The 2/20 rule simply refers to a 2% management fee and a 20% outperformance fee. That is, investors typically pay 2% of committed capital to the management company to manage the fund and 20% of returned funds above the initial capital as an incentive.

I mentioned committed capital, because in most private equity funds, investors commit capital rather than invest capital. Their capital is called as required by new investments. So in practice, a firm may not invest a single dollar for two years, but based on committed capital of say $1b, $20m a year is paid as management fees to… sift through opportunities. This is one of the many beauties of the private equity model (for private equity firms at least).

I once heard a prominent partner of a large New York private equity firm say, “There are three certainties in life: death, taxes and a 20% carry.” Of course the monetary value of the carry isn’t a certainty, but what he was inferring is that the private equity industry will stick by its 20% carry rule irrespective of what anyone else thinks because it is their livelihood.

As for the 2% management fee, it keeps the fund running; it pays the staff, the lease on the office, the electricity bills, and those infamous lunches that introduce new investees to the big time. Since the fee is fixed, employees are rarely paid bonuses in the private equity space; the 20% carry is their incentive. Additionally, distributed funds from exited investments aren’t included when calculating the management fee (even that would be too audacious for a private equity firm); only invested or uncalled capital attracts fees.

The 2/20 rule sounds simple enough, but it really is the lifeblood of the industry. Some of the best strategic thinkers go to private equity because of the combination of small teams, large funds and the 20% carry. Equally, the 2% management fee is vital to facilitate great deals, mainly because the carry is contingent on many variables and often not paid for five or so years into a fund (until exits occur).