Structuring the Hedge Fund
Structuring a hedge fund involves both the creation of one or more entities through which investments will be made (domestic and offshore hedge funds), as well as the management entities through which the advisory services will be provided to the hedge funds (the general partner and/or the investment manager). The structure and domicile of the hedge fund is primarily dependent upon two variables: (i) the nature and demographics of the prospective investors, and (ii) the investment strategy employed by the investment manager. Investors can be divided into three classes: (i) U.S. taxable investors, (ii) U.S. tax exempt investors, and (iii) non-U.S. persons. In the majority of circumstances, if the investors are U.S. taxable investors, the fund will be formed as a U.S. limited partnership or limited liability company. The U.S. fund is often referred to as a “domestic fund.” Most domestic funds are organized in Delaware. If the investors are U.S. tax-exempt investors or non-U.S. persons, the fund generally will be formed in a jurisdiction outside of the U.S. as a corporation (or other analogous entity). The non-U.S. entity is often referred to as an “offshore fund.” Most offshore hedge funds organized on behalf of U.S. based investment managers are organized in Bermuda, the British Virgin Islands and the Cayman Islands. U.S. tax-exempt investors typically prefer to invest in an offshore fund set up as a corporation because if the offshore fund purchases securities on margin (often referred to as leverage), an offshore fund which is set up as a corporation blocks the unrelated business taxable income (“UBTI”) that would otherwise be taxable to the U.S. tax-exempt investor.
In determining whether to form both a domestic and an offshore hedge fund, it is advisable to anticipate the funds’ asset size within a few months after launch. The anticipated aggregate investment at or shortly after the launch of the business may not justify the formation of both a domestic fund and an offshore fund and to create both may impair the investment manager’s ability to survive due to the organizational expenses and the costs of maintaining both domestic and offshore hedge funds. With early stage managers, cash burn is often overlooked and can be critical to the survival. The manager must have an opportunity to establish a proven track record.
Types of Hedge Fund Structures
Side-by-side: In a side-by-side structure, the domestic fund and the offshore fund make direct investments pursuant to the investment strategy, and trade executions are allocated between the domestic fund and the offshore fund.
Master-feeder: In a master feeder structure, a third entity is created (the “master fund”) and the domestic fund and the offshore fund, rather than making direct investments, invest substantially all of their assets into the master fund and in turn, the master fund makes the investments on behalf of the domestic fund and the offshore fund (often referred to as the domestic feeder and offshore feeder, respectively).
Mini-Master: The mini-master structure generally is comprised of two entities; an offshore feeder and a master entity. While the offshore feeder is taxed as a corporation to benefit U.S. tax exempt investors and block UBTI, the master entity may be structured for tax purposes as a partnership. Rather than the U.S. based manager receiving its incentive revenue as a fee from the offshore fund and being subject to ordinary income tax, the U.S. based manager may receive incentive revenue as an allocation from the master entity, in an attempt to benefit from capital gains tax treatment.
Several legal and commercial drivers determine the ideal hedge fund structure. For example, if the strategy calls for significant investment in illiquid or thinly-traded positions which are difficult to allocate among two brokerage accounts, a master feeder structure may be preferred. The investments will be allocated on a pro rata basis at the master fund yet only require the investment manager to purchase and sell the positions through one brokerage account. Also, in many transactions involving early stage or “seed” investments, if the seed investor is located offshore, it may prefer a master feeder structure so that all fees and allocations may be taken at the master fund and thus avoid the U.S. tax regime. Conversely, employing a tax efficient strategy for U.S. taxable investors may be of little benefit or detrimental to U.S. tax-exempt investors and non-U.S. persons. Thus, a side by side structure allows the investment manager the ability to employ tax efficiency with the domestic fund, while maximizing the entry and exit points of each securities position without regard to long term tax gains for the offshore fund.
Structuring and Domicile of the Investment Manager
The structure and domicile of the investment manager is primarily determined by the citizenship and tax considerations of its principals, as well as the regulatory regime of the jurisdiction. Empirical evidence suggests that the super majority of hedge funds are managed by U.S. domiciled entities structured as either limited liability companies or limited partnerships which are taxed as flow through vehicles (rather than as corporations). In circumstances involving non-U.S. persons, if the non-U.S. persons own the majority of equity in or receive the majority of the economics from the investment manager and their interests are controlling, the investment manager may be organized in an offshore jurisdiction to accommodate the tax needs of the non-U.S. persons.
Historically, federal and state regulation often impacted the location at which the investment manager maintained its office in the United States. Certain states have compulsory registration requirements which require an investment manager with an office in those states to register as an investment adviser prior to the launch of the hedge fund. Prior to The Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) certain managers chose to maintain offices in neighboring states which did not have compulsory registration requirements so as to avoid having to register as an investment adviser. Post Dodd Frank, managers have accepted registration as an investment adviser as inevitable.