Master Fund

A master fund is the investment vehicle at the centre of a master-feeder structure. It holds the portfolio, employs the investment manager and executes all trades, while its investors are not the public but one or more feeder funds that have collected money from different groups of investors and placed substantially all of it in the master. The arrangement lets a manager run a single pool of assets while offering investors separate entry points suited to their tax position, currency or regulatory status.

The structure is standard among hedge funds and common in private equity, private credit and some regulated retail funds. Each feeder fund is a separate legal entity with its own investors and documents, and a master fund should be distinguished from a fund-of-funds, which spreads money across many unrelated underlying funds rather than concentrating it in one.

Investors subscribe for shares or interests in a feeder. The feeder passes the cash to the master in exchange for shares or partnership interests in it, and the master invests. Gains, losses, income and expenses arising in the portfolio are allocated to the feeders in proportion to their holdings in the master, and each feeder then allocates its share to its own investors after deducting feeder-level costs.

Trading counterparties, prime brokers and custodians contract with the master, which is therefore the entity that signs trading documentation and posts collateral. Fees can be charged at either level. Commonly the management fee and the performance fee are charged at feeder level so that different terms can be applied to different investor groups, though practice varies.

The classic case is a manager with both United States taxable investors and other investors. US taxable investors generally prefer a vehicle that is transparent for US tax, such as a Delaware limited partnership, so that gains and losses flow through to them. Non-US investors and US tax-exempt investors such as pension plans and endowments generally prefer to invest through an offshore corporation, often in the Cayman Islands, which shields them from US tax filing obligations and from tax on certain debt-financed income. A master fund lets both feeders invest in one portfolio.

The benefits follow from pooling:

• One portfolio. The manager avoids splitting each trade between parallel funds and rebalancing them as money flows in and out, so all investors receive the same gross return.
• Scale. A larger single pool obtains better financing and trading terms and meets minimum sizes for some investments more easily.
• Lower running costs. There is one set of trading agreements and one set of portfolio records for fund accounting.
• Flexibility. New feeders, for example in another currency or for a particular distributor, can be added without disturbing the portfolio.

The master's net asset value is calculated first, and each feeder's value is derived from its holding in the master plus or minus its own cash, hedges and accrued expenses. Fund administration therefore runs at two levels, and dealing days and cut-off times must be aligned so that feeder subscriptions and redemptions can be matched by transactions in the master.

Currency is a frequent complication. A feeder denominated in a currency other than the master's may run its own hedging programme, similar to share class hedging, and the gains and losses on those hedges belong only to that feeder. Audited financial statements are prepared for each entity, with the feeder's accounts usually attaching or referring to those of the master.

Treatment depends on the type of fund. In the European Union, the directive governing retail funds has allowed master-feeder arrangements since the 2009 revision: a feeder fund must invest at least 85 per cent of its assets in a single master, and the two funds, their depositaries and auditors must have information-sharing agreements in place. Rules for alternative funds look through to the master when deciding whether a feeder may be marketed across borders.

In the United States, registered investment companies may use master-feeder structures under an exemption in the Investment Company Act, and private funds rely on the exemptions generally available to funds sold only to qualifying investors. Offshore masters are subject to the fund laws of their domicile, including registration and audit requirements, and the management company or adviser is regulated where it operates.

The structure adds entities, and with them formation costs, directors, audits and regulatory filings. Tax outcomes are a compromise: trading that is efficient for one feeder may be inefficient for another, for instance where withholding tax is suffered at master level and cannot be reclaimed by all investors. Large redemptions from one feeder force the master to sell assets, and the costs fall on the remaining investors in every feeder unless tools such as a dilution levy are applied. Investors in a feeder also depend on the governance of the master, where they have no direct vote, which is why due diligence normally covers both levels and the service providers to each.