For high-net-worth individuals, the complexities of divorce can extend far beyond the division of traditional assets. This is particularly true for private equity (PE) professionals whose unique compensation structures and illiquid holdings demand a sophisticated and forward thinking approach to divorce planning. As the planning partner with The Summa Group, I’ve had the privilege of guiding numerous clients through these challenging waters and it’s become clear that proactive planning and expert guidance are paramount to securing a fair and equitable outcome.
The world of private equity (PE) with its intricate fund structures such as carried interest, long term investment horizons all present a distinct set of hurdles in divorce proceedings. Unlike publicly traded stocks or easily divisible real estate, PE interests are often shrouded in valuation complexities, transfer restrictions, and uncertain future payouts. Ignoring these nuances can lead to protracted legal battles, unintended financial consequences and a significant disruption to both parties’ futures.
THE UNIQUE LANDSCAPE OF PE ASSETS IN DIVORCE
Several factors distinguish the divorce planning landscape for PE professionals:
The Elusive Valuation: Determining the fair market value of private equity interests, including carried interest (the coveted share of fund profits), partnership stakes, and direct investments is often the first and most significant hurdle. These assets lack the daily price discovery of public markets. Their value hinges on future fund performance, market conditions and the specific terms outlined in partnership agreements. Engaging seasoned valuation experts who understand the intricacies of PE is highly recommended. They can dissect fund financials, analyze potential future returns, and provide a defensible valuation that withstands legal scrutiny.
The Intriguing Case of Carried Interest: The treatment of carried interest in divorce proceedings is a frequent point of contention. Is it a marital asset subject to division, or is it considered future income? Courts often take a nuanced approach, recognizing that the portion of carried interest attributable to efforts exerted during the marriage is generally divisible. However, the illiquid nature and future vesting schedules of carried interest necessitate creative solutions for equitable distribution often involving deferred sharing agreements or careful consideration of present value.
The Liquidity Conundrum and Transfer Restrictions: Private equity investments are inherently illiquid. Partnership agreements typically contain clauses restricting the transfer of ownership interests, which can prevent a simple division of assets. This illiquidity necessitates exploring alternative strategies like buyouts, where one spouse compensates the other for their share using other marital assets, or “if, as, and when” distribution models tied to future payouts from the fund.
The Specter of Future Obligations: Some PE investments come with the obligation of future capital contributions. Divorce settlements must address how these potential obligations will be handled ensuring that one party is not unfairly burdened with future financial demands related to an asset the other now shares.
The Taxing Reality: Dividing PE interests can trigger significant capital gains taxes and other tax liabilities. A well-structured divorce settlement must account for these potential tax consequences to help ensure a net equitable distribution of wealth. Failing to do so can lead to a seemingly fair division on paper that results in drastically different after-tax outcomes.
The Paramountcy of Confidentiality: PE professionals operate in a world of significant confidentiality. Divorce proceedings, with their inherent disclosure requirements, can raise concerns about safeguarding sensitive fund information. Legal counsel experienced in handling high-net-worth divorces involving PE understands these sensitivities and can work to protect client confidentiality throughout the process.
PROACTIVE PLANNING: THE CORNERSTONE OF A SMOOTH TRANSITION
The complexities outlined above underscore the critical importance of proactive planning ideally long before the prospect of a divorce arises.
The Power of Prenuptial and Postnuptial Agreements: For PE professionals, prenuptial agreements are invaluable tools for establishing clear guidelines on how private equity interests and carried interest will be treated in the event of divorce. These agreements can preemptively address valuation methodologies, division strategies, and the handling of future earnings and bonuses. Postnuptial agreements can serve a similar purpose if entered into during the marriage. These documents, when carefully drafted with full transparency and legal counsel for both parties can significantly reduce the potential for protracted and costly disputes down the line.
Meticulous Asset Inventory and Documentation: Regardless of marital agreements, maintaining a comprehensive and meticulously documented inventory of all assets, with a particular focus on all private equity holdings, is crucial. This includes partnership agreements, capital account statements, K-1’s and compensation records. Having this information readily available streamlines the discovery process and provides a solid foundation for valuation and negotiation.
NAVIGATING THE DIVORCE PROCESS: BUILDING YOUR EXPERT TEAM
When divorce becomes a reality, assembling a skilled and experienced team is paramount:
- A Seasoned Family Law Attorney: Seek out a family attorney with a proven track record in high-net-worth divorce cases, particularly those involving complex assets like private equity. They will understand the applicable state laws, navigate the legal complexities of valuation and division and advocate for your best interests.
- A Strategic Financial Advisor: A financial advisor specializing in divorce can help analyze the short-term and long-term financial implications of various settlement scenarios. They can assist with budgeting, projecting future financial needs and ensuring that the settlement aligns with your overall financial goals.
- A Forensic Accountant and Business Valuator: As mentioned earlier a qualified forensic accountant with expertise in valuing illiquid assets, including private equity interests and carried interest, is indispensable. They will provide an objective and defensible valuation that forms the basis for equitable negotiation.
STRATEGIES FOR DIVIDING PRIVATE EQUITY INTERESTS: TAILORING SOLUTIONS
Given the unique nature of PE assets, a one-size-fits-all approach to division simply won’t work. Several strategies can be employed, often in combination:
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- The Buyout Strategy: One spouse buys out the other’s interest in the PE holdings, typically using other marital assets for equalization or through a structured payment plan. This approach allows the PE professional to maintain control of their investments, which is often a priority.
- Deferred Sharing (“If, As, and When”): This method involves an agreement to divide the proceeds from the PE investment when they are actually realized (e.g., upon fund liquidation or distribution). While it addresses the illiquidity issue, it requires careful drafting of the agreement to specify the division percentages, reporting requirements, and potential adjustments for future contributions.
- In-Kind Transfer (Less Common): In some limited circumstances, a direct transfer of a portion of the PE interest to the non-titled spouse might be feasible, although partnership agreement restrictions often make this challenging.
- Offsetting with Other Assets: Often, the most practical approach involves offsetting the value of the PE interests with other more liquid marital assets, such as real estate, retirement accounts, or investment portfolios.
THE PATH FORWARD: INFORMED DECISIONS AND EXPERT GUIDANCE
Divorce is undoubtedly a challenging life event and for private equity professionals the complexities of their financial holdings can add another layer of stress and uncertainty. By understanding the unique challenges posed by PE assets, engaging in proactive planning and building a team of experienced legal and financial advisors, you can navigate this process with greater clarity and confidence. At The Summa Group, we understand the intricacies of wealth management for professionals in the private equity space. Our collaborative approach integrates financial planning, investment management and coordination with legal counsel to ensure our clients receive comprehensive and tailored guidance through all of life’s transitions. By taking a proactive and informed approach you can protect your financial future and emerge from this challenging period positioned for continued success even after a divorce.
Article provided by Robert Dalie, Managing Director/Investments, with Stifel, Nicolaus & Company, Incorporated, Member SIPC and New York Stock Exchange, who can be contacted in the Sherman Oaks office at (818) 793-5233.
Stifel does not provide legal or tax advice. You should consult with your legal or tax advisor regarding your particular situation.
