How Offshore Funds Operate With Limited Partnerships

Why Offshore Funds Use Limited Partnerships

Offshore LPs exist because they solve three problems at once: alignment, tax neutrality, and operational flexibility.

• Alignment. Limited partnerships reflect how private capital works. Investors commit capital; a general partner (GP) manages it; profits flow according to a negotiated waterfall. The GP carries unlimited liability and control; limited partners have limited liability and no day‑to‑day control. That architecture matches risk and decision rights.

• Tax neutrality. In most leading fund domiciles, LPs are treated as pass‑through or fiscally transparent. Income is taxed where it arises or at the investor level, not as an extra layer in the fund’s domicile. That lets a diverse investor base (taxable, tax‑exempt, and non‑US) invest side‑by‑side without unnecessary leakage, using blockers or alternative investment vehicles (AIVs) only where they truly add value.

• Flexibility. LP agreements are contracts. You can tailor management fees, carry mechanics, capital calls, overrides, recycling, excuse rights, investor transfers, and governance. Try getting that range of options from a standard corporate statute.

Jurisdictions compete to make this model attractive. Cayman’s Exempted Limited Partnership (ELP) became the default for global private funds because it’s quick to form, tax‑neutral, and familiar to institutional investors. Jersey and Guernsey LPs are popular with UK‑facing managers, while Luxembourg’s SCSp is widely used when treaty access or EU marketing is a priority. BVI LPs offer cost advantages for mid‑market strategies. Each has nuances—regulatory filings, audit requirements, depositary rules—but they all support the same core GP–LP engine.

For scale: Cayman continues to dominate alternatives. CIMA reports well over 25,000 registered open‑ and closed‑ended funds across regimes, and independent surveys consistently estimate that more than 70% of hedge funds (by count) are domiciled there. In private equity, Guernsey, Jersey, and Luxembourg have captured significant market share, but Cayman ELPs remain a global workhorse.

The Core Structure: GP–LP and the Operating Stack

At the heart of an offshore fund LP:

• General Partner (GP). The GP has authority and (in theory) unlimited liability. In practice, the GP is typically a special‑purpose entity—often Cayman for Cayman LPs—with indemnities from the fund and D&O coverage. The GP delegates portfolio management to an investment manager or adviser under a management agreement.

• Limited Partners (LPs). Investors commit capital and receive economic rights under the limited partnership agreement (LPA). They don’t manage the fund and risk losing limited liability if they cross the line into control, so LPAs and side letters spell out information, advisory committee participation, and approval rights carefully.

• Investment Manager/Adviser. Often onshore (e.g., U.S. SEC‑registered adviser or UK FCA‑authorized firm), sometimes mirrored offshore to meet local rules. It earns management and incentive fees and handles the portfolio and risk management tasks.

Key documents hold this together:

• LPA. The constitution. Sets commitment mechanics, investment restrictions, fees, carry, distributions, default remedies, governance, conflicts, and wind‑down.

• Offering document/PPM. Risk factors, strategy, fees, conflicts, service providers, and legal disclosures.

• Subscription pack. Investor eligibility, AML/KYC, regulatory forms (e.g., FATCA/CRS), and representations for exemptions (e.g., U.S. 3(c)(7)).

• Side letters. Tailored terms for anchor investors or specific needs (fee breaks, reporting, MFN rights, excuse rights, ERISA provisions).

• Management agreement. Links the fund/GP with the manager/adviser and sets the fee base, services, and delegation.

• Administrator, auditor, and custody/prime broker agreements. Operational backbone—NAV, capital accounts, audit, cash movement, custody and financing.

Practical insight: I’ve seen too many managers treat the LPA as “legal paperwork” rather than an operating manual. Bring operations, finance, IR, and deal teams into the drafting process early. You’ll catch things like recycling rules that clash with a credit strategy or a valuation policy that isn’t auditable.

Common Structures You’ll See

Master‑Feeder (Open‑Ended Strategies)

For open‑ended hedge or liquid credit strategies with monthly or quarterly liquidity, the master‑feeder is standard:

• U.S. feeder (Delaware LP or LLC) for U.S. taxable investors to avoid PFIC issues and receive K‑1s.

