Hedge Fund Fees: Is 2 and 20 Fair and Appropriate?

by: Christopher Holt

Beyond being recognized as one of the founding fathers of hedge funds, Alfred Winslow Jones (see AllAboutAlpha’s tribute here), who would have hit the lofty age of 109 last month, in 1949 also introduced a concept not seen before: an incentive fee structured as a function of realized profits, with a set management fee to offset operating costs.

Sixty years on, the concept of “2 and 20” (bumped up from “1 and 20” about a decade ago, presumably due either to inflation, greed or both), has held as the hedge fund industry benchmark. While variations have emerged over the years, ranging from “1 and 10” for funds of hedge funds to “5 and 30” for highly sought after, pedigreed enterprises, most managers have stuck with it, for the main reason that most investors have been willing to pay it.

One of the reasons for this is that hedge fund fees (unlike mutual fund fees) respond immediately and proportionately to performance. Critics who cry foul that hedge fund fees seem to stay the same in the face of lackluster returns often ignore the fact that last year’s poor returns mean that many hedge funds are charging “2 and nothing” this year. Indeed, this recent article shows that some funds have gone beyond this and actually provided investors with a performance fee holiday – regardless of how 2009 turns out.

Of course, each time the markets have hit a snag, the debate over the hedge fund fee structure has heated up, with the onset of the credit crisis and market downturn a year ago no exception. Even over the past few weeks, a flurry of published reports have argued for and against the current hedge fund structure, with some arguing they should be revamped to be more “private equity” like and others saying they don’t need to be changed at all, since the bulk of most fees typically only come from profits – and noting they aren’t.

Even on the private equity front, there is ongoing debate over whether the fee structure is fair and appropriate, as one of our editorial board members elaborated on in this recent post.

Regardless, since the credit crisis picked up steam a year ago, investors looking to hit the eject button have been at least willing to discuss staying put if, among other things, the manager has been willing to cut fees. Likewise, managers looking to preserve capital and avoid forced redemption-demand fire-sales have been willing to offer fee cuts as incentive for their investors to remain put.

No matter, arguments have once again emerged concerning whether hedge fund managers shouldn’t be paid — differently — and perhaps take 20% only of realized gains, reducing the risk of hedge fund valuation fraud as the incentive to manipulate “mark to market” prices essentially disappears, and prompting payment of fees on actual disposal prices, removing the problem of paying compensation using estimated, hypothetical values.

Paying 20% to some degree makes sense when returns well exceed the benchmark, when the fee is net and when the underlying assets are liquid. Paying 20% when there’s nothing being put on the table, when the menu is sketchy at best and when you are not allowed to get up from your seat for at least a year or longer, is at minimum prompting much more thought and consternation than before – at least until the markets and economy get back to feasting again.

Either way, the debate is good fodder for the moment, while the industry is still in the process of dusting itself off. Longer term, however, unless the mean revert to a different fee structure, chances are the “2 and 20″ combo meal deal isn’t going away.