Master-Feeder Structure

What is a Master-Feeder Structure?

A master-feeder structure is an investment setup where multiple investment funds (feeders) pool assets into a single fund (master), often used in hedge funds to optimize tax and regulatory advantages.

Hedge Funds use a Master Feeder structure to pool money from different places at a single destination. It is then managed by a designated fund manager to invest and diversify into various investments.

It is used so that investments from U.S. taxable, U.S. tax-exempt, and non-U.S. investors can accumulate in a single place known as the Master Fund. Investors put their money in separate feeder funds, which are established for each group of investors.

The money then goes to the Master Fund, which handles all trading and investing activities. All the management and performance fee is paid at the feeder fund level.

The Feeder Fund purchases stocks of the Master Fund, while the Master Fund makes all the portfolio investments. This structure allows the Master Fund to accumulate a mass of assets.

Also, the structure helps improve operational efficiencies and minimizes costs. It also helps fund managers benefit from a large pool of assets and capital.

How the Master Feeder Structure Works

The Master feeder structure, designed in the 1990s, is most commonly used by asset managers to reduce their tax liability by attracting investors from all over the world. 

Investors can choose to directly invest in a partnership, or they create feeder funds, which then deposit capital into the master fund. Feeder funds are often used by those specific investors that have unique needs, like institutional investors, charity investors, family offices, foreign investors and many more. 

This feeder fund can then purchase portions or shares of the master fund. All the investments made into the feeder fund are then consolidated and then channeled into the master fund. The master fund then acts on behalf of all the feeder funds and makes the main decisions involved in trading. 

Whether the master fund incurs profits or losses, they are divided and distributed back to feeder funds, in proportion to their share of investment made. 

The specifics of the master feeder structures vary and can have different regulatory frameworks depending on the area of jurisdiction the different investors are involved in. Hence, it is vital for investors and managers alike to thoroughly go through any requirement needed before investing. Consulting with financial and legal experts is extremely vital in order to understand the intricacies and implications of such structures. 

Composition of Master-Feeders

The taxable U.S. investors pool their money into an onshore Limited Liability Corporation (LLC), which functions as a feeder fund. The non-taxable and foreign investors invest in offshore feeder funds.

Feeder Funds get a continuous inflow of capital all the time. It's from investors interested in the investment scheme. The Feeder Fund then invests the money in the Master Fund.

The Master fund then pools the money from different Feeder Funds and invests the money into the market according to the terms and conditions of the customers and the market conditions.

The profits and losses are then shared with the feeder fund according to the capital inflow from each side. The Feeder funds then divide the profits and losses among the individual investors who invested.

The Investment Manager handles the trades and investments from the master fund and the management of the portfolio. They are paid a specific fee for their advice and management services.

Real-World Examples of Master-Feeder Structure

The most famous example of a master feeder structure is that in the hedge fund industry, particularly that of the Cayman Islands. Another one is the case of the Ardon Maroon Asia Dragon Feeder Fund and the Ardon Maroon Asia Master Fund. We will explore both examples below.

1. Cayman Islands

Caymans Islands, a British overseas territory popular as a tourist spot, is also well known in the finance community as the hub for master feeder structures. The financial and tourism sector makes up a good portion of this territory’s economy. Its features, particularly the low taxation, has led to there being many corporations registered, in fact there are more private corporations than its population! 

Given that many master funds are established in the Cayman Islands, it behaves as the main investment vehicle, and directly invests in assets or trades securities. It is an offshore entity and operates as the central domain for investments. 

The feeder funds (those that pool into the master fund) are often located in various other jurisdictions. They attract investors and ‘collect’ capital from them and channel it to the master fund, instead of directly investing in assets themselves. 

2. Ardon Maroon Asia Dragon Feeder Fund and the Ardon Maroon Asia Master Fund

This is a specific example of a master-feeder structure that was based in the Cayman Islands. In this case, the master fund was the Ardon Maroon Asia Master Fund. The feeder funds were Ardon Maroon Asia Dragon Feeder Fund, and Ardon Maroon Asia Eagle Feeder Fund LP. 

