What are 2 and 20 (Hedge Fund Fees)?
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents the management fee (flat rate fee) of the total assets under management, and the 20% represents the performance fee charged on the value of profits that the hedge fund generates for its investors beyond a certain profit threshold. The 2% fee is charged on the assets under management regardless of the performance of the investments under the fund manager’s pool. However, the 20% fee is only charged when the fund achieves a certain level of profits or performance.
How the 2 and 20 Hedge Fund Fee Structure Works
The 2 and 20 fee structure helps hedge funds finance their operations. The 2% flat rate charged on the total assets under management is used to pay staff salaries, administrative and office expenses and keep the fund running. The fund holds the remaining 20%, from which the hedge funds reward its executives, portfolio managers, and other staff members with bonuses for impressive performance. This bonus structure what leads hedge fund managers to be some of the highest paid people in the world.
How the 20% Performance Fee is Calculated
The 20% performance fee is the biggest source of income for hedge funds. However, the performance fee is charged depending on the performance levels that the fund manager has agreed with the investor. Most agreements will set a return of 8%. It means that the hedge fund will only charge a fee if the profits for the year surpass the 8% level.
For example, if the fund earns a return of 15% during a specific year, then the 20% performance fee will be charged on the incremental 7% profit, (i.e., 15% – 8%). Assuming the hedge fund manages the assets of 10 large investors and they all return a substantial profit, the hedge fund could earn a considerable income running into millions, and sometimes, billions of dollars.
Justification of the 2 and 20 Fee Structure
While some investors consider this hedge fund fee structure too high, some hedge funds have maintained this compensation structure over the years. Some of these hedge funds have had impressive returns for their investors and their clients are always willing to stay with them even with the high fees.
An example of a hedge fund manager that has kept this fee is Renaissance Technologies, which is led by Jim Simmons. The company maintained an average return of 71.8% between 1994 and 2015, with a gain of 21% as its worst performance during the period. Due to its high yields on the investors’ funds, the company sometimes charged a 44% performance fee and the clients were willing to remain with the hedge fund firm.
Criticisms against the 2 and 20 Fee Structure
Both investors and politicians have put hedge funds under pressure for their 2 and 20 compensation structure. From the investor’s point of view, most hedge funds have been underperforming and mostly having inconsistent performance. For example, investors who have earned low or zero returns on their investments may feel overcharged when they are charged the 2% management fees, yet the fund has been underperforming. As a result, a huge number of investors have been redeeming their assets being managed by poorly performing funds and transferring these investments to large hedge funds that charge lower fees and have a positive track record.
From the politician’s point of view, the 2 and 20 compensation structure results in high profits, and as such, these profits should be classified as ordinary income for tax purposes. As it is, hedge fund profits are classified as capital gains, which are taxed more favorably than regular incomes. Hedge funds have protested such an arrangement since their income is based on performance and is not a salary that is paid every year. Due to pressure from politicians and investors, most hedge funds have reduced their fees structure to suit their diverse clients. However, some hedge funds have maintained the 2 and 20 structure due to their high levels of returns.
Alternative Hedge Fund Fees Structures
Rather than lowering the fee structure to attract investors, some hedge funds have adopted alternative fee structures that are favorable to them and investors. Some of these alternatives include:
1. Hurdle Rate
A large proportion of hedge funds have adopted a hurdle rate that requires that the fund manager attains a certain minimum net return before charging performance fees. Hurdle rate refers to the minimum rate of return that a fund manager should generate before charging performance fees. In most cases, the hurdle rate is tied to the S&P 500. For example, if the fund sets a hurdle rate of 7% and the fund returns 15%, the fund manager will charge the performance fees on the increment above the 7%.
2. Founders Shares
Startup and emerging hedge funds offer incentives to interested investors during the early stages of their business. These incentives are known as “founders shares,” where the fund gives the first clients an attractive offer like 1.5 and 10. Another option is to use the 2 and 20 fee structure but with a promise to reduce the fee when the fund reaches a specific milestone. Such an offer compensates the investors for the risk of investing in a hedge fund with a zero track record.
3. Discounts for Allocation’s Lockup
A hedge fund may decide to offer a substantial discount to investors who are willing to lock up their investments with the company for a long period, such as 5 years, 7 years or 10 years. It is most common with hedge funds that require longer illiquidity to generate meaningful returns for their clients. In exchange for the longer lockup period, the clients benefit from a reduced fee structure.
High watermark clause
Most hedge funds include a watermark clause that states that a hedge fund manager can only charge performance fees after the fund has generated new profits. Additionally, if the fund incurs losses, it must recover the losses before charging performance fees.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: