Private Equity 2/20 business model
Hi guys,
Just learning finance on my own. Would appreciate if anyone can throw some light on the business model of 2 and 20 of Private Equity firms.
Assume XYZ firm, a PE, raises $100 from investors, takes a 2% cut (of AUM) to take care of its internal operations. XYZ then invests $90 in 3/6 private companies (all unlisted). The cash which can still be invested is 100-2-90= $8
In Year 2, XYZ again charges 2% of its management fee and since it hasn't made any exit, 20% cut isn't charged.
I would like to know on what is the 2% management fee is charged? $98 or $90 or $8?
In the case, 2% is charged on $90, I would like to argue that since the stakes are in unlisted entities they can be hard to value to arrive at the AUM figure.
There is no universal rule and many funds come out with their own basis for management fee. In your example most normal thing that I would expect is to charge 2% of 100 every year until investing period expires. Furthermore, management fee in many cases goes "above" committed capital for investments. So in your example, assuming investing period of two years, in firs year limited partners will spend $92 (90 for investments and 2 for management fee), and 12 in second year ($10 for investments, 2 for management fee).
However, I have seen plenty of variations for management fee calculations, most notable and typical: 1. Different management fee for committed and invested (e.g. 1.5% for committed uninvested, 2% for invested). 2. Different management fee during investment period (usually 3-5 years) and after (another 4-7 years). In most funds I have came across, not only the fee itself (%) is different after investment period, but the basis for its calculation is also different (management fee charged only on invested capital to date, not on committed) 3. Management fee is calculated as 2% of Net Asset Value, as determined by independent valuer (very rare, normally LPs won't accept that, because valuers often produce very strange results). 4. For listed funds management fee is charged on market cap or market cap linked metric
Etc etc., many variations.
Also, continuting to address your example, you need to define AUM first. Many companies, when talking about AUM, means something like "sum of enterprise values of portfolio companies". Other firms, however (Blackstone is one example) by AUM mean only fair value of equity in their portfolio companies.
Management fee is rarely charged on AUM anyway. For unlisted funds it is normally charged on commited and/or invested capital.
Thanks mate for the detailed answer.
Just a follow up question: How do you assess fair value of equity (eg for Blackstone) ? If I have invested $92 in the first year, then how do I assess the market value on $92 which is invested in the portfolio companies?
Fair value is usually estimated using in-house DCF models. Funds normally have to report valuation to Limited Partners on a quarterly / semi-annual / annual basis anyway, so sum of outputs of these models is used as AUM. Example from my firm: when we invest in the asset, we have our final acquisition model locked in, say it shows 27% IRR. After acquisition is done, every quarter we update the model (revising our forecast based on new information / actual performance) and discount future cash flows at 27% discount rate. The resulting NPV is your valuation of equity. We report this value to our investors as fair value of fund's holdings. EV of the model goes to assets under management calculation.
Sometimes for valuation (for reportage purposes) external valuers are hired, but from my experience it is very rare.
Given that AUM is sort of "for your information only" the number is not scrutinized in great detail by anyone.
Thanks FairValue for clarifying this. Much Appreciated.
Great info. SB+
How prominent is the 2 and 20 HF/PE model these days? (Originally Posted: 07/20/2017)
Just curious, I grew up having this engrained in my brain. Friend tells me Im a fucking idiot and that no one uses this, just some derivative of this business model. I work at a search fund so our fund doesnt operate that way, thoughts?
At least from what I've seen, it's a beginning for negotiations. If an LP wants to be in a fund but believes they can move their weight around, then they can either cut fees (1.5/15) or come up with a different structure (Xmm in the fund under 2/20, FROR for co-invest) that essentially accomplishes the same thing. On the flip side, if a fund is over-subscribed, then it's 2/20 or GTFO.
Thank you for your insight, much appreciated
Are you referring to the management + incentive fee model or the specific 2/20 cut?
The specific 2/20 cut. I know that of course not every fund uses it, but is it still commonplace? Do most megafunds recreate their own derivative of it?
Will there ever be a hedge fund to stop with the 2 & 20? Perhaps go 1 & 10? (Originally Posted: 10/21/2015)
Curious to see what others have to say. In theory it doesn't sound like a bad idea to get more clients.
Almost every hedge fund cuts its headline 2 & 20 fees for large or early investors. Many hedge funds already charge 1 & 15 or 1 & 10.
Very few clients really pay 2 and 20. Virtually every client negotiates its own special arrangement with the fund (much lower fees, slightly lower fees but only if the fund meets an X% hurdle first, etc). And the standard rate at the last several funds I worked at was lower than 2 and 20, but we advertise that number to make clients things they're getting a deal. So yes, there's already lots of funds charging less than 2 and 20.
Nice! I guess I should've put, "Will 1 and 10 or 1 and 15 become the standard for HF?''
http://www.wsj.com/articles/giant-hedge-funds-radical-idea-performance-…
1.5 and 15 is good if you're a young fund. You really have to be proven before you can 'demand' 2/20, and nowadays even then ppl will rarely pay the full fee. I would say standard is already between the 2/20 and 1.5/15, and will probably drift closer to the latter over time
There has been significant pressure on fees. While people may state that they have a 2/20 model, the effective rate is often notably lower than that. "Founding" LPs (original money, or in some cases, money in within the first year) will commonly receive 1/10. Large commitments (e.g. $200m into a fund with
This thread really allows you to appreciate how insanely good the geniuses at Renaissance Tech. were. If I'm not mistaken, they were charging over 40% in performance fees alone and still outperforming every single year. It's absolutely amazing.
