Carried Interest in Divorce

Valuing a private equity partner’s carried interest is challenging. The concept of carried interest, or a share in the future profits of an investment fund, is a blend of deferred compensation, investment return, and reward for personal skill. In marital dissolution proceedings, their valuation is speculative, liquidity is non-existent, and their very nature is subject to fierce, ongoing debate. The valuation and division of such assets requires the highest levels of awareness, financial sophistication and strategic foresight far beyond that needed for conventional marital property like real estate or publicly traded securities.

The dominant structure for private equity funds is the limited partnership. This model creates a symbiotic relationship between two distinct groups: the General Partner (GP) and the Limited Partners (LPs).

The GP is the fund manager or the management firm. This entity is the active participant, responsible for creating the fund, raising capital, sourcing and vetting investment opportunities, managing the portfolio of companies the fund acquires, and ultimately orchestrating the “exit” from those investments to generate a profit. The GP brings the strategic vision, industry expertise, and operational oversight to the partnership.

The LPs are the passive investors. They are typically institutional investors like pension funds, university endowments, insurance companies, and high-net-worth individuals who provide the vast majority of the investment capital. Their liability is generally limited to the amount of their investment, and they rely entirely on the GP’s expertise to manage the fund and generate returns.

The typical lifecycle of a private equity fund spans a decade or more, a critical factor that is a mandatory consideration in the event of divorce. This long, illiquid timeline begins with a capital-raising period, followed by an investment period of several years where the GP acquires controlling or significant stakes in various companies. The subsequent holding period involves active management to increase the value of these portfolio companies. The final phase is the exit period, where the GP seeks to realize profits by selling the companies or taking them public through an Initial Public Offering (IPO). Only at this final stage are significant profits, and thus carried interest, typically realized.

The compensation structure for a GP is designed to cover operational costs with strong incentives for performance. This is most commonly achieved through the “2 and 20” model, which consists of two separate and distinct revenue streams: a management fee and carried interest.

The management fee is a predictable, stable source of income for the GP. It is typically calculated as an annual percentage, often 2%, of the total capital committed by the LPs or the assets currently under management. This fee is intended to cover the day-to-day operating expenses of the fund, including staff salaries, office overhead, travel, legal fees, and the costs associated with conducting due diligence on potential investments. The management fee is paid to the GP regardless of the fund’s performance. Even if the fund ultimately loses money, the GP collects these fees to maintain operations. In a divorce context, management fees are generally treated as regular, predictable income to the GP spouse.

Carried Interest

Carried interest, also known as “carry” or a performance fee, is the GP’s primary reward for generating profits. It represents a share, typically 20%, of the fund’s net profits. It is essential to understand that carried interest is not an “interest” payment in the traditional sense, like interest on a loan. It is a “profits interest”—a contractual right to a portion of the future profits generated by the fund’s investments. This compensation structure is the cornerstone of the private equity model, as it is designed to directly align the financial interests of the GP with those of the LPs. The GP only achieves a significant payout from carried interest if the fund is successful enough to generate substantial returns for its investors, creating the incentive to maximize performance.

The dual nature of carried interest is the genesis of nearly all conflict in divorce proceedings. For tax purposes, it is treated as a return on investment, qualifying for lower capital gains tax rates. Yet, for compensation purposes, it functions as a performance bonus, rewarding the GP’s labor and expertise. This fundamental contradiction creates a legal gray area for divorce courts. While the tax code provides one classification, family law operates on principles of equity, forcing a judge to decide whether the asset represents a divisible “fruit of the marital partnership” or non-divisible compensation for future, post-marital effort. Courts have explicitly recognized this ambiguity, with rulings that describe carried interest as a “hybrid resource” with characteristics of both capital and income.

Payment of carried interest is not automatic. It is governed by a strict hierarchy of distributions detailed in the fund’s Limited Partnership Agreement (LPA). This hierarchy ensures that investors are prioritized, making the carry a high-risk, high-reward instrument for the GP.

