Feeding frenzy

The rising popularity of private equity ‘feeder funds’ in the US is fueled by the flexibility of these structures, but tax and default complexities should be carefully considered.

As is well known, investor interest in private equity funds has risen dramatically. With this rise in popularity, private equity fund sponsors are seeking new structures that will permit them to raise additional capital from both US and non-US institutional and retail investors efficiently while still satisfying the particular legal, tax and regulatory concerns applicable to such investors. These sponsors have looked to the hedge fund world for inspiration and have determined that the use of masterfeeder fund structures is one way in which this objective can be achieved.

In a typical master-feeder fund structure, separate ?feeder? funds are organized by a sponsor to accumulate assets from US taxable, US-tax exempt and non-US investors. These assets are then invested by the feeder funds on a commingled basis in a single ?master? fund. The investment objectives of each feeder fund in a master-feeder fund structure are the same as the investment objectives of the master fund, but the feeder funds achieve their objectives by investing substantially all of their assets in the master fund (with a small portion of the assets of a feeder fund typically reserved at the feeder fund level to meet certain costs and expenses that are unique to such feeder fund). The investment manager then causes the master fund to engage in all of the investment activity for the fund and its investors.

Although there are a variety of master-feeder fund structures, the most commonly used structure involves an offshore master fund established as a partnership or company in a tax efficient jurisdiction such as the Cayman Islands. A typical master-feeder fund structure is shown at right.

As indicated in the accompanying table, one or more feeder funds are usually structured as Delaware limited partnerships through which US taxable investors invest. US taxable investors strongly prefer to invest in master funds and feeder funds that elect to be treated as partnerships for US tax purposes so that they can receive favorable tax treatment. If the master fund is treated as a corporation rather than as a partnership for US tax purposes, US taxable investors could be exposed to onerous tax rules applicable to passive foreign investment companies or controlled foreign corporations. In addition, such investors could be subject to corporate level taxes that they would not otherwise be subject to if they were investing in an entity electing to be treated as a partnership for US tax purposes.

For US tax-exempt and non-US investors, one or more feeder funds are normally established as offshore corporations. US tax-exempt investors may prefer to invest through an offshore corporation rather than an offshore limited partnership because the latter could cause such investors to be liable to US taxing authorities for unrelated business taxable income. Non-US investors generally prefer to invest through offshore corporations to avoid having income attributed to them that is effectively connected with the conduct of a trade or business in the US (ECI). If an offshore partnership is used and ECI is generated, such investors likely would be obligated to file US tax returns.

Hedge fund history
Traditionally, the main advantage of utilizing a master-feeder fund structure was to address the tax concerns of certain investors without affecting the tax position of other, differently-situated investors. Over time, however, hedge fund sponsors came to realize that the master-feeder fund structure provides some additional benefits. For example, the larger size of a master fund often enables such fund to obtain better financing and credit terms and to meet applicable asset size-based investment qualifying tests (e.g., the $100 million threshold necessary to be a ?qualified institutional buyer? for purposes of Rule 144A under the US Securities Act of 1933).

Additionally, for purposes of the management and administration of a fund and its investment portfolio, the single investment portfolio of a master-feeder fund structure enables economies of scale to be achieved that would not otherwise exist in a fund structure utilizing parallel investment vehicles. For example, only a single set of transaction documents will be required for each investment, rather than multiple sets as would be required if each feeder fund were set up as a parallel investment vehicle. These economies of scale generally result in lower transaction and operational costs for the fund.

In the hedge fund context, use of a master-feeder fund structure also eliminates the need for a sponsor to split tickets (i.e., making one trade but directing the clearing broker to allocate the securities equally among the different parallel investment vehicles) or to otherwise engage in rebalancing trades. Furthermore, in situations where a sponsor cannot obtain the allocation of a particular security that it desires, such sponsor will not have to determine the appropriate way to allocate such securities among multiple parallel investment vehicles. This helps to ensure that the performance will be the same for each feeder fund (which is not always the case where multiple parallel investment vehicles are used).

Private equity evolution
Private equity fund managers now find feeder funds useful for some of the same reasons noted above in the context of hedge funds. Certain advantages of using private equity feeder vehicles seem more important now than even a short while ago, including the following:

  • ? Feeder funds help reduce the number of parallel funds. It is typical for a private equity fund manager to create a very limited number of parallel funds, which can be established only to accommodate tax, legal or similar considerations of investors. As long as regulatory requirements are met, there can be multiple feeder funds that invest in the master fund. Investors in the master fund are not disadvantaged as long as the feeder funds controlled by the manager do not vote on matters that require investor approval or the investors in such feeder funds bypass the manager and vote their indirect interests in the master fund.
  • ? Many investors have limits on the percentage interest that they can own or vote in an investment vehicle. By increasing the size of a master fund rather than creating separate accounts or parallel vehicles, managers are able to increase the commitments of such investors to such master fund.
  • ? Feeder funds can be tailored for specific markets. For example, feeder fund investors that cannot invest in a Cayman Islands parallel fund may be able to invest in a feeder fund formed in the Channel Islands, which will then invest in the master fund.
  • ? Feeder funds are a means of accessing new distribution channels. It is particularly important to note that feeder funds can provide a means for investors to gain access to private equity funds that would otherwise not admit such investors, usually because their commitments are below the minimum threshold.
  • ? Feeder funds permit intermediaries to structure the terms of their clients' investment in a manner that will attract investors who otherwise would not invest in the fund. For example, feeder fund vehicles can provide economic assurances that are not available to the investors in the master fund in return for higher management fees or a higher carried interest.
  • Structural complexities
    Feeder funds pose legal and tax challenges that the fund manager would not otherwise have to face. For example, the manager will need to seek the advice of counsel as to whether the feeder vehicle will be ?integrated? with the main fund, which would raise issues under the securities laws of the United States and other jurisdictions. Additional tax issues will need to be examined as well, such as whether the feeder fund should elect to be treated as a corporation for U.S. tax purposes.

    In addition to legal and tax issues raised by the use of feeder vehicles, fund managers will need to consider how to deal with defaults by investors in these vehicles. On the one hand, when a direct investor in the master fund fails to satisfy a capital call, the consequences are clearly spelled out in the master fund legal documents, which permit action to be taken directly by the fund manager against the defaulting investor. On the other hand, when an investor in a feeder vehicle defaults, it would be an undesirable result for the entire feeder vehicle to be in default, although that would be the result without additional contractual provisions. The solution – the creation of notional capital accounts that track the investments of feeder investors, even though they are not technically a part of the master fund – is only one of the complexities caused by the use of feeder vehicles.

    The innovative use of feeder funds, for some time the provence of hedge fund managers, can provide private equity fund manager with an important recipe for raising capital and satisfying the needs of different classes of investors. For certain investors seeking admission to private equity funds, feeder funds will be the means by which access to some of the most significant funds will be granted.

    Louis Singer, a partner at Morgan, Lewis & Bockius LLP, chairs his firm's global private investment funds practice. Corey LoPrete is a senior associate in Morgan Lewis' private investment funds group.