The Union Bank of Switzerland (UBS) was one of the investors in the Ardon Maroon Asia Dragon Feeder Fund. In 2014, UBS redeemed shares with a magnificent value of 15 million USD. However, Ardon Maroon Asia Dragon Feeder Fund did not offer any prior notice to the master fund, which resulted in Ardon Maroon Asia Master Fund not being able to liquidate the mentioned amount. 

This resulted in a long 4 year court case wherein both the master and feeder funds were placed in a voluntary liquidation under the supervision of the Cayman Grand Court. 

The root issue in this case came from legal ambiguity surrounding the documentation exchange between the main fund and its feeder. Additionally, there was an assumption that one corporate entity could copy the practice of another merely because they had common directors, which is unlawful in the absence of a clear agreement. 

This case shows us that whilst the master-feeder structure is financially appealing, knowing the intricate legalities behind it is extremely crucial before fully committing to it. 

Master-Feeder Structure vs Fund Of Funds

In terms of structure, the master-feeder structure involves the whole process of creating feeder funds and then aggregating it into the master fund. The master - feeder structure has a clear and well established hierarchy. On the other hand, a Fund of Funds is when a single fund invests in multiple underlying investments, instead of a single security. 

The master-feeder structure involves direct investment in the master fund. The master fund controls the trading activities directly. Conversely, a fund of funds typically involves indirect investment in their investments. The fund of funds has no involvement in any trading decisions. 

When it comes to the primary objective, The master-feeder structure has a master fund that mainly does the trading and manages investments directly, whereas the fund of funds’ aim is that of diversification across multiple investments (as mentioned previously). 

The master-feeder structure offers a concentrated risk based on the strategies and investments of the master fund. In the case where the master fund incurs loss, the loss is then divided across the feeder funds depending on their share. The fund of funds always looks to mitigate such risks and hence why their aim is diversification, it reduces their overall portfolio risk. 

Advantages of the Master-Feeder Structure

There are various advantages to using a Master Feeder Structure. Some are listed below:

1. Reduced Trading Costs

Pooling a large amount of capital from various investors allows fund managers to execute trades for multiple investors in a single trade. This helps minimize trading fees.

Usually, trading fees are levied on every single transaction made by investors. Here in the Master-Feeder Structure, when the portfolio manager trades for everyone, they avoid paying multiple transaction fees.

2. Economies of Scale

Creating a Master Fund generates economies of scale and provides various benefits, like saving time, reduced transaction fees, management fees, and operational costs.

For example, portfolio managers can conduct risk and security analyses for a single trade which can be executed for all investors. Different feeder funds would require them to conduct analyses for different trades and consume time.

3. Diversity of Investors

The Master Feeder Fund structure allows investments from around the world, making the invested money a larger pool of funds.

Also, onshore and offshore feeder funds ensure that the tax processes are maintained for the U.S. taxable income.

Disadvantages of the Master-Feeder Structure

On the other hand, there are multiple disadvantages to using a Master Feeder Structure. Some are listed below:

1. Complex tax Accounting

The Feeder funds in this structure must maintain their accounting books in addition to the Master funds. This makes it a long and tedious process.

Also, because the profits and losses have to be distributed to different investors in different ratios, it is a complicated process.

In addition to this, an offshore fund is generally subject to a 30% withholding tax on U.S. dividends. If a fund tries to avoid such transactions, it incurs increased costs that it otherwise would not experience.

2. Strategic Conflicts

The Master fund takes its funds from the different Feeder funds in which investors pool their money. These investments come in from a lot of other people.

All these different people have different investment goals, purposes, and strategies. While some might look for risk-free investments with annual gains, some might be risk-seeking investors.

This leads to the fund manager looking for different interests and consequences with the same fund. This may lead to strategic conflicts during investing from the Master Fund.

3. Securities constrained by regional restrictions

Although the investments come into the Feeder fund from the investors' sides, some regional restrictions may complicate some investors investing in certain securities.

This makes investing from the Master Fund also difficult. Therefore, it limits the securities the Master fund can invest in.

Researched and authored by Prabhav Gupta | LinkedIn

Reviewed and edited by Sreelakshmi Sreejith | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Active Return
• Convergence
• Margin
• Seed Financing
• Timberland