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1st July 2024

Richard Kershaw and Nicholas Yates KC discuss private equity on divorce in FTAdviser

Richard and Nicholas Yates’ (1 Hare Court) article was published in the FTAdviser, 1 July 2024, and can be seen here.

How the courts treat carried interest in divorce

The huge sums generated by private equity fund managers by way of carried interest are in the spotlight once again, with Labour’s manifesto pledging to raise £565mn through changing how it is taxed: “Private equity is the only industry where performance related pay is treated as capital gains. Labour will close this loophole”.

Whether carried interest (or “carry”) ought to be characterised as capital or income has also been the focus of several High Court divorce judgments.

In that context, the question affects the extent to which carry should be shared on divorce – and, in contrast to the tax position, it has to date generally been treated as in the nature of income rather than as a gain.

Carry is paid to private equity fund managers where the fund’s performance exceeds a pre-determined rate of return for its investors, typically 8 per cent (the “hurdle rate”). Once that rate is reached, the partners are entitled to a fixed proportion of the fund’s profit, often around 20 per cent.

This remuneration tends to dwarf the management fees paid to the fund managers (typically 1-2 per cent of assets under management) and, unlike those fees, is currently taxed as a capital gain rather than as income.

While this reflects that the sums derive from the gains made on buying and selling investments, many regard it as a performance-related bonus paid by investors to the fund managers, and argue that it should be taxed accordingly.

By contrast, in financial litigation on divorce, fund managers tend to argue that carried interest (as opposed to co-investment) should be seen as more akin to income rather than as a gain on an investment.

This reflects the case-law that, on divorce, the value of investments generated during the marriage (which will normally include co-investments made during it) will generally be shared equally, even if they are currently illiquid or will not pay out for some time.

The underlying rationale is that it is marital funds that have been invested, meaning the proceeds should be shared whenever they become available (or bought out).

However, income earned after the breakdown of the marriage (that is carry) is not subject to sharing, as it is not considered the fruit of the marital partnership.

A bonus for effort

The first reported divorce case in which the nature of carried interest was considered was B v B [2013] EWHC 1232 (Fam) (in which the authors represented the wife).

It was agreed that the carried interest already received by the husband should be shared equally, but whilst the wife argued that carried interest entitlements from funds established during the marriage were akin to returns on an investment generated during the marriage, the husband argued that they were a performance related reward.

Mr Justice Coleridge (having considered each party’s “ingenious” arguments) accepted that carry “is in the nature of a bonus for effort earned for generating a super profit”, meaning the wife was not entitled to share in that portion of future carry payments reflecting the husband’s post-divorce work.

Therefore, the wife was awarded half of the future carried interest payments in respect of a fund almost at the end of its life, she was entitled to only 20 per cent of the carry in a fund mid-way through its term, and received no interest in the carry in a fund which had only recently commenced.

The judge took an instinctive approach to the fair division of each fund, having received detailed submissions on the work required at different stages in a fund’s life.

However, in the next reported private equity divorce case, A v M [2021] EWFC 89, the judge, Mr Justice Mostyn, took a more mathematical approach.

A hybrid resource

As in B v B, each party had argued for a particular characterisation of carry. However, in this case the judge held “it is my view that carried interest (‘carry’) is neither exclusively a return on a capital investment (as [the wife’s barrister] would have it) nor an earned bonus (as contended for by [the husband’s barrister]) but rather a hybrid resource with the characteristics of both”.

Nevertheless, like Mr Justice Coleridge before him, Mr Justice Mostyn approached carry in much the same way as a bonus. He held that the proportion of the fund’s projected life that fell during the marriage should be calculated. That proportion of the husband’s carried interest receipts would be divided equally, and the wife would have no interest in the balance.

Late last year, a further private equity-type divorce came before the High Court, ES v SS [2023] EWFC 177 (in which the authors again acted for the wife).

Here, the situation was somewhat different, as there were a number of individual investments run on a carried-interest model but outside a fund structure, with the husband’s investment company identifying suitable investments for others to invest in, developing and managing the investment and then sharing the fruit of the sale proceeds for its endeavours.

The judge, Sir Jonathan Cohen, took an instinctive approach to the share the wife should receive, awarding her 50 per cent of receipts from a fund the existence of which was wholly within the marriage, and a range of between 20 per cent and 40 per cent for future receipts from the remaining investments, depending on how close to the end of the marriage the particular investment was made.

It can thus be seen that despite Mr Justice Mostyn characterising carried interest as a “hybrid” resource, neither he nor any of the other judges dealt with it on a hybrid basis on divorce – it has simply been treated as income, with only that proportion of the return referable to efforts during the marriage shared.

Arguably, this reflects the reality that carried interest is a bonus for effort paid by investors from their gains, rather than a gain realised by fund managers on their own investments.

It therefore seems a disconnect exists between the Treasury treating carried interest as a capital gain and the divorce courts treating it as income.

Wells sharing

Meanwhile, the divorce courts have to grapple with one issue that the Treasury does not: valuation.

While tax only bites after the carried interest has been received, which may be many years after a divorce has been finalised, the division of a carried interest entitlement on divorce typically takes place before receipt, as carried interest tends to become payable in the latter years of a fund’s life.

The likely payouts cannot be estimated with any precision; while a broad estimate based on past performance or market averages can be calculated, the returns will be heavily dependent on the particular investments and the economic circumstances in which they come to be sold.

In some cases, this will lead a court to adopt a “Wells sharing” approach (named for the case in which it was first suggested), in which the division of an illiquid and/or unquantifiable asset is mandated at the date of a court order but which only actually takes place when the investment or carry is realised – potentially many years after the divorce.

While this has the benefit of fairness, it necessitates an ongoing financial relationship between the parties, which conflicts with the court’s duty to consider terminating the parties’ financial obligations to each other as soon as “just and reasonable”.

The alternative to Wells sharing is to use the best estimates of future value that are available and apply the relevant percentage to provide for the payment of a fixed sum.

This can create tough choices for recipients (usually wives). Should they seek a share of future receipts, risking that they may fail to materialise and therefore delaying their receipt of funds, or should they seek a fixed sum now, knowing it may significantly undervalue future receipts? In our experience, husbands usually prefer to pay out a fixed lump sum (perhaps reflecting their confidence in the future success).

Which approach is ultimately taken will depend on a number of factors including the reliability of the valuation, how long it will likely be until the fund pays out, whether the wife needs immediate funds and whether there are particular reasons to avoid an ongoing financial nexus between the parties.

In B v B, Mr Justice Coleridge prioritised fairness, providing for the carried interest to be shared on receipt, notwithstanding that this could result in payments being made many years into the future.

In A v M, Mr Justice Mostyn was more sensitive to the husband’s opposition to such an arrangement, recognising “his great unhappiness that the wife should be a shadow carry partner in both funds”, and so “relocating” the wife’s interest in the second fund to give her a larger interest in the first fund.

In ES v SS, the fact that one of the investments sold during the proceedings for 10 times more than the value that had been attributed to it contributed to the judge taking a Wells approach, despite the husband “rail[ing] against” this outcome.

The Treasury and the divorce courts have adopted opposing characterisations of carried interest; in both cases the approach selected operates to the advantage of the fund manager. Labour’s proposed changes would arguably introduce more consistency.

On the other hand, it must be recognised that there are different considerations and motivations at play.

In the divorce courts the judges must achieve a fair settlement between the two individuals before them, with the valuation difficulties posing additional problems, whereas tax policy must consider far wider concerns – not only fairness, but also the broader economic consequences of changes to the tax regime.

It will be interesting to see whether a new governmental approach brings the two closer together.