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June 2022
Dividing up complex investments can be a very complicated process. Working together, matrimonial attorneys, wealth managers and other key advisors can help their clients devise a plan to value and separate these assets during a divorce proceeding.
Complex investments can further complicate the challenges of divorce. Increasingly, high-net-worth investors are participating in private investments, both directly and in a variety of fund structures. Unlike more common marital assets such as a house, retirement plan, stocks and bonds or tangible personal property (e.g., cars, jewelry, and collectibles), private investments can be more challenging to value and may have significant future tax and legal consequences that could require the attention of legal, tax and wealth management professionals.
There are many types of private investments in real assets, private debt, real estate, and private equity. While experts at BNY Mellon Wealth Management can help clients and their advisors unwind all types of complex assets in a divorce, private equity funds are the most common alternative investment appearing in the portfolios of ultra-high-net-worth families. Let’s look at what these investments entail, how to estimate their value, options for separation and potential tax consequences.
Private equity funds
Private investments such as private equity funds have historically provided the potential for higher returns compared to public investments, but they also come with more risk and less liquidity. Generally, managers of these funds require that investors commit capital for several years, allowing the management team time to nurture illiquid investments; and investors tend to commit a specific amount of capital to the fund. This capital is called at the portfolio manager’s discretion over the initial investment period, which is generally within the first four to five years. The size and frequency of capital calls can depend on the type of underlying investments. Ultimately, the goal of a private equity fund is to sell all underlying investments and return the capital as well as investment gains back to investors. Private equity funds have long-term investment horizons that typically last from five to 15 years before all distributions are finalized.
Considerations for valuation in divorce
Resolving property issues in divorce cases can be complex and involve numerous considerations, such as jurisdiction, the existence of prenuptial or post-nuptial agreements and other factors. Among the key issues that need to be resolved is the asset valuation of frequently hard to value assets, such as private investments. At the time of divorce, calculating the present value of a private investment, such as a private equity fund, can be particularly challenging because there may be continuing capital requirements, supernormal returns upon exit, early redemption discounts, and potential tax consequences during the term of the investment. Couples should consider these issues with their legal and tax advisors. Prior to agreeing to the distribution of these assets, legal and tax advisors may require an analysis that extends beyond the amount of the initial investment.
The analysis may begin with an examination of information gathered, including the distribution schedule, current stage of investments, past performance of the fund manager and the performance of similar funds. The process should include the review of subscription agreements, the private placement offering memorandum and the limited partnership agreement (the LPA), all contributions and distributions made by and to the investor since inception as well as the most recent quarterly net asset value. Depending on the size of the investor's commitment to the fund, this process may include a conversation with a principal or director of the investment to understand the nature and status of the fund.
In some cases, if a valuation cannot be agreed upon, it may be necessary for one or more independent valuation professional to be engaged. However, this can cost more than the investment is worth (e.g., valuation of an internet start-up company), and the choice of valuation expert can be contentious. In other cases, research and a deep analysis by a valuation expert could result in a more accurate estimate of value as well as a more equitable division of the asset. Clients who desire full liquidity can also investigate pricing levels in secondary exchanges, although they should expect a significant discount to the current net asset value.
Options for separation
Once the valuation analysis has been completed, there are several options for separation and distribution of a private investment. The two most prevalent are the “in-kind” option and the “buy-out” option.
In-Kind-Option: A division of the ownership and transfer of equitable percentages to each spouse “in-kind” depends upon several factors. First, the investment or fund documents must allow division and reregistration of the asset, and the transferee spouse must meet the requirements of new ownership. Second, the transferee spouse must have the financial ability to continue in the fund, which may require additional capital calls depending upon the stage of the investment. The upside to this approach is that a detailed valuation is not needed, and both spouses have the same risk exposure.
Buy-Out-Option: The other common approach is the “buy-out” option, where one spouse retains the entire partnership’s interest and gives an off-setting interest in another asset of the spousal property. This option does not necessarily eliminate the fundamental valuation question; however, it may avoid the complicated path of obtaining a true fair market value.
When effectuating a transfer of the fund, additional thought should be given to non-valuation impacts. It should be expected for a fund administrator to have additional fees for the legal and administrative work required to split and reregister partnership interests.
Tax consequences
Once the partnership interests are transferred, the cost basis in the asset carries over and the spouse retaining the asset is responsible for the gain or loss realized upon the conclusion of the investment. If the asset declines in value, the spouse who retains the investment will have a capital loss to net as a deduction against his or her taxable income (long-term capital gains and/or ordinary income). Future growth that results in a realized gain is taxable to that spouse.
Matrimonial law attorneys may need to factor a change in rates and the deferred income tax liability into the valuation. To be sure, that is a complicated question, and courts take vastly different approaches to whether tax burden should be part of the calculus. Of course, tax policy is continuously debated, and could result in tax rate increases in the future. Additionally, upon the division of assets in a divorce, a basic tax calculation often doesn’t account for the dynamic way that taxes can move over time. Not only are increases to federal capital gains rates a possibility, but state taxes may also rise. For individuals domiciled in states with a state income tax, rates may be as high as 13.3%.
As shown in the example, when a change in the capital gains tax rate is factored into the valuation of the asset, the spouse that inures to the asset nets about $180,000 less with the rate change. This is an important consideration for private equity investments because the holding period for the investment is multiple years, and there is generally no way to liquidate the position earlier.
Next Steps
Dividing up complex investments can be a very complicated process. Working together, matrimonial attorneys, wealth managers and other key advisors can help their divorcing clients devise a plan that allows them to enter the next chapter of their lives with confidence. To learn more about BNY Mellon Wealth Management’s Family Law advisory capabilities, including how an experienced wealth manager can assist in producing a detailed analysis that helps provide clients and their advisors options for separating complex assets such as private investments, please contact your relationship manager or use the Contact Us button.
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