What is the Two and Twenty Rule for Compensation?

In hedge funds (as well as venture capital and private equity) there are certain charges which a private client needs to pay for investment and wealth management practices to be executed. First, a client is required to submit 2% of the assets being managed to the manager or firm, and also submit 20% of profits earned to the same manager or firm depending on the benchmark attached. These two fees; the 2% of AUM (the assets being managed, known as assets under management), and 20% of profits are what makes up the concept of Two and Twenty. It is thus easy to see the reason why hedge fund managers are incredibly wealthy, sometimes to the detriment of their clients.

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How Does the Two and Twenty Rule Work? 

Hedge funds managers will always go home with 2% without regards to how well the investment is performing. Also, there are only allowed to get 20% of the profits after performance reaches a benchmark; otherwise termed a hurdle rate. Hurdle rates can be agreed upon as percentages or may be based on a threshold such as equity or bond index returns. Mathematically, if a hedge fund manager is overseeing an investment of $2billion, he or she must be given up to $40 million yearly, as this is amount is the 2% of the AUM. Hedge funds might get to contend with high watermarks which are associated with their performance fee. In hedge funds, a high watermark policy states that the fund manager will be paid a part of the profits only if the net profit from that year surpasses that of the preceding year. Thus, this reduces the chances that a fund manager will get paid large sums even if the funds performance is declining.

Important Details about Two and Twenty

• In Two and Twenty, Two (2%) is the percentage of the hedge fund that must be paid to the manager and twenty (20%) is the percentage of the profits above a hurdle rate that must be paid to that same manager
• Most hedge fund managers have managed to become millionaires and even billionaires due to Two and Twenty, and this has resulted in a lot of criticisms on the part of investors and politicians
• Investors can choose to apply a high watermark to the performance fee, where fund managers will only be paid if the returns from that year surpass the funds all-time high.

Two and Twenty: A Reasonable Model or Not?

In 1982, Jim Simons, who is the highest-paid hedge fund manager, created the Renaissance Technologies. As an award-winning mathematician, Jim applied his skills to develop his company as a quant fund which made use of many mathematical models, strategies and techniques. Renaissance is currently recognised as the best firm with the highest hedge fund returns due to its top program; the Medallion. Launched in 1988, Medallion proved to be an element of wonder as it generated over 40% annual returns during its first 30 days. It also made an average of 71.8% each year between 1984 and 2014. These returns were only published after the firm collected their 5% management fee from AUM, and their 44% of management fees. This company, however, has decided to shut its doors to investors as it is now focused on helping only employees. In June 2018, Renaissance was estimated to have $57 billion in AUM, and this has contributed significantly to the net worth of Jim Simons even though he stepped down from being CEO of the company in 2010. The case of Jim Simons is an exception in the hedge fund industry, as most funds performance since 2009 are nothing to write home about. From 2009, the average returns on fund investments were 6.09%, a bit lower than that of the S&P 500, which has been said to be seeing its worst days. However, in 2018, the hedge fund industry managed to surpass the S&P 500 on total returns, but only by an insignificant margin. In 2017, Warren Buffett addressed the Berkshire Hathaway shareholders saying that the search for greater advice on the part of typical hedge fund investors has led to a loss of over $100 billion in the last ten years.

More on the Two and Twenty Model

Investors have been exiting the hedge funds industry due to the high level of under-performance and unrealistic management fees. More than $94.3 billion has been pulled out of this industry since 2016. However, this market has seen a steady increase since the beginning of 2019, where returns have increased by $78.8 billion, making the total assets valuation to be $3.18 trillion. Exposure has also caused a decline in the returns and performance of hedge funds, as there are more than 11000 actively managed portfolios compared to 1000 in 1989. Nowadays, medium investors are charged 1.5% as a management fee, and 17% for performance fee as compared to 1.6% for management and 16% for performance in 1989. Hedge fund managers are also facing lots of criticisms, as politicians are looking for means to classify performance fees as ordinary income. This way, managers will get to pay taxes on them. The 2% is, however, classified in this category as managers get to pay income taxes on the twos. However, the twenties are not awarded as cash in hand, but rather reinvested into the funds investment, thus eliminating the possibility of ordinary tax rates. These performance fees are bonded by the capital tax rate, which is 23.8%, compared to the regular tax rate, which is 37%. Congressional Democrats stepped in during March 2019 to amend the legislation to put an end to these capital interest tax rates. 

A Mathematical Illustration of Two and Twenty 

Let us assume that a hedge fund ABX investments have over $3 billion in assets under management (AUM) in their first year. We also assume that this hedge fund company is closed to new investors. Now, assume that this fund grows to $3.20 billion in the first year, but drops to $2.7 billion in the second year. It, however, bounces back and hits an all-time high of $3.5 billion in the third year. In a situation where the Two and Twenty model is applied to this fund, the annual fees at the end of each management year are: 

First Year: Assets under management at the start of the year = $3,000M AUM at the end of the year = $3,200M Management Fee = 2% of AUM at the end of the year = $64M Performance Fee = 20% of returns = 20% x $3,200M - $3,000M = 20% x $200M = $40M Total Fee = $40M + $64M = $104M 

Second Year: Assets under management at the start of the year = $3,200M AUM at the end of the year =$2,700M Management Fee= 2% of AUM at the end of the year = $57M Performance Fee = Not Payable due to high watermark policy (end year AUM is less than that of the first year) Total Fee = $57M 

Third Year: Assets under Management at the start of the year = $2,700M AUM at the end of the year = $3,500M Management Fee = 2% of $3,500M = $70M Performance Fee = 20% x $3,500M - $3,200M = 20% x $300M = $60M Total Fee= $60M + $70M = $130M.