What Is a Master-Feeder Structure?

A master-feeder structure is a common mechanism employed by hedge funds to consolidate taxable and tax-exempt capital from investors, both domestic and international, into a central master fund. This structure involves establishing separate investment vehicles, known as feeder funds, for different investor groups.

Investors contribute capital to their respective feeder funds, which then channel these funds into the master fund for portfolio investments and trading activities. The feeder funds manage management and performance fees at their level.

How the Master-Feeder Structure Works

The master-feeder structure commences with investors depositing capital into the feeder fund. The feeder fund, acting as a container for all investor capital, then purchases shares of the master fund, enabling it to receive the income attributes of the master fund, such as interest, gains, and dividends.

While this two-tiered structure can manifest in various forms, it is prominently utilized by hedge funds serving a diverse investor base spanning from the U.S. to offshore locations. This setup allows fund managers to leverage a larger capital pool and create specialized investment funds for specific market segments.

Composition of Master-Feeders

Typically, a master-feeder structure includes an offshore master fund coupled with an onshore feeder and an offshore feeder. Feeder funds investing in the same master fund possess flexibility in choosing various attributes such as investor types, fee structures, and investment criteria.

This structure grants feeder funds independence to invest in multiple master funds instead of being tied to one specific option, enhancing diversification and risk management capabilities.

For instance, if feeder fund A contributes $100 and feeder fund B contributes $200 to a master fund, fund A would receive one-third of the returns, while fund B would receive two-thirds.

Advantages of the Master-Feeder Structure

An essential benefit of the master-feeder structure is the consolidation of portfolios into a single entity, leading to cost reductions and economies of scale. A larger portfolio opens doors to better services and favorable terms from financial institutions.

Pros

• Economies of scale

• Tax-advantaged partnership status

• Convenient for both domestic and international investors

Cons

• Dividends subject to withholding tax (if offshore)

• Difficulty of setting universal investment strategy

Disadvantages of the Master-Feeder Structure

A primary drawback of the master-feeder structure is the imposition of a 30% withholding tax on U.S. dividends for funds held offshore. Additionally, the structure’s heterogenous investor base can lead to challenges in aligning investment strategies with varying investor preferences.

Balancing the divergent needs of different investor types can be complex, posing obstacles in developing a cohesive investment approach that caters to all participants.

Real-World Example of Master-Feeder Structure

The dynamics between a master fund and its feeder funds were brought to light in a 2018 legal case, highlighting issues related to redemptions in a liquidation context.

In the case of the Ardon Maroon Asia Dragon Feeder Fund and the Ardon Maroon Asia Master Fund, mutual leadership and shared service providers complicated redemption processes when both funds faced liquidation.

A legal dispute arose upon the failure of the feeder fund to formally notify the master fund of a redemption request, leading to a contentious legal battle and a verdict in favor of the master fund.

This exemplifies the intricacies and potential challenges of managing a master-feeder structure in real-world scenarios, underscoring the importance of clear communication and compliance with operational protocols.