Characterise the usual organizational structure of a hedge fund and account for why that structure is chosen.
The idea
A hedge fund is usually not a single entity. A management company, often a limited liability company, employs the investment staff and earns the management and performance fees. It also acts as general partner of the fund, which keeps the fund's liabilities away from the firm. The fund itself is commonly split into two. An onshore limited partnership serves US taxable investors, who want tax pass-through. An offshore corporation, often in the Cayman Islands, serves non-US and US tax-exempt investors, who avoid unrelated business taxable income from leverage. In a master-feeder structure both feeders invest in one master fund that runs a single portfolio, so trades are not duplicated. An independent administrator, custodian, auditor and prime broker give control and credibility. Limiting investor numbers or admitting only qualified purchasers keeps the fund outside registered investment company rules. Exam point: structure follows tax status, liability limits, regulatory exemption and operational efficiency.
A practice question
Why do many hedge funds operate both an onshore limited partnership and an offshore corporation?
- To let the manager avoid paying any performance fees to investors.Why not: Wrongly suggests the structure removes fee obligations; fees are set in fund documents.
- To allow the fund to borrow more than regulations permit for either entity alone, using each as a separate borrower.Why not: Leverage limits are not what the dual structure is for.
- To split the portfolio so that each entity holds different securities and follows its own strategy.Why not: Both generally follow the same strategy, often through a master fund.
- To serve investors with different tax status, such as US taxable and non-US investors. - correct
Taxable US investors usually prefer a pass-through partnership, while foreign and US tax-exempt investors prefer an offshore corporation. Running both lets one manager serve both groups with one strategy.
A harder one
A manager runs one strategy for taxable US investors and for non-US investors. In a master-feeder structure, which description is most accurate?
- Each feeder runs its own portfolio, and the master fund only consolidates the reported returns of both.Why not: The master actually holds and trades the portfolio.
- The master fund sells units to investors, and the feeders hold only cash for redemptions and fees.Why not: Investors subscribe to the feeders, not to the master.
- Each feeder gathers capital from its investors and invests in one master fund that trades. - correct
- The master fund is the manager, which collects fees from the feeders for running the trades.Why not: The master is a portfolio vehicle, not a management company.
Feeders are the investor-facing entities, each suited to its investors' tax position, and both invest in the master. Trades are executed once, and all investors share the same portfolio and performance.
The hardest tier
A master-feeder structure serves a taxable onshore feeder and an offshore feeder. Which is the most important operational drawback for the onshore feeder's investors?
- Onshore investors lose the pass-through tax treatment because the master is a corporation, whatever the feeder.Why not: Tax treatment follows the feeder's own form, so this is not the main drawback.
- The master fund cannot use leverage, which reduces onshore returns relative to the offshore feeder.Why not: The master can use leverage; it is the portfolio vehicle.
- The offshore feeder's trades are executed first, so onshore investors receive worse prices on theirs.Why not: Trades are executed once at the master and shared pro rata.
- Offshore redemptions force the master to sell assets, and the costs fall on all master investors. - correct
Because both feeders share the master's portfolio, redemptions at one feeder may force the master to raise cash by selling assets. The costs and the loss of diversification fall on the remaining investors, including the other feeder.
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