The Hurdle Rate (Preferred Return)

Before the GP is entitled to receive any carried interest, the fund’s profits must first be used to repay 100% of the capital contributed by the LPs. Furthermore, the LPs must receive a minimum, pre-agreed rate of return on their investment, known as the “hurdle rate” or “preferred return”. This hurdle rate is typically set at around 7% to 9% per annum. Only after the LPs’ capital has been returned and this preferred return has been fully paid can the GP begin to share in the remaining profits. This subordination of the GP’s interest ensures that the managers are rewarded only after delivering a baseline level of success to their investors.

The Distribution Waterfall

The precise sequence of profit distribution is outlined in a contractual provision known as the “distribution waterfall.” This cascade ensures that all proceeds from the fund’s asset sales are allocated correctly between the LPs and the GP according to a multi-step process. A typical waterfall proceeds as follows:

1. Return of Capital: First, 100% of distributions go to the LPs until they have received back all of their contributed capital.
2. Preferred Return: Next, 100% of distributions continue to go to the LPs until they have received their full preferred return (e.g., an 8% annualized return on their investment).
3. GP Catch-Up: After the LPs have been made whole, a “catch-up” provision allows the GP to receive a high percentage of the profits (often 80% or even 100%) until the GP has “caught up” to its agreed-upon share of the total profits. For a 20% carry, this means the GP receives profits until its total take equals 20% of all profits distributed above the initial capital return.
4. Residual Split: Finally, once the catch-up is complete, all subsequent profits are split according to the final agreed-upon ratio, typically 80% to the LPs and 20% to the GP.

American vs. European Waterfalls

The structure of the waterfall itself has a profound impact on the risk and timing of carried interest payments. The two primary types are:

• American Waterfall (Deal-by-Deal): In this structure, the waterfall calculation is applied to each investment exit individually. This allows the GP to receive carried interest from an early, successful deal, even if other investments in the fund are underperforming and the fund as a whole has not yet cleared the hurdle rate. This model provides earlier liquidity for the GP but introduces a significant risk.
• European Waterfall (Whole-Fund): This is a more investor-friendly model where carried interest is calculated only at the level of the entire fund. The GP receives no carry until all LP capital contributions for the entire fund have been returned and the overall fund-level preferred return has been met. This defers payment to the GP but significantly reduces risk for the LPs.

The distinction between these waterfall types is more than academic. The structure dictates the real-world risk profile of a carried interest and is therefore critical for valuation. An American waterfall provides the potential for earlier payouts but comes with a substantial “clawback” risk. Any valuation of such an interest must therefore apply a discount for this contingency. A European waterfall has a much lower clawback risk but defers any potential payout for many years, increasing the uncertainty and the discount that must be applied for the time value of money. A valuation expert cannot properly assess a carried interest without knowing the specific waterfall structure mandated by the fund’s LPA, making this document essential evidence in a divorce.

To mitigate the risk inherent in the American waterfall model, most LPAs include a “clawback” provision. This contractual clause gives LPs the right to reclaim or “claw back” carried interest distributions previously paid to the GP if subsequent losses in the fund mean that the GP was ultimately overpaid on a whole-fund basis. For example, if a GP receives carry from an early successful exit but the fund later suffers significant losses, the clawback requires the GP to return a portion of that carry to ensure the LPs receive their contractually promised share of the final, overall profits. This provision means that even carry that has been distributed is not truly “final” until the fund is fully liquidated, creating a contingent liability that adds another layer of profound uncertainty to any valuation attempt.

The Three-Year Rule: Carried Interest and Tax Law (IRC Section 1061)

The tax treatment of carried interest has long been a subject of intense political and economic debate. This debate centers on what critics call the “carried interest loophole,” which has significant implications for how the asset is valued and divided in a divorce.

Historically, carried interest has been taxed at the preferential long-term capital gains rate (currently a maximum of 20%), rather than the much higher ordinary income tax rate applicable to most forms of compensation (currently a maximum of 37%). The rationale is that the carry represents a return on the GP’s investment of expertise and “sweat equity,” and thus should be treated like other investment gains. Critics, however, argue that it is functionally a performance bonus for services rendered and should be taxed as ordinary income.

