What is a Master-Feeder Structure?
A master-feeder structure is a device—commonly used by hedge funds—to pool taxable and tax-exempt capital raised from investors in the United States and overseas into as a master fund. Separate investment vehicles—otherwise known as feeders—are established for each group of investors.
Investors put capital into their respective feeder funds, which ultimately invest assets into a centralized vehicle known as the master fund. The master fund is responsible for making all portfolio investments and conducting all trading activity. Management and performance fees are paid at the feeder-fund level.
- In a master-feeder structure, investment funds are formed from investor capital; these feeder funds, in turn, invest in a centralized master fund.
- Hedge funds commonly use master-feeder structures to accommodate both U.S. and non-U.S. investors.
- The master-feeder structure allows funds to benefit from economies of scale and favorable "pass-through" tax treatment.
How the Master-Feeder Structure Works
The master-feeder structure begins with the investors, who deposit capital into the feeder fund. The feeder fund, containing all the limited partnership/shareholder capital, then purchases "shares" of the master fund, much like it would buy shares of any company’s stock. The primary difference, of course, is that a feeder fund—by buying into the master fund—receives all of the master fund’s income attributes, including interest, gains, tax adjustments, and dividends.
Although this two-tiered structure can exist in a variety of forms—like "funds of funds" mutual funds—the master-feeder structure is especially common among hedge funds catering to both U.S. and offshore or overseas investors. The use of the master-feeder fund structure allows asset managers to benefit from a large capital pool while also being able to fashion investment funds that cater to niche markets.
Composition of Master-Feeders
The average master-feeder structure involves one offshore master fund with one onshore feeder and one offshore feeder. Feeder funds investing in the same master fund have the option of choice and variation. In other words, the feeders may differ in investor type, fee structures, investment minimums, net asset values, and various other operational attributes. In this way, the feeder funds do not have to adhere to a specific master fund but can function legally as independent entities with the ability to invest in various master funds.
For example, if feeder fund A's $100 contribution and feeder fund B's $200 contribution provided the total investments to a master fund, then fund A would receive one-third of the master fund profits while fund B would receive two-thirds of the returns.
Advantages of the Master-Feeder Structure
One significant advantage of the master-feeder structure is the consolidation of various portfolios into one entity. Consolidation allows for reductions of operation and trading costs. A larger portfolio has the benefit of economies of scale. Also, because of its size, the portfolio has better options when it comes to service and more favorable terms offered by prime brokers and other institutions.
Economies of scale
Tax-advantaged partnership status
Convenient for both domestic and international investors
Dividends subject to witholding tax (if offshore)
Difficulty of setting universal investment strategy
Disadvantages of the Master-Feeder Structure
The primary drawback to the master-feeder structure is that funds held offshore are typically subjected to a 30% withholding tax on U.S. dividends. There is another disadvantage inherent in the structure, as it pools together a combination of investors that often have a wide spectrum of characteristics as well as investment priorities.
Often, the battle to find a middle ground is uphill, if not entirely impossible, as investments and strategies that are suitable to one specific type of investor will be unsuited, if not oppositional, to the requirements of a different type of investor.
Real World Example of Master-Feeder Structure
Relationships between a master fund and its feeder funds can be complex, as a 2018 court case showed. At issue was how redemptions by a feeder fund from a master fund are treated in a liquidation scenario.
The Ardon Maroon Asia Dragon Feeder Fund was a feeder fund to the Ardon Maroon Asia Master Fund. The same people served as directors of two funds. Also, both funds appointed the same investment manager, administrator, and transfer agent.
In 2014, one of the feeder fund's investors submitted a redemption notice. The feeder fund, which held no assets of its own, assumed the master fund would automatically satisfy the redemption request—something called a "back-to-back redemption." However, both funds went into liquidation a few months later. When the original investor submitted a proof of debt, seeking to collect their money, it was rejected by the liquidators of the Ardon Maroon Asia master fund, on the basis that Asia Dragon had never officially submitted a separate redemption request notice to it.
A lawsuit ensued, filed in the Cayman Islands, where the funds were based. In mid-2018, the Grand Court of the Cayman Islands decided in favor of the master fund. Although back-to-back redemptions are common industry practice, the court noted that the constitutional documents of Ardon Maroon Asia did require a written notice of redemption from its feeder funds.
So, Asia Dragon had been remiss in not separately notifying its master fund—even though the same people served as directors of two funds, and both appointed the same investment manager, administrator, and transfer agent.