• Cayman feeder (ELP or exempted company) for non‑U.S. and U.S. tax‑exempt investors to shield them from UBTI and avoid direct U.S. filing.

• Cayman master fund that aggregates the feeders for a single pool of assets and uniform execution.

Subscriptions and redemptions occur at the feeder level on dealing days, with capital flowing to/from the master. Equalization or series accounting ensures fair allocation of incentive fees across different entry points.

Parallel Funds and AIVs (Closed‑Ended PE/VC/RE/Credit)

Closed‑ended strategies usually run a family of parallel funds to accommodate tax and regulatory needs:

• Cayman ELP for non‑U.S. investors and U.S. tax‑exempts.

• Delaware LP for U.S. taxable investors.

• AIVs/blockers for specific deals (e.g., U.S. real estate triggering FIRPTA or operating businesses generating ECI/UBTI). Luxembourg or U.S. corporate blockers are common, depending on treaty and exit planning.

• Co‑investment vehicles for larger tickets with reduced fees and tighter mandates.

Governance often includes an Advisory Committee (LPAC) to review conflicts, valuations for related‑party deals, or consented deviations from the mandate.

Umbrella and Segregation Options

Open‑ended strategies may use a Cayman Segregated Portfolio Company (SPC) to ring‑fence strategies and share infrastructure across portfolios. LPs themselves don’t create statutory segregation across compartments, so multi‑compartment LPs rely on contract, not law, for segregation—another reason SPCs are used for hedge platforms, while LPs dominate closed‑end private funds.

Economics and Terms That Matter

Capital Commitments and Calls

Closed‑ended LPs run on capital commitments. Investors sign up for, say, $50 million and receive drawdown notices as deals close.

• Notice period. Typically 10–15 business days. Cross‑border funds add FX guidance and multi‑currency bank details.

• Default remedies. Interest on late payments (e.g., Prime + X%), suspension of distributions, clawback of prior distributions, and, ultimately, forfeiture of interests or forced sale. Draft these with precision. Ambiguity around cure periods or what counts as “excused” capital becomes a real issue during stressed markets.

• Excuse rights. LPs may opt out of deals breaching their internal policies (e.g., sanctions, ESG exclusions). Without a clean process and timing, excuse mechanics can jam closing timetables.

Open‑ended LPs, where used, operate with subscriptions/redemptions rather than commitments, but it’s uncommon; companies or unit trusts are more typical for hedge funds.

Fees and Expenses

• Management fee. Commonly 1.5%–2% on committed capital during the investment period, stepping down to invested or net asset value (NAV) thereafter. Credit funds often use net invested capital from day one, especially if they don’t call the full commitment quickly.

• Offsets. 100% (sometimes 50%) of transaction or monitoring fees offset management fees. LPs expect transparency and quarterly reporting of all fee income.

• Organizational expenses. Capped (e.g., up to 0.5% of commitments or a fixed dollar cap) and amortized over the investment period. Don’t treat the cap as a target. Bring admin and audit quotes early; overruns during first close sour investor relations.

Carried Interest and Waterfalls

Carry aligns the GP with performance. The two archetypes:

• American (deal‑by‑deal). Carry crystallizes per deal once that deal returns capital and hurdle; requires robust escrow and clawback protections.

• European (fund‑as‑a‑whole). Carry only after returning all contributed capital and preferred return to LPs; safer for LPs and increasingly the norm outside buyout funds with rapid distributions.

A typical build:

• Hurdle/preferred return: 8% simple annual rate on unreturned capital.

• Catch‑up: 100% to the GP until it catches up to 20% of total profits.

• Carry: 80/20 split thereafter.

Simple example: $100 million fund; 8% hurdle; European waterfall. After several exits, $130 million is available:

1) Return of capital: $100 million to LPs. 2) Hurdle: Assume, for simplicity, $10 million cumulative pref due; pay that to LPs. 3) Catch‑up: $10 million to GP so it reaches 20% of the $50 million profits (once complete). 4) Remainder: Split 80/20. If $10 million remains, $8 million LP / $2 million GP.

Always build a carry escrow (10%–30%) and a GP clawback with joint and several obligations and a tail extending beyond fund life. I’ve seen clawbacks fail because the GP entity had no assets when audited true‑ups were due.

