Why do I need a Cayman fund and a Delaware Fund? Can’t I have the US investors and the non-US investors in my Cayman fund or in my US fund?
These are probably the most frequently asked questions, certainly among start-up and emerging managers.
Where a manager is looking to attract US taxable investorsand has set-up or is setting-up a US fund, typically a US limited partnership or US limited liability company, generally organised in Delaware, the manager will often market to or come across US tax-exempt investors, such as US charities, US pension funds, and US university endowments, as well as non-US investors, who like the product and want to invest.
If this is the case then simultaneously with the set–up of the US fund, the manager will set up a Cayman fund as part of the pooled investment structure to take in the US tax-exempt investors and non-US investors.
We know this is the solution, but what is the problem that is being solved?
In short, the manager is creating this structure to avoid the non-US investors and the US tax-exempt investors from being exposed, unnecessarily, to the 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 counsels and the US audit firms, and I apologise in advance for the tax talk as follows:
1. 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 UBITfor 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 UBIT even if no debt financing is involved. US tax-exempt investors can avoid such UBIT exposure by investing through a Cayman 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). Therefore, the Cayman fund, or the Cayman master fund in which it invests, can use debt without creating UBIT exposure for the tax-exempt investors in the Cayman fund.
2. 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 in dividual 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.
Therefore, managers wanting to attract US taxable investors, US tax-exempt investors and non-US investors will generally set-up both a US fund and a Cayman fund. The manager needs to decide from the outset which investor groups they will be targeting and attracting and in doing so manager need to be really focus on being self-reflective.
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 a Caman 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 non-US investors. For these managers the best route may be to set-up a US fund which will lead to the establishment of a Cayman fund once they have established their track record.
And most non-US managers will likely have access to non-US investors from the start but may not yet have the critical mass or network to attract allocations from US taxable investors. For these managers the best route may be to set-up a Caymanfund which will lead to the establishment of a US fund once they have established their track record, as well as the famous Cayman master fund.
And for the more established, mid-market and billion-dollar-plus managers they will typically already have the internal infrastructure and resources to establish the US fund and a Cayman fund at the same time in order to approach both markets from the outset.
Its all about horses for courses!