When high net worth couples divorce, private equity investments often represent some of the most valuable—and most complex—assets to divide. Unlike publicly traded stocks with transparent daily pricing, private equity holdings involve illiquid investments, uncertain valuations, extended time horizons, and intricate fee structures that can dramatically affect what these assets are actually worth to divorcing spouses.
If you or your spouse holds private equity investments, whether as a fund manager with carried interest or as a limited partner investor, understanding how these assets are treated in divorce is essential to protecting your financial future.
What Is Private Equity?
Private equity involves investment in private companies not traded on public exchanges. Private equity firms raise capital from institutional investors and wealthy individuals, then invest that capital in private companies, typically seeking to improve operations and eventually sell at a profit.
Common private equity structures include:
Leveraged buyouts (LBOs): Acquiring established companies, often using significant debt financing, with plans to improve performance and sell within 3-7 years.
Growth equity: Investing in mature companies needing capital for expansion, typically taking minority stakes.
Venture capital: Investing in early-stage, high-growth potential companies, accepting high risk for potentially extraordinary returns.
Distressed debt: Buying debt of troubled companies at discounts, potentially converting to equity through restructuring.
For divorcing couples, private equity exposure typically comes in two forms: carried interest (if one spouse works for a private equity firm and receives a share of fund profits) or limited partnership interests (if the couple invested as fund LPs). Each creates distinct divorce complications.
The Carried Interest Complication
Carried interest—commonly called “carry”—represents the general partner’s share of fund profits, typically 20% of gains after investors receive their preferred return. For private equity professionals, carry often constitutes the majority of total compensation and can be worth millions or tens of millions of dollars.
The divorce challenges with carried interest include:
Valuation uncertainty: Carry value depends on future fund performance, which is inherently speculative. A fund that looks promising today might ultimately underperform, making current carry worth less—or nothing.
Vesting schedules: Carry typically vests over time, often requiring continued employment. If the private equity professional spouse leaves the firm (whether voluntarily or due to divorce stress), unvested carry may be forfeited.
Clawback provisions: Even distributed carry can be subject to “clawback”—if later fund investments perform poorly, previously distributed carry may need to be returned. This creates contingent liabilities that affect valuation.
Extended time horizons: Private equity funds typically have 10-year lives. Carry earned during marriage may not fully materialize for years after divorce, creating questions about division.
Tax treatment: Carried interest receives favorable capital gains tax treatment under current law (though this remains politically controversial). The after-tax value is what actually matters to divorcing spouses.
Timing manipulation: Private equity professionals might delay distributions or manage timing to reduce apparent carry value during divorce proceedings.
Texas Law on Carried Interest
Texas is a community property state, meaning assets acquired during marriage generally belong equally to both spouses. For carried interest, Texas courts must determine:
Is the carry community or separate property? Carry earned through work performed during marriage is generally community property, while carry attributable to separate property investments or post-divorce work is separate property.
How should unvested carry be valued? Texas courts have grappled with valuing contingent future interests. The general approach involves determining the present value of expected future payments, discounted for risk and time value of money.
What portion of carry is attributable to post-divorce efforts? If a private equity professional continues working after divorce, Texas uses formulas to allocate carry between community property (work during marriage) and separate property (post-divorce work). This often involves variations of the “time rule” used for stock options.
Unlike some states that might treat unvested carry primarily as future income for support calculations, Texas more typically treats it as a divisible asset, valuing and dividing it at divorce. This can result in substantial awards to non-working spouses even for carry that hasn’t vested or been received.
Limited Partnership Interests in Private Equity Funds
When couples invest as LPs in private equity funds, different issues arise:
Capital calls: Private equity funds don’t receive all committed capital upfront. Instead, they “call” capital as investment opportunities arise. At divorce, the couple may have committed $2 million but only funded $1.2 million, with $800,000 in future obligations. How are these unfunded commitments handled?
Illiquidity: LP interests cannot simply be sold on an exchange. Most fund agreements prohibit or severely restrict transfers without general partner consent. This means spouses cannot easily cash out or divide positions.
J-curve effect: Private equity funds typically show negative returns early (as fees are paid and investments made) before later profits materialize. If divorce occurs early in a fund’s life, current value may be negative or minimal even if ultimate returns will be strong.
Distribution timing: Funds distribute capital as investments are sold, which occurs unpredictably over the fund’s life. Divorcing spouses face questions about how to divide future distributions.
Valuation opacity: Unlike public securities, private equity holdings aren’t valued by markets. Fund managers provide periodic valuations, but these are estimates using various methodologies—not definitive market prices.
Commitment periods: Fund agreements often prohibit withdrawals during commitment periods (typically 5-10 years). Spouses cannot simply withdraw their share.
Valuation Methodologies for Private Equity in Divorce
Several approaches are used to value private equity holdings:
Net Asset Value (NAV): The fund’s most recent reported NAV provides a starting point. This represents the estimated value of fund holdings minus liabilities, divided among investors. However, NAV has limitations: it’s backward-looking (often 3-6 months old), based on estimates rather than actual transactions, doesn’t account for future management fees, and doesn’t reflect lack of marketability or control.
Discounted Cash Flow (DCF): Projects future distributions from the fund and discounts to present value using an appropriate discount rate. This requires assumptions about investment performance, exit timing, and appropriate discount rates—all highly uncertain.
