Hedge Funds Are Crazier Than You Thought
Take a look into the incredible and complex workings behind some of the most powerful funds.
You hear stories all the time about how some secretive hedge fund manager set up a complex web of controlled funds to cheat taxes and hide profits. But usually, the story stops there.
The world of inter-woven corporate fund structures gets complicated fast, but when you take a second to unpeel the layers, it becomes much more simple, and a lot more interesting.
So, let’s break down how one of these structures work and see why they’re used so much.
Master-Feeder Funds
A master-feeder structure is a common arrangement used by hedge funds to pool together assets from multiple investors while addressing their diverse legal, tax, and regulatory requirements. It consists of two main entities: the master fund and the feeder funds. Here’s what you need to know:
- Master Fund: The master fund is the central entity that makes investment decisions and holds the assets. It is typically organized in a tax-neutral jurisdiction like the Cayman Islands, British Virgin Islands, or Bermuda.
- Feeder Funds: Feeder funds are separate investment vehicles that pool investor capital and feed it into the master fund. These feeder funds are created to cater to different types of investors based on their jurisdiction, tax status, and investment preferences. The most common types of feeder funds are:
- Domestic Feeder Funds: This fund is designed for investors who are residents or domiciled in the same country as the hedge fund manager. This feeder fund is typically structured as a limited partnership (LP) or limited liability company (LLC).
- Offshore Feeder Funds: This fund is tailored for non-resident investors or tax-exempt U.S. investors such as pension funds, endowments, and charities. It is usually organized in a tax-neutral offshore jurisdiction.
All About The Taxes
Now that you know how the structure works, let’s see why it’s so useful:
Let’s say that a hedge fund manager, based in the United States, wants to invest in a European company and wants to attract investment capital from both US-based and European-based investors. The manager sets up a master fund in the Cayman Islands, a domestic feeder fund in the U.S., and an offshore feeder fund in Bermuda. The domestic fund receives investments from US-based investors, while the offshore fund receives investments from Europe-based investors.
The master fund then invests directly in the European company, using the assets held by the feeder funds.
Now, let’s assume that the European company pays a dividend to the master fund. Since the Cayman Islands has a lower tax rate than the U.S., the master fund pays a lower tax rate on the dividend income it receives from the European company. If the master fund were located in the US, it would pay the US corporate tax rate on the dividend income, which is significantly higher than the Cayman Islands tax rate.
So, by using a master-feeder structure, a fund manager can accept money from domestic and international investors, while having a significantly lower tax bill on profits.
Politics aside; that is one creative structure!
If this article piqued your interest, you’d likely enjoy some of my other posts just like this one:
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Happy trading! :)
