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» FAQ - Hedge Fund & Private Equity
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Domestic Fund
A domestic or an onshore hedge fund is typically organized as a limited partnership for the purpose of managing the assets of investors who reside in the United States. An investor may become a limited partner in a domestic hedge fund by purchasing a limited partnership interest in the fund. The profit and loss of the fund is allocated to each investor based on their pro-rata shares of the partnership interest.
The manager generally forms an entity to serve as the general partner of the partnership for the purpose of limiting personal liability. Depending on the state in which the fund conducts its business, the general partner can be organized as a limited liability company, limited partnership or corporation. For more information, please consult with a qualified attorney regarding this matter.
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Offshore Fund
An offshore hedge fund is typically organized as a corporation in a specified domicile (i.e. Cayman Islands, British Virgin Islands, Bahamas) for the purpose of managing assets of investors who reside outside of the United States or entities which are qualified as U.S. tax-exempt organizations. In selecting a jurisdiction, the manager should consider the residency of its majority investors, local requirements for maintaining an investment fund as well as costs for operating in a certain jurisdiction. For example, Cayman Island is known for its well organized regulatory system, but typically requires higher costs to operate due to many requirements such as independent directors, offshore administrators, and offshore auditors for hedge funds operating under Cayman Island laws.
The manager generally forms a corporate entity to serve as the investment manager of the fund for the purpose of limiting personal liability. If the hedge fund manager already manages a domestic partnership as a single corporate entity, the general partner of the partnership can also act as the investment manager of the offshore fund. This is also known as a Master-Feeder structure.
An offshore fund is an appealing investment vehicle for U.S. tax-exempt organizations (i.e. qualified pension funds or endowment funds) as a way to avoid being subject to unrelated business taxable income and also offer privacy as well as tax advantages. A U.S. tax-exempt investor who is an investor in an offshore fund utilizing leverage may be subject to income tax on any debt-financed income and may be required to file a tax return.
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Master-Feeder Structure
A Master-Feeder structure is typically organized as a limited partnership which permits both types of investors residing in the United States and non-U.S. investors to invest in the same offshore corporate entity. Typically, U.S. taxable investors who invest in a master-feeder structure would invest in a limited partnership fund that has been organized in the United States. This is known as the domestic feeder fund. This domestic feeder fund invests directly in the master fund. The offshore investors and U.S. tax exempt organizations invest in the offshore corporation. This is known as the offshore feeder. The offshore feeder directly invests in the master fund. The fund manager conducts all the investment trading activities under the name of the master fund.
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Side-By-Side Structure
Another way of managing both domestic and offshore funds is through a side-by-side structure. In this structure, the U.S. investors typically invest in a limited partnership organized in the United States and offshore investors invest in an offshore corporation. The fund manager doesn’t have to worry about being “tax inefficient” for U.S. taxable investors since the offshore and onshore are two separate entities in the side-by-side structure. Because the domestic and offshore funds are operating independently, the fund manager has the ability to minimize the tax liability for U.S. investors while maintaining the economic interest for offshore investors who are not subject to U.S. taxation. Both funds may share the same trading strategies and each trade may be allocated separately by the prime broker. The downside of the side-by-side structure is that it may be more costly to operate and may not have as much leveraging power since the total assets are separated into two pools. Hedge fund managers seeking to establish both a domestic and an offshore fund should consider the different implications of taxes, legal, and other accounting and operational issues when deciding whether to utilize a master feeder or a side-by-side structure. Our professionals will help determine the best solution for your needs.
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Compensation to Fund Manager
A fund manager generally charges a management fee and an incentive allocation for managing investor assets. Typically, the manager charges a management fee payable on a monthly or quarterly basis based on a set percentage of assets under management. Although there are no set rules, managers generally assess their management fees ranging from 1% to 2% of the total net assets on an annual basis. Fund of Funds managers usually charge their investors 1% per annum or less for management fee since the assets invested are already subject to management fee by the underlying funds.
Fund manager also charges an incentive allocation (also known as performance fee or carried interest) equal to a set percentage, usually at 20% of the total gain above the high-watermark at the end of the year. In some instances, the 20% incentive allocation is only charged if the fund performs above the hurdle rate set by the manager. In addition, the fund manager may decide to structure the fund so that certain business expenses such as legal and professional fees are incurred at the fund level. Please keep in mind that if your fund is relatively small, the more expenses run through the fund, the less attractive your performance may be to your investors. For this reason, fund managers may wish to consider absorbing such expenses at the management company level in the early years until the net assets of the fund grow into a sizable portfolio.
Limitation on Registered Advisers Charging Performance Based Fees
There are limitations as to how the fund managers are legally compensated for providing their services from its investors. Generally, a hedge fund manager who is registered as an investment adviser can receive performance based compensation if each of the investors is a qualified client.
A qualified client is defined as an investor with a net worth in excess of $1,500,000 at the time of investment or at least $750,000 of assets under management with the manager, per the Investment Advisors Act of 1940. Some states use a lower standard but additional restrictions are imposed on managers. We recommend that you consult with an attorney who is handling the formation of the fund in your particular state.
Non-U.S. persons are not required to meet the requirements of a qualified client.
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