The Master-Feeder Conundrum

A commonly employed fund legal structure, which is popular among both hedge funds and private

equity funds, is the master-feeder structure. Under this type of two-tiered structure, a master fund

sits above a feeder fund. Investors typically allocate capital to a feeder fund, which then takes this

capital and makes an investment in the master fund. Ultimately, it is the master fund that makes the

investments on behalf of the whole fund complex.

The master-feeder fund relationship is one which is replete with operational intricacies. When one

gets into the operational nuts and bolts of the ways in which these different fund vehicles interact,

the complexity of such relationships may at first be overwhelming. Putting aside the legal pros and

cons of such a fund, arrangements aside, during the operational due diligence process a number of

other operational complexities may surface regarding this structure. Many of these additional layers

of detail typically center around accounting procedures. Examples of these items can include the

allocation of trades among the funds, distribution of profits and losses among the funds, the

allocation of management and incentive fees, the tax allocation implications of multiple fund

arrangement, and tracking of the fund’s inflows from the master and feeder funds.

While each of these considerations could merit their own separate discussion, in this article we

instead want to focus on a different aspect of the master feeder relationship as reflected in the

audited financial statements of funds. During the operational due diligence process, one of the key

documents investors may seek to collect are the audited financial statements of the fund(s) under

consideration. Typically an investor is considering allocating capital towards one fund vehicle in

particular. In a master-feeder situation, there are typically at a minimum, fund vehicles that are

appropriate for onshore or domestic investors and one which is more appropriate for offshore or

foreign investors. From a U.S. perspective, the onshore vehicle is typically organized via a limited

partnership or "L.P." structure where the offshore vehicle is via a Limited Liability Company or "Ltd."

Investors may tend to focus the bulk of their due diligence efforts on a particular fund vehicle which

is most appropriate for them. This is a dangerous trap that can lead many investors astray. Not only

is it considered best practice that investors consider all other pari passu funds in the same complex

(i.e. - a domestic investor should review the offshore fund as well), but also to consider the role of the

master fund.

Continuing our example, when collecting and reviewing audited financial statements; investors

should request both the onshore and offshore audits. It is also advisable for investors to collect and

review the master fund's financial statements as well. Once all of these statements have been

collected, how is an investor to go about reconciling these statements?

What exactly should investors look for? While the analysis of fund audited financial statements can

be a complex and time consuming exercise, there are a number of basic checks investors can

perform as part of the operational due diligence process, to ensure the basics of the master-feeder

relationship are functioning properly among the multiple funds. These checks can include:

Do the feeder funds own 100% of the master fund?

If not, are there other fund vehicles for which you have not reviewed the audited financial

statements for?

Can you track the allocation of fund expenses from the master to the feeder funds?

What about the allocation of profit and losses?

At which level are fees such as management fee and performance fee charged? The master

level? The feeder level? Do the financial statements accurately reflect your understanding of

this arrangement?

Have the fund's always been organized in this manner?

Making the situation more complex can be situations in which feeder funds invest in multiple

masters or when investors make investments directly into the master fund skipping the feeders

altogether. Analyzing the relationship among master-feeder funds is a good example of an area

where investors should coordinate their reviews of the fund’s legal documents, such as the offering

memoranda, and the review of the audited financial statements. By taking the time to understand

the way in which a master fund and feeder fund interact via audited financial statement analysis,

investors will likely be able to better target the focus of their operational due diligence reviews to

ensure that they fully vet the intricacies of these relationships.

Originally posted in the February 2012 edition of Corgentum Consulting's Operational Due

Diligence Insights.

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Tel. 201-360-2430 About Corgentum Consulting: Corgentum Consulting is a specialist consulting firm which performs operational due diligence

reviews of fund managers. The firm works with investors including fund of funds, pensions,

endowments, banks ultra-high net-worth individuals, and family offices to conduct the industry's

most comprehensive operational due diligence reviews. Corgentum's work covers all fund strategies

globally including hedge funds, private equity, real estate funds, and traditional funds. The firm's sole

focus on operational due diligence, veteran experience, innovative original research and

fundamental bottom up approach to due diligence allows Corgentum to ensure that the firm's clients

avoid unnecessary operational risks. Corgentum is headquartered at 26 Journal Square, Suite 1005

in Jersey City, New Jersey, 07306. Phone 201-360-2430. For more information visit,

www.Corgentum.com or follow us on Twitter @Corgentum.