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.

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.

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.