Description of a Hedge Fund
A "hedge fund" is a private investment vehicle organized for the purpose of pooling investors' assets. The sponsor of the hedge fund, commonly referred to as the hedge fund manager, invests the hedge fund's assets pursuant to a predetermined investment strategy. It is argued that in the absence of such a pooling vehicle, an investor, on its own, would not be able to diversify its assets or have the resources to monitor, evaluate and implement the investing and trading strategies to be engaged in by the manager. Although historically the defining characteristic of a hedge fund was to "hedge" against market risk and volatility, hedge funds today apply a variety of investment techniques. Unlike mutual funds, which are highly regulated, hedge funds: (i) are not required to redeem investors' assets within seven days from the date on which it receives a notice for redemption from an investor; and (ii) may take illiquid positions without limitation and may engage in leveraged transactions with greater freedom.
Legal Structure
The legal structure of a hedge fund largely depends who its investors will be. For example, a private investment vehicle formed for the benefit of persons who reside outside of the United States will be organized differently than an investment vehicle formed for the benefit of United States residents.
Domestic Partnership
For the purpose of managing the assets of persons residing in the United States, a hedge fund is ordinarily organized as a limited partnership. By purchasing an interest in the partnership, an investor becomes a limited partner of the partnership.
In an attempt to limit personal liability, the manager of a domestic fund usually forms an entity to provide advisory services to the partnership. This entity serves as the general partner of the partnership. Depending on the laws of the state in which the general partner will maintain its office, the hedge fund manager will organize the general partner as a limited liability company, corporation or limited partnership. In certain cases, however, the manager will form two entities, one entity to serve as the general partner and the other entity to serve as a management company. The use of an entity as the general partner or management company, however, will not shield an individual manager from personal liability for fraud and other claims under the federal securities laws
Offshore Fund
For the purpose of managing the assets of persons residing outside of the United States, an offshore fund is ordinarily structured as a corporation and organized in a tax haven jurisdiction (e.g. Bermuda, British Virgin Islands, Cayman Islands, Ireland). The jurisdiction in which the fund is organized often depends on the countries in which investors reside and the type of entity the sponsor desires to form. Also, certain jurisdictions, such as the Cayman Islands, have a well-developed regulatory system for organizing and maintaining investment funds but are more expensive than other jurisdictions, such as the British Virgin Islands, which do not have as extensive a regulatory scheme.
Often, the manager of an offshore fund forms a corporate entity to provide advisory services to the fund. This entity serves as the investment manager of the fund. If the hedge fund manager already manages the assets of a domestic partnership through a single corporate entity, the general partner of the partnership may also serve as the investment manager of the offshore fund. If the sponsor is managing the assets of a partnership through two corporate entities, the entity serving as the management company of the domestic partnership will ordinarily serve as the investment manager to the fund.
Offshore funds are also attractive to United States tax-exempt organizations (e.g. individual retirement accounts, qualified pension and profit sharing trusts) as a method for avoiding unrelated business taxable income. A United States tax-exempt investor who has purchased an interest in a domestic partnership utilizing leverage may be subject to income tax on any debt-financed income. For example, if a tax exempt organization purchases an interest in a limited partnership and that partnership purchases stock in a company and finances fifty-percent (50%) of the purchase price with debt and then subsequently sells the stock for a gain, the tax exempt organization would have unrelated business tax income equal to its share of fifty-percent (50%) of the gain offset by fifty-percent (50%) of its share of net interest cost. A tax-exempt organization must prepare and file a tax return and pay taxes if it receives $1,000 or more of gross income in computing the unrelated business tax income.
Master-Feeder Structure
This structure, also known as a "hub and spoke," allows investors residing in the United States and investors residing offshore to invest, indirectly, in the same offshore corporate entity commonly known as the "master fund." The master fund is typically structured as a limited partnership. Ordinarily, U.S. taxable investors investing in a master-feeder structure directly invest in a limited partnership organized in the United States. This limited partnership is referred to as the "domestic feeder." The domestic feeder invests its assets in the master fund. The offshore investors and U.S. tax-exempt organizations (e.g. IRAs) directly invest in an offshore corporation. This offshore corporation is referred to as the "offshore feeder." The offshore feeder also invests its assets in the master fund. The hedge fund manager then purchases and sells securities in an account held in the name of the master fund.
Side-By-Side Structure
In a side-by-side structure, U.S. investors typically invest in a limited partnership organized in the United States and offshore investors invest in an offshore corporation. The prime broker typically allocates trade tickets between the domestic fund and the offshore fund.
For hedge fund managers seeking to establish both a domestic and an offshore fund, there are various tax, administrative and other issues the manager should consider in determining whether to utilize a master feeder or a side-by-side structure. The choice will depend on the manager's strategy and goals.