In 2017, the Tax Cuts and Jobs Act (TCJA) sought to address this controversy by enacting Section 1061 of the Internal Revenue Code. This new law did not reclassify carried interest as ordinary income. Instead, it significantly tightened the requirements to qualify for the favorable long-term capital gains rate. Under prior law, an asset had to be held for more than one year to qualify. Section 1061 extended this holding period to more than three years specifically for gains attributable to an “applicable partnership interest” (API), which includes virtually all forms of carried interest.

The three-year holding period is measured by the fund’s holding period of the underlying asset that was sold, not necessarily the partner’s tenure with the fund or their holding period of the API itself. If a fund sells a portfolio company it has held for three years or less, any capital gain allocated to the GP as carried interest is automatically recharacterized as a short-term capital gain and is taxed at the higher ordinary income rates. Since many private equity funds have holding periods of five to seven years for their investments, much of the carry will still qualify for the long-term rate, but this rule introduces a critical new variable.

This tax rule impacts divorce. The PE spouse, having unique visibility into the fund’s portfolio and potential exit timelines for its various investments, can credibly argue that the value of carry attributable to assets held for less than three years should be discounted to reflect the significantly higher tax burden that will be incurred upon their sale. The non-PE spouse must consider agreeing to a lower present-day valuation or accepting a deferred payment structure that allows the assets time to meet the three-year threshold. This information asymmetry provides the PE spouse with a distinct negotiating advantage and underscores the necessity for the out spouse’s legal counsel to acquire detailed information about the holding periods of the fund’s underlying assets.

Valuation of Carried Interest

Valuing a private equity professional’s carried interest for the purpose of marital dissolution is one of the most speculative and contentious exercises in all of family law. Unlike a bank account or a publicly traded stock, unrealized carry has no objective, readily ascertainable market value. Its worth is entirely contingent on a series of future events, making any attempt to assign a concrete number at a single point in time an exercise in sophisticated forecasting, fraught with uncertainty and potential for dispute.

The fundamental problem with valuing unrealized carry is that it represents a potential future payment, not a present-day asset. Its value is dependent on a complex and uncertain cascade of future events, each of which must occur successfully for any payout to materialize. Key uncertainties include:

• Fund Performance: The ultimate value of the carry is directly tied to the performance of the fund’s underlying portfolio companies. There is no guarantee that these companies will grow in value or even survive. Early-stage funds, in particular, are highly speculative investments.
• Successful Exits: Even if portfolio companies perform well, the GP must be able to orchestrate successful “liquidity events,” such as a sale to another company or an IPO, at a price that generates a profit.
• Market Conditions: The success of an exit is heavily influenced by the broader economic climate, interest rates, and public market sentiment at the time of the potential sale, factors that are impossible to predict years in advance.
• Timing and Illiquidity: The long, 7-to-10-year lifecycle of a PE fund means that any potential value is locked up and deferred for years. This illiquidity and long time horizon make any present-day valuation an exercise in forecasting the distant future, requiring significant discounts for time and risk.

Adding to this investment-level uncertainty are contingencies specific to the individual partner, which further complicate valuation:

• Vesting Schedules: A partner’s right to their allocated share of the fund’s carried interest is often subject to a vesting schedule, much like employee stock options. For example, a partner’s interest might vest over five years. If that partner leaves the firm before being fully vested, they forfeit the unvested portion. This introduces a personal, employment-related risk that is entirely separate from the fund’s investment performance. A valuation must account for the possibility of forfeiture.
• Clawback Provisions: As previously discussed, the existence of clawback provisions means that even carry that has already been distributed to a partner is not truly secure. It remains a contingent liability until the fund is fully liquidated and the final accounting is complete. A valuation must discount for the risk that previously received payments may have to be returned.

These elements of uncertainty—fund performance, market timing, personal employment status, and contingent liabilities—combine to make the valuation of unrealized carried interest profoundly speculative.

