Two and twenty sounds like a quarter of the return at most. Worked backwards from the net, it is a third in one year and nearly half over ten.
Under a standard 2 and 20, with the management fee taken first and the performance fee charged on what is left above the high-water mark, a hedge fund has to earn 12.00 per cent gross for its investors to keep 8.00. The formula is gross = net ÷ (1 − 20%) + 2%. Fees take 4.00 points, a third of the gross return in a single year, and 45.0 per cent of the gain over ten years once the lost compounding is counted.
Worked in full in Alternative Investments by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
"Two and twenty" sounds like a quarter of the return at most. It is more than that, because the 2 per cent is charged on assets rather than on gains, and it is charged whether or not the year is good. The order in which the two fees are applied, the base the management fee is struck on and whether a hurdle applies all move the answer, so it is worth doing the sum from the offering document rather than from the headline.
| Term | Value |
|---|---|
| Management fee | 2.0% a year of opening NAV |
| Performance fee | 20% of the gain after the management fee |
| High-water mark | Yes, no hurdle |
| Crystallisation | Annual |
| Net return the investor wants | 8.0% a year |
| Starting NAV | 100 |
Work backwards from the net. The investor keeps 80 per cent of the gain after the management fee, so that gain must be 8.00 ÷ 0.80 = 10.00. The management fee of 2.00 comes before it, so the portfolio must earn 12.00.
Net = (Gross − management fee) × (1 − performance fee rate)
Gross = Net ÷ (1 − performance fee rate) + management fee = 8.00 ÷ 0.80 + 2.00 = 12.00%
In Excel, with the target net in B1, the performance rate in B2 and the management fee in B3: =B1/(1-B2)+B3
On 100 invested for a year:
| Line | Amount |
|---|---|
| Gross gain on the portfolio | 12.00 |
| Management fee, 2% of 100 | −2.00 |
| Gain after management fee | 10.00 |
| Performance fee, 20% of 10.00 | −2.00 |
| Net gain to the investor | 8.00 |
One year understates the cost, because every point paid in fees also stops compounding. At 12.00 per cent gross, 100 grows to 310.58 in ten years; at 8.00 per cent net it grows to 215.89. The gross gain is 210.58 and the investor's is 115.89, so the fees and the compounding they forgo take 94.69, or 45.0 per cent of everything the portfolio made. The single-year third becomes nearly half over a normal holding period, which is the same effect the book's smoothing, fees and exit workbook measures in money on a private fund, and which this article works for a private equity fund.
| Structure | Gross needed for 8% net | Fees (points) | Share of gross |
|---|---|---|---|
| 2 and 20, fee on opening NAV | 12.00% | 4.00 | 33.3% |
| 2 and 20, fee on average NAV | 12.12% | 4.12 | 34.0% |
| 1.5 and 20 | 11.50% | 3.50 | 30.4% |
| 1 and 30 | 12.43% | 4.43 | 35.6% |
| 1.5 and 15 | 10.91% | 2.91 | 26.7% |
| 2 and 20 over a 5% hard hurdle | 10.75% | 2.75 | 25.6% |
Two results deserve a second look. The "1 and 30" structure sold as aligned is more expensive than 2 and 20 at this level of return: it needs 12.43 per cent gross. The two cost the same at 9.0 per cent gross, and 1 and 30 is cheaper only below that, which is not the scenario anyone is paying 30 per cent for. And a 5 per cent hard hurdle is worth more than half a point of management fee: it cuts the gross needed to 10.75, below the 11.50 of a plain 1.5 and 20.
The share of the return taken by fees also depends heavily on how well the fund does:
| Gross return | Net return | Fees (points) | Fees as share of gross |
|---|---|---|---|
| 4.0% | 1.60% | 2.40 | 60.0% |
| 6.0% | 3.20% | 2.80 | 46.7% |
| 8.0% | 4.80% | 3.20 | 40.0% |
| 10.0% | 6.40% | 3.60 | 36.0% |
| 12.0% | 8.00% | 4.00 | 33.3% |
| 15.0% | 10.40% | 4.60 | 30.7% |
| 20.0% | 14.40% | 5.60 | 28.0% |
The management fee makes the structure regressive: in a weak year fees take most of the return, and in an ordinary one nearly half. A fund earning 6.0 per cent gross hands its investors 3.20.
Less than people expect, provided there is a high-water mark. Run 100 through five years of 25, minus 10, 6, 20 and 12 per cent gross. The fund pays 11.14 of management fees and 9.01 of performance fees, 20.15 in all, no performance fee is charged in the two years spent below the high-water mark of 118.40, and NAV ends at 136.05 against 160.27 gross. That is 6.35 per cent a year net against 9.89 gross, almost exactly the 6.31 the smooth formula gives for 9.89. Without the high-water mark, the recovery years would be charged again and the gap would widen; the mechanics are set out in how a performance fee works with a high-water mark.
Applying the two fees in the wrong order. Taking 20 per cent of the gross return first and then subtracting 2 gives net = 0.80 × gross − 2, which needs 12.50 per cent gross for 8 net, 0.50 points more than the standard calculation. Some documents do charge the performance fee on the gain before management fees, and on those the 12.50 is right. The point is that the half-point difference is a term of the contract, and it should be read there, not assumed.
Gross needed = net ÷ (1 − performance rate) + management fee. For 8 per cent net under 2 and 20 that is 12.00 per cent gross, a third of the return in one year and 45.0 per cent of the gain over ten. Before comparing a hedge fund with any other alternative, put both on the same footing: the return that actually reaches the investor. The cash-flow and fee models for the private funds side of that comparison are in the free workbook for this case.
Deduct the 2 per cent management fee from the gross return, then charge 20 per cent of what remains above the high-water mark. On 100 earning 12.00 gross, the management fee is 2.00, the gain after it 10.00, the performance fee 2.00 and the investor nets 8.00. Fees take 33.3 per cent of the gross gain. Check the offering document: some charge the performance fee before management fees.
Not at normal returns. To net 8 per cent, 1 and 30 needs 12.43 per cent gross against 12.00 for 2 and 20, so it costs the investor more. The lower management fee only wins when gross returns are low enough that the extra 10 per cent of performance fee bites on very little. A 1.5 and 15 structure needs 10.91 per cent and is cheaper than both.
Under 2 and 20 it falls as the return rises, because the management fee is fixed. At 12.0 per cent gross fees take 33.3 per cent of the return, at 6.0 per cent they take 46.7 and at 4.0 per cent 60.0. Over ten years at 12.00 gross and 8.00 net, fees and the compounding they forgo take 45.0 per cent of the total gain.
This article is one calculation from Alternative Investments. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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