What happens if the gross return is 2.5%? Does the fund manager still get everything (2% fee plus 20% of the 2.5% gross)...?
Clearly if the returns are between 0 and 2% the fund manager wins and the investor loses. Seems to be open to all kinds of gaming of the system.
But honestly, if rich people can't figure out that their fund manager is ripping them off, then to hell with them. Fund managers, at least, prey on people who are already rich. Better than a lot of other sleazes who take advantage of the undereducated and poor. I'm not saying it's right, I'm just saying that if you have enough money to write John Paulson a check, then you should know what you're doing. I can't say the same for an old woman in a bad neighborhood who was talked into refinancing her house of 50 years so she could take out cash to buy a conversion van. The people who preyed on her are far worse, in my mind, than your average fund manager who does nothing of virtue for his clients.
Which is exactly why I think carried interest should be taxed as ordinary income.
/soapbox
No, if the fund doesn't make money, they don't get performance fee NOR do they have to take 20% of the loss.
Also, the 20% performance fee is applied on the 'Net Gain' and not gross return.
E.g. Going back to my example, if hedge fund made, 10MM on 100MM assets. They will first pay themselves 2MM and charge 20% performance fee on 8MM and not 10MM.
Again, investors are not stupid either, if the hedge fund can't show them gains, they will take their money somewhere else. [Obviously they can still become victim to Madoff like outright fraud.]
Of course not. This idea that the person who carries the most (financial!) risk gets the biggest pay off rarely actually exists in the real world.