Partner & Head of Family
Stevens & Bolton
The financial consequences and processes of divorce can be baffling even when the parties’ assets are reasonably straightforward. Lawyers are prone to using jargon and acronyms that are entirely unfamiliar to the lay client. Where the financial assets include private equity or hedge fund investments, the degree of complexity and jargon increases exponentially.
For those who do not work in the world of private equity, the investment structures and how they work are often entirely alien concepts. Those who do work in that world are so familiar with it that they struggle to explain those concepts to the uninitiated. This can leave a divorcing spouse feeling completely lost; the gradient on their learning curve becomes significantly steeper.
Matrimonial and Non-Matrimonial: To Share or Not To Share
For long marriages, courts will look to equally share the value of wealth accumulated by a couple during the marriage. However, where possible, a non-sharing approach will be taken to wealth brought into the marriage, wealth created after the marriage and inherited wealth.
Broadly, it is considered fair that a party should be able to keep the benefit of the wealth they create after separation because it’s attributable to effort made after the marriage has ended.
Therefore, whilst the capital and pension assets accumulated during a marriage are likely to be shared, future income will not. Income (or maintenance) orders are assessed against ongoing income needs.
Things are seldom clear cut; bonuses are often paid in the financial year after they were earned. A bonus received in the first year of separation is quite likely to have been referable to work undertaken in the final year of the marriage. Marriages don’t break down on schedule, so there is scope for argument where a marriage breaks down partway through the financial year against which a bonus is judged.
With private equity investments, the lines can blur where matrimonial wealth is invested in long running funds which may not pay off for many years after a marriage is over. An additional complication arises as the structure of these funds means that future payments cannot be clearly said to be either capital or income – so what approach is the court to take?
Private Equity Fund Structure
Managers establish a fund and over time raise funds for investment. A management fee is charged for the funds under investment. As many of these funds are worth hundreds of millions of dollars, the management fees themselves can be significant.
The fund managers are usually required to co-invest in it, demonstrating that they have ‘skin in the game’, albeit usually at much lower levels than the institutional investors they attract.
Investments are then made in carefully chosen businesses, with the aim that these will be built up and sold at a profit over the lifetime of the fund, on average a period of 8-10 years.
A hurdle rate is set for the fund; this is the minimum return that must be achieved for the investors before the fund managers can share in any additional profit created. The entitlement to share in that surplus profit is known as ‘carry’. Not every fund’s return will exceed the hurdle rate so the amount of carry is inherently uncertain.
Co-Invest and Carry Upon Divorce
Co-invest
Usually, but not always, co-invested fund managers will share in the carry. However, in some funds managers can be entitled to share in the carry without having invested. Establishing the detail is key; if the co-invested funds emanate from matrimonial sources they would be shareable, albeit the sharing of that value may be deferred until the fund makes distributions. These often occur when an underlying business is sold.
Carry
The entitlement to share in the carry is far more complicated. To understand how the court approaches this, you must ascertain:
- the degree of involvement a fund manager has had after the fund has been invested;
- the dates the fund was established and the date on which the ‘close’ occurred – namely the point when all funds had been raised.
Continuing involvement with the fund
Not all private equity funds are invested in the same way. Whilst some funds invest directly into underlying companies, others invest in larger private equity funds which make those direct investments.
For the former, fund managers will be actively involved with the underlying companies invested in.
For the latter, often known as ‘funds of funds’, managers will decide upon the best fund(s) to invest in but will not be involved in the ongoing management of the underlying investments. Whilst it requires skill to select the right fund, once the choice is made, the ‘fund of funds’ manager’s involvement is minimal compared to the manager who remains directly involved with the development of the underlying companies.
Using the principles above to reflect post-marital effort, the court could consider that once the ‘fund of funds’ investment is made, the investment return is attributable to the efforts of others and that any returns of co-invest or carry entitlement flowing from the performance of the ‘fund of funds’ should be shared.
Where the divorcing spouse is the actively involved fund manager, the development of the underlying companies can be argued to be a direct result of their ongoing efforts during the lifetime of the fund. In that case, the court will calculate and share the element of carry that is matrimonial.
That is assessed by reference to the period from establishment of the fund to the date of trial, taken as a proportion of the expected term of the fund from the date of close. For example, in the case of A v M [2021], the period between establishing the fund and the trial was 60 months. The period from close to the expected end of term for the fund was 113 months. The judge decided therefore that 53% (60/113) of the carry should be shared equally between the parties, with the fund manager retaining for themselves the remaining 47% to reflect the work they would do over the remaining term of the fund.
Specialist Advice and Drafting
For the large funds, the divorce of an individual whose investment is minimal compared to the overall fund size means that the parties have very limited power to call for the return of funds. Unless one party is prepared to offset other assets to pay off their spouse sooner, they must usually wait for the fund to run its course before funds are received. As investments do not always pay off, most prefer to share the risk, meaning payments from distributions of co-invest or carry will be deferred, potentially for years.
An order reflecting the division of monies emanating from such a fund requires detailed drafting. Inevitably they are lengthy and complex because they must contain the safeguards to protect the receiving party from any attempts to thwart payments being made. They must also include requirements to provide documentary evidence of the performance of the fund, the timescales for the payments, the actual amounts paid and the tax consequences of those payments.
Some funds may permit the co-invest to be shared so that future distributions can be made direct to each spouse. Where this is possible, the order must make specific provision for the assignment, and further advice from corporate lawyers to implement the assignment will be needed.
If there are private equity or hedge funds involved in your divorce, it’s essential for experienced, specialist family lawyers to be involved to help you navigate and understand these complex investments, and to ensure that you actually receive the sums that you are entitled to.
About Nicola Harries
Nicola is the head of the family team at Stevens & Bolton, looking after clients coping with all aspects of family breakdown. Nicola has extensive experience dealing with mid to very high value divorce, including complex financial proceedings. She has drafted numerous pre and post nuptial agreements and advises unmarried families on the breakdown of their relationships, as well as dealing with disputes in relation to children. Nicola is ranked in the Legal 500 and Chambers UK Legal Directories and is a trained collaborative lawyer as well as a member of Resolution.
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