Feeder Fund

A feeder fund is a pooled investment vehicle that does not buy securities itself. Instead it raises capital from investors and invests substantially all of it in a single other fund, called the master fund, which holds the portfolio and carries out all trading. Several feeders usually invest in the same master. Each feeder is a separate legal entity with its own investors, documents and often its own fees and currency, while the investment management takes place once, at master level.

The arrangement is known as a master-feeder structure. It is standard among hedge funds and common in private equity, private credit and some retail funds. A feeder differs from a fund of funds, which spreads its assets across many underlying funds run by different managers. A feeder has one destination and adds no investment selection of its own.

The main reason is that different groups of investors need different legal and tax wrappers but the manager wants to run a single portfolio. A classic hedge fund structure has two feeders.

• Onshore feeder. A limited partnership, often formed in Delaware, for taxable United States investors. A partnership is transparent for tax purposes, so gains, losses and expenses flow through to investors.
• Offshore feeder. A company formed in an offshore financial centre such as the Cayman Islands, for non-US investors and for US tax-exempt investors such as pension funds and endowments. Investing through a corporation shields tax-exempt investors from tax that could otherwise arise when a fund uses borrowing, and keeps foreign investors outside the US tax filing system.

Both feeders invest in one master fund, usually also offshore. The manager avoids splitting trades between parallel portfolios, all investors receive the same gross performance, and the larger pool obtains better financing and trading terms and lower costs per investor. Further feeders can be added for particular countries, currencies or distribution channels without disturbing the portfolio.

An investor subscribes to a feeder and receives its shares or partnership interests. The feeder uses the money to subscribe for interests in the master. The master invests, and its gains and losses are allocated to each feeder in proportion to its holding. Each feeder then calculates its own value by taking its share of the master and deducting feeder-level costs. The feeder's net asset value calculation therefore depends on the master's valuation being completed first. Redemptions run in reverse: the feeder redeems from the master to pay its investor.

Fees can be charged at either level. Management fees and any performance fee are often charged in the feeder, so that different investor groups can have different terms, with the master bearing only trading and financing costs. A feeder whose shares are denominated in a currency other than the master's may hedge the difference, in the same way as share class hedging. The feeder may also keep a small cash balance for expenses.

In the European Union, the UCITS rules have allowed master-feeder structures for retail funds since 2011. A feeder UCITS must invest at least 85% of its assets in units of a single master UCITS, and may hold the rest only in cash and hedging instruments. The rules require an agreement between master and feeder, information sharing between their depositaries and auditors, and approval from the feeder's regulator. The feeder's depositary continues to perform depositary oversight. Alternative fund rules also recognise feeder structures and look through to the master when deciding which marketing regime applies. In the United States, registered funds may invest all their assets in a master portfolio under specific conditions.

Private equity and private credit managers use feeders to admit investors who cannot or prefer not to invest directly in the main partnership. Banks and wealth platforms set up feeder vehicles that pool many smaller commitments from individual clients into one limited partner commitment to the main fund, handling capital calls and distributions for them. These access vehicles charge their own fees on top of the underlying fund's.

• Extra layer of cost. Each feeder has its own administration, audit, legal and regulatory expenses, and sometimes an additional layer of fees.
• Dependence on the master. A feeder holds one illiquid asset. If the master suspends redemptions or imposes a gate, the feeder must do the same.
• Spillover between feeders. Large redemptions by one feeder can force the master to sell assets, affecting investors in the others, and one feeder's borrowing or tax position may have consequences at master level.
• Transparency. Investors are a step removed from the portfolio and rely on the feeder's operator to carry out due diligence. Several feeder funds lost almost everything in 2008 because they had channelled client money into Bernard Madoff's fraudulent scheme with little independent verification.
• Tax complexity. The benefit depends on the tax treatment of each entity, including withholding tax on the master's income.

Accounting, valuation and investor servicing for both levels are normally handled by one fund administration provider.