2% management fee + 20% performance fee
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The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
Again, the 2% fee is charged on the assets under management regardless of the performance of the investments under the fund manager. However, the 20% fee is only charged when the fund achieves a certain level of profit.
The graphic below should make the compensation structure clear.
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 total assets under management (AUM) is used to pay staff salaries, administrative and office expenses, and other operational expenses. The 20% performance fee is used to reward the hedge fund’s key executives and portfolio managers. This bonus structure is what makes hedge fund managers some of the highest paid financial professionals.
How the 20% Performance Fee is Calculated
The 20% performance fee is the biggest source of income for hedge funds. The performance fee is only charged when the fund’s profits exceed a prior agreed-upon level. A common threshold level used is 8%. That means that the hedge fund only charges the 20% performance fee if profits for the year surpass the 8% level.
For example, assume a fund with an 8% threshold level generates a return of 15% for the year. Then the 20% performance fee will be charged on the incremental 7% profit above the 8% threshold. If the hedge fund manages assets of 10 large investors and makes a sizeable profit, its income for the year may run into millions – sometimes billions – of dollars.
Justification of the 2 and 20 Fee Structure
Some investors consider the common 2 and 20 hedge fund fee structure excessively high. Nonetheless, the industry has generally maintained this compensation structure over the years. It is able to do so primarily because hedge funds have consistently been able to generate high returns for their investors. Therefore, clients have been willing to put up with the fees, even if they consider them somewhat exorbitant, in order to obtain very favorable returns on investment. (ROI)
Renaissance Technologies, a hedge fund managed by Jim Simmons, maintained an average annual return of 71.8% between 1994 and 2015. Its worst year during the period still showed a 21% profit. Because of the high yields delivered to investors, they were willing to pay performance fees up to 44%.
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 in recent years. This is largely due to the fact that, in the wake of the 2008 financial crisis, hedge funds – like many other investments – have struggled to perform at optimally high levels. As a result, an increasing number of investors have sought out hedge funds that charge fees lower than the traditional 2 and 20.
Politicians have sought a larger cut of hedge fund profits, seeking to have them taxed as ordinary income rather than at the lower capital gains rate. As of 2018, the hedge fund industry has been able to maintain the lower tax rate, arguing that their income is not a fixed salary and is based on performance.
Alternative Hedge Fund Fees Structures
Some of the alternative fee structures adopted by some hedge funds are as follows:
1. 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”. The founders shares entitle investors to a lower fee structure, such as “1.5 and 10” rather than “2 and 20”. 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. For example, the fund might charge 2 and 20 on profits up to 20%, but only charge “2 and 15” on profits beyond the 20% level.
3. Discounts for Capital 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 specified time period, such as five, seven, or 10 years. This practice is most common with hedge funds whose investments typically require longer time frames to generate a significant ROI. In exchange for the longer lockup period, 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. If the fund incurs losses, it must recover the losses before charging performance fees.
Additional Resources
Thank you for reading CFI’s guide on 2 and 20 (Hedge Fund Fees). To keep learning and advancing your career, the additional CFI resources below will be useful:
- Private Equity vs Hedge Fund
- Hedge Fund Strategies
- Exchange-Traded Funds (ETFs)
- Investing: A Beginner’s Guide
- See all wealth management resources
FAQs
The correct answer is: b.
What is 2 and 20 best explained as with regard to hedge funds? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
Do hedge funds still charge 2 and 20? ›
Hedge funds typically charge a 2% management fee on total assets, alongside a 20% performance fee on profits generated. The structure has been used for decades but has been trending downwards in recent years, with hedge funds now introducing 'pass-through' and 'compensation' fees to make up the shortfall.
What is the VC 2 20 rule? ›
The 2 and 20 fee structure is a compensation model commonly used by venture capitalists. It involves a fixed management fee (typically 2% of the total asset value) and a performance fee (usually 20% of the fund's profits) that the VC manager receives.
What is an example of a 2 and 20 fee? ›
You choose to place that money in a fund charging two and twenty. Over the course of one year, you'll pay roughly $2 million x 2% = $40,000 for the 2% management fee. If during that year, the fund returned 20%, your $2 million would grow by $400,000 to $2.4 million.
Which of the following best describes the 2 20 fee that is used by most hedge funds? ›
which of the following best describes the 2/20 fee that is used by most hedge funds? The investor pays a 2% management fee and gives 20% of the profits to the fund manager.
How much money do you need to be considered a hedge fund? ›
3 In exchange, the Securities and Exchange Commission (SEC) requires a majority of hedge fund investors to be accredited, which means possessing a net worth of more than $1 million and a sophisticated understanding of personal finance, investing, and trading.
What is the 2 and 20 hurdle rate? ›
A two-and-20 arrangement is a common fee structure for hedge funds, private equity, and venture capital firms. The fund charges investors 2% of assets under management plus 20% of profits over a hurdle rate annually. Typically, the hurdle rate is 7% to 10%.
What is the average hedge fund management fee? ›
The asset management fee is generally between 1% and 2% of the fund's net assets, and is typically charged on a monthly or quarterly basis. The performance fee, structured as an allocation of partnership profits for tax purposes, has historically been 15 – 20% of each investor's net profits for each calendar year.
What is the average management fee for a hedge fund? ›
A "2 and 20" annual fee structure—a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits—is a standard practice among hedge funds.
But it's important to understand how the math works here — and how it figures into how much to raise. My simple advice when you raise capital: assume you have to return a liquidity event (sale or IPO) of at least 10x the amount you raise for raising venture capital to be worth it. Valuations change from round to round.
What is the hurdle rate in a hedge fund? ›
A hurdle rate is the minimum rate of return that the hedge fund manager should generate before it is able to charge a performance fee. Hurdle rates are either a fixed or variable rate, often linked to a benchmark interest rate, such as Libor.
What percentage of VC investments fail? ›
It may ebb and flow, but it will always be there as a strong demand. There will always be money to be raised. And yet, despite all that cash flowing into VC-backed companies, twenty-five to thirty percent of them will fail.
What is the 2 in 20 fee structure? ›
This is also known as the “2 and 20” fee structure and it's a common fee arrangement in private equity funds. It means that the GP's management fee is 2% of the investment and the incentive fee is 20% of the profits. Both components of the GPs fees are clearly detailed in the partnership's investment agreement.
What is the 2 and 20 calculation? ›
"Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark.
What is the average return of hedge funds? ›
All hedge funds tracked by BNP Paribas returned an average of 7.66% in 2023, differing from the survey results released on Feb. 12. In 2022, these hedge funds returned an average of 0.42%, said a BNP spokesperson. However, survey respondents said their hedge fund portfolios returned an average of 1.1% in 2022.
What does 50% hedge mean? ›
At the beginning of the hedge, Company A would have a hedge ratio of 0.5 (meaning that 50% of the portfolio is protected from currency risk). Over the course of the six months, however, their portfolio's value will likely increase or decrease, which will change their hedge ratio.
What is the basic explanation of a hedge fund? ›
A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.
What is a 1 or 30 hedge fund fee? ›
A common option is for the manager to take a 1% management fee with a reduction of the same amount to the performance fee so that total fees are capped at 30%. If the 1% management fee exceeds 30% of alpha during the performance period, any performance fee not recouped is carried forward to subsequent years.
Are hedge funds Level 2 assets? ›
Level 2 assets may include debt securities, bank loans, short-term floating rate notes and asset-backed securities, securities held within consolidated hedge funds and certain equity method limited partnership interests in hedge funds valued based on NAV where the Company has the ability to redeem at the measurement ...
