Advisors and lawyers now have clients in the era of private equity and venture capital “big money” divorces. The quirks of the ways in which these asset classes work have particular implications for settlements, as this article shows.
The following article is illustrates the complexities arising
from divorce settlements when one or both of the parties is
involved in the areas of venture capital and private equity.
These areas are changing: the new Labour government in the UK
wants to tax “carried interest” differently
from hitherto – which could affect the earnings of
those involved. Even so, recent cases highlight why the VC and PE
sectors create particularl issues for those going through
divorces.
The authors are Joshua Moger, partner, Family Law and
Catherine Costley, partner, Funds, Finance and Regulatory at
law firm Fladgate.
Ella Leonard
Joshua Moger
The editors are pleased to share these insights; the usual
disclaimers apply. Email tom.burroughes@wealthbriefing.com
if you wish to respond.
“Big money” divorces move with the financial cycles. Pre-2000
they were the landed gentry. From 2000 to 2008 it was the
bankers. From 2008 to 2020 it was the turn of entrepreneurs whose
businesses had grown exponentially post-financial
crash.
We are now in a new era – the private equity (PE) and venture
capital (VC) “big money” divorces. The UK now has the second
largest private equity market in Europe, relative to GDP. The UK
PE industry has more than doubled from £1.8 trillion ($2.33
trillion) in 2012, to £3.6 trillion in 2023 (1). But it is the PE
remuneration structures that make PE divorces unique, and why
having advice not only from a matrimonial lawyer, but a funds
lawyer too, is of fundamental importance. Bankers have
traditionally received bonuses annually – but carry entitlement
is awarded up front, with frequently decade long horizons for
payout – what happens if a divorce takes place mid-way through
the fund life?
Arguably co-invest rewards should be treated differently; it is
often funded by the PE professional putting matrimonial funds in
– but do judges appreciate that distinction?
However, this new era is “young.” Despite numerous PE
divorces coming across our desks, there is only really one
precedent setting case law – A v M [2021] and that case was
decided at first instance, i.e. it is not an appeal decision and
therefore does not bind other judges. It also related to a small
PE house co-owned by the husband and his business partner, which
is not the norm for the PE industry.
This means for PE professionals divorcing (and those thinking of
pre-nuptial or mid-nuptial agreements), that whilst A v M is very
helpful guidance, there is plenty of scope for lawyers to
distinguish it from the PE cases on their desk – to seek to
reshape the A v M guidance to achieve a better outcome for their
clients.
A v M
In 2016 the husband was awarded carry and co-invest in “Fund
1.” In 2018, it was awarded to him in “Fund 2.” The
wife petitioned for divorce in 2019 and the final hearing was in
October 2021. The end of the two fund terms (if not extended)
would be between 2025 to 2028. This gap between award, vesting
and payout is entirely standard which means that this situation
is not uncommon in PE divorces.
Mr Justice Mostyn (“Mostyn J”) alighted upon a linear,
time-based, formula to determine the ‘marital’ element of the
husband’s carry, which would be shared equally. Fund 1 was
established in October 2016 (first close March 2017) with
committed funds of €187 million ($203.7 million). Fund 2 was
established in October 2018 (first close June 2019) with
committed funds of €323 million. The funds had slightly different
anticipated terms and extension periods, however Mostyn J used an
assumed term of nine years from the first close for both. His
formula to determine the ‘marital’ element, as applied to Fund 1,
was:
Therefore 53 per cent of the carry in Fund 1 was marital (the
wife would receive 26.5 per cent). The same calculation for Fund
2 produced 31 per cent as marital (the wife receiving 15.5 per
cent). However, determining that the husband “would be much less
unhappy if [the wife] were a shadow carry partner in one fund
only” the judge “relocate[d] the wife’s share of the husband’s
carry in Fund 2 in the husband’s carry in Fund 1.
Mostyn J factored in that the Fund 2 committed funds (and
therefore potential carry value) were far larger than the Fund 1
size, meaning that this reattribution gave the wife a 48.53 per
cent interest in the carry payout from Fund 1, and no entitlement
from Fund 2. No account was taken of the relative performance of
the two funds and the potential effect of treating the
entitlement in this way. The wife’s entitlement was tied to the
husband’s carry, i.e. as and when the husband received carry
payouts, 48.53 per cent of that (net) would be transferred to the
wife.
Comparatively Mostyn J shared the co-invest “equally.” He
gave no reasoning for this different treatment of
co-invest.
Possible alternative approaches
As above, A v M is the only recent PE divorce precedent. There
remains scope for a different judge to take another
approach:
1. In A v M the husband effectively started his own PE fund
but most people working in PE are employees/partners in a large
PE house. Another judge may say the post-divorce effort (and
risk) in those circumstances is lesser than in A v M and discount
the amount of ‘post-matrimonial credit’ in calculating the
marital element.
2. Another judge may be willing to distinguish between carry
payout on a European waterfall structure (aggregate/end of the
fund life) and that on a US waterfall structure (deal-by-deal).
They may also factor in the impact of clawback clauses.
3. It is arguable that the “harvest” phase of a PE
fund, typically towards the end, is where most endeavour, risk
and skill is at play. If the parties separated or divorced
shortly before the harvesting phase, a different judge may take
greater account of this ‘enhanced’ post-separation endeavour,
rather than treating it linearly with the other phases.
4. Mostyn J shared the co-invest equally. There was no
reasoning given. It is assumed that it was because the
co-investment was made with marital funds. However, another judge
may say that this unduly disregards the husband’s post-separation
endeavour for the co-invest to payout or alternatively that the
post-separation endeavour is adequately rewarded in his share of
the carry.
5. Mostyn J used a marital period ending with the date of
the trial, rather than the date of the divorce petition. If that
date (July 2019) had been used, the marital element of Fund 1
would have been 29 per cent (compared with 53 per cent).
Another judge may use the date of divorce petition or date of
separation.
6. The use of the “establishment of the fund” start date
might not be followed. Another judge may use an earlier relevant
date, to reflect the preparatory work prior to establishing a
fund. Or they may simply use the ‘first close’ date for A (in the
calculation), taking the view that this is when the real effort,
and investment, starts.
7. Mostyn J’s view was that carry is a “hybrid resource”
with characteristics of income and capital. In dividing the
carry in the way he did, the judge effectively treated it as
capital. This capital/income distinction is crucial as it is well
established law that applicants can share capital accrued during
the marriage but have no right to share income. A different judge
may treat it as income.
8. If Fund 1 didn’t meet the hurdle by 2026, and Fund 2 did,
Mostyn J’s approach of aggregating the wife’s interest into Fund
1 would mean that she receives a nil payout from her 48.53 per
cent interest, and the husband retains his Fund 2 payout in full.
Another judge might say that is too high a risk of occurring, and
not aggregate in the way Mostyn J did.
9. A v M does not address the situation where one party
seeks to be ‘cashed out’ of the share that they would otherwise
have in the other’s carry. Cashing out is arguably even more
fraught with issues, particularly relating to valuation, but
other judges may be amenable to it in the right
circumstances.
In this “new era” of PE divorces, A v M is a helpful first
precedent. But precedent setting cases ‘two’ and ‘three’ may be
even more important. As will be getting the right matrimonial and
funds advice.
Footnote
1, Statista, June 2024