The Capital vs. Income Debate

Is carried interest a divisible marital asset or non-divisible future income? The answer to this question fundamentally shapes how it is treated by the court. The spouse who is the private equity professional will almost invariably assert that the carry is compensation for their future, post-separation labor. They will contend that realizing any value from the interest requires their continued skill, effort, and active management to guide the portfolio companies to a successful exit. From this perspective, the carry is a bonus for work yet to be performed, and as such, it should be characterized as separate, non-divisible future income. The other spouse will counter that the right to receive the carried interest was granted during the marriage. They will argue that this right was earned as a result of the marital partnership’s collective efforts, including their own non-financial contributions (such as managing the household and raising children) that enabled the PE spouse to dedicate their time and energy to the fund. In this view, the PE spouse was effectively “trading with the marital partnership’s capital,” both financial and human, and the eventual profits are therefore a return on that marital investment and should be treated as a divisible asset.
Faced with these competing and compelling arguments, courts generally reject an all-or-nothing approach. In the influential English case A v M, the court explicitly rejected both extremes, concluding that carried interest is a unique “hybrid” asset, possessing characteristics of both a return on capital investment and an earned bonus. This judicial recognition of its dual nature means that courts are unlikely to exclude it from the marital estate entirely, but are also unlikely to treat 100% of it as a divisible asset. This leads directly to the need for a nuanced apportionment methodology, discussed below.

When a point-in-time valuation is required, the most common method proposed by financial experts is the Discounted Cash Flow (DCF) analysis. In this method, a valuation expert attempts to project the future cash flows that the fund’s investments will generate, estimates the portion of those cash flows that will be distributed as carried interest, and then discounts those highly uncertain future payments back to a single present value. The discount rate used is typically very high to reflect the significant risks involved.

Despite its widespread use in corporate finance, the DCF method is viewed with considerable skepticism by many family courts for several reasons:

1. Compounded Speculation: The DCF model is only as reliable as its inputs, which, in the case of carried interest, are almost entirely speculative. The expert must make a series of educated guesses about future investment returns, the timing of exits, future tax rates, and the appropriate discount rate for risk and illiquidity. Each assumption layers speculation upon speculation, potentially leading to a result that is divorced from reality.
2. The “Future Labor” Argument: The most potent legal criticism of using DCF to value carried interest in a divorce is that it implicitly assigns a value to the PE spouse’s post-marital labor, which is legally considered separate, non-divisible property. Family law jurisprudence is clear that a spouse is not entitled to a share of the other’s future career earnings post-divorce. Because a DCF model projects future profits that can only be realized through the PE spouse’s continued, active management long after the marriage has ended, the model is valuing something the court is legally prohibited from dividing. This creates a fundamental contradiction that a skilled divorce attorney can use to discredit a DCF-based valuation and advocate for an alternative approach.
3. Flawed Liquidation Scenarios: Some valuation approaches try to avoid future projections by calculating the value of the carry based on a “hypothetical liquidation” of the fund’s assets at their current reported values. However, this method is also deeply flawed. It fails to capture the significant “time value” or “option value” of the carried interest—that is, the potential for the fund’s assets to appreciate significantly in the future. This optionality is a key component of the carry’s economic value, especially in the early years of a fund’s life, and a simple liquidation analysis ignores it completely.

Alternative Approaches to Valuation and Division

Given the profound difficulties and legal objections associated with assigning a single, fixed value to carried interest, courts and litigants often turn to alternative methods for division. The choice of method is not a neutral calculation but a strategic decision about how to allocate the immense risk and uncertainty inherent in the asset. The primary alternatives are deferred sharing and immediate offset, with more sophisticated option pricing models also emerging as a possibility.
The following table provides a comparative analysis of these methodologies, distilling the complex strategic choices into a clear format. It highlights the fundamental trade-offs between achieving finality, ensuring fairness, and allocating risk, transforming abstract legal concepts into a practical decision-making tool for litigants and their counsel.

