Management Fees, Performance Fees and Hurdles

A hedge fund's fee structure is usually described in shorthand like "2 and 20," meaning a 2% annual management fee on assets under management, charged regardless of how the fund performs, plus a 20% performance fee on the profits it generates. The management fee covers the fund's operating costs — salaries, data, technology — and is charged whether the year is good or bad; the performance fee is what aligns the manager's incentives with making money for investors, since it's only paid on actual gains.

A hurdle rate is a minimum return the fund must clear before any performance fee applies at all — commonly tied to a risk-free rate or a fixed percentage like 5–8%. Without a hurdle, a manager collects a performance fee on any positive return, even one that simply matched what an investor could have earned risk-free; with a hurdle, the manager only earns performance fees on returns genuinely above that baseline. A related mechanic, the high-water mark, requires a fund to recover any past losses before charging a new performance fee, preventing a manager from collecting fees repeatedly on the same gains after a drawdown.

Concrete illustration. A fund with $100m under management, a 2% management fee, a 20% performance fee, and a 5% hurdle earns a 12% gross return in a year. It collects $2m in management fees regardless. The performance fee applies only to the return above the 5% hurdle — the 7 percentage points of excess return — so it takes 20% of that $7m, or $1.4m, not 20% of the full $12m gain.