Recycling, Reinvestment, and Leverage

• Recycling. Permits reinvestment of proceeds up to a cap (e.g., to cover broken deal expenses or to maintain portfolio size) without raising a new fund. Align definitions—“recycling of recallable distributions”—with the IRR and hurdle math to avoid disputes.

• Subscription lines. Credit facilities secured by uncalled commitments can boost IRR optics but change how and when LPs deploy capital. Provide a look‑through IRR and disclose usage. Some LPs now insist on caps (e.g., not more than 20% of commitments outstanding for longer than 180 days).

• NAV facilities. Facilities secured by portfolio NAV help manage liquidity or bridge exits in later years. They come with covenants that can restrict distributions. Be transparent with the LPAC.

Tax and Regulatory Considerations You Can’t Ignore

U.S. Investor Landscape

• Investment Company Act exemptions. Most private funds rely on 3(c)(1) (≤100 beneficial owners) or 3(c)(7) (qualified purchasers only). That choice affects marketing and fund scale.

• Advisers Act. Managers with U.S. nexus are often SEC‑registered. Even exempt reporting advisers must file certain reports. Side letter promises around transparency or fee offsets need to be consistent with Form ADV disclosures.

• UBTI and ECI. U.S. tax‑exempt investors (e.g., endowments) want to avoid UBTI. Non‑U.S. investors want to avoid ECI. Offshore LPs use corporate blockers for operating income, U.S. real estate (FIRPTA), or leveraged income that could taint tax‑exempt investors. Placement of blockers—U.S. vs. non‑U.S.—depends on where income arises and exit strategy.

• PFICs. U.S. taxpayers invested in non‑U.S. corporate funds face PFIC rules. LPs help avoid PFIC status at the fund level, but AIVs or feeder companies can reintroduce it. U.S. feeders for U.S. taxable investors typically use pass‑through entities and K‑1 reporting.

• Withholding and reporting. For ECI‑generating vehicles, Sections 1446(a)/(f) withholding applies. LPs need robust processes for W‑8/W‑9 management and tracking effectively connected allocable income.

• Carried interest rules. Section 1061 extends the required holding period to three years for long‑term capital gain treatment on carry allocations. Your deal pacing and early exits can change the GP’s after‑tax results.

ERISA and Plan Asset Risk

• 25% test. If benefit plan investors exceed 25% of any class of equity interests (excluding GP and affiliates), the fund’s assets can become “plan assets,” pulling the manager into ERISA fiduciary territory.

• VCOC/REOC. Private equity and real estate funds often qualify as Venture Capital Operating Companies or Real Estate Operating Companies to avoid plan asset status. This requires specific rights (e.g., management rights) and annual compliance tests.

• Side letters. Expect ERISA‑specific covenants: no indemnification for certain fiduciary breaches, restricted transactions, and enhanced reporting.

Non‑U.S. Investor Points

• Treaty access. If treaty benefits matter for portfolio income, consider Luxembourg or other treaty‑friendly platforms for the blocker or AIV, not necessarily the main fund.

• Documentation. W‑8BEN‑E, CRS self‑certifications, and beneficial ownership attestations (including controlling person disclosures) are standard. Prepare investors early to prevent closing delays.

FATCA/CRS and Economic Substance

• FATCA/CRS. Offshore LPs are typically treated as Financial Institutions. They must register (e.g., obtain a GIIN for FATCA), classify investors, and report annually to local tax authorities for exchange under CRS. Administrators can handle reporting, but the GP remains accountable.

• Economic Substance. Investment funds are generally out of scope, but fund managers and certain holding companies or service entities may be in scope. Expect annual filings and local “mind and management” requirements for in‑scope entities.

Local Fund Regulation Snapshot

• Cayman Private Funds Act (closed‑ended). Requires registration, annual audit, valuation policy, safekeeping of assets, and cash monitoring. AML officers (MLRO, DMLRO) and a compliance officer must be appointed.

• Cayman Mutual Funds Act (open‑ended). Registration for most open‑ended funds, with an auditor and administrator; certain small funds exempt under specific thresholds.

