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OpEd: Estate Planning with Hedge Fund Performance Allocations (part one)

New York (HedgeCo.net) – By hedge fund specialist law firm Holland & Knight partner Bradley M. Van Buren.

As the economy improves, advisors have experienced a reemergence of hedge funds and hedge fund managers are again focused on their performance allocations as an optimal asset to engage in tax-efficient wealth transferring. Further, the recent (and potentially temporary) increase in the federal gift tax exemption from a previous $1,000,000 to now $5,000,000 per individual, as a result of the enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, has provided additional incentive for hedge fund Managers to implement the strategies necessary to effectively transfer these interests.

The increased gift tax exemption underscores a fundamental objective of estate planning for high net-worth individuals, which is to optimize the use of such individual’s gift tax exemption by focusing on assets that have the most potential post-transfer appreciation. A hedge fund’s interest, particularly a Manager’s Performance Allocation, is exactly that type of asset.

This article will review the basic hedge fund structure, describe the nature of a Manager’s interest in a hedge fund and identify the techniques available to a Manager to transfer his or her Performance Allocation in a tax-efficient manner.

Hedge Fund Primer

The individuals who founded and/or operate a hedge fund are commonly referred to as the “Managers” of the fund. More specifically, Managers are those individuals who ultimately own an interest in the general partner entity of the HF and thus possess the right to share in any Performance Allocation generated by the fund. A “Performance Allocation” (also known as an “Incentive Allocation” or “Carried Interest”) is typically equal to 20% of the aggregate net profits (determined after reduction for any Management Fees (described below) for the fiscal year) allocable to investors during such fiscal year. Generally, Performance Allocation will be realized only in the event net profits exceed an investor’s loss recovery account (commonly referred to as a “High Watermark”). An investor’s loss recovery account will be credited with aggregate net losses and debited with aggregate net profits (but not reduced below zero). The Performance Allocation applicable to such investor will not be allocated until the investor has recovered any net losses credited to his, her or its loss recovery account. Thus, to value a Performance Allocation, the appraiser must consider the uncertainty of fund performance, from an investment return perspective, the challenge of enticing investors to contribute capital, the need to maintain performance to retain such investors, and the inherent lack of marketability and lack of control associated with the interest itself. As a result, in comparison to the Performance Allocation transfer date value, the Performance Allocation may ultimately result in appreciation far in excess of such value, which makes it optimal for wealth transfer strategies.

Hedge Fund Structure Base

To adequately understand the nuances of implementing wealth transfer techniques with Performance Allocations, it is imperative that the client and his or her advisors understand the hedge fund structure. Typically, the hedge fund will include two separate feeder funds, each designed to accommodate specific classes of investors (for the purposes of this article, those feeder funds will be referred to as the “U.S. Fund” and the “Offshore Fund”). Unlike a private equity fund in which an investor makes a capital commitment that is called incrementally by the general partner over a prescribed time period (commonly referred to as the “investment period”), an investor in a HF contributes all of his, her or its capital upon subscription.

The U.S. Fund

The U.S. Fund is intended to invite investment from U.S. resident investors (other than U.S. based tax-exempt organizations). It is generally structured as a U.S. (commonly Delaware) limited partnership, which is a pass-through entity for U.S. income tax purposes; that is, there is no entity level tax and thus all tax attributes of the limited partnership flow through and are taxed to the partners. As a limited partnership, the U.S. Fund will consist of limited partners (those who generally have creditor liability only to the extent of their capital contribution) and at least one general partner (a partner who is subject to personal creditor liability for the actions of the fund). In the HF context, outside investors, such as institutions and wealthy individuals, will be the limited partners of the U.S. Fund.

The general partner interest of the U.S. Fund is commonly owned by a U.S. limited liability company (the “GP LLC”) in which the founders and other senior members of the fund are the managing members. Junior equity holders may be granted non-managing member interests in the GP LLC. Unlike a limited partnership, a limited liability company affords all of its members personal liability protection; therefore, the potential creditor issues associated with a general partner interest are contained within the GP LLC. Generally, it is a Manager’s ownership interest in the GP LLC that entitles him or her to a portion of the Performance Allocation, and thus that interest is the primary focus of most estate planning strategies.

The U.S. Fund will commonly invest substantially all of its assets in a Master Fund, as described below, although it may have the option to invest a portion of its assets directly. In exchange for its contribution of assets, the U.S. Fund will become a limited partner of the Master Fund.

The Offshore Fund

The Offshore Fund allows investment from foreign investors and U.S. tax-exempt organizations and is separate from the Onshore Fund for U.S. tax-efficiency reasons. The Offshore Fund is typically structured as a Cayman Limited Company, which issues shares to its investors. U.S. organized hedge funds generate ordinary taxable income (or short-term capital gains taxed at ordinary income rates) which can result in effectively connected income (ECI) of a trade or business. As such, foreign investors will be subject to U.S. income taxation on their HF earnings. Further, the income generated by such funds may generate unrelated business taxable income (UBTI) (e.g., debt-financed income) for otherwise U.S. tax-exempt organizations, which can result in such income being taxable to the U.S. tax-exempt organization at ordinary corporate income tax rates or, if the organization is not incorporated, at trust income tax rates. Accordingly, as a Cayman Limited Company considered a non-U.S. corporation for U.S. income taxes, foreign investors and tax-exempt organizations are not connected to a U.S. trade or business and thus are blocked from U.S. income taxation on their return of investment.

