What will happen to my carried interest on divorce? - Boodle Hatfield

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27 Aug 2021

What will happen to my carried interest on divorce?

5 min read

For those working in the private equity world, the incentive compensation provided to fund managers (known as "carried interest") can be significant. Many would be forgiven for thinking that this would be protected from attack on divorce given that the private equity process is a long game - ordinarily, the life cycle of a fund is 10 years. Thus, if a fund manager is getting divorced when the private equity fund is only in its infancy, surely any realisation that comes by way of carried interest in many years to come would not feature in any financial award to their spouse?

Of course, there is inherent uncertainty in such funds and carried interest is by no means guaranteed - it relies upon success at each of the four stages of the fund's cycle:

  • raising capital for the fund: investors are invited to commit monies to the fund;
  • deploying that capital into investments: typically fund managers then seek out existing and established companies to acquire a controlling ownership interest;
  • holding those investments and managing them with the aim of increasing their value significantly before a sale: this ordinarily involves inserting board members and exerting strict control over how the business is run; and
  • selling those investments to enable capital to be returned to the fund's investors: at an opportune time in the market, the business is sold - hopefully at a profit.

Carried interest in essence, provides fund managers with "skin in the game" - a way of showing the fund's capital-providing investors that they believe in the investments that are being made by aligning their interests with them. The fund managers must 'co-invest' with the external investors into each business into which the fund invests. Carried interest is a percentage of the fund's profits that fund managers are entitled to keep on top of their management fees (which fund salaries and bonuses). However, it is only at the end of the fund's life and provided that a certain hurdle rate has been reached (which ensures that investors' original money is returned plus additional positive returns) that carried interest for the fund managers is realised. However, for many, if a fund is successful, the carried interest that is realised from a private equity deal has the capacity to run to many millions and dwarf all other assets. As a consequence, the spouses of fund managers are unlikely to give up their claims to carried interest lightly.

The English Family Court is required to take all assets into account when determining the most appropriate financial outcome on divorce. This includes not only those assets that exist at the time and which are physical or 'in specie' such as property, cash and shares but also any potential financial resources which may be realised in the foreseeable future. Carried interest falls within this latter category. A private equity spouse would be expected on divorce to provide full disclosure in relation to his or her interests in any funds with supporting documentary evidence. Undoubtedly questions would then be asked by the other spouse to ascertain exactly what may become available by way of carried interest in future years. The Court will not disregard it but it will treat it in a different category to those tangible, liquid assets referred to above.

The extent of a wife's entitlement to her husband's carried interest in three funds after their long marriage came before the High Court in 2013 (Boodle Hatfield represented the husband). The judgment provides an illuminating insight into the structure and mechanics of the operation of a private equity house. There was a significant difference between the parties' respective positions going into the trial which amounted, in all probability, to many millions of pounds. The wife sought to advance an argument that the carried interest was the product of endeavours made by the husband during the marriage. In contrast, whilst the husband accepted that the wife should share in the value of the investments made during the marriage, the husband asserted that it was far-fetched to suggest that he had existing investments in businesses that were, in some instances, not yet even identified. As a consequence, his case was that much of the work required to bring the funds to fruition would take place after the parties' separation as the husband was actively participating in the management of the funds and so was continuing to contribute to their value.

Looking first at co-investment, which the Judge described as 'capital saved out of annual income', the Court found that the wife should share equally in the co-investments made in the underlying investments that existed at the date of separation. She was NOT entitled to share in new co-investments in the third fund that had been made post-separation given that it was found that this represented part of the husband's post-separation remuneration to which the wife had not made a contribution. The wife's entitlement to these co-investments was strictly on the basis that she should be required to contribute equally to any further calls in relation to those co-investments, otherwise she would forfeit her right to any potential upside.

As for carried interest, which the Judge described as 'a bonus for effort earned for generating a super profit...only ascertainable at the very end of the investment management process', the Court treated each of the three funds differently depending on what stage of the life cycle each fund was at as at the date of separation. The first fund had achieved its hurdle rate as at the date of separation whereas the second and third funds had not. In the latter two funds, the carried interest had not yet been earned and had a present value of nil and the Judge found that particularly in relation to the third fund, the carried interest was entirely speculative and may not be established or ascertained ever or at least for many years to come. The wife was therefore awarded 50% of the carried interest in the first fund and 20% of the carried interest in the second fund as and when it was received, with 0% in the third.

The potential value of a spouse's carried interest entitlement means that it is often likely to be an area of contention within the divorce arena. The guidance from the Court on how such illiquid and contingent assets should be approached ought to provide those in the private equity world with at least some clarity on what they can expect if they are faced with a divorce.

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