• Jersey/Guernsey regimes. Multiple routes (e.g., JPF, JFSC funds; Guernsey Private Investment Fund) allow fast‑track private fund registration with recognized administrators.

• Luxembourg AIFs. SCSp with an AIFM (authorized or registered). EU marketing is controlled by AIFMD; non‑EU managers often rely on national private placement regimes.

• UK/EU marketing. If you market into the EU or UK, map out AIFMD/NPPR requirements early. File pre‑marketing notices where applicable and prepare Annex IV reporting.

Regulatory lesson learned: map your marketing countries before finalizing structure. I’ve seen managers form Cayman‑only platforms and then discover that half their pipeline is German insurance capital that insists on a Luxembourg‑based feeder with an AIFM and depositary‑lite. Fixing that mid‑raise is expensive and slow.

Operations and Governance

Valuation and NAV

• Policy. Establish who values what, using what sources, and how overrides are approved. For level 3 assets, a valuation committee with external input (e.g., third‑party valuation agents) helps satisfy auditors and LPs.

• Frequency. Quarterly for closed‑end funds; monthly or quarterly for open‑end. Tie incentive fee crystallization and carry accruals to valuation frequency and audit sign‑off thresholds.

• Consistency. If you change methodology (e.g., shift from cost to model‑based), document reasons and impacts. LPs care less about a perfect model and more about consistency and disclosure.

Cash, Custody, and Leverage

• Bank accounts. Segregate operating, subscription, and distribution accounts. Use dual authorization and administrator oversight. I’ve seen fraud attempts target distribution notices; out‑of‑band confirmations with investors reduce risk.

• Custody. Hedge funds use custodians and prime brokers. Private equity funds often rely on safekeeping arrangements and legal title controls rather than daily custody. For AIFMD‑covered funds, depositary or depositary‑lite solutions are required.

• Facilities. Subscription lines and NAV facilities require ongoing covenant tracking (borrowing base, eligible investors, concentration). Keep your admin, counsel, and GP ops in lockstep on covenant compliance and investor eligibility changes.

Investor Onboarding and AML/KYC

• What slows closings. Missing beneficial ownership documents for corporate investors, outdated passports for signatories, unclear source‑of‑funds letters, and PEP screening delays.

• Smoother onboarding tips:

• Send a one‑page KYC checklist with examples of acceptable documents.

• Offer secure e‑sign and a portal for uploads; ban email for sensitive IDs.

• Start KYC as soon as the term sheet is agreed—don’t wait for final LPA.

Meetings, Reporting, and Audits

• Reporting cadence. Quarterly investor letters, financials with capital account statements, and an annual audited report. Closed‑end funds add deal‑level updates and exit summaries.

• LPAC. Meet at least twice a year or ad hoc for conflicts/valuation approvals. Provide materials early and record decisions carefully.

• Audits. Offshore funds must appoint recognized auditors in their domicile. Plan the audit calendar with your admin. Late audits trigger regulator attention and can freeze distributions.

Side Letters and MFN

• MFN mechanics. Define “class” carefully—fee classes, regulatory classes—so MFN doesn’t create unintended economic parity across unlike investors.

• Operationalizing. Keep a side letter register. Train ops and IR teams on obligations (e.g., reporting formats, fee breaks, ESG audits). I’ve seen MFN breaches happen not from malice but spreadsheets going stale.

Step‑by‑Step: Setting Up an Offshore LP Fund

1) Define your investor map. Who are you raising from—U.S. taxable, U.S. tax‑exempt, non‑U.S., EU/UK? Your investor mix dictates domicile, feeders, and marketing path.

2) Choose domicile(s). Cayman ELP for broad global appeal; add Delaware for U.S. taxable investors; consider Luxembourg SCSp if EU treaty access or AIFMD marketing is core.

3) Sketch the structure. Parallel funds vs master‑feeder; blockers; AIVs; co‑invest sleeves. Diagram cash flows and tax paths. Pressure‑test with two example deals.

4) Line up service providers. Counsel (onshore/offshore), fund administrator, auditor, bank, custodian/prime broker (if needed), AML officers, and potentially a depositary (EU‑focused funds).

