2 and 20

2 and 20 is the classic, and often notorious, fee structure traditionally used by alternative investment funds, particularly hedge funds and private equity funds. Think of it as the manager's “salary and bonus” package, paid for by the investors. The “2” represents a 2% management fee, an annual charge on the total amount of money the fund manages. The “20” represents a 20% performance fee (also known as carried interest), a share of the profits the fund generates. For example, if you invest $100,000 in a fund with this structure, you'd pay around $2,000 annually as a management fee, regardless of how the fund performs. If the fund then makes a $10,000 profit on your investment, the manager takes an additional $2,000 (20% of the profit) as a performance fee. This model is designed to cover the fund's operational costs with the management fee while incentivizing the manager to produce high returns with the performance fee. However, for investors, this dual fee structure can create a significant drag on returns over time.

To truly understand the impact of “2 and 20,” let's break down its two components. They work very differently, but together, they have made fund managers extraordinarily wealthy.

The management fee is the steady, reliable income stream for the fund manager.

• How it works: It's an annual fee calculated as a percentage of the fund's total Assets Under Management (AUM). If a fund manages $500 million, a 2% management fee generates $10 million in revenue for the management company each year.
• The “cost of doing business”: This fee is charged whether the fund makes or loses money. It covers the firm's overhead—salaries for analysts, office rent, technology, legal fees, and marketing.
• The drag on performance: For you, the investor, this is a guaranteed annual hurdle. Your investment must first grow by more than 2% just to break even and start earning a real return.

This is the “bonus”—the part that's supposed to align the manager's interests with the investors'. The manager only gets this hefty payout if they generate profits.

• How it works: The performance fee is a percentage of the fund's profits, typically calculated annually. If a fund's value increases from $500 million to $600 million in a year, it has generated $100 million in profit. The manager would earn a performance fee of $20 million (20% of $100 million).
• Investor Protections: To make this fairer, reputable funds include a couple of important provisions:
  • High-Water Mark: This is the highest value your investment has ever reached. A manager can only charge a performance fee on profits that push the fund's value above its previous peak. This prevents managers from losing money, regaining it, and charging you a performance fee for simply getting back to where you started.
  • Hurdle Rate: Some funds also have a hurdle rate, which is a minimum return (e.g., 6% per year) that the fund must achieve before the performance fee kicks in. This ensures investors aren't paying a large performance fee for mediocre returns that they could have achieved in a simple index fund.

From a value investing standpoint, the “2 and 20” model is viewed with deep skepticism. Value investors are laser-focused on costs, as they directly erode long-term returns. As the legendary Warren Buffett has frequently pointed out, high fees are a major reason why the vast majority of professional money managers fail to beat the market over time.

• Fees are a certainty; profits are not: The 2% management fee is a guaranteed headwind you must overcome every single year. Over a decade, that's a significant portion of your capital eaten away by fees before you've even seen a penny of profit.
• Misaligned Incentives: While the performance fee is meant to align interests, it can sometimes do the opposite. A manager might be tempted to take excessive risks (“swing for the fences”) to chase that 20% bonus. If the bets pay off, the manager gets rich. If they fail, the investor bears the loss while the manager continues to collect their 2% management fee. This runs counter to the core value investing principle of capital preservation.
• The Trend is Your Friend: Fortunately, the classic “2 and 20” model is under pressure. Increased competition and investor awareness have forced many funds to lower their fees to “1.5 and 15,” “1 and 10,” or even adopt management-fee-only structures. This shift is a huge win for investors.

The “2 and 20” fee structure can be a powerful wealth-building engine—for the fund manager. For the investor, it represents a very high bar that the manager must consistently clear to be worth the cost. Before ever investing in a fund with such a structure, you must be convinced that the manager possesses a truly exceptional and repeatable skill. Always remember: costs are one of the few things you can control as an investor. Scrutinize every fee, because what truly matters for your long-term compounding journey is not what you earn, but what you keep.