What Is the Definition of a Master-Feeder Structure?
Hedge funds frequently use a master-feeder structure to combine cash from U.S. and foreign investors that is taxable and tax-exempt into a master fund. For each group of investors, separate investment vehicles, known as feeders, are established.
Investors put money into their feeder funds and then invest it in a centralized vehicle known as the master fund. The master fund is in charge of all portfolio investments and all trading activity. Fees for management and performance are collected at the feeder-fund level.
The Master-Feeder Structure in Action
The master-feeder system begins with investors putting money into the feeder fund. The feeder fund, which contains all the limited partnership/shareholder capital, then purchases “shares” of the master fund like it would buy stock in any corporation. The critical distinction is that a feeder fund obtains all of the master fund’s income qualities, including interest, gains, tax adjustments, and dividends, by investing in it.
Although this two-tiered structure can exist in various forms, such as “funds of funds” mutual funds, the master-feeder structure is persistent among hedge funds catering to domestic and international investors. The master-feeder fund structure enables asset managers to benefit from a large capital pool while designing investment funds for specialist markets.
The Master-Feeder Composition
A typical master-feeder arrangement consists of one offshore master fund, one onshore feeder, and one offshore feeder. Feeder funds that invest in the same master fund have the opportunity for diversity and choice. In other words, the feeders may differ regarding investor type, fee structures, investment minimums, net asset values, and various other operational characteristics.
As a result, the feeder funds are not required to adhere to a particular master fund. They can operate legally as autonomous companies investing in various master funds.
For example, if feeder fund A contributed $100 and feeder fund B contributed $200 to a master fund, fund A would receive one-third of the master fund returns while fund B would receive two-thirds.
The Benefits of the Master-Feeder Structure
The master-feeder structure’s merging of diverse portfolios into one organization is a significant advantage. Consolidation allows for cost savings in operations and trading—a broader portfolio benefits from economies of scale. Furthermore, because of its size, the portfolio has more possibilities for service and attractive conditions from prime brokers and other institutions.
Pros
- Scale economies are advantageous.
- Partnership status with tax advantages
- Both domestic and international investors will find it helpful.
Cons
- Dividends are subject to withholding tax (if distributed offshore)
- Difficulty in establishing a universal investing strategy
The Master-Feeder Structure’s Drawbacks
The main disadvantage of the master-feeder structure is that money stored offshore often faces a 30% withholding tax on U.S. profits. Another downside of the structure is that it brings together a diverse group of investors with various characteristics and investing objectives.
Often, finding a middle ground is difficult, if not impossible, because investments and tactics that are good for one type of investor would be unsuitable, if not opposing, to the criteria of a different type of investor.
Real-World Application of the Master-Feeder Structure
A 2018 court case demonstrated the complexities of relationships between a master fund and its feeder funds. The problem was how redemptions by a feeder fund from a master fund were handled in the event of a liquidation.
The Ardon Maroon Asia Dragon Feeder Fund supplemented the Ardon Maroon Asia Master Fund. The directors of the two funds were the same people. Furthermore, both funds used the same investment manager, administrator, and transfer agent.
One of the feeder fund’s investors submitted a redemption notice in 2014. The feeder fund, which had no assets of its own, expected the master fund would automatically fulfill the redemption request, known as a “back-to-back redemption.” Both funds, however, were liquidated a few months later. When the original investor sought to retrieve their money, the liquidators of the Ardon Maroon Asia Master Fund rejected it because Asia Dragon had never legally submitted a separate redemption request notice to it.
A lawsuit was launched in the Cayman Islands, where the funds were located. The Grand Court of the Cayman Islands ruled in favor of the master fund in mid-2018. Although back-to-back redemptions are usual in the business, the court noted that Ardon Maroon Asia’s constitutional papers did demand a formal notification of redemption from its feeder funds. So Asia Dragon had failed to notify its master fund separately, even though the same people served as directors of both funds and nominated the same investment manager, administrator, and transfer agent.
Conclusion
- People put money into investment funds in a master-feeder system. These feeder funds then put money into a central master fund.
- Hedge funds often use master-feeder arrangements to work with clients from the U.S. and other countries.
- The master-feeder arrangement lets funds take advantage of economies of size and “pass-through” tax breaks.
