2 and 20 Fee Structure
Hedge funds managers have finally found an ultimate solution to the way they charge for their services.
The 2 and 20 private equity fee structure is a compensation method for most equity firms, where “two” 2 represents 2% of the annual management fee used for the cover overheads and the amount used to pay salaries from the capital deployed. The “twenty” 20 (hurdle rate) represents 20% of the fund’s profits above a certain predefined benchmark.
This appealing fee has resulted in many hedge managers making good money. You will realize that most private firms work for 20% because most of their compensation is made.
Approximately 8 % of their limited partners will stipulate a set of returns. Additionally, if, for instance, there is a find return of 14%, then 6 % of the increment will have been made to carry the kickback of 20%. Therefore, this 2 and 20 fee structure has been largely used in the hedge fund industry. That is why every business owner should understand this compensation structure to help strategize its impact on business.
How 2 and 20 works – hedge fund 2 and 20 rule example
Irrespective of the funds’ performance, a 2% management fee is paid to the hedge funds managers. For instance, if a hedge fund manager has $ 1 billion, AUM will earn at least $20 million if he performs poorly that year. Therefore, the 20% performance fee will be charged when it exceeds the hurdle rate, a base threshold based on a benchmark, or a preset percentage. Additionally, a high watermark on hedge funds applies to the performance fee.
This policy emphasizes that the current net value should exceed the previous highest value so that the fund manager can be paid. This ensures that any losses resulting from a poor performance are precluded before a hedge manager is paid large funds, which will not correspond to his performance.
Therefore, the 2 and 20 fee structure is useful in finance because the 2% fee on the total assets is used to pay office expenses, administrative and staff salaries, and other expenses. The 20% performance fee is used to reward portfolio managers and reward hedge fund managers, making them among the most paid financial professionals.
Hedge fund fee structure example
The hedge fund has $50M in assets.
Period 1: At the end of Period 1, the hedge fund has $70M in assets.
Period 2: At the end of Period 2, the hedge fund has $40M in assets.
Period 3: At the end of Period 3, the hedge fund has $90M in assets.
Period 1 Hedge fund fee structure
Period 1 hedge fund fee structure: Fund growth = $70M – $50M = $20M
Period 1 Management fee = 2% of assets under management × $70M = $1.4M
Period 1 Incentive fee = 20% of growth in fund value = $20M × 20% = $4M
Period 1 Return to investors: (20M – 1.4M – 4M)/50M= 29.2%
Period 2 Hedge fund fee structure
Period 2 hedge fund fee structure: Fund growth = $40M – $70M = -$30M
Period 2 Management fee = 2% of assets under management × $40M = $0.8M
Period 2 Incentive fee = 0 because loss
Period 2 Return to investors: (-30M – 0.8)/70M=- 44%
Period 3 hedge fund fee structure
Period 3 hedge fund fee structure: Fund growth = $90M – $40M = $50M
Period 3 Management fee = 2% of assets under management × $90M = $1.8M
Period 3 Incentive fee = 20% of growth above high-water mark = (90M-70M) × 20% = $4M
Period 3 Return to investors: (50M – 1.8M-4M)/40M=110.5%
The hedge fund fee structure that management has taken is Period 1+ Period 2+ Period 3 = 1.4+4+0.8+0+1.8+4 = 4.8M.
0% Performance Fee Calculation example
Hedge funds managers are great beneficiaries of the 20% performance fee. This fee is only charged when the profits exceed the specified levels. The common threshold used is 8%. Therefore, any amount that exceeds 8% will be eligible to charge the hedge funds’ 20% performance fee.
Based on Wikipedia, In 2018, the highest-paid hedge fund managers total up to $7.7 billion. The following firms’ owners, two sigmas, citadel, Bridgewater associates, and renaissance technologies, have made hundreds of millions in the management fees only. The strategies they used for the performance fees have earned them billions of dollars because of their exemplary performance. However, the big question is whether the majority of the fund managers can satisfy the 2 and 20 fee model by getting substantial funds returns.
For instance, an 8% threshold level can generate a 15% return for the whole year; then the 20% will be charged on a 7% profit above the 8% threshold.
Is Two and Twenty Justified
Jim Simons founded Renaissance technologies in 1982. This highest-paid hedge manager established a quant fund that employs techniques and sophisticated quantitative models that formed the basis of his trading technique. Renaissance has been regarded as one of the world’s successful hedge funds because of its amazing returns. Therefore Simon went forward and launched the flagship Medallion fund, which generated approximately 40% annual return.
Between the years 1984 -2015, he manages to maintain an annual return of 71 %. The 21% profit marked it’s the worst year. Additionally, the investors were willing to pay up to 44% performance fees because of the high yield.
Therefore, some investors consider 2 and 20 hedge fund structures very high though this compensation structure has been maintained for a long time. Most investors have been able to put up with the fees because they obtained favorable returns on investments despite the perception that the structure is exorbitant.
However, the system’s high fees and underperformance have made most investors bail out the hedge funds. The managers also experience pressure from the politicians who want the performance fees to be subjected to the tax. Therefore, the 2% is taken to be the ordinary income while 20% is treated as capital gains as if they were reinvested with the fund. This carried interest has enabled private equity and high-income managers to have a 23.8% streamed tax at the capital gains.
Since 2018 the hedge fund industry introduces a lower tax rate, arguing that their income is based on performance; hence it is not a fixed salary.
Alternative Hedge fund Fees Structures
The following are some of the alternative Hedge fund structures:
High water mark Clause
This clause states that charge performance fees can only be put in place by the hedge fund manager after generating new profits. Therefore when losses occur, they must be recovered before the performance fee is charged.
Discounts for Capital Lockup
If an investor is willing to lock up their investments, the hedge fund can substantially discount a specified period. This is common amongst those investments that take a long time to generate a substantial return on investment. Therefore, the client will benefit from a reduced fee structure in exchange for the extended lockup period.
Incentives are offered to the investors interested in the business’s initial stages by the emerging hedge funds and start-up. The investors will be entitled to the founder shares, which have a lower fee structure such as 1.5 and 10. Alternatively, one can opt to use 2 and 20 but guarantee that there will be a few reductions when the fund reaches the specified amount.
Therefore, these alternatives can also provide a good platform to ensure that you have the best model that you will be able to account for the performance fees.