This question is asked by start-up and emerging managers all of the time and for good reason. Generally it's the manager who’s putting down their cash to set-up the Fund, albeit the set-up fees will be amortized at the Fund level when investors come-in. As such the manager needs to be extremely confident (show me a manager who isn’t extremely confident...) that they need a US Fund and the Offshore Fund, rather than one or the other. To make this decision, the manager needs to be focused and strategic with their marketing and to have discussed the pros and cons with their legal counsel. Otherwise the manager could well be wasting their own money. Let’s jump into why a manager should be setting-up a US Fund and the Offshore Fund at the same time.
Where a manager is setting up a US Fund (a US limited partnership or US limited liability company, generally organised in Delaware) to attract US taxable investors, the manager will often market to or come across US tax-exempt investors, such as charities, pension funds, and university endowments, as well as non-US investors, who like the product and want to invest. If that’s the case then simultaneously with the set-up of the US Fund, the manager will set up an Offshore Fund as part of the pooled investment structure to take in the US tax-exempt investors and non-US investors. Why? Well, in short, to avoid potential US tax exposure that could result from direct investment in a US pass-through entity such as a US limited partnership or US limited liability company. It’s been explained to me by US Counsel, and I apologise in advance for the tax talk that follows (shoot me now...):
- US Tax-Exempt Investor Issues. When a US tax-exempt investor derives income that is separate from its US tax-exempt purpose, then such income may be subject to a form of US federal income tax known as unrelated business income tax (UBIT). Certain types of passive income are specifically exempt from UBIT, including short-term and long term capital gains, dividends, and interest income. However, such UBIT exemptions do not apply if the income is considered "debt-financed income". Thus, if the partnership or other pass-through fund uses borrowed funds, there could be UBIT for the US tax-exempt investors that are direct investors in that fund. In addition, if the pass-through fund invests in businesses organised as partnerships (including publicly traded partnerships), the income and gains realised could be UBTI even if no debt financing is involved. US tax-exempt investors can avoid such UBIT exposure by investing through an Offshore Fund that is treated as a foreign corporation for US tax purposes. There is no pass through treatment in the case of investments made in a fund that is treated as a corporation (hence the term "blocker" corporation). Thus, the Offshore Fund, or the Offshore Master Fund in which it invests, can use debt without creating UBIT exposure for the tax-exempt investors in the Offshore Fund.
- Non-US Investor Issues. Non-US investors are also advised to invest in funds that are organised as foreign "blocker" corporations for US tax purposes. There are two US tax reasons. First, if the US partnership fund were to engage in a US trade or business (other than merely trading in stocks or securities for its own account), then the non-US investors in such fund would be subject to US income tax on their share of any of the fund's income that is treated as effectively connected US trade or business income (ECI). The non-US investor in the partnership fund would be required to file US income tax returns even if the fund's ECI for the year is nominal or a negative number. In the case of non-US individual investors, there is also US estate tax exposure if the investor invests directly in the US partnership fund. Non-US individuals are not subject to US estate tax at death if they own stock in a non-US corporation that owns US securities, whereas direct ownership of an equity interest in a US partnership fund would be treated as "property situated in the US" which is subject to such US estate tax.
Managers wanting to attract US taxable investors, US tax-exempt investors and non-US investors will generally set-up both a US Fund and an Offshore Fund in a jurisdiction such as the Cayman Islands – they could also choose the BVI or Bermuda. As to which offshore jurisdiction to choose, I’ll tackle that particular hornet’s nest of a question in a later post! As such the manager needs to decide from the outset which investor groups they will be targeting; and in doing so managers need to be realistic. Much will depend upon their track record, history and story for the new fund. The early stages in the capital-raising of a new fund will generally, with some exceptions, be challenging.
To set up both a US Fund and an offshore fund is not insignificant in terms of organisational and running expenses; particularly with a start-up or emerging manager, their survival depends upon making the right decision from the outset. Most US based managers will likely have access to US taxable investors from the start but may not yet have the critical mass to attract allocations from US tax-exempt investors or may not yet have a network of international investors. For these managers the best route may be to set-up a US Fund which will lead to the establishment of an Offshore Fund once they have established their track record. More established, mid-market and billion dollar plus managers will typically already have the internal infrastructure and resources to establish the US Fund and the Offshore Fund at the same time in order to approach both markets from the outset.
The final word here is speak to your US Counsel and Offshore Counsel and get their advice – we do this for a living and we can help!
This post includes comments shared by me in a recent interview with HFM Week, which was published in their report, How to start a Hedge Fund in the US. For a copy of the full interview, click here, and for more information, please get in touch.