Calculation Steps:

1. Calculate end-of-year AUM before fees:

   • Beginning AUM = $50 million
   • Annual return before fees = 20%
   • End-of-year AUM before fees = $50 million × (1 + 0.20) = $50 million × 1.20 = $60 million

2. Calculate management fee:

   • Management fee = 2% of end-of-year AUM before fees
   • Management fee = 2% × $60 million = 0.02 × $60 million = $1.20 million

3. Calculate return net of management fees:

   • Return before fees = $60 million - $50 million = $10 million
   • Return net of management fees = $10 million - $1.20 million = $8.80 million

4. Calculate incentive fee:

   • Incentive fee = 20% of return net of management fees
   • Incentive fee = 20% × $8.80 million = 0.20 × $8.80 million = $1.76 million

5. Calculate total fees:

   • Total fees = Management fee + Incentive fee
   • Total fees = $1.20 million + $1.76 million = $2.96 million

Verification:

• Option A ($2.80 million) would be incorrect because it doesn't account for the proper calculation of incentive fees on returns net of management fees.
• Option C ($3.20 million) would be incorrect because it might calculate incentive fees on the gross return before management fees (20% of $10 million = $2 million, plus $1.20 million management fee = $3.20 million).
• Option B ($2.96 million) is correct as calculated above.

Key Concept: In hedge fund fee structures, incentive fees are typically calculated on returns net of management fees, not on gross returns. This creates a "fee-on-fee" structure where management fees reduce the base on which incentive fees are calculated.