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A feeder fund is a type of investment fund that invests its capital into a larger master fund. Known as a master-feeder structure, a master fund is generally the central investment fund for several feeder funds to pool their capital and take advantage of economies of scale. This structure is most commonly used by hedge funds.

What is a feeder fund?

Basically, a feeder fund is where investment begins. Investors deposit money into a feeder fund, which takes that money and invests in a master fund. The master fund then invests the money in an attempt to generate profits, which are then allocated to all of the feeders.

Several different feeder funds can provide capital for a master fund, and each of them can have completely different investment fees, minimum contribution requirements, and net asset values. On the other hand, an individual feeder fund can invest its capital through more than one master fund.

The master-feeder structure

The master-feeder structure is often used by hedge funds to pool investment capital from U.S. and overseas investors into one central investment vehicle. This two-tiered structure involves a series of feeder funds and an umbrella fund known as the "master fund," where one advisor handles all investment activity.

A common master-feeder structure involves an offshore master fund with two feeder funds, one U.S.-based and one non-U.S. based, in order to allow the master fund to accept investments from both tax-exempt and U.S.-taxable investors.

While a master fund is typically an offshore operation, it can choose to be taxed as a partnership for U.S. taxation purposes. By doing so, an onshore feeder fund will receive pass-through tax treatment for the master fund's profits and losses, thereby avoiding the double taxation that affects most corporate profits.

Pros and cons

There are a couple of big advantages to using the master-feeder structure:

  • Cost benefits: By pooling the capital of several feeder funds into one centralized master fund, it achieves economies of scale. In other words, it can operate less expensively than the individual feeder funds could on their own with lower administrative and trading costs.
  • Possible tax savings: By choosing to be taxed as a partnership, feeder funds receive "pass-through" tax treatment, avoiding double taxation.

On the other hand, there are some disadvantages to be aware of, including:

  • Offshore funds are typically subject to a 30% withholding tax on U.S. dividends.
  • Different investment strategies may not be universally appropriate. For example, a master fund may hold an investment longer so its U.S. investors can get favorable tax treatment, while such a strategy may not be necessary for offshore investors.

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