How to Handle Carried Interest and Performance Fees from Venture Capital, Private Equity, and Hedge Funds in Divorce

The San Francisco Bay area is recognized for its vibrant market of venture capital firms, hedge funds, and private equity funds. As compensation, fund managers often receive carried interest, performance fees, management fees, and profit interests.

These sophisticated assets can be incredibly lucrative down the road, but they can present a challenge if you’re facing a divorce right now.

The more complex your assets, the more complicated your divorce can get. Unlike straightforward assets like cash or property, the value of carried interest and performance fees can be difficult to estimate, especially if your holdings have yet to vest. High-net-worth divorces require special considerations to protect your wealth.

Does your spouse have any claim to your carried interest or performance fees in a divorce? If your spouse is the fund manager, do you have any interest in their earnings? If so, how do you go about appraising and dividing these types of assets between each of you?

Under California’s property division rules, carried interest can qualify as separate property or community property. In a divorce, you get 100% of your own separate property and 50% of all the community property accumulated during the marriage.

If your marital estate includes carried interest or performance fees, how much counts as separate versus community property? The answer to that question depends on a number of factors, including the specific terms and conditions of the fund in question.

Every divorce has high stakes, but high-net-worth divorces could have millions on the line. Taking the wrong approach to your carried interest assets during the divorce process could prove costly for you. To maximize your wealth for the future, you must work with an attorney with the proper expertise.

How Carried Interest and Performance Fees Work

Carried interest and performance fees provide incentives for managers of venture capital firms and private equity funds. As a fund manager, your compensation depends on the fund’s performance. The nature of this earning structure involves future payouts for the work you do now.

Fund managers usually receive carried interest after all the initial capital is returned to the contributing partners in addition to a previously set rate of return. Generally, performance fees are rewarded when the value of the fund exceeds the previous point of distribution – the “high-water mark.” However, allocation may vary according to the terms and conditions under the entity’s limited partnership agreement.

Your carried interest or performance fee package may include additional terms such as:

• Detailed conditions for vesting
• Rules for cross-collateralization of assets
• Restrictions on transferring your interest to others

It’s not unusual to see intricate vesting schedules for carried interest. Your carried interest may vest partially in the first few years after an acquisition with the remainder vesting a decade later. Your fund may even distribute carried interest on a per-investment basis.

While private equity funds tend to have a limited time span of operation specified in their partnership agreements, many hedge funds have no such limit and operate in perpetuity.

As a result of these intricacies, appraising the value of your carried interest for the purpose of a divorce can be a challenge. You must consider and determine:

• Are you contractually able to transfer any of your interests to your spouse?
• Which spouse will keep equity interest in the assets after your divorce settlement?
• If you’re unable to agree on how to split the carried interest or performance fees, will the other spouse accept financial compensation to make up for the difference?
• What happens if your divorce decree requires a payout but the investment doesn’t have enough money to pay out the carried interest?
• How do you account for future risk in your divorce negotiations now?

Taking all of these variables into account now helps reduce your risk of having to return to court at a later time to hash out any complications in the future.

Splitting Complicated Assets in California Divorce

When it comes to determining community property in California, carried interest functions similarly to stock options and restricted stock units (RSUs). Anything you earn during the course of your marriage falls under community property to be divided equally between spouses.

Community property ends on your “date of separation,” when at least one spouse decides the marriage is over and takes action to split from the other.

Your carried interest will likely qualify (in part or in whole) as community property in a California divorce if:

• You enter a compensation agreement before your marriage but the carried interest vests during your marriage;
• You enter a compensation agreement during your marriage and your carried interest vests during your marriage; or
• You enter a compensation agreement during your marriage, you perform work during your marriage to enhance the value of the fund, and your carried interest vests after separation.

Although compensation you receive for work you do after your date of separation generally qualifies as separate property that belongs to you, an exception exists if you use your post-divorce efforts to enhance the value of a community property asset.

Generally, the later you get compensated after your date of separation, the lower proportion of that interest will qualify under community property. So your spouse would have a greater claim over carried interest vesting a month after your date of separation versus five years later.

The latter scenario is where the formula gets more tricky to determine, especially with the inherent risks of private equity investment. Your fund may perform much differently five years from now than you’d originally projected – for better or for worse.

Figuring the math over these assets – potentially worth millions of dollars – can take the efforts of a team of divorce lawyers, accountants, tax specialists, asset valuation experts, and venture capital or hedge fund appraisers. The final details of your marital decree may ultimately be determined on the negotiating table or before a judge. It’s critical that you establish an accurate assessment of your assets to get a fair division of property in your divorce decree.

The right Silicon Valley divorce lawyer can help you formulate and execute the best strategy for your capital interest assets. An experienced legal team can recommend experts you can trust based on your needs. Managing all of these issues now helps reduce your risk of having to come back to court or renegotiate the terms of your divorce years later.