their hedge funds in an offshore jurisdiction, and in particular, the Cayman Islands, which is one of the biggest offshore alternative investment funds jurisdictions in the world.
Tax and regulatory reasons
This is due to a mix of regulatory and tax-related reasons, with the primary one being the issue of double taxation. Double taxation is where the hedge fund itself is taxed in the jurisdiction it is domiciled in, and the investor is taxed again as tax resident of his own jurisdiction when the investor redeems his investment. Tax neutrality will allow the investor only to be taxed once, where the proceeds of the investment is returned and taxed at the individual level, as capital gains or income (depending on the tax legislation & policies where the investor is tax resident).
To mitigate the effects of double taxation, a unique structure is used where a fund has a mix of both US and non-US investors. We refer to this setup as the ‘US Investors Module’.
Let's Welcome US Investors
US taxable investors are tax-disadvantaged when they invest in or dispose of shares of ‘passive foreign investment companies’. As such, there is a tendency for US investors to invest in US funds. The Master-Feeder structure is an effective method of structuring a fund that will achieve tax efficiency for US taxable investors, whilst at the same time allow non-US investors to invest in the same fund.
The ‘Master’ fund will be typically located offshore, where the capital from the two feeder funds will congregate and be used for investments. Non-US and non-US taxable investors will invest in the offshore feeder fund, whereas US investors will invest via a Delaware entity (Partnership/LLC/C-Corp depending on the tax strategy). The master fund would typically have an onshore or offshore investment manager, for governance-related reasons. The fund managers would retain fund auditors for both the Master fund, and the feeder funds, and set up bank accounts for all legal entities. Service provider agreements would be negotiated with third-party service providers (including prime brokers, custodians and depositories)
This structure will allow the Master fund to achieve economies of scale, by plugging in several funds into one master fund (thereby increasing AUM for the fund), whilst at the same time, taking jurisdiction-specific tax and regulatory frameworks into consideration (allowing both US and non-US investors to invest efficiently).
The structuring and the day-to-day operations of a Master-feeder fund is more complex as compared to a standalone offshore Cayman fund, due to its cross-jurisdictional and multi-entity nature. Three separate offering documents (PPMs) will have to be drafted for each legal entity (Cayman Master Fund; Offshore Cayman-based feeder fund; Onshore US/Delaware-based feeder fund), and an investment management agreement drafted and signed between the all three fund entities and the fund’s investment management entity. Constitutional documents such as the MoA, AoA, LPA and subscription agreements will have to be drafted and incorporated into the fund formation process.