Separation anxiety

The division of assets in divorce cases involving private equity partners can be a particularly complex process. Calculating the values of carried interest and co-investment are difficult anyway, without having to then assess a fair division between a separating couple.

Some established principles apply in UK courts and yet there are cases in progress that could challenge these assumptions. And a recent case involving a hedge fund manager opens up the possibility that awards in divorce cases could extend beyond a share of carried interest earned before trial to consider the underlying value of a PE firm.

A fair settlement
Typically in divorce cases where proceeds from PE funds form part of marital funds, the disputed area is carried interest, which is “considered neither exclusively a return on a capital investment nor an earned bonus but rather a hybrid resource”, as set out by Justice Mostyn in a ruling for 2021. The calculation set out in this case was A divided by B equals C, where A is the period in months from fund establishment to date of the trial and B is the estimated total term of the fund, so C is the marital fraction of the husband’s carry.

The projected value of the husband’s carry is then multiplied by C to give the marital carry, which is then split between the parties.

Note that the calculation is based on the date of the trial rather than the date the two parties separated. This has been the default position in previous cases but there are ongoing cases where this is in dispute. The gap between separation and divorce could be counted in years and result in a very different carry amount to be split.

Katie Male, Senior Associate in the family team at law firm Boodle Hatfield, says: “In order to persuade the court that it should be the date of separation, it would be necessary to distinguish the facts of this case from recent authority, which uses today’s date as the end point.”

While arguing for an earlier date for carry calculation is yet to be tested in court, a ruling from a recent case involving a hedge fund manager points to the possibility that a former spouse may be judged to be entitled to a share of a fund manager’s income post-divorce.

Male, who represented the spouse in the hedge fund case, says that fundamental to the ruling was the judgment that the management firm, and not just the assets that it manages, has intrinsic value.

“We argued that the management entity itself had significant value. The court agreed with us and ruled that our client had contributed to that value creation,” Male says.

Intrinsic value
In his judgment in the 2021 case, Justice Mostyn dismissed the idea that earnings or profits that have been generated after the dissolution of partnership should be shared was “completely unprincipled”. The judge added: “It would be a good thing if this argument were finally to bite the dust.”
A ruling from last year however suggests that this argument could be made and won in future cases. The 2023 case involved a hedge fund manager in which the court ruled their spouse should receive 17.5% of the profits and any capital realisation from the hedge fund that the husband might realise during the next four years.

Male, who represented the spouse in this case, explains: “That is unusual, as there is clear authority that one spouse does not have an entitlement to a share of the other spouse’s post-separation income.”

The husband in this case had founded the firm using funds built up during the marriage. The judge ruled that it would be “plainly unfair if [the spouse] were not to share any further in the benefits” from the fund post-divorce.

He said: “It cannot be said that the benefits that will flow in the future relate to a new venture which has no connection with the marital partnership.”

Two experts were used to determine the valuation of the firm. It was agreed by both that a sale of the husband’s stake in the firm was unlikely due to his key-man status and it was very difficult to put an exact valuation on the firm. Their initial valuations were far apart but they came to a compromise position.

“What is interesting in this case is that even though both experts and the judge agreed that the husband was the key man in the hedge fund, and the estimated value of the firm was only likely to be available to him and not a third party, it was still something the wife was deemed to be owed a share of,” Male says.

The calculation of 17.5% over four years post-separation was based on the husband’s share of the business and the intended timeline for succession.

The implication of the ruling for future divorce cases involving PE funds could be significant. Unlike hedge funds, the value of PE firms is much better understood and demonstrated on a regular basis through GP stake sales.

If lawyers can successfully argue that the spouse and/or the couple’s shared marital funds contributed to the establishment of a PE firm, it may be possible to prove, against precedent, that they are entitled to a share of carry or other proceeds for a period post-divorce.

“One of the challenges in this case was the absence of examples of hedge funds of this size being bought and sold,” Male says. “I think if you have recent examples of stake sales in private equity funds, that is going to be dynamite for anyone trying to argue that there is intrinsic value to the firm that the spouse should share in.”

For ongoing and future divorce cases involving PE partners, this leaves significant uncertainty regarding settlements. There may be a case that successfully argues that carry should only apply up until separation, if the gap between then and the trial is large enough.

Conversely, we could see a case where a spouse successfully argues that they are entitled to ongoing benefit from a PE firm they contributed to the creation of.

This article was written by Jon Whiteaker at The Drawdown in July 2024. The reported case in reference is CG v DL [2023] EWFC 82 (25 May 2023) (bailii.org) where Emily Brand and Katie Male acted for the wife.