Hedge funds, venture capital firms, and other managers of “alternative” investments often calculate their fees using a “2 and 20” structure. Clients pay a fee of 2% of their assets under management, plus 20% of any profits.
While not all private equity managers use this exact formula, the performance-based fee model has been around for decades. Lately, it’s come under fire for being excessive, particularly as more retail investors have turned to private equity.
Yet a new theoretical model built byJonathan Berk and Peter DeMarzo, professors of finance at Stanford Graduate School of Business, finds that such fees are optimal not only for private equity managers but also for investors who seek higher returns from alternative investments.
Their “unified theory of delegated capital management” also explains why the simple fee model used by mutual funds breaks down in private markets. Mutual funds typically charge a flat fee (usually less than 1%) based on assets under management, with managers receiving no share of the profits if they outperform.
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If you want to earn positive alpha, you have to put in the effort to investigate the manager. Very few investors can do that well.
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— Jonathan Berk
The reason comes down to two fundamental differences between private markets and mutual funds: liquidity and information. Information about publicly traded stocks and bonds is easy to come by, and investors can quickly sell their assets if they find a better-performing option. “If you’re a mutual fund investor, you can pull your money out at any time and use public information to assess performance,” Berk says. “In alternatives, you don’t have that option. Your money is locked in.”
Not only are the underlying assets in alternative investments illiquid and opaque, but it is also difficult to judge the skill of the managers overseeing them. This puts up a barrier to entry for potential investors. Investors who invest more time and money in acquiring information prove better at picking managers, and that information advantage shows up in above-average returns. “If you want to earn positive alpha, you have to put in the effort to investigate the manager,” Berk says. “Very few investors can do that well.” Even after paying a performance fee, well-informed investors earn profits that exceed those of investors who don’t do due diligence.
No Free Rides
This leads to one of the study’s most counterintuitive findings concerning fund size. Private equity managers often cap the amount of capital they accept, even when demand for their services is robust. Why do they turn away money when investors are lining up to give it to them?
Without fund limits, Berk and DeMarzo find, a few investors would identify the best managers, and other investors would copy them, killing off the incentive to research investments. Fund limits prevent this free riding, ensuring that alpha is possible for the investors who do their homework and that their money is put to work as effectively as possible — an “optimal” outcome.
Performance fees play a complementary role, ensuring that managers earn more only when their funds do well. Together with fund-size caps, they form the contract Berk and DeMarzo say is needed to keep the system working.
Their paper sets out a theoretical model of private markets that explains several long-standing “puzzles” in alternatives.One is why some investors in alternatives consistently outperform, particularly university endowments, which have repeatedly earned excess returns. Berk and DeMarzo suggest this comes back to who has better information and the ability to identify skilled managers.
Their model also explains why investors in alternatives don’t pay the same fees to their fund managers. If all investors faced identical terms, they would earn the same returns. That would set up opportunities for free riding, allowing uninformed participants to profit from others’ research without paying for it. Different terms are necessary to sustain the incentive for those investors who do the work of gathering information in the first place. Others who invest without bearing those costs must accept less attractive terms.
Berk and DeMarzo argue that the higher returns earned by well-informed investors are not free money; they reflect the cost of research and the ability to identify top managers. Whether investors are better off once these costs are accounted for depends on the efficiency of their research. Only investors with a competitive advantage in conducting research can capture the benefit of doing so.
In the end, Berk and DeMarzo make it clear that liquidity is the key factor in the structure of private markets, shaping everything from fees and fund size to who earns the highest returns. The result is a market where returns vary across investors, fees are not uniform, and access is constrained. Rather than signaling inefficiency, Berk and DeMarzo suggest these features are part of a system that works as intended, even if “2 and 20” may seem excessive to some.