Comparison of Carried Interest Division Methodologies

The choice between these methods is a critical strategic decision that pre-determines who bears the future investment risk. A PE spouse who is highly confident in a fund’s future success has a powerful incentive to push for an immediate offset based on a conservative, early-stage valuation, effectively betting they can buy out their spouse’s interest cheaply. Conversely, an ‘out’ spouse who is risk-averse and desires finality might accept a discounted buyout to avoid the years of uncertainty associated with deferred sharing. This strategic calculus, driven by the unique and speculative nature of the asset itself, lies at the heart of all carried interest disputes in divorce.

Apportionment

Once a court decides to treat carried interest as a divisible asset, the next critical task is apportionment: determining what portion of the interest was earned through the efforts of the marital partnership and is therefore subject to division, and what portion is attributable to post-separation efforts and remains the separate property of the PE spouse. This process is essential for achieving an equitable distribution in line with established legal principles.

The Coverture Fraction

The foundational principle of property division in most jurisdictions is that only marital property—assets acquired or earned during the marriage—is divisible upon divorce. Property acquired before the marriage or after its termination is generally considered separate property. The legal tool most commonly used to apportion assets that are earned over a period that straddles the marriage is the “coverture fraction.” This is a time-based formula that seeks to isolate the portion of the asset’s value that is attributable to the marital period.

The challenge with carried interest is applying this principle to an asset where the “earning” process is a long and continuous effort. The right to the carry may be granted during the marriage, but the work required to bring that right to fruition and generate value extends for many years, often long after the parties have separated. This extended timeline necessitates a clear and defensible methodology for drawing the line between marital and separate contributions.

The Time-Based Formula

An influential framework for this apportionment was issued by Mr. Justice Mostyn in the English family law case, A v M [2021] EWFC 89. Faced with the task of dividing carried interest from two separate private equity funds, the court established a linear apportionment formula to calculate the marital share. This approach has been widely cited for its logical and mathematical clarity.

The formula is expressed as: A÷B=C

• A = The Numerator (The Marital Period): This represents the period of time, measured in months, during which the marital partnership contributed to the earning of the asset. The clock starts when the specific fund generating the carry was established and ends at the legal termination of the marriage (e.g., the date of separation or the date of the final trial).
• B = The Denominator (The Total Earning Period): This represents the total projected period, also in months, over which the effort to generate the carry is expended. In the A v M case, the court determined this period by starting at the fund’s establishment and adding a standard projected fund life of nine to ten years from the fund’s first close. This denominator represents the full “blood, sweat, and tears” required to bring the venture to fruition.
• C = The Marital Fraction: The resulting percentage is the portion of the total carried interest that is deemed to be marital property and is therefore subject to division between the spouses.

To apply the formula, the total projected value of the PE spouse’s carried interest in a given fund is multiplied by the marital fraction (C). The result is the value of the divisible marital asset. For example, if the marital period (A) was 60 months and the total projected fund life (B) was 120 months, the marital fraction (C) would be 50%. If the total projected carry was $10 million, the divisible marital portion would be $5 million.

The elegance of the A v M formula lies in its simplicity and its attempt to create a predictable, objective standard. The formula provides what can be seen as a presumption of linearity—that is, it assumes that the effort required to generate value is spread evenly over the entire life of the fund. A skilled litigator can challenge this core assumption. For instance, a PE spouse might argue that the most critical, value-creating activities, such as sourcing the initial investments and performing the initial due diligence, occurred at the very beginning of the fund’s life (perhaps pre-marriage). Conversely, they might argue that the most intense work will be required at the very end (post-marriage) to negotiate and secure profitable exits. The ‘out’ spouse, on the other hand, could argue that the foundational work of building the portfolio during the marriage was the most critical phase. The A v M formula provides a logical default, but it is not unassailable and can be challenged with compelling evidence of non-linear effort.

