Some of the most important considerations managers must account for with respect to the decision on fund structure are the manager’s investment strategy; the nature and place of domicile of its investors; and the total amount of assets expected to be raised.
The simplest fund structure continues to be “side by side.” Here the domestic and offshore fund each make their own separate investments. Trade executions are usually allocated based upon capital in each fund, assuming similar investment strategies. Each fund is responsible for and pays it own expenses. The offshore is used for non-US investors and US tax exempt investors. Off-shore funds are attractive to US tax-exempt investors to avoid Unrelated Business Taxable Income (UBTI) which typically comes about if the fund buys securities on margin.
A typical master-feeder structure is comprised of three entities: a master fund, usually domiciled in an offshore location, and two feeder funds, one a US domicile and the other an off-shore. The two feeder funds invest all their assets into the master fund which then makes all the investments. The investments are allocated to the feeder funds based upon their respective capital balances. Similarly, common expenses are paid by the master fund and allocated to the feeders based upon capital. Foreign investors do not want the IRS to try and declare their income effectively connected to a US trade or business as that would expose them to US income tax. The master fund must make a “check the box” election to be taxed as a partnership for US tax purposes.
The mini-master structure came about because of the Economic Stabilization Act of 2008. Rather than three entities typical of the master-feeder structure, in this instance we have two funds, typically an offshore feeder and a domestic master fund. The offshore feeder is taxed as a corporation to avoid UBTI for US tax exempt investors. If the master fund is structured as a partnership, the manager would receive its performance fee as an allocation of income which would retain the same character as was generated at the fund level. Therefore, the manager would be able to benefit from any long-term capital gains created by the master fund.
The benefit of the master-feeder or mini-master structure is a single trading entity and one portfolio to manage. Also, there is just one performance result which needs to be maintained.