Understanding Master Feeder Accounting

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Title: Master Feeder Funds: Understanding the Accounting and Operational Aspects

Introduction

Master feeder funds are a common structure in the hedge fund industry, allowing investors with varying tax statuses to pool their capital into a single investment vehicle. This article aims to provide an overview of master feeder fund structures and address the accounting and operational complexities associated with them. Keep in mind that the specifics of each master feeder fund may vary, and it's essential to tailor your accounting system to your fund's unique needs.

Master Feeder Fund Structure

A master feeder fund structure consists of two primary entities: the "feeder" funds and the "master" fund. Investors initially contribute their capital to the feeder fund(s), which subsequently invest in the master fund. The master fund, in turn, executes trading activities in the market.

Typically, there are two feeder funds: one for U.S. taxable investors (onshore) and another for non-U.S. or tax-exempt investors (offshore). However, feeder funds can vary in terms of investor types, investment minimums, fee structures, and other operational features. Feeder funds maintain their independence as separate legal entities, enabling them to invest in various master funds.

The master fund is usually an offshore corporation that can elect to be taxed as a U.S. partnership, providing pass-through tax treatment to onshore feeders. The investment manager of offshore funds can be an offshore corporation owned by the fund manager or the manager's U.S. entity.

Advantages and Disadvantages of Master Feeder Structure

Advantages:

  1. Reduced Trading Costs: The structure minimizes the need to split tax lots, simplifying trade administration.
  2. Administrative Efficiency: Managing a single pooled trading account streamlines operations.
  3. Performance Fee Flexibility: General partner performance fees can preserve underlying tax attributes from onshore feeders.
  4. Enhanced Financing Benefits: Combined fund assets can lead to greater leverage or lower interest rates on borrowed securities.

Disadvantages:

  1. Withholding Tax: Offshore funds may face a 30% withholding tax on U.S. dividends, potentially increasing costs.
  2. Strategy Conflicts: Investment strategies may not align with all investors' needs, potentially creating conflicts.
  3. Unsuitable Investments: Some investments like REITs and mutual funds may not be suitable for offshore investors due to regional restrictions.
  4. Complex Allocations: Uneven allocations of P&L and tax accounting can be cumbersome, potentially offsetting time and cost savings.

Advanced Topics in Master Feeder Fund Accounting

  1. Hot Issues: Master feeder structures typically classify securities into two categories: hot issue and non-hot issue. Allocations of hot issue P&L to feeders can be done using either the "pro rata" or "look-through" method, depending on system capabilities.

  2. Multiple Masters/Multiple Feeders: Feeders are not limited to investing in a single master fund, and a master can have more than two feeders. Calculating P&L allocations in such scenarios may be more complex.

  3. Direct Investments by Limited Partners: In some cases, investors can invest directly in the master fund, bypassing feeder funds. This introduces additional complexities, especially in fee calculations.

  4. Currency Hedges: Feeders in a different currency than the master may require currency hedges to protect NAV. These hedges can be executed at the feeder or master fund level.

  5. Performance Fees/Management Fees at the Master: Charging performance and management fees at the master fund level adds complexity to fee calculations and requires a general partner for performance fees.

  6. Sidepocket Classes: Investments in sidepocket classes involve considerations related to capital account percentages, income treatment, management fees, and performance fees.

  7. Equalization: Equalization methods may be needed to ensure fair distribution of performance fees, especially in offshore funds.

  8. Bid/Offer NAV: Some funds have bid/offer NAVs, which require accounting adjustments to handle the premium over calculated NAV.

Conclusion

Master feeder funds offer flexibility for investors with varying tax statuses, but they come with accounting and operational complexities. To address these complexities, it is crucial to carefully evaluate your fund's unique requirements and choose an accounting system that aligns with your specific needs. A deep systems evaluation can help ensure that your system implementation matches your workflow and minimizes operational challenges.

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