Defining the Marital Period: Critical Dates

The calculation of the marital fraction hinges on the precise definition of the start and end dates of the relevant periods. A crucial point established in the case law is the Start Date. The “clock” for the apportionment formula begins not when the PE spouse joined their firm or even when they were granted the interest, but on the date that the specific fund generating the carry was legally established. This means that for a partner who has been at a firm for many years, the marital portion of carry from a newer fund will be smaller than that from an older fund established earlier in the marriage.
The choice of the End Date for the marital period (the numerator) can be a significant point of contention. In A v M, the court used the date of the final trial, reasoning that the “economic features of the parties’ marital partnership will have remained alive and entangled up to that point”. However, this is not a universal rule. Many jurisdictions use the formal date of separation as the hard cutoff for the acquisition of marital property. The difference of several months or even years between separation and trial can significantly alter the size of the marital fraction. The
A v M court emphatically rejected the argument that the marital portion should be extended beyond the date of the trial to reflect one spouse’s ongoing contributions, such as raising the parties’ children. The court found it “unprincipled” to argue for a share in earnings generated after the economic partnership has ended.
The denominator of the fraction—the total projected fund life—is also important. While the LPA may state a 10-year term, funds can often be extended by the GP for several additional years. The PE spouse has a clear incentive to argue for a longer projected fund life, as a larger denominator (‘B’) will result in a smaller marital fraction (‘C’) and thus reduce the size of the divisible asset. The ‘out’ spouse’s legal team must be prepared to counter this by presenting evidence of industry norms and arguing for a shorter, more standard fund life in order to maximize the marital portion. The denominator is not a fixed fact; it is an estimate and, therefore, a point of contention.

Challenges for Each Spouse

The division of carried interest is a high-stakes strategic puzzle where each spouse faces many challenges. For the spouse who is not the private equity professional, obtaining a fair share of the carried interest is an uphill battle fought against opacity, complexity, and significant financial disadvantages. The most significant hurdle for the ‘out’ spouse is a massive information deficit. The PE partner and their firm possess exclusive control over all the critical documents and data needed to value and divide the asset. This includes the Limited Partnership Agreement (LPA), internal portfolio company valuations, capital call notices, distribution statements, and vesting schedules. The ‘out’ spouse is entirely dependent on the formal legal discovery process to obtain this information, a process that can be slow, expensive, and often met with resistance from the PE firm, which has its own confidentiality concerns. This structural imbalance in information creates a dynamic where the ‘out’ spouse is always playing catch-up.

The world of private equity is notoriously opaque. Unlike public companies, PE funds are not required to make extensive public disclosures. This lack of transparency can be exploited in a divorce. The PE spouse may be tempted to manipulate valuations, understate performance projections, or strategically time fund distributions to minimize the apparent value of the carried interest at the time of the divorce proceedings. In more extreme cases, a spouse may attempt to hide assets by transferring interests to friends, relatives, or complex trust structures, requiring extensive and costly forensic investigation to uncover.

The legal and financial burden of proving the value of the carried interest and establishing its marital portion falls squarely on the ‘out’ spouse. To level the playing field against the information asymmetry and complexity, they must retain a team of expensive specialists, including forensic accountants to trace assets, valuation experts to analyze the fund’s financials, and specialized legal counsel with experience in this niche area. The high cost of this necessary expertise can be prohibitive, creating immense pressure to settle for less than a fair share, especially when the PE spouse controls the majority of the marital estate’s liquid assets.

The ‘out’ spouse is often constrained by legal documents they may have signed years earlier with little understanding of their implications. Many PE firms require spouses of partners to sign a “spousal consent” form. These documents, along with the LPA itself, typically contain strict provisions that prohibit the transfer of any partnership interest to a non-partner, including an ex-spouse in a divorce. These restrictions effectively block the court from ordering an “in-kind” division of the asset, forcing the ‘out’ spouse to accept a deferred cash payout or an offset with other assets, thereby limiting their strategic options.
The tax implications for the ‘out’ spouse can be daunting. Under IRS Revenue Ruling 2002-22, if they are awarded a share of the carry distributions, they become liable for the income tax on that income when it is received. However, a subsequent ruling clarified that for employment tax purposes (Social Security and Medicare), the income is still treated as wages of the PE spouse and reported on their W-2. This creates a messy situation where the PE spouse pays the employment tax on income received by the ‘out’ spouse. A meticulously drafted order is required to ensure the ‘out’ spouse reimburses the PE spouse for these taxes, adding another layer of complexity and potential for future disputes.