5) Draft the LPA and PPM. Align the economics (fees, carry, waterfall, recycling) with your strategy. Get operations to run “day‑in‑the‑life” scenarios against the draft.

6) Build the subscription and KYC pack. Include FATCA/CRS forms and a clean eligibility questionnaire for 3(c)(1)/(7), QP, QIB, ERISA status, and sanctions screening.

7) Form entities. GP, fund LP(s), feeder(s), AIVs, and manager entities. Reserve names, file registers, and appoint directors/managers where required.

8) Register with regulators. CIMA registration for Cayman funds, obtain GIIN, set up AML policies, file AIFMD NPPR notices for targeted EU/UK countries, and prepare Form ADV updates if U.S. registered.

9) Secure facilities. Negotiate a subscription line early; covenants influence your LPA (e.g., eligibility criteria, reporting frequency).

10) Launch the data room. Include final drafts, track changes, a term summary, and a KYC guide. Record Q&As; consistent answers avoid side letter sprawl.

11) First close and capital call. Send admit notices, collect KYC, open capital accounts, and call a small amount for fees and initial investments.

12) Operational run‑rate. Establish reporting calendar, LPAC schedule, valuation committee cadence, and audit timeline. Train your team on side letter obligations and MFN processes.

Timeline and costs (ballpark for an institutional build):

• Timeline: 12–20 weeks to first close if documents and providers are organized; longer if EU marketing is heavy.

• Legal and formation: $250k–$600k depending on complexity and jurisdictions.

• Administrator: Basis points on NAV/commitments; a mid‑market closed‑end fund might pay $150k–$350k annually for core services.

• Audit: $75k–$200k+ depending on portfolio complexity and jurisdictions.

• Miscellaneous: AML officers, regulatory filings, bank fees, KYC tools. Budget buffer for translations and local filings if marketing broadly.

Case Studies

Case Study 1: Global Credit Fund with Parallel LPs

Goal: Lend against mid‑market corporate assets across North America and Europe. Investors include U.S. taxable family offices, U.S. endowments, and European insurers.

Structure:

• Delaware LP for U.S. taxable investors.

• Cayman ELP for non‑U.S. and U.S. tax‑exempt investors.

• Luxembourg S.à r.l. blocker for selected U.S. loan‑to‑own deals and European withholding optimization.

• Subscription line sized at 20% of commitments, with 180‑day cap on borrowing to satisfy LP preferences.

Terms:

• 1.5% management fee on invested capital; 15% carry with an 8% hurdle; European waterfall.

• 100% offset of transaction and monitoring fees.

• Recycling of principal repayments up to 100% during the investment period.

Operational highlights:

• LPAC approves any loan‑to‑own conversions to equity.

• Valuation quarterly with third‑party reviews for level 3 assets.

• ERISA 25% monitored continuously with a dashboard; early side letters commit the manager to VCOC‑compatible rights for a subset of deals.

Outcome: Smooth closings and no tax surprises. The subscription line accelerated early IRR but the manager provided a look‑through net IRR to keep LPs comfortable.

Case Study 2: Macro Fund with Master‑Feeder

Goal: Daily‑traded macro strategy targeting global rates and FX, just‑in‑time liquidity.

Structure:

• Delaware LP feeder for U.S. taxable investors (3(c)(7)).

• Cayman exempted company feeder for non‑U.S. and U.S. tax‑exempt investors.

• Cayman master fund with ISDAs across prime brokers and a tri‑party custody setup.

Terms:

• 2% management fee and 20% performance allocation with monthly crystallization and a high‑water mark.

• Monthly dealing with five business days’ notice; quarterly gate at 25% to manage liquidity.

Operational highlights:

• Administrator calculates NAV daily; formal dealing NAV monthly.

• Equalization shares prevent cross‑subsidization of incentive fees.

• FATCA/CRS handled centrally; multi‑jurisdiction marketing relies on reverse solicitation logs and UK NPPR filings.

Outcome: Institutional investors appreciated the clean separation of feeders, tight liquidity controls, and consistent shadow NAV from an independent pricing agent.

Common Mistakes and How to Avoid Them

• Over‑engineered structure. Adding feeders and blockers “just in case” creates cost and friction. Start with investor‑driven needs. Build optionality via AIV provisions rather than forming empty entities.

