Offshore Hedge Funds vs. Onshore Hedge Funds

The onshore and offshore hedge fund seek to accomplish the same thing: positive returns under all kinds of market conditions, using a variety of high-risk trading strategies. What makes them different is how they are taxed and structured and how they facilitate the goals of their various investors. Hedge funds purposely set up alternative venues for their investors to appeal to the needs of their diverse clients, who might otherwise be penalized by one type of fund or the other.

Onshore hedge funds differ from offshore hedge funds in the kinds of investors who participate. The criteria imposed on the first type are more stringent than those on the latter. To invest in a registered onshore hedge fund, an individual investor must have a net worth of $2 million; if investing in a nonregistered fund, she must be either an accredited investor with $1 million in net worth or a qualified investor with $5 million in investable assets. Nonetheless, most U.S.-based investors would not find offshore hedge funds worthwhile, because they do not confer the capital gains benefits of onshore hedge funds. Those who find offshore hedge funds appealing are non-U.S. citizens and U.S. tax-exempt entities, which make up the bulk of offshore clients. The latter are able to stay clear of the unrelated business taxable income (UBTI) that they would have to pay in an onshore fund. Hedge funds sometimes maintain both an onshore and offshore facility to cater to different investor needs.

Onshore hedge funds tend to be limited partnerships or limited liability companies that pass through gains and losses to investors. Offshore hedge funds can take several forms: corporation, unit trust or limited partnership. Incorporation is a common route for both open-ended funds, which have no fixed shares, and close-ended, or fixed-share, funds; the offshore unit trust offers an open-ended, unincorporated mutual fund structure with low operating costs that can be diversified into sub-trusts. The limited partnership form exemplified by many Cayman Islands hedge funds follows the Delaware limited partnership template, which is governed by the Delaware Revised Uniform Limited Partnership Act. In this type of entity, the general manager manages the business, while the limited partners are passive investors.

Onshore and offshore hedge funds can stand on their own, but a fund manager might choose to establish an overarching structure to connect them. To this end, he might build a side-by-side setup, where he creates and oversees both fund types to meet the needs of his investors. With this type of structure, the manager would have to make duplicate trade decisions for each fund, making it more administratively cumbersome than other structures. Alternatively, he might choose a master feeder structure, where the operations of each "feeder," whether onshore or offshore, are unified in a single decision for all entities.

Offshore hedge funds offer a number of advantages or benefits, making them an appealing alternative to onshore funds in the matter of jurisdictional considerations. In the Caribbean, where the Cayman Islands, Bermuda and the British Virgin Islands have long served as popular offshore domiciles, hedge funds are subject to low or no taxation. Thus offshore hedge funds may be exempt from U.S. income tax on distributions, estate tax and withholding tax due to their outlying location. Moreover, the regulatory environment in these domiciles is equipped to identify money laundering and to prosecute lawbreakers in a legal system grounded in English common law.