Do you want to form a hedge fund? Do you want to restructure your existing funds in light of the current economic environment?  This article is for fund managers who want to start a new fund or restructure existing funds.

Part I- Structural Options

I. Defining “Hedge Fund”

A “hedge fund” is a private investment vehicle organized for the purposes of pooling investors’ assets and applying a centralized investment strategy and management style. The sponsor of the hedge fund is commonly referred to as the “asset manager” or “investment advisor.” Although historically, the defining characteristic of a hedge fund was to “hedge” against market risk and volatility, hedge funds today apply a variety of investment techniques. Because financial engineers constantly develop new mechanisms and strategies to increase investment returns, it has become difficult to define hedge funds solely by investment style. Hedge funds are, in fact, more readily defined by their form of organization and manner of operation, rather than by the substance of their activities in the financial markets. Hedge funds have the common characteristics of (a) centralized management, (b) co-investment, (c) performance-based compensation, and (d) limited liquidity. 

II. Structural Options for Hedge Funds

The legal structure of a hedge fund largely depends upon the characteristics of its targeted investors. For example, a private investment vehicle formed to manage the assets of U.S. taxable investors will be different from a private investment vehicle formed to manage assets of U.S. tax-exempt investors (such as charitable foundations and pension funds) and non-U.S. investors.

A. Domestic Fund

For the purpose of managing the assets of U.S. taxable investors (U.S. persons other than endowments, charitable foundations, pensions, and other tax-exempt investors), a hedge fund is typically organized as a limited liability company (LLC) or limited partnership in Delaware, as this legal structure affords great management power and flexibility and enables the fund to have tax efficiency for its investors (LPs). By purchasing an ownership interest in the LLC or the partnership, an investor becomes a non-managing member (in the case of an LLC) or a limited partner (in the case of a partnership), while the asset manager becomes a managing member (in the case of an LLC) or a general partner (in the case of a partnership).

See Chart I below for a typical domestic fund structure.

As shown above, in an attempt to limit personal liability, the sponsor-asset manager of a domestic fund usually forms another entity to provide advisory services to the domestic fund. Instead of the sponsor-manager firm, it is this new entity that will serve as the managing member (in the case of an LLC) or the general partner (in the case of a partnership) of the fund.  Depending on the laws of the state in which this advisory firm will be domiciled, the hedge fund manager (i.e., the sponsor-manager) will organize the advisory firm as a limited liability company, corporation, or limited partnership. In certain cases, the sponsor-manager will form two entities, one entity to serve as the managing member (or general partner, in the case of a partnership) who will receive performance-based compensation from the fund, and the other entity to serve as the asset manager/advisory firm who will receive 1-2% of the asset management fee.

The use of an entity as the general partner or investment adviser, however, will not shield an individual manager from personal liability for fraud and other claims under federal and state securities laws.

B. Offshore Fund

For the purpose of managing the assets of non-U.S. investors and U.S. tax-exempt investors (such as endowments, pensions, and charitable foundations), an offshore fund is predominantly structured as a corporation and organized in a tax haven jurisdiction. Under tax regimes of many countries, an offshore corporation organized in a tax haven will often enable non-U.S. investors to defer taxes in their home countries on earnings from the fund until they dispose of their shares. An offshore partnership doesn’t afford such a deferral.  In addition, an offshore corporation (that is not engaged in U.S. trade or business and that withholds dividend and interest income) will not be required to file a U.S. tax return; an offshore partnership is required to file a U.S. tax return.  Offshore funds are attractive to U.S. tax-exempt investors (e.g., individual retirement accounts, charitable foundations, pensions, endowments, and profit-sharing trusts) as a method for avoiding tax liabilities related to “unrelated business taxable income.”

As shown in Chart II below, the sponsor-manager of an offshore fund often forms a corporate entity to provide advisory services to the fund. If the sponsor-manager already manages the assets of a domestic fund through a single corporate entity, the managing member or the general partner of such domestic fund may be used to serve as the asset manager of the offshore fund.  If the sponsor is managing a domestic fund through two corporate entities, the entity serving as the asset manager of the domestic fund will ordinarily serve as the asset manager of the offshore fund.

C. Other Structural Options

Fund managers with both U.S. taxable investors and non-U.S. investors (as well as U.S. tax-exempt investors) would need to establish both a domestic and an offshore fund.  In such a situation, either a parallel fund structure or a master-feeder fund structure is utilized. There are various tax, administrative and other issues that the manager should consider in determining whether to utilize a master-feeder fund structure or a parallel fund structure.

1. Parallel Fund Structure

In a parallel fund structure, U.S. investors typically invest in an LLC or a limited partnership organized in the United States and offshore investors and U.S. tax-exempt investors invest in an offshore corporation. The prime broker typically allocates trade tickets between the domestic fund and the offshore fund.

2. Master-Feeder Fund Structure

This structure allows U.S. investors and non-U.S. investors to invest, indirectly, in the same offshore corporate entity known as the “master fund” via two feeder funds, one domestic and one offshore. Mainly for tax reasons, U.S. taxable investors directly invest in a fund organized in the United States. This fund is referred to as the “domestic feeder.” The offshore investors and U.S. tax-exempt investors directly invest in an offshore corporation. This offshore corporation is referred to as the “offshore feeder.” Each feeder fund, then, invests all assets into the master fund. The fund manager then purchases and sells securities in an account held in the name of the master fund. The master fund can be structured as a limited partnership or an offshore company.

3. Mini-Master Fund

U.S. fund managers of offshore funds generally receive their incentive compensation from offshore funds in the form of an incentive fee, as opposed to an incentive allocation from a partnership (note the difference between a fee and an allocation).  For many years, fund managers deferred receipt of performance fees generated from their offshore funds in order to avoid taxation and permitted these pre-tax fees to be reinvested in the offshore funds.  In 2008, however, section 475A of the Internal Revenue Code was enacted, which effectively eliminated this tax deferral benefits. With the benefits of tax deferral and the potential for pre-tax appreciation of offshore fees gone, fund managers restructured their fund structure to enable the manager to receive an incentive allocation from the co-investment entity in lieu of a fee.  These co-investment structures are commonly referred to as “mini-master fund structure.”

Under a mini-master fund structure, the offshore corporation invests in an entity (the “mini-master fund”) that is treated as a partnership for U.S. federal income tax purposes. The GP of the mini-master fund is the manager, which itself is organized as an entity treated as a partnership for tax purposes. This way, the manager receives an incentive allocation rather than an incentive fee from the offshore fund. When the underlying trading generates long-term capital gains, non-corporate managers may benefit from a lower tax rate.  Section 457A does not apply to partnership allocations. 

The mini-master structure has two types: (a) offshore mini-master parallel structure and (b) mini-master master-feeder structure.  Please see Chart V and Chart VI below.