• Sloppy waterfall math. Ambiguity around the order of distributions, treatment of broken deal costs, or FX gains/losses can lead to disputes. Run numerical examples and audit them.

• Subscription line overuse. Using facilities as a performance crutch rather than a liquidity tool erodes trust. Disclose policies, caps, and IRR presentation standards.

• Ignoring ERISA until late. If ERISA capital is in the pipeline, architect VCOC/REOC compliance and plan the 25% test upfront. Retrofits are painful.

• Weak valuation governance. “Manager marks” without controls won’t pass diligence. Create a valuation committee, engage third‑party support for hard‑to‑value assets, and document overrides.

• Side letter chaos. MFN rights that unintentionally level fees, conflicting reporting obligations, or untracked ESG commitments lead to breaches. Keep a centralized register and map obligations to workflows.

• KYC bottlenecks. Investors abandon closings when KYC becomes a scavenger hunt. Provide clear checklists, accept apostilles where needed, and use a secure portal.

• GP clawback blind spots. Without escrow and true joint and several obligations from carry recipients, clawbacks become unenforceable. Fix this before you launch.

• AIFMD missteps. Marketing in Europe without proper NPPR filings or ignoring pre‑marketing rules gets flagged fast. Align your IR strategy with legal pathways.

Practical Tips from the Trenches

• Write your LPA like an operating handbook. Every clause should answer “what do we do on a Tuesday morning when X happens,” not just recite standard legalese.

• Build your first‑100‑days calendar. Map the first close, first capital call, audit kickoff, LPAC scheduling, and reporting cadence before the term sheet is signed.

• Over‑communicate fee offsets. Report gross and net, disclose sources of offsets, and reconcile quarterly. Transparency buys goodwill.

• Model three tough scenarios. A busted deal with expense allocations; a defaulting investor during a closing; and a NAV facility covenant breach. If your documents and processes survive those, you’re in good shape.

• Get your bank accounts ready early. KYC for bank onboarding is as demanding as investor onboarding. Parallel‑process these to avoid closing delays.

• Limit bespoke terms. Fee breaks are fine; operational exceptions are costly. Use side letter templates with pre‑approved language and guardrails.

• Stress test investor eligibility. Your subscription line’s borrowing base depends on “eligible investors.” Side letters that cap capital calls, or transfers to non‑eligible entities, can shrink your line unexpectedly.

Frequently Asked Questions

• Do I need a Cayman GP for a Cayman ELP? Typically yes. The GP is usually a Cayman entity to meet statutory requirements, though management can be delegated to an onshore adviser.

• Can a single LP force a change? Only if the LPA grants that right or via LPAC decisions for specific matters. Most LPAs require supermajority votes for GP removal (with or without cause) and material amendments.

• How fast can I form an offshore LP? Entity formation in Cayman can be done in days. Realistically, budget 12–20 weeks for a full institutional setup including docs, providers, and first close readiness.

• What’s a reasonable org expense cap? Market ranges from a fixed dollar cap (e.g., $1–2 million) to a percentage (e.g., 0.5% of commitments) for mid‑market funds, but investors increasingly push for the lower of the two.

• Should I offer both American and European waterfalls? Pick one that matches your strategy and investor base. If you select American, strengthen escrow and clawback and be ready to explain why deal‑by‑deal makes sense.

• When do I need a depositary? EU AIFMD requires a depositary for EU‑domiciled AIFs and for many EU marketing routes. Non‑EU funds marketed under NPPR may use depositary‑lite services for safekeeping, oversight, and cash monitoring.

Final Thoughts

Offshore limited partnerships aren’t exotic anymore; they’re standard plumbing for global capital. The difference between a fund that runs cleanly and one that stumbles is rarely the headline strategy—it’s the invisible architecture: the LPA that anticipates hard days, the tax paths that don’t spring surprises, the admin files that match the auditor’s requests, and the side letters that your team can actually deliver on.

The best time to simplify and harden your structure is before first close. Map your investor base, design the minimum viable structure, and write documents that your operations team can live with. The result is a fund that raises faster, runs cheaper, passes diligence, and puts more of everyone’s energy where it belongs—into compounding capital.