Two and Twenty
Two and Twenty (or 2 and 20) is a fee structure that is standard in the hedge fund industry and is also common in venture capital and private equity. Hedge fund management companies typically charge their clients management and performance fees. Two is 2% of assets under management (AUM) and refers to the difference between the management fee and the performance fee for the fund as a whole. That’s a 2.5% fee on a $100 million investment in a fund.
Twenty refers to the difference between the management fee and the performance fee for the fund as a whole or the total AUM of the entire fund.
The fee structure has come under fire from investors and politicians in recent years for making many hedge fund managers multi-millionaires and even billionaires. The lucrative fee system has been scrutinized by investors, politicians, and many hedge fund managers, and has led to enormous wealth.
However, to a certain extent such scrutiny is driven by headline greed and envy. For sure many politicians and those in other industries see the hedge fund manager as nothing more than a button pusher. They discount the fact that management of hundreds of millions of dollars is actually a very expensive business. Staff costs, regulatory costs, bank account feels, valuations all add up. The hedge fund manager is not simply pocketing the 2%, it is used for actively managing the fund, and the funds expenses.
A hedge fund manager with a billion AUM earns $20 million a year in management fees, even if the fund performs poorly. Performance fee is the high watermark that determines what percentage of return a fund manager must receive before the net value of that fund exceeds its previous peak. A management fee of 2% is paid to hedge fund managers, regardless of the performance of their fund.
A 20% performance fee is charged when a fund reaches a certain level known as the threshold. The threshold could be based on a number of factors, such as the fund’s AUM, its size or its performance over the past year.
Hedge funds also face high watermarks in their performance fees. High watermarks require that fund managers receive a percentage of profits if the net value of a fund exceeds its previous peak. This prevents the fund manager from receiving large sums for poor performance and ensures that losses must be recouped before the performance fee is paid.
The table below shows the top five fund managers who have made the most money in 2018 and their performance fees. The five highest-paid hedge fund managers in the United States collectively earned $7.7 billion in fees and raised a total of $1.5 billion in their own money.
|Owner||Firm||Total hedge fund income in 2020 (US$)|
|James Simons||Renaissance Technologies||$1,600,000,000|
|Ray Dalio||Bridgewater Associates||$1,260,000,000|
|John Overdeck||Two Sigma||$770,000,000|
|David Siegel||Two Sigma||$770,000,000|
The giant hedge funds founded by these fund managers have grown so large that they alone can collect hundreds of millions in management fees, but they also bring billions in performance fees to the fund. The fees that the hedge fund charges may be justified by its continued out-performance, but the question is also whether the majority of fund managers generate enough returns to justify their fee model.
Renaissance Technologies was founded in 1982 by William Simon, one of the highest paid hedge fund managers in recent years. He is best known for his flagship Medallion fund, which has delivered huge returns over the past 30 years, with returns of more than 30% a year. Simon launched Medallion in 1988 and has delivered an average annual return of over 20% over the next 30 years, including an annual return of over 40% in each of his first three years at the helm.
Medallion closed in 2005 to outside investors and currently manages only money for Renaissance employees, and it has $57 billion in AUM as of June 2018. Those returns are more than twice the average for all hedge fund managers in the United States, but the outsize fees should help Renaissance increase its fortunes since Simon stepped down as CEO in 2010.
Hedge funds have generated an annualized return of 4.07%, compared with the total return of the S & P 500, which includes dividends. This excellence is in stark contrast to the performance of the US stock market over the same period.
The performance of the hedge fund lags behind the stock index because it is assumed that it will make money in the market by taking long or short maturities, and it has been the subject of much speculation about its performance in recent years.
Strong performance in most markets has allowed the hedge fund industry to increase its assets to $3.18 trillion, but chronic under performance and high fees including the two and twenty have prompted investors to bail out the hedge funds. Since the beginning of 2016, the SEC has pulled a net $94.3 billion from the market, according to the Securities and Exchange Commission.
Warren Buffett estimates that his Berkshire Hathaway shareholders are leading the charge against the typical hedge fund investor, who is worth $1.2 billion, or about one-third of the company’s total assets. The influx of new investors, estimated at more than 11,000 active investors, compared with fewer than 1,500 at the end of last year, has also pushed down fees.
The average fund now charges a performance fee of 17 percent, compared with an average 22.5 percent over the past five years, according to data from the Securities and Exchange Commission and the New York Stock Exchange.
Will two and twenty prevail?
Hedge fund managers have also come under fire from politicians who want to tax performance bonuses as ordinary income rather than capital gains. While the 2% management fee levied by hedge funds is treated as regular income, the 20% is often treated as capital gains, although returns are not usually paid out, but are treated with the investor’s money by reinvesting in the fund. Transferring interest to funds allows for income streams that are taxed more heavily than ordinary profits, such as dividends, interest, and dividends on stocks.
Two and Twenty… and tax
In March 2019, Democrats in Congress reintroduced legislation to end the much-maligned tax break for carry interest. By the end of the first year, the fund’s AUM had grown to $1.15 billion, but by the third year it had fallen to about $920 million, recovering to about $1.25 billion in early 2018, according to Federal Reserve data.
When is Two and Twenty Justified?
2 and 20 can be absolutely justified in for actively managed and aggressive funds such as Asset Secured Investments which is a medium to long term mortgage backed investment vehicle with a Global reach and significant scale. Because asset backed situations are relatively illiquid the 2% makes absolute sense and the 20% provides a solid performance enhancing KPI linked to Global Property and Fixed Income markets.
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