A hedge fund is a vehicle for pooling the capital of a group of investors, each with their own attributes and preferences, in order to invest jointly in a targeted market, employing one or more alternative strategies under the direction of a designated professional advisor who is compensated with both a management fee and with a performance fee.
There is a common structure for organizing this pool to accommodate the requirements of the various constituencies, including tax and regulatory authorities, called a Master/Feeder structure. Subsequent articles will address tax and regulatory issues.
How Hedge Funds are Structured: Hedge Funds Have Many Constituents
Descriptions in the popular press often confuse the hedge fund manager and the hedge fund, using the catch-all phrase “hedge fund”. The hedge fund manager is the management company that acts as the investment advisor to the hedge fund, the vehicle actually engaged in investing. Sometimes, the press will refer to an individual as the hedge fund manager, often the Chief Investment Officer of the management company.
In practice, the hedge fund is not a single vehicle, but an assortment of affiliated companies acting as a hedge fund family. When the press talks of hedge funds or a particular hedge fund, they refer to this family of affiliates.
Here is a brief list of the key constituents whose characteristics factor into the structuring of the hedge fund family:
- The hedge fund management company
- The partners in the hedge fund management company
- US taxable “onshore” investors
- US tax-exempt investors
- “Offshore” investors who are not US taxpayers
- Government and other regulatory authorities
A US tax-exempt investor is a person that qualifies as exempt from US taxation by virtue of its purpose, including endowments, foundations, pension plans and other organizations. The hedge fund management company is typically an onshore vehicle the partners of which are themselves US taxable persons. Note that US taxation law is citizenship-based, not location-based. A US citizen living in, say, Singapore still has to pay US taxes, despite living in a low-tax jurisdiction. Offshore investors are foreign citizens who are not required to file US tax returns and pay US taxes.
The Hedge Fund Advisor Forms A Management Company And General Partnerships
Also, note that the hedge fund management company compensation includes a management fee and an incentive fee. This is important because of something called the Unincorporated Business Tax, a tax in New York City, home to many hedge fund managers. New York City charges a tax of 4% of the net income for unincorporated businesses including “trades, professions, and certain occupations of an individual, partnership, limited liability company, fiduciary, association, estate or trust.”
The Hedge Fund Blog writes on the UBT’s practical implications for hedge fund organization:
“New York City’s Unincorporated Business Tax (‘UBT’) currently is, and has been historically imposed only on management fees earned in the city, but not on incentive allocations. This tax treatment was formally approved by a statutory amendment to the UBT law over 15 years ago. For this reason, fund managers have formed one entity to be the management company that will receive the asset-based management fees, and another entity to serve as a fund’s general partner and receive the profits-based incentive allocations.”
The management company receives the management fee from which it pays specific expenses that are not associated directly with the investment activities of the fund:
- Employee salaries and benefits
- Employee bonuses
- Office rent
- Legal fees related to the establishment of the management company entity
- Ongoing legal fees
- Management company accounting
- Miscellaneous office expenses, including telephone
Other expenses related directly to investment activities are charged to the fund, as an offset to the gross returns:
- Travel related to investment (e.g. conferences, company visits)
- Bloomberg terminals
- Research services such as Capital IQ
- Data fees
- Fund administration fees
- Fund auditor fees
- Legal fees related to the establishment of the investing entities
- Ongoing legal fees related to the investing entities
The exact split of expenses to be charged back to the fund and expenses to be borne by the management company will be identified in the fund’s offering documentation, essentially the private placement memorandum for interests in the fund.
A feeder fund is a fund that participates in the investments made in another fund, called a master fund. There may be other feeder funds that contribute, or feed, capital into the master fund where the hedge fund advisor manages them jointly, allocating trades and profits on a pro rata basis.
Having different feeder funds may permit differences along (at least) the following axes within the same hedge fund structure:
- Taxable (onshore feeder) vs. tax-exempt (offshore feeder)
- Required redemption notice periods
The diagram below shows the master/feeder structure in its basic format.
Reference: Advent Software
Note that in this diagram, there is only a general partnership for the US onshore feeder. In practice, most often, there would be a general partnership for the offshore feeder, as well.
We need to consider several classes of transactions:
- Subscriptions and redemptions in which investors place capital with and withdraw capital from the feeder funds
- The execution of trades
- The payment of fees
When an investor places capital with one of the feeder funds, she does so by subscribing to the equity interests issued by the feeder fund, a limited liability company. This subscription takes place after the investor has read thoroughly the offering memorandum and subscription documents for the relevant feeder. Once eligible, i.e. after lockups have expired and with the contractual notice, an investor may withdraw, or redeem, some or all of his capital account, the value of which will have been adjusted for gross returns less fees and fund expenses, by selling her interests back to the feeder fund. Subsequent articles will discuss the various terms that form the substance of the offering.
Once the investor has subscribed to the equity interests of the feeder funds, the feeder funds in turn buy equity interests in the master fund, itself a partnership or limited company. Trading takes place in one book at the master fund where the gross returns accumulate on a pro rata basis across the various equity interests. The taxable characteristics of the master fund flow through its equity interests back to the feeder funds owners of these interests.
Investors pay the management fees and the incentive fees at the level of the feeder fund. The management fee is paid by the feeder funds to the management company, while the incentive fee is paid by the feeder funds to their general partnerships, as appropriate. Note also that the fund expenses will be allocated and paid out at either the feeder fund or master fund level.
Each feeder fund may have more than one share class, differing in terms of the fees they pay, their liquidity, their required redemption periods, etc.
A hedge fund’s reported net returns are the returns of the feeder fund, by share class, after deducting fund expenses and fees from the gross returns generated by their share of the trading activity.
How Hedge Funds are Structured: The Master/Feeder Structure Introduces Tremendous Organizational Flexibility
Hedge funds are designed for flexibility. They can pursue a broader variety of investment strategies than traditional investment vehicles, for example. The master/feeder structure permits the hedge fund to target investors regardless of their taxable status, in addition to being able to offer simultaneously multiple combinations of contractual features.
 For the purposes of explanation, we will explain everything from the perspective of the United States.
 NYC Unincorporated Business Tax (UBT) http://www.nyc.gov/html/dof/html/business/ubt.shtml
 Hedge Fund Blog, “New York City Unincorporated Business Tax Update,” February 13, 2012 http://www.hedgefundlawblog.com/new-york-city-unicorporated-business-tax-update.html
 Advent Software, “Understanding Master Feeder Accounting, “www.advent.com/collateral/understanding_master_feeder_accounting.pdf