2 and 20 Model

The 2 and 20 Model is a classic compensation structure used primarily by hedge fund and private equity managers. Think of it as the manager's price tag for their services. The name breaks down into two distinct parts: a 2% management fee and a 20% performance fee. The management fee is an annual charge, calculated as 2% of the total assets under management (AUM)—the total market value of the investments a fund manages on behalf of investors. This fee is charged regardless of the fund's performance and is meant to cover the firm's operational costs, such as salaries, rent, and research. The second part, the 20% performance fee (also known as carried interest), is where the real money is made for the manager. It's a share of the fund's profits, typically 20%, which acts as a powerful incentive for the manager to generate high returns. This combination of a steady income stream and a potentially massive performance bonus has made “2 and 20” the long-standing industry standard for alternative investments.

Understanding the “2 and 20” model is simple once you break it down. It's designed to reward the fund manager in two different ways: for managing the money and for making it grow.

This is the manager's bread and butter. Each year, they take a 2% cut of the total assets they are managing for you and other investors.

• Example: If a hedge fund has $500 million in AUM, the management firm collects 2% x $500 million = $10 million in management fees that year. This happens whether the fund made a 30% gain or suffered a 10% loss. It's a fixed cost of doing business for the investor.

This fee ensures the lights stay on at the fund's office, but as we'll see, it can create a conflict of interest.

This is the juicy steak for the fund manager. After the fund achieves a certain level of profit, the manager gets to keep 20% of those gains. This fee is what attracts top talent to the industry, as it offers a limitless upside. However, to protect investors, two important safeguards are often put in place:

• Hurdle Rate: This is a minimum rate of return the fund must achieve before the performance fee kicks in. For example, if a fund has a 6% hurdle rate, the manager only earns a performance fee on profits above that 6% threshold. This prevents managers from getting paid for mediocre performance that you could have gotten from a safer investment.
• High-Water Mark: This is a crucial protection. It ensures that if a fund loses money, the manager cannot charge a performance fee until the fund's value has recovered past its previous peak. This prevents investors from paying for performance twice—once for the initial gain and again for simply recovering from a loss.

Let's say you invest in a fund with $100 million in AUM that uses a simple 2 and 20 model (with no hurdle rate for this example).

1. Initial AUM: $100 million
2. Year 1 Gross Profit: The fund has a great year and generates a 30% return, or $30 million in profit.
3. Management Fee: 2% of the initial $100 million AUM = $2 million.
4. Performance Fee: 20% of the $30 million profit = $6 million.
5. Total Fees to Manager: $2 million + $6 million = $8 million.
6. Net Profit for Investors: $30 million (Gross Profit) - $8 million (Total Fees) = $22 million.
7. Your Net Return: $22 million / $100 million = 22%.

As you can see, your 30% gross return was whittled down to a 22% net return after the manager took their cut. Those fees can make a massive difference.

For value investors, the “2 and 20” model is often viewed with deep skepticism. While it's designed to align interests, it can create significant problems and often benefits the manager far more than the investor.

The structure itself presents a classic “heads I win, tails you lose” scenario.

• The 2% management fee incentivizes the manager to simply gather as many assets as possible, rather than focus on generating superior returns. A larger asset base means a larger guaranteed paycheck, even with poor performance.
• The 20% performance fee can encourage excessive risk-taking. With a massive potential payday on the line, managers might be tempted to make highly speculative bets. If the bets pay off, they get rich. If they fail, they still collect their management fee, while the investor bears the full brunt of the loss.

Warren Buffett, the patriarch of value investing, has famously criticized the high fees charged by hedge funds. He argues that over the long term, the drag from fees makes it nearly impossible for the vast majority of funds to outperform a simple, low-cost index fund. In his 2016 letter to shareholders, he described how the “2 and 20” structure allows Wall Street “promoters” to reap “stunning sums” from investors who receive “sub-par results.” For Buffett, the math is simple: high costs are the enemy of high returns.

Investor pushback and increased competition have put the traditional model under pressure. Many newer funds, or older funds seeking to retain clients, have moved to more investor-friendly structures. Fee models like “1 and 15” or “1.5 and 10” are becoming more common, and some funds are eliminating the management fee entirely in favor of a higher performance fee, creating a purer “pay-for-performance” model.

• High-Cost Hurdle: The “2 and 20” model is a very expensive fee structure. The high fees create a significant performance hurdle that a manager must overcome just for you to keep pace with the market.
• Know the Details: Always look for investor protections like a high-water mark and a reasonable hurdle rate. Don't be afraid to ask about them.
• Alignment Is Everything: The best investment managers align their success directly with yours. For most value investors, the “2 and 20” structure often fails this fundamental test.
• Consider the Alternative: As Warren Buffett advises, for the vast majority of people, investing in a broad, low-cost index fund is a more reliable path to building long-term wealth than chasing high-flying returns with a high-cost fund manager.