2 and 20 is a common hedge fund fee structure, charging a 2% management fee and 20% performance fee on profits. It aligns manager incentives with fund performance but can significantly impact investor returns.
The '2 and 20' fee structure is a widely used model in hedge funds and private equity funds, where managers charge a 2% annual management fee on assets under management (AUM) and take a 20% cut of any profits generated, known as a performance or incentive fee. This model is designed to motivate fund managers to deliver high returns by aligning their compensation directly with fund performance. The management fee, typically 2%, covers operating expenses, salaries, research, and other administrative costs, regardless of investment outcomes. The 20% performance fee, however, is only charged on profits above a defined benchmark or hurdle rate, sometimes with a high-water mark provision to ensure investors do not pay multiple times for the same performance. While the 2 and 20 structure incentivizes active fund management and alpha generation, it can dilute investor returns, especially in years of modest profit. Alternative fee models—such as flat fees or modified tiered incentives—have emerged in response to increased scrutiny and competitive pressure. In institutional use, including pensions, endowments, and family offices, careful negotiation of these terms is common practice to ensure proper transparency and cost alignment.
Understanding the 2 and 20 structure is essential for negotiating and assessing private fund agreements, especially in family office investment allocations involving hedge funds or private equity. The structure directly affects investment return net of fees, risk-adjusted performance, and long-term capital efficiency across portfolios. This model also impacts governance decisions, such as manager selection, due diligence, and monitoring practices. Family offices evaluating alternatives will need to assess whether the value added by an active manager is worth the cost and how these fees compare to other asset classes and vehicles.
A family office allocates $10 million to a hedge fund using the 2 and 20 structure. The management fee is 2% of AUM ($200,000 annually). If the fund earns a 10% return ($1 million in profit), the manager also earns a 20% incentive fee on profits, equaling $200,000. The total fees paid by the investor in this scenario are $400,000, reducing the net return to 6% ($600,000).
2 and 20 vs. Performance Fee
While '2 and 20' includes both management and performance fees, a 'Performance Fee' refers solely to the incentive-based portion of fund compensation. Understanding the distinction helps investors evaluate how much of the manager's pay depends on actual excess returns versus a flat percentage of capital managed.
Is the 20% performance fee always charged on total profits?
Not always. Many funds include a hurdle rate or high-water mark. This means the performance fee is only applied to profits above a minimum return (e.g., 5%) or after past losses are recovered.
Can a fund charge 2 and 20 without producing positive returns?
Yes, the 2% management fee is charged regardless of performance. However, the 20% performance fee is typically only applied when the fund generates positive profits or exceeds specific benchmarks.
Are 2 and 20 fees negotiable for large investors or family offices?
Yes, family offices and institutional investors often negotiate lower fees or alternative arrangements, such as reduced management fees, tiered incentives, or co-investment opportunities.
