two_and_twenty

Two-and-Twenty (also known as the '2 and 20' fee structure) is the classic, and some would say notorious, compensation model for managers of alternative investment funds, particularly hedge funds and private equity firms. It’s a simple but potent recipe for making fund managers wealthy. The name breaks down into two parts: a 2% management fee and a 20% performance fee. The 'two' refers to an annual fee of 2% calculated on the total assets under management (AUM) in the fund. This is the manager's bread and butter, paid regardless of whether the fund makes or loses money. The 'twenty' is the sizzle—a 20% cut of the fund's profits, often called carried interest. This performance-based reward is designed to incentivize managers to generate high returns. So, if a manager oversees a $100 million fund, they'll collect a $2 million management fee, and if they generate a $10 million profit, they'll pocket an additional $2 million as a performance fee. For investors, this structure can be a double-edged sword, and understanding its nuances is critical.

The 2% management fee is the steady paycheck for the fund manager. It's charged annually on the total value of assets in the fund, come rain or shine. If a fund manages $1 billion, it automatically rakes in $20 million a year to cover its operating expenses like salaries, rent, research software, and legal costs. From a value investing perspective, this is the most problematic part of the model. Why? Because it rewards asset gathering, not necessarily investment skill. A manager’s top priority can easily shift from generating superior returns to simply attracting more capital to grow the AUM and, consequently, their guaranteed fee. It creates a 'heads I win, tails you still pay me' scenario that isn't perfectly aligned with the investor's goal of, well, making money.

The 20% performance fee is the manager's reward for a job well done. It’s the carrot that’s supposed to align the manager's interests with the investors'. However, the devil is in the details, and savvy investors look for two key provisions that make this fee fairer:

• Hurdle Rate: This is a minimum rate of return the fund must achieve before the performance fee kicks in. For example, with an 8% hurdle rate, the manager only earns their 20% cut on profits above that 8% return. This prevents managers from getting paid for mediocre performance that an investor could have achieved in a simple index fund.
• High-Water Mark: This is a crucial protection for investors. It ensures that a fund manager cannot collect a performance fee on the same gains twice. If a fund's value drops, it must first recover all losses and surpass its previous highest value (the high-water mark) before the manager can start charging the performance fee again. This stops managers from 'earning' a fee just for making back money they previously lost.

For decades, the 2-and-20 model was the unchallenged king of Wall Street. However, its crown has slipped, largely thanks to blistering critiques from legendary investors like Warren Buffett. Buffett famously made a 10-year bet that a low-cost S&P 500 index fund would outperform a portfolio of hedge funds, chosen by an investment professional. Buffett’s argument was simple: the exorbitant fees charged by the hedge funds would act as an anchor, dragging down their net returns over the long run. He won the bet in a landslide. The lesson for value investors is profound: fees are a gargantuan hurdle. A 2% management fee means your investment has to climb a 2% hill each year just to break even, before even considering the performance fee. As Buffett puts it, this structure can turn 'a bunch of smart people into a grab bag of mediocrity'.

The good news is that investor pressure and increased competition have forced a change. The classic 2-and-20 is no longer standard. Many funds now offer lower fees, such as '1.5 and 15' or even '1 and 10'. Some funds, especially in high-growth areas like venture capital, might still command high performance fees (sometimes 25% or 30%), but they often come with more investor-friendly terms like high hurdle rates. Your key takeaway as an investor is this: read the fine print and do the math.

1. What is the management fee? Is it charged on committed capital or invested capital?
2. Is there a performance fee? Does it have a hurdle rate and a high-water mark?
3. How do these combined fees compare to other alternatives?

Fees are one of the few reliable predictors of your future net returns. Don't let a slick sales pitch distract you from what is often the single most important number in an investment proposal.