In addition, a foreign (non-resident alien) investor owning a direct investment in a U.S. company at the time of his or her death may subject such investor to U.S. estate tax. By including the Offshore Fund as a “blocker” entity in the structure, foreign investors will not be deemed to own an interest directly in a U.S. company for estate tax purposes.

As is the case with the U.S. Fund, it is very common for the Offshore Fund to be a limited partner of a Master Fund, as described below, and invest substantially all of its assets in such Master Fund, although it may have the option to invest a portion of its assets directly. In such case, the Performance Allocation associated with the Offshore Fund will inure entirely to the GP LLC via the Master Fund.

The Master Fund

A Master Fund is an entity included in the HF structure to coordinate the investments of the U.S. Fund and Offshore Fund (collectively the “Feeder Funds”). The Feeder Funds will usually employ parallel investment strategies. To avoid the negative U.S. tax consequences associated with passive foreign investment companies (PFICs), the Master Fund will be structured as a limited partnership for U.S. tax purposes and is often formed under Cayman Island law. The Feeder Funds contribute their assets to the Master Fund in exchange for Master Fund limited partner interests. The Master Fund will very often have the same general partner as the U.S. Fund (i.e., GP LLC). The Master Fund is commonly the entity that administers the bond trading and custody accounts. The appropriate Performance Allocation and Management Fee to be paid to the GP LLC and Management Company, respectively, may be determined at the Master Fund or Feeder Fund level.

The Management Company

It is also common for the hedge fund to form an additional management company limited liability company (“Management LLC”) that provides investment advice and basic operational services to the fund, such as contracting for office space and coordinating payment of fund expenses (such as, operating expenses, employee salaries, bonuses, etc.).

The Management LLC generally has no ownership interest in the fund, but is commonly owned by the same founders and senior individuals who own an interest in the GP LLC. In exchange for its services, the Management LLC enters into a management contract with the fund, which entitles it to receive a “Management Fee” equal to a specified percentage of the current net asset value of the underlying fund portfolio (generally ranging from 1.5% to 2%). Due to its relatively predictable value and potential assignment of income issues, estate planning transfers generally do not include a Manager’s interest in the Management LLC. Further, since the Management LLC typically only engages in a contractual arrangement to provide services to the funds, it does not possess any economic rights in the fund that would require it to be included in any Performance Allocation transfer, as required by the conventional Vertical Slice transfer technique described below.

To properly plan with hedge fund Performance Allocations, it is also important that a client’s advisors take into consideration certain features of a fund’s administrative policies and investment strategies. Certain aspects of a fund, such as Redemptions and Side Pocket Investments, may both affect the value ascribed to such fund interest as well as limit the usefulness of certain wealth transfer structures.


The term “Redemption” or “Withdrawal” generally refers to an investor’s ability to withdraw all or a portion of his, her or its capital account in a Feeder Fund. The ability to withdraw is often limited by a Lock Up Period (e.g., 12 months following the initial contribution by the investor), during which time the investor will be either prohibited from withdrawing or penalized for making a withdrawal (e.g., 5% of the amount permitted to be withdrawn). Following the expiration of the Lock Up Period, investor withdrawals will be permitted on a regular basis provided, in many cases, that sufficient notice is received by the fund. In today’s more difficult capital raising environment and the need of investors to have transparency, the frequency in which investors may withdraw is commonly on a quarterly basis. Accordingly, the volatility associated with potentially a large investor capital withdrawal should be considered in forecasting and valuing Performance Allocations, particularly with unproven start-up funds.

Side Pocket Investments

Certain assets acquired by a HF may be or become illiquid, restricted or difficult to value (e.g., investments in financially distressed companies). Accordingly, it is common for a hedge fund to segregate such assets (commonly referred to as “Side Pocket Investments”) from its other assets and exclude such Side Pocket Investments from valuation, management fees, Performance Allocations and withdrawals by investors. Since the Side Pocket Investments represent an equity interest in the fund, the Manager should include a proportionate amount of such investments in any Vertical Slice transfer, as described below. Of course, due to the general illiquidity of Side Pocket Investments, an appraiser should view such investments similarly to a private equity fund investment and apply the appropriate valuation discounts. Further, it is important to note that due to the illiquid nature of Side Pocket Investments and the more challenging valuation methodology needed to ascertain the fair market value of such investments, Side Pocket Investments are generally not relied upon to service the obligations of certain wealth transfer strategies (e.g., GRAT annuity payments).


The use of Profits Allocation for lifetime gifting can produce extraordinarily successful results in shifting wealth to future generations. The availability of valuation discounts, resulting from the difficulty in raising capital and retaining investors when the potential for investor withdrawals is looming, make these assets prime for transfer. In order to engage in wealth-transfer techniques with Performance Allocations, the Manager and his or her advisors must have a significant understanding of the fund structure and tax issues associated with each transfer technique. In addition, it is important to consider whether the transferee individual or trust fully meets the Accredited Investor and Qualified Purchaser definitions, which is beyond the scope of this article.

— The author would like to thank his partners, David Scott Sloan, Private Wealth Service; Chair Estate Planning and Scott R. MacLeod, for their valuable input in the preparation of this article.

Link to part two: Wealth Transfer options

Editing by Alex Akesson
For HedgeCo.net
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