What Is 2 and 20? The Hedge Fund Fee Structure Explained

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2 and 20 (also written “two and twenty” or 2/20) is a fee structure in which a fund manager charges investors a 2% annual management fee on assets under management (AUM) plus a 20% performance fee on profits, usually only on profits above a hurdle rate or a previous peak value. It is the traditional fee model for hedge funds and is also widely used in private equity and venture capital. Many funds charge lower percentages, but “2 and 20” remains the shorthand for the two-part structure: a fixed fee for managing money and a variable fee for making money.

How 2 and 20 Works

The Management Fee

The management fee is a percentage of the assets the fund manages, typically accrued over the year and charged monthly or quarterly. It covers salaries, research, trading systems, compliance and other operating costs, and it is paid regardless of performance. A manager with $1 billion in AUM collects about $20 million a year from a 2% fee even in a losing year.

Because the fee scales with assets, the manager earns more simply by gathering more capital. A fund that grows from $1 billion to $5 billion in AUM multiplies its management fee income fivefold without any change in returns.

The Performance Fee

The performance fee (incentive fee) is a share of the fund’s profits, traditionally 20%. It is meant to reward the manager for generating returns, ideally alpha, or returns beyond what the market would have delivered anyway. The fee is usually calculated on the change in the fund’s net asset value (NAV), and the offering documents specify whether it is measured before or after the management fee and how often it is locked in (for example, annually).

Hurdle Rates and High-Water Marks

Two provisions limit when the performance fee is paid.

• Hurdle rate. The fund must earn a minimum return before the performance fee applies. The hurdle can be a fixed percentage or tied to a benchmark, such as a bond or equity index return. With a hard hurdle, the fee applies only to profits above the hurdle. With a soft hurdle, once the fund clears the hurdle, the fee applies to the entire profit.
• High-water mark. The manager earns a performance fee only when the fund’s value exceeds its previous highest value. If the fund falls, it must first recover those losses before any new incentive fee is charged. This prevents a manager from being paid twice for the same gains after a drawdown.

Example of 2 and 20

The example below is hypothetical. It assumes:

• An investor puts $1,000,000 into a fund at the start of Year 1.
• The management fee is 2% of the investor’s value at the start of each year.
• The performance fee is 20% of the gain after the management fee, assessed annually.
• There is a high-water mark and no hurdle.
• Gross returns are +15% in Year 1, −20% in Year 2 and +30% in Year 3.

Year 1

• Gross value: $1,000,000 × 1.15 = $1,150,000
• Management fee: 2% × $1,000,000 = $20,000, leaving $1,130,000
• Gain after management fee: $130,000
• Performance fee: 20% × $130,000 = $26,000
• Ending value: $1,104,000 (a 10.4% net return on a 15% gross return)
• New high-water mark: $1,104,000

Year 2

• Gross value: $1,104,000 × 0.80 = $883,200
• Management fee: 2% × $1,104,000 = $22,080, leaving $861,120
• Performance fee: none, because there is no gain

Year 3

• Gross value: $861,120 × 1.30 = $1,119,456
• Management fee: 2% × $861,120 = $17,222.40, leaving $1,102,233.60
• Performance fee: none, because the value is still below the $1,104,000 high-water mark

Over three years, the investor paid $85,302.40 in fees and ended with about $1,102,234, roughly 10.2% above the starting amount. Before fees, the same returns would have produced $1,196,000 (1.15 × 0.80 × 1.30 × $1,000,000), a 19.6% gain. The high-water mark kept the manager from collecting a second performance fee in Year 3, but the management fee was charged every year, including the losing one.

Adding a Hurdle Rate

Rerun Year 1 with a 5% hurdle measured on the starting $1,000,000, so the first $50,000 of gain is exempt:

• Hard hurdle: fee on $130,000 − $50,000 = $80,000, so 20% × $80,000 = $16,000
• Soft hurdle: the 13% return after the management fee clears 5%, so the fee applies to the full $130,000, which is $26,000

The same headline “2 and 20” can therefore produce noticeably different costs depending on the fee terms in the fund documents.

