Yes, I would pay 2 and 20

Who is dumb enough to pay 2 and 20?  Me, actually.  Source: Google Images.

Who is dumb enough to pay 2 and 20? Me, actually. Source: Google Images.

The alternative investment world (namely private equity and hedge funds) has grown fat on the 2 and 20 fee structure.  For those unaware, that means 2% p.a. management fees, plus 20% of all investment gains, paid by the investor.  Sounds steep, right?  It is.  With the poor relative returns of alts the past five years (versus a screaming S&P 500, I mean), there has been much vitriol over the old fee structure.  A watershed moment may have been Calpers’s decision to close its hedge fund portfolio; I say watershed mainly because of the publicity generated, rather than the impact on the alt investment business.  With $4bn in hedge funds, Calpers wasn’t close a huge hedge fund investor.

As I was walking today I reflected on the fee structure.  Why did it happen, and why or why not pay that amount?  My notes:

  • Genesis: I imagine a smart guy working for a big bank or asset manager.  Suppose he comes up with a great strategy:
    • Will the bank or asset manager compensate his for this luck/skill?  Maybe: it definitely worked for a guy like Andrew Hall.
    • But maybe not: what does this guy do then?  Perhaps he starts trading his own money, or those of a close circle: thus begins prop firms, which are ubiquitous in the business.  Especially for strategies that are low-capital outlay and/or high ‘edge’ (e.g. discretionary macro or HFT market making, respectively).
    • Finally: he decides to start his own fund, managing public money.  He needs enough capital to do 2 things, preferably simultaneously:
      • Pay the bills: office expenses, Bloomberg feed, etc.
      • Incentivise the manager: this guy supposedly has a great idea, so he wants to be compensated for making others rich.
  • Why 2 and 20? How about some quick and dirty math:
    • Yearly office expenses, including hiring a couple guys to make the fund viable (I have in mind a CRO/COO and a CFO/CLO, with ~$150k salary each) probably runs $500k-$1m.  Starting capital for a fund is frequently targeted at around $25-50m.  So 2% of this amount pays the office expenses.
    • Of course the strategy type matters here, but let’s imagine the expected gross (pre-fees) performance of the strategy is 15% p.a. The owner of the fund company (the guy who came up with the strategy) gets 20% * (15% – 2%) = 2.6% of AUM p.a. in incentive fees.  With $25-50m AUM, and a successful year, the strategy owner makes $650k-$1.3m for managing the fund.  So our guy with a great idea made a million bucks (assuming he gets all the performance fee).
    • Hopefully this quick illustration shows why 2 and 20 is so ‘standard’: at reasonable startup AUM, this is the sort of fee structure needed to pay office expenses + give enough incentive to the guy with the strategy in the first place.
  • Where did/does it go wrong?  I think 2 and 20 can be contrasted with a group like Vanguard (pre the news this morning that the latter may have used taxpayer funds to subsidise its operations).
    • As AUM swells, the 2 becomes a larger and larger profit centre for the fund.  At some point, the 20 becomes just an upside call, with 2 being the prime focus.  That’s when fund volatility drops, institutional investors (wanting low volatility and lower fees for high-AUM checks) are in charge, and hedge fund performance starts dragging.  I don’t think I’m unique in spotting that hedge funds relying on the 2 frequently begin to ‘calm things down’ to protect assets.
      • Aside: I recall being on the road, listening to long-time clients saying ‘please don’t drop your volatility target…I am paying you for the volatility’.  Thankfully there were enough of those investors to keep AUM at a sustainable level, so the target didn’t need to be compromised.
    • Groups like Vanguard instead use the higher AUM to spread their office expenses wider and thinner… management fees as a % drop as AUM increases.  Though this frequently happens with hedge funds as well (fee discounts become more and more common), the Vanguard model is more explicit and mechanical, and benefits investors equally.
  • OK, back on point.  When would I pay 2 and 20?
    • I believe in the strategy.  Clearly.
    • I’m convinced the 2 is used to pay office expenses.  That means the organisation running the fund needs that fee level to sustain operations.  I don’t want the smart guy with the strategy fretting whether to buy a data set because the check will bounce.
    • The fund owner(s) are satisfied, but a bit hungry, with the 20%.  I want my asset manager rich, but I want him to keep trading my money.  So not too rich to do silly things, nor so rich that he/she walks away.  Also, not making so little that his/her opportunity to go back to the bank/big firm becomes the right choice.  To be clear, having a high-water mark is a necessity: no multiple bites!
    • I’m convinced the fund will hang around, and be consistent with strategy.  One of the issues with small funds is their unfortunate tendency to blow up – hence why institutional investors tend to prefer large, steady return streams of big hedge funds.  As a small private investor, I want the ‘juice’ of the strategy in as pure and concentrated form as possible while keeping the business alive.  I will not pay 2% a year for a strategy expected to return 5% net of fees, for example.  If it’s expected to return 15-25%?  Now we’re talking…

End soapbox.


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