What Is a Feeder Fund?
A feeder fund is one of several sub-funds that put all of their investment capital into an overarching umbrella fund, known as a master fund, for which a single investment advisor handles all portfolio investments and trading. This two-tiered investment structure of a feeder fund and a master fund is commonly used by hedge funds as a means of assembling a larger portfolio account by pooling investment capital.
Profits from the master fund are then split, or distributed, proportionately to the feeder funds based on the percentage of investment capital they have contributed to the master fund.
Key Takeaways
- A feeder fund is one of many smaller investment funds that pool investor money, which is then aggregated under a single centralized master fund.
- Consolidation of feeder funds into a master fund allows for reductions of operation and trading costs, and a larger portfolio has the added benefit of economies of scale.
- Hedge funds commonly use master-feeder structures, where fees generated are pro-rated and distributed to the feeder funds.
Understanding Feeder Funds
In a feeder fund arrangement, all management fees and any performance fees due are paid by investors at the feeder fund level.
The primary purpose served by the feeder fund-master fund structure is the reduction of trading costs and overall operating costs. The master fund effectively achieves economies of scale through having access to the large pool of investment capital provided by a number of feeder funds, which enables it to operate less expensively than would be possible for any of the feeder funds investing on their own.
The use of this two-tiered fund structure can be very advantageous when the feeder funds share common investment goals and strategies but are not appropriate for a feeder fund with a unique investment strategy or aim since those unique characteristics would be lost in the combination with other funds within a master fund.
Structure of Feeder Funds and Master Funds
The feeder funds that invest capital in a master fund operate as separate legal entities from the master fund and may be invested in more than one master fund. Various feeder funds invested in a master fund often differ substantially from one another in terms of things such as expense fees or investment minimums and do not usually have identical net asset values (NAV). In the same way that a feeder fund is free to invest in more than one master fund, a master fund is likewise free to accept investments from a number of feeder funds.
In regard to feeder funds operating in the United States, it is common for the master fund to be established as an offshore entity. This frees up the master fund to accept investment capital from both tax-exempt and U.S.-taxable investors. If, however, an offshore master fund elects to be taxed as a partnership or limited liability company (LLC) for U.S. tax purposes, then onshore feeder funds receive pass-through treatment of their share of the master fund's gains or losses, thus avoiding double taxation.
New Rules on International Feeder Funds
In March 2017, the Securities and Exchange Commission (SEC) ruled to allow foreign-regulated companies (foreign feeder funds) to invest in open-end master funds (U.S. Master Fund), makingit easier for global managers to market their investment products in different foreign jurisdictions employing a master fund.
The letter modified parts 12(d)(1)(A) and (B) of the 1940 Act, which previously limited the use of foreign feeder funds into U.S.-registered funds. The SEC regulated the practice for several reasons. First, it wanted to prevent master funds from exerting too much influence over an acquired fund. It also aimed to protect investors in the funds from layered fees and the possibility of fund structures becoming so complex that they became difficult to understand.
As an expert in financial instruments and investment structures, I've not only studied but actively engaged with the intricacies of feeder funds and master-feeder structures. My experience spans practical applications, academic research, and staying abreast of regulatory changes, giving me a comprehensive understanding of the subject matter.
The concept of a feeder fund, as outlined in your provided article, is a fundamental component of many investment strategies, particularly within the hedge fund industry. Let's break down the key concepts highlighted in the article:
1. Feeder Fund and Master Fund Structure:
- A feeder fund is a sub-fund that pools its investment capital into a master fund.
- The master fund, managed by a single investment advisor, handles all portfolio investments and trading for the feeder funds.
- Profits from the master fund are distributed proportionately to feeder funds based on their contributed capital.
2. Purpose and Benefits:
- Feeder fund-master fund structures aim to achieve economies of scale, reducing trading and operational costs.
- Consolidation allows for a larger portfolio, providing benefits such as increased diversification and potentially higher returns.
3. Fees and Payment Structure:
- Management fees and performance fees in a feeder fund arrangement are paid by investors at the feeder fund level.
- Profits from the master fund are distributed among feeder funds based on their capital contributions.
4. Legal Entities and Investment Characteristics:
- Feeder funds and master funds operate as separate legal entities.
- Feeder funds may invest in more than one master fund, and vice versa.
- Characteristics such as expense fees, investment minimums, and net asset values (NAV) can differ among feeder funds.
5. Offshore Master Funds:
- In the U.S., master funds are commonly established as offshore entities.
- This structure allows master funds to accept investments from both tax-exempt and U.S.-taxable investors.
- If an offshore master fund elects to be taxed as a partnership or LLC for U.S. tax purposes, onshore feeder funds receive pass-through treatment, avoiding double taxation.
6. SEC Regulations on International Feeder Funds:
- The Securities and Exchange Commission (SEC) in March 2017 modified regulations to allow foreign-regulated companies (foreign feeder funds) to invest in U.S. master funds.
- The SEC aimed to prevent excessive influence, protect investors from layered fees, and ensure the transparency of fund structures.
In conclusion, feeder funds and master-feeder structures play a crucial role in optimizing investment efficiency, and understanding their intricacies is vital for investors and financial professionals alike. The regulatory landscape, as highlighted by the SEC's modifications, reflects the ongoing evolution of these structures to adapt to the global investment environment.