2 and 20 in Private Equity and Venture Capital

Private equity and venture capital funds use a similar split, though the mechanics differ from hedge funds:

• The management fee (often around 2%) is often based on committed capital during the fund’s investment period rather than on a changing market value. It may step down later in the fund’s life.
• The “20” is called carried interest, or carry. It is the general partner’s share of profits, usually realized when portfolio companies are sold rather than marked to market each year.
• Many funds set a preferred return (a hurdle) that investors receive before carry is paid. Some include a catch-up provision and a clawback, which requires the manager to return carry if later losses mean it was overpaid.

Is 2 and 20 Justified?

The case for 2 and 20 rests on two arguments. First, the performance fee aligns the manager’s pay with investor returns, especially when combined with a high-water mark. Second, a skilled manager who delivers returns unavailable elsewhere, or returns with lower correlation to stock markets, may be worth a premium.

The best-known example of fees being absorbed by performance is Renaissance Technologies’ Medallion fund, a quantitative fund founded under mathematician Jim Simons. Medallion has been reported to average about 40% a year after charging a 5% management fee and a 44% performance fee, far above 2 and 20. It has been closed to outside investors since 1993 and manages money for Renaissance employees.

Medallion is an exception. Hedge funds can go long and short, which in principle lets them profit in falling markets, but many have trailed broad equity indices for long stretches, and long-run comparisons with the S&P 500 have frequently favored the index. When gross returns are only slightly ahead of an index, a 2% fixed fee plus a 20% profit share can leave investors behind a low-cost index fund. Weak relative returns and high fees have both been cited as reasons investors have pulled money from hedge funds.

Comparing a fund’s net returns with a benchmark, and looking at risk-adjusted measures such as the Sharpe ratio, shows more about whether the fees are earned than headline gross returns do.

How Fees Have Changed

“2 and 20” is now more a reference point than a standard price. Hedge Fund Research reported average hedge fund fees of 1.36% (management) and 16.19% (incentive) in mid-2023, so the typical fund charges less than the traditional rate. Other arrangements include:

• 1.5 and 20 or 2 and 15, which cut one component
• 1 and 10, sometimes offered to large or early investors
• Founders’ share classes, which give lower fees to investors who commit capital when a fund launches
• Higher-than-standard fees at a few in-demand funds, as the Medallion terms show

Large institutional investors such as pension funds and endowments negotiate terms, so two investors in the same fund may pay different rates.

Limitations of 2 and 20

• The fixed fee is paid in losing years. A 2% charge compounds over time and can consume a large share of modest gross returns.
• Asymmetric payoff. The manager shares in gains but does not refund fees for losses (outside clawbacks in some private funds). This can encourage extra risk-taking, especially when a fund is far below its high-water mark and the incentive fee looks out of reach.
• High-water mark resets and fund closures. If a fund falls far below its peak, a manager may close it and launch a new fund rather than work back to the old high-water mark.
• Paying for beta. Without a hurdle tied to a relevant benchmark, investors can pay 20% for returns that simply reflect a rising market.

2 and 20 vs. Related Terms

Taxes on 2 and 20

Neither fee is untaxed. In the United States, management fee income is generally taxed to the manager as ordinary income. Carried interest has drawn scrutiny because it can qualify for long-term capital gains rates, which are lower than top ordinary income rates. Since the Tax Cuts and Jobs Act of 2017, carried interest generally must relate to assets held for more than three years to receive long-term treatment. For investors, fees reduce the fund’s returns, and their tax treatment depends on the fund’s structure and current rules.

Who Can Invest in a 2 and 20 Fund?

Hedge funds and most private equity funds are private offerings, generally open only to accredited investors and institutions, and some only to qualified purchasers. Under SEC rules, an individual is accredited with income above $200,000 in each of the past two years ($300,000 jointly with a spouse or spousal equivalent), net worth above $1 million excluding a primary residence, or a Series 7, Series 65 or Series 82 license in good standing.

FAQs

The Bottom Line

Accredited investors and institutions weighing a hedge fund or private equity fund should read the fee terms closely, since hurdle type, high-water marks and negotiated rates change the real cost. The fixed fee is charged even in losing years, so a fund's net returns and risk-adjusted results against a low-cost index show whether the manager earns the fees.