Comparable Transaction Method: Examines sales of similar fund interests in secondary markets. However, comparable transactions are rare, secondary market pricing reflects distressed sales, and each fund’s characteristics differ significantly.
Marketability Discounts: Even after determining base value, substantial discounts (often 20-40% or more) are typically applied to reflect illiquidity. A $1 million NAV might be valued at $600,000-$800,000 accounting for lack of marketability.
Option Pricing Models: Some experts use option pricing techniques to value carry and other contingent interests, treating them as call options on fund performance.
Texas courts generally allow expert testimony on these valuation methods but scrutinize aggressive assumptions. The burden is on the party claiming value (typically the non-investor spouse) to establish credible valuation through qualified experts.
The Timing Challenge
Private equity creates significant timing issues in divorce:
Investment stage: Funds at different stages present different challenges. Early-stage funds may have minimal current value but significant potential. Late-stage funds approaching liquidity have more certain but potentially lower remaining upside.
Exit events: If major exits (sales of fund investments) are anticipated soon after divorce, settlement timing becomes strategic. Waiting could provide clarity but also delay resolution.
Market conditions: Private equity values fluctuate with market conditions. The same fund interest worth $3 million in strong markets might be worth $2 million during downturns.
Filing strategy: In Texas, community property typically includes assets acquired through the date of divorce (or sometimes separation). When divorce is filed relative to fund distributions or exits can significantly impact division.
Division Strategies for Private Equity Assets
Several approaches can be used to divide private equity holdings:
Immediate buyout: One spouse keeps the private equity interest and compensates the other with cash or other assets equal to half the present value. This requires substantial liquidity and agreement on valuation but provides clean separation.
Deferred distribution: The couple agrees to divide future distributions as received, often 50/50. This defers valuation questions but maintains financial entanglement for years. The agreement should specify: what percentage each spouse receives, how long the arrangement continues, whether it survives remarriage or death, how expenses like capital calls are handled, and who makes decisions about fund matters.
If/as/when received approach: Similar to deferred distribution but specifically ties division to actual receipt. “Wife receives 50% of all distributions from the ABC Fund if, as, and when received by Husband, for the life of the fund.”
Hybrid approaches: Combining immediate payment for vested/certain value with deferred sharing of speculative future value. For example, wife receives $500,000 now plus 25% of carry distributions over $1 million received in the next five years.
Offsetting assets: The private equity holder keeps the full interest while the other spouse receives a greater share of liquid assets. This requires other substantial assets and agreement that the offset is fair.
Texas-Specific Considerations
Texas community property law creates specific considerations for private equity division:
Characterization focus: Texas law emphasizes correctly characterizing property as community or separate. For private equity, this requires tracing whether: investments were made with community funds (during marriage) or separate funds (pre-marriage or inherited), work generating carry occurred during or after marriage, and whether separate property investments appreciated due to community labor or time.
Reimbursement claims: If separate property was used to make private equity investments that benefited the community, or vice versa, reimbursement claims may arise. These can be complex with commingled investment accounts.
Inception of title: Texas uses “inception of title” rules—property character is generally determined when acquired. A private equity investment made with community funds remains community property even if it appreciates after separation (though post-separation appreciation may be argued as separate in some circumstances).
No mandatory 50/50 split: While community property is jointly owned, Texas allows “just and right” division, which need not be exactly equal. Courts can award one spouse more than 50% based on factors like fault, earning capacity, education, health, and size of separate estates.
Discovery tools: Texas provides robust discovery tools for uncovering and valuing private equity interests. Spouses can subpoena fund documents, depose fund managers, and require detailed financial disclosure.
Tax Implications
Private equity division involves significant tax considerations:
Section 1041 transfers: Transfers between spouses incident to divorce are generally tax-free. However, this doesn’t eliminate tax liability—it transfers tax basis to the receiving spouse, who will pay taxes when ultimately selling or receiving distributions.
Carried interest taxation: Carry receives capital gains treatment (currently 20% federal rate plus 3.8% net investment income tax). This favorable treatment continues post-divorce, but only if the holding period and other requirements are met.
Partnership allocations: If one spouse receives LP interests in divorce, they’ll receive K-1s reporting their share of partnership income, gains, and losses—even if no cash is distributed. This can create “phantom income” tax obligations without cash to pay the tax.
State tax considerations: Texas has no state income tax, which is advantageous for carry recipients. However, if a spouse moves to a high-tax state post-divorce, they may face substantial state taxes on distributions.
Alternative Minimum Tax (AMT): Certain private equity investments can trigger AMT, affecting overall tax burdens.
Estate tax planning: Large private equity holdings may have estate tax implications that should inform how assets are divided.
Proper tax planning is essential. The after-tax value of private equity interests can differ dramatically from pre-tax value, and settlement structures should account for who bears future tax liabilities.
Conflicts of Interest and Disclosure Issues
Private equity creates unique disclosure challenges:
Confidentiality restrictions: Fund agreements typically impose strict confidentiality. The investor spouse may claim they legally cannot share detailed fund information with their divorcing spouse or the court.
Resolution: Courts can issue protective orders allowing disclosure under confidentiality restrictions. Fund managers must typically comply with court orders even if agreements restrict disclosure.
Conflicts for fund managers: Private equity professionals owe fiduciary duties to fund investors. Divorce disputes can create conflicts between personal interests and fiduciary obligations.
Hidden interests: Private equity professionals sometimes have side interests or co-investment opportunities not fully disclosed on regular fund