Two and Twenty is a term that is used to refer to a compensation strategy that is sometimes used by hedge fund managers. With this approach, the managers will structure the total compensation so that a portion is based on the actual performance of the assets involved. The name for the term implies that the manager will charge a flat rate in the amount of 2% for managing the asset on behalf of the investor, while also claiming 20% of whatever profits are generated by the investment as the remaining compensation.
One of the benefits of the Two and Twenty approach is that if the hedge fund does perform exceptionally well during the period under consideration, the manager stands to earn a higher return for his or her time and efforts. The flat fee of 2% is guaranteed, regardless of how the fund should perform, providing the manager with at least some compensation for the effort. Since the real money is made when the fund performs at a higher level, the manager will do everything that is legally possible to ensure maximum returns for the fund. When this happens, that 20% is obviously also higher, providing the manager with incentive to manage the hedge fund as competently as possible.
Hedge fund managers who enter into this type of compensation agreement do assume some degree of risk. Should the fund fail to perform well during a given period, the Two and Twenty approach may in fact mean that the hedge fund manager may take in less compensation than a manager who settles for a higher flat fee on the front end. In many cases, the possibility of this occurring is relatively low, since hedge funds that are managed properly typically post impressive returns on an annual basis. This means that a manager who goes with the Two and Twenty approach to compensation is likely to earn considerably more money each year than a manager who sticks with a flat percentage fee that is based only on total asset value and does not take into account the total profits generated during the period.
For investors, going with a Two and Twenty approach may also mean enjoying greater returns overall. Since this approach does provide the fund manager with additional incentives to handle the fund in a manner that is likely to produce the highest possible profits per annum, there is a good chance that even allowing for the additional 20% paid to the manager, the investor ultimately receives more returns than would have occurred if the fund had been managed with less attention and effort. From this perspective, the Two and Twenty approach has the potential to benefit everyone involved by providing the best possible returns from the hedge fund.