Although they continue to grow in popularity, there are still some general misconceptions regarding the nature and use of offshore hedge funds. This article addresses the various reasons for organizing offshore funds, the most common jurisdictions for offshore funds and the typical structure of offshore funds.
Reasons for Organizing an Offshore Hedge Fund
Offshore funds are often preferable for non-U.S. investors concerned about confidentiality, particularly with avoiding disclosure to U.S. tax and regulatory authorities. Whereas all investors in domestic funds are ordinarily identified through fund tax returns, the identities of non-U.S. investors in offshore funds are not ordinarily reported to the IRS or other U.S. regulatory authorities for tax or other purposes. Although the preference to invest in offshore funds for confidentiality purposes partly arises out of habit and convention, offering an offshore fund to non-U.S. investors can nonetheless be a significant marketing advantage.
Offshore funds are generally preferable for U.S. tax-exempt investors – such as pension plans and charitable organizations – who want to avoid unrelated business taxable income (characterized as debt-financed income under Code section 514), which is taxable to tax-exempt investors. Because an offshore fund is ordinarily structured as a corporation instead of a partnership (in contrast to a domestic fund), the debt-financed income is not deemed to pass-through to the tax-exempt investors.
Offshore Fund Jurisdictions
The two leading jurisdictions to establish an offshore fund are the Cayman Islands (“Cayman”) and the British Virgin Islands (“BVI”), both of which are discussed below.
The Cayman has developed into the preeminent global jurisdiction for offshore funds, due in part to its “no tax” status (Cayman does not impose its own tax burden on investment funds or investors in such funds), as well as its sophisticated regulatory system and favorable laws. The Cayman Islands Monetary Authority (“CIMA”) is the regulatory authority that oversees the Mutual Funds Law, Cayman’s primary legislation with respect to investment funds. The majority of Cayman based funds are required to register with CIMA; however, funds in which the shares are held by not more than fifteen investors, the majority of which are capable of removing the directors, are exempted from CIMA registration.
British Virgin Islands
The BVI is another popular jurisdiction for offshore funds. Like the Cayman, the BVI features favorable tax treatment, as well as a sophisticated regulatory system and industry-friendly laws. Organizing an offshore fund in the BVI also tends to be easier and considerably less expensive than other offshore jurisdictions. A standard BVI fund is organized as a BVI business company under the BVI Business Companies Act, recognized as either a private fund or a professional fund with the BVI Financial Services Commission pursuant to the Securities and Investment Business Act. Professional funds are available only to “professional investors” (typically, a person with a net worth in excess of $1,000,000) who subscribe for a minimum of $100,000. Private funds are less restrictive, but are allowed no more than fifty investors and the shares must be offered on a private basis.
Offshore Fund Structures
This is the most common structure for offshore managers with no U.S. presence and who therefore expect to gear the fund predominately to non-U.S. investors (and possibly U.S. tax exempt investors). This is simply the offshore equivalent to launching a stand-alone domestic fund.
In a side-by-side structure, the manager establishes a domestic stand-alone fund and an offshore stand-alone fund in order to offer the same strategy to non-U.S. investors and U.S. tax-exempt investors as it does to U.S. taxable investors. However, there are certain inherent inefficiencies in managing side-by-side funds; for example, the manager must allocate trades (i.e. “split” tickets) among its domestic fund and offshore fund while trying to achieve equivalent performance returns between the funds.
To overcome the inherent inefficiencies of managing side-by-side funds, amanagers often elect to organize “master-feeder” structures. The standard master-feeder structure comprises one “master” fund and two “feeder funds.” The feeder funds are typically (1) a domestic fund for U.S. taxable investors and (2) an offshore fund for non-U.S. investors and U.S. tax-exempt investors. Both feeder funds in turn invest all their capital in the master fund, which is also typically an offshore investment vehicle, with all portfolio investment activities conducted at the master fund level. In addition to the cost-control benefits and administrative efficiency of a master-feeder structure, master-feeder funds can oftentimes be structured more tax-efficiently. However, forming a master-feeder fund triggers a variety of nuanced structural and accounting considerations that should be discussed with a qualified hedge fund attorney on the front-end. As with all fund structures, it is important that managers seek an experienced hedge fund lawyer familiar with the issues involved and able to help determine the most appropriate structure for each particular situation.
Please contact us for a free consultation if you are interested in launching an offshore fund or would like to discuss the offshore fund formation process in greater detail.