Over the last twenty years, the open-end fund industry (also referred to as hedge funds) has matured. Investors and regulators continue to evolve, becoming more sophisticated and asking more probing questions and the laws governing open-end funds have become increasingly complex. Now more than ever, successfully launching an open-end fund is dependent upon selecting the proper structure and complying with the ever-changing regulations governing such funds. Structuring an open-end fund involves both the creation of one or more entities through which: (a) investments will be made - the structure and domicile of the entity through which investments will be made is dependent upon the type and location of prospective investors; and (b) the management entities through which advisory and other related services will be provided to the open-end funds - in the European Union, this is referred to as the alternative investment fund manager, but is also known as the investment manager. The structure and domicile of the open-end fund is primarily dependent upon two variables: (i) the nature of the fund’s prospective investors (e.g., retail or institutional) and the demographics of the fund’s investors (e.g., taxable vs. non-taxable, and domicile of primary residence or principal place of business); and (ii) the investment strategy employed by the investment manager. The structure and domicile of the investment manager is primarily determined by the citizenship and tax considerations of its owners, as well as by the regulatory regime of the cities and countries in which the investment manager maintains its office(s). Due to the pandemic and the increase in the number of persons who work remotely, the actual physical location of each of these persons must be taken into consideration for an accurate assessment for tax and regulatory implications.
Structuring the Open-End Fund
In the United States, investors can be divided into three categories: (i) U.S. taxable investors, (ii) U.S. tax exempt investors, and (iii) non-U.S. persons. In the majority of circumstances, if the fund’s investors are U.S. taxable investors, the fund will generally be formed as either a limited partnership or limited liability company. In the United States, this fund is often referred to as a “domestic fund.” Most domestic funds are organized in Delaware as the laws in Delaware are perceived by industry participants to be more favorable to the sponsor. If the fund’s investors are U.S. tax-exempt investors or non-U.S. persons, the fund will generally be formed in a jurisdiction outside of the U.S. as a corporation (or other analogous entity). The non-U.S. fund entity is often referred to as an “offshore fund.” Most offshore open-end funds organized on behalf of U.S.-based investment managers are organized in Bermuda, the British Virgin Islands and the Cayman Islands. U.S. tax-exempt investors typically prefer to invest in an offshore fund set up as a corporation because, if an offshore fund purchases securities on margin or utilize leverage and such offshore fund is set up as a corporation, then such structure serves to “block” a tax known as “unrelated business taxable income” (“UBTI”) that would otherwise be levied on U.S. tax-exempt investors.
Economic Analysis
In determining whether to form both a domestic and an offshore open-end fund, the investment manager should: (x) determine the amount of assets it expects will be invested in the funds within a few months after the launch of the funds and (y) conduct a cash flow analysis to determine its ability to sustain the operating expenses of running the funds. If a relatively small amount is expected to be invested in the fund structure in the short term, it may not justify the formation of both a domestic fund and an offshore fund and initially launching both may impair the investment manager’s ability to survive due to the organizational expenses and the costs of maintaining both funds (i.e., domestic and offshore). It may take several years to attract assets. Thus, the likelihood of success of an emerging manager is dependent, in part, upon the manager’s ability to sustain itself economically and provide itself with a longer period of time in which to attract investment assets. With early-stage managers, cash burn is often overlooked and can be critical to the survival of the newly-formed asset management firm. The investment manager must have an opportunity to establish a proven track record.
Side-by-Side, Master-Feeder and Mini-Master Structures
Managers seeking to launch both domestic and offshore funds have several options available in structuring such funds. The three most common structures are: side-by-side, master-feeder and mini-master. In a side-by-side structure, the domestic fund and the offshore fund make direct investments pursuant to the same investment strategy, and trade tickets are allocated between the domestic fund and the offshore fund. In a master-feeder structure, a third entity is created (called the “master fund”) and both the domestic fund and the offshore fund, rather than making direct investments, invest all or substantially all of their assets into the master fund, and, in turn, the master fund makes investments on behalf of the domestic fund and the offshore fund (in this context, often referred to as the domestic feeder and offshore feeder). Finally, the mini-master structure generally is comprised of two entities as follows: an offshore feeder fund entity and a master entity domiciled in the U.S. In both structures with a master fund, while the offshore feeder is taxed as a corporation to benefit U.S. tax-exempt investors and block UBTI, the master fund may be structured for tax purposes as a partnership. Rather than the U.S.-based manager receiving its incentive-based compensation as a fee from the offshore fund and being subject to ordinary income tax, the U.S.-based manager may receive its incentive-based compensation as an allocation from the master fund entity, and potentially benefit from capital gains tax treatment.
There are many legal and commercial drivers in determining the ideal structure for a fund. For example, if the strategy calls for significant investment in illiquid or thinly-traded positions which are difficult to allocate among two brokerage accounts, a master-feeder structure may be preferred as the investments will be allocated on a pro rata basis at the master fund level, yet will only require the investment manager to purchase and sell the positions through one brokerage account. Also, in many transactions involving early-stage or “seed” investments, if the seeder is located offshore, it may prefer a master-feeder structure so that all fees and allocations may be taken at the master fund level and thereby allowing it to avoid the U.S. tax regime. Conversely, employing a tax-efficient strategy for U.S. taxable investors may be of little benefit or even detrimental to U.S. tax-exempt investors and non-U.S. persons. Thus, a side-by-side structure allows the investment manager the ability to employ tax efficiency with the domestic fund, while maximizing the entry and exit points of securities positions without regard to long-term tax gains for the offshore fund.
Structuring and Domicile of the Investment Manager
Empirical evidence suggests that the supermajority of open-end funds that are managed by investment managers domiciled in the United States are managed by entities formed in the United States which are structured as either limited liability companies or limited partnerships that are taxed as flow-through vehicles (rather than as corporations). In connection with United States federal tax obligations, we often advise clients domiciled in the United States to structure the investment manager as a limited partnership to reduce the self-employment tax. The structure and domicile of the investment manager is primarily determined by the citizenship and residency of its principals, generally focusing on enhancing tax efficiency and minimizing regulatory impact. Tax efficiency and regulatory requirements may be impacted by the location(s) where the investment manager maintains its office(s) in the United States, as well as the location(s) of those persons performing services for or employed by the investment manager. Due to the pandemic, the work force is increasingly working remotely. In the last two years, less and less people are deeply rooted to any one location, making the foregoing analysis more challenging as staff move from one location to another without realizing that working from different locations may have legal repercussions. The location of each of these persons must be considered in order to provide an accurate assessment with respect to tax and regulatory implications. Certain states have very specific tax methodologies or regulatory registration requirements. For example, certain states require an investment manager that has an office or an employee working from their home in those states to register as an investment adviser prior to the launch of the private fund, regardless of the amount of assets under management. In circumstances in which principals of the investment manager are non-U.S. persons, if the non-U.S. persons own the majority of equity in or receive the majority of the economics from the investment manager and their interests are controlling, the investment manager may be organized in an offshore jurisdiction to accommodate the tax needs of the non-U.S. persons.
Investment managers should also consider creating more than one management entity to work in concert with one another such that one management entity receives the management fee, while another management entity receives the incentive allocation/carry. Not only is this recommended for tax efficiency in certain jurisdictions (e.g., to minimize unincorporated business tax in New York City), but it also reduces cross-collateral risk for the principals of the investment manager. Given that the incentive allocation often is the greatest source of a private fund manager’s wealth, protecting the incentive allocation from litigation is a worthwhile exercise. Pursuant to this structure, the entity receiving the incentive allocation/carry (e.g., the general partner or the management company) ideally should have no counterparties. Conversely, the entity receiving the management fee (e.g., the investment manager), should be the party to various contracts, such as employment agreements and real estate and equipment leases. As investment managers launch new products utilizing different strategies, they would have their existing investment manager provide advisory services to the new product and receive the management fee, but would organize a new corporate entity to receive the incentive allocation rather than using a preexisting entity which receives the incentive allocation from another product. Imagine two open-end funds—one which trades fixed income and another which trades digital currency. One product may materially outperform the other product. If the incentive of both products is allocated to the same entity, the investors of the underperforming product may bring an action against that entity and, if meritorious, will have access to the incentive allocation derived from the product which has not underperformed.
Additionally, for those managers utilizing proprietary technology for trading, such as algorithms, consider forming a corporate entity solely for the purpose of owning the codes whereby the entity that owns the codes would enter into a licensing agreement with its affiliated investment manager. There are many circumstances in which the algorithm is successful despite the fact that the fund has failed for reasons unrelated to the algorithm (e.g., failure of trade execution also known as slippage).
Responding to Investor Due Diligence
Due diligence is a critical part of the open-end fund investment process. A successful fund launch also depends upon providing prospective investors with comfort regarding non-investment considerations, such as the investment manager’s operations, compliance, and risk management. Having a standard due diligence questionnaire (“DDQ”) is recommended. It is critical that managers be consistent in all of their disclosures to investors. Consistency across documents is vital to the maintenance of a manager’s credibility in the due diligence process. The same level of care and consideration should be invested in marketing materials, DDQs and requests for proposals. Each of these documents should respond to each item in the same manner. A different sentence, or even a single word, can materially change the message or meaning and may result in a different understanding to the investor.
Conclusion
While cash burn is critical to a new manager, the quality of the firm’s infrastructure cannot be sacrificed. Having spent over twenty-five years practicing law in this industry, both as an enforcement attorney with the SEC and in private practice, I have had the benefit of witnessing many successes and failures. It is important to use service providers who have corporate, tax and regulatory experience in connection with structuring open-end funds. Failure to properly structure your firm will have material opportunity costs. A firm with structural issues is less likely to attract investment assets and more likely to be plagued with investor litigation, regulatory investigation or even prosecution, limitation on capital resources and/or reputational damage. The costs associated with fixing a problem far exceed the costs of doing the job correctly at the outset.
If you have any questions about this alert, or any other matters, do not hesitate to reach out to:
Ron Geffner (Partner - Head of the Financial Services group) at 212.573.6660 or via rgeffner@sadis.com
Yelena Maltser (Partner - Financial Services & Corporate groups) at 212.573.8429 or via ymaltser@sadis.com