While the PE partner holds the informational advantage, they face their own set of severe constraints and pressures that can place them in a precarious position. The single greatest challenge for the PE partner is that their most valuable asset is profoundly illiquid. Carried interest is a future promise of cash, not cash in the bank. They cannot simply write a check to their spouse to settle the marital claim on the carry. If a court orders a large, immediate lump-sum offset, it could force the PE partner into a dire financial situation, potentially requiring them to sell other assets at a loss or take on significant personal debt to satisfy the judgment. This liquidity crunch creates immense pressure to avoid a large, upfront buyout.

A contentious divorce can become a significant business problem that impacts partnership and investor relations. The PE firm’s other partners and its LPs have a vested interest in stability and confidentiality. Partnership agreements are specifically designed to prevent outsiders, especially the ex-spouses of partners, from gaining any rights, access to information, or influence over the fund. The PE partner is under intense pressure from their own firm to resolve the divorce quickly, quietly, and in a manner that does not violate the LPA or create administrative burdens for the fund.

A partner’s interest in a PE fund is not just a right to receive profits. It often includes an obligation to contribute more capital in the future through “capital calls”. If the ‘out’ spouse is awarded a percentage of the future profits, the divorce settlement must explicitly and clearly address who is responsible for funding that percentage of future capital calls. If the agreement is silent on this issue, the PE partner could be left solely responsible for making capital contributions to preserve an asset that their ex-spouse will partly own, a financially untenable position. 

 If the PE partner agrees to an immediate offset and “buys out” their spouse’s share of the carry, they are effectively making a highly leveraged bet on the fund’s future success. They are taking on 100% of the investment risk. If the fund subsequently underperforms or fails, they could find themselves having paid out millions of dollars in tangible, liquid assets on a bad bet that ultimately proves to be worthless.

The discovery process in a divorce can force the disclosure of sensitive fund information, including internal valuations, investment strategies, and performance data. The public filing of such information could damage the partner’s professional reputation, strain relationships with investors, and violate confidentiality agreements, creating significant career risk.

This conflict creates a vicious cycle of cost and complexity. The inherent challenges faced by the ‘out’ spouse—complexity and information asymmetry—force the retention of expensive experts. The high cost of this litigation, in turn, puts immense pressure on the PE spouse, whose primary asset is illiquid and who is facing pressure from their partners to settle. This dynamic structurally favors the party with greater access to liquid capital to fund the legal battle, which is almost always the PE partner who receives the steady stream of management fees. Furthermore, the Limited Partnership Agreement acts almost as a third party in the divorce. Its legally binding transfer restrictions and capital call provisions were created to protect the business, not to facilitate a divorce. As a result, these terms directly conflict with the goals of family law, such as equitable distribution and a clean break. This means any settlement is not just a contract between two spouses; it must be a three-way solution that satisfies the spouses and does not violate the LPA, dramatically narrowing the range of possible outcomes.

Best Practices and Recommendations

Embrace proactive planning. The most effective way to mitigate the conflict and cost of dividing carried interest is to address the issue proactively. Prenuptial agreements are invaluable tools for this purpose. A well-drafted agreement can pre-emptively characterize carried interest as separate property, establish a clear and binding formula for its division, or outline a specific process for valuation and distribution in the event of a divorce. This can transform a multi-year, high-conflict litigation into a more predictable and manageable process.

Assemble an expert team. Navigating this unique, high stakes landscape is virtually impossible without a strong team of experienced professionals. It must include a family law attorney with a proven track record in high-net-worth cases involving complex compensation, a forensic accountant skilled in tracing assets and analyzing opaque financial structures, and a business valuation expert who specializes in illiquid, alternative investments like private equity. The cost of this expertise is significant, but the opportunity cost of proceeding without it is invariably higher.

While the carried interest dilemma presents a unique and daunting set of obstacles, it is not insurmountable. By understanding the asset’s financial mechanics and legal complexities, parties can make informed strategic decisions. A disciplined, long-term approach, grounded in expert advice, will permit both parties to achieve the finality necessary to move forward with their lives.