Of course, I say 'were' since they're now closed-off to external investors. One can only imagine what goes on in there.
It's only the Medallion fund which has been closed. Their other funds are open, but don't exhibit the same performance.
Did some googling on renaissance tech and all I can say is WOW!!!!!! Their performance is amazing and has been for a long time.
very very few do 2 & 20 that I've seen. particularly with major firms selling hedge funds to investors, you have the bargaining power of GS, MS, ML, etc., so you can negotiate a fee down just to get on the platform. also, fund of funds that are on platforms have tremendous bargaining power as well, so fee compression is a very real thing.
private equity, not so much, but then again, those returns have justified themselves, so investors don't really seem to care (at least not that I've seen).
Private equity is down as well, but there it has been more a function of reductions along the edges while maintaining the same 1.5/20 headline economics. So increasingly seeing things like hurdles, reduced management fees on uninvested commitments, etc
I don't see the PE distinction. Firstly, PE does the same crap. They pay every platform (usually a lot more than HF do) to get distribution. 2nd, doesn't PE have a hurdle rate on the incentive fee? I'm no expert on how PE works, but that already seems to bring down the fees a lot. Finally, PE gets the benefit of no mark-to-market. Investors might be happy or they might not be, but PE is raising new funds on the back of incomplete results. PE is probably in a lot more trouble than people realize vs. HF - a ton more fees are baked into portfolio companies that the regulators are going after hard. Regardless, both under a lot of pressure, but won't be as quick to chance as many think.
the fee structure of hedge funds has become quite bifurcated...most new fund start with fees much lower then 2 and 20 while many old established funds still get away with charging well North of that amount.
What are some examples of funds that still charge north of 2/20 in L/S world?
Idk about HF but PE will remain 2/20 for a while, IMO. The fee reductions come vis-a-vis co-invest (i.e., "free work"). CalPERs tried to ask for haircuts on 2/20 and a lot of funds balked. Plenty of insurers willing to pay.
I'd also add, PE funds have begun dropping the 8% pref hurdle rate. https://www.pehub.com/2015/09/advent-proposes-dropping-preferred-return…
To put it frankly, no one pays that. Not even the "small" investors. If you want the best deal and are willing to take more risk that the HF industry already has, invest in funds that are skirting their margin calls. These guys need cash and are likely to forgo all entrance fees and will prob cut their fee on gains as well. However you run the risk of the entire fund imploding and loosing a good chunk of your investment.
Is 2 and 20 Dead? (Originally Posted: 01/10/2013)
As of September 2012, the average hedge fund charged 1.6 percent annually in management fees and collected 18.7 percent of any gains, according to data provider Preqin.
It seems like 2-and-20 is no longer the norm, as we see a pretty clear downward trend, espeically in management fees. And things are not looking so hot for 2013 either. 2012 was a pretty bad year for hedge funds. HFRX global index shows 3.25% YTD return as of December 27, compared to 13% for MSCI global index. Surely investors don't want to pay more... for less, so I think on average, fees will continue to decline in the near term.
Here's an article that attempts to explain the "new normal" in hedge funds and the underperformance:
It goes on to predict more fee-cutting in the future.
Besides declining fee, what's the future trend for hedge fund fees? A bifurcation maybe?
What do you think? Is 2-and-20 a thing of the past?
Happy new year btw!
In short, it will a thing of the past for all but the best funds. Investors will still pay an extra 50-100bps in management fees for an extra 5-10% in performance - but most funds aren't delivering.
It's not the performance fees that are the issue but the management fees and the capital aggregation it encourages.
Yes, 2 and 20 is far from the norm now, though it differs depending on the strategy. Some good quant funds can still charge 2 and 20 or higher for strategies where a limited amount of capital can be put to work. A couple of the most successful multi-strat funds can also still change high fees. But the vast majority of fundamental equity l/s and distressed funds are closer to 1.5 and 15 for large investors (individuals investing a couple million often pay a higher rate closer to 2 and 20).
This is deceptive because there are countless funds with tiny AUM that are going to drag down #s. If there were AUM-adjusted figures to look at, it'd be much closer to 2/20.
This is very true. I worked for a tiny shop with 75M in AUM and they charged 1/15 but with a 3 year lock-in period. And this was an extremely successful fund averaging 15% returns a year for 20 years. I know people aren't going to believe that a fund can perform so well and still be so small, but it happens.
Good topic.
My opinion, as some of the other guys have mentioned above me, 2/20 can't be a firm number in the years to come.
I predict that it will be rang pound performance compensation. Management fee will still be in place of 100-200bp, but the performance will look something like:
Return:10%+ YTD Fee: 15%
Return: 9.99%-8% YTD Fee: 12%
etc etc..
I think the industry needs to adapt and be more flexible and show there investors that in this environment of poor HF performance that they have a larger vested interest in 'beating the market'. They can do that by having these flex fee schemes.
Personally as an investor I would be pissed if the fund I was invested in made 5% and then charged me 2/20 on top of that.
I know a lot HF implement watermarks and hurdle rates on PM's to protect the investor, but I think a new fee structure needs to be implemented, that takes into consideration losses as well.
Just my $0.02.
Even Baupost is not 2/20, so go figure.
Meanwhile SAC can chuckle with trey and fiddayyy
Please for the love of god, if you are still in college and speculating just to engage in the topic, stop because you dilute the discussion.
I think the norm, in RE at least, seems to be 1.5% IM fee and possibly a fee break for very large committments. Promotes on the other hand, seem to be all over the place but the norm is 15% all with very unique and creative catch-ups/step-ups.
Obviously this all depends on the manager's track record, vintage of the fund etc..
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