The 2/20 model is a common fee structure used by hedge funds, private equity firms and other alternative investment managers. It consists of two components: a management fee and a performance fee.
The management fee is usually 2% of the assets under management (AUM) and is paid annually to the fund manager for managing the fund’s portfolio. The management fee covers the operational costs of the fund, such as salaries, rent, legal fees, etc.
The performance fee is usually 20% of the profits generated by the fund above a certain threshold, known as the hurdle rate or the high watermark. The hurdle rate is the minimum return that the fund must achieve before the manager can collect the performance fee. The high watermark is the highest value that the fund has ever reached and ensures that the manager does not get paid for recovering past losses.
For example, suppose a hedge fund has $100 million AUM and charges a 2/20 fee structure with a 10% hurdle rate and a high watermark. In the first year, the fund earns 15% and increases its value to $115 million. The manager receives a 2% management fee of $2 million and a 20% performance fee of 20% x ($115 million – $110 million) = $1 million. The total fee is $3 million and the net return to investors is 12%.
In the second year, the fund loses 5% and decreases its value to $109.25 million. The manager receives a 2% management fee of $2.185 million but no performance fee since the fund did not exceed the hurdle rate or the high watermark. The total fee is $2.185 million and the net return to investors is -7.185%.
In the third year, the fund earns 20% and increases its value to $131.1 million. The manager receives a 2% management fee of $2.622 million and a 20% performance fee of 20% x ($131.1 million – $115 million) = $3.22 million. The total fee is $5.842 million and the net return to investors is 14.158%.
The 2/20 model has been widely adopted by alternative investment managers because it aligns their interests with those of their investors and incentivizes them to generate high returns. However, it has also been criticized for being too expensive, rewarding excessive risk-taking, creating conflicts of interest, and being insensitive to market conditions.
Some investors have negotiated lower fees or different structures with their fund managers, such as 1/10, 1/15, or 1/20. Some fund managers have also voluntarily reduced their fees or offered more flexible terms to attract or retain investors.
The 2/20 model is not a fixed rule but rather a market convention that may change over time depending on supply and demand factors. As an investor, it is important to understand how fees affect your returns and to compare different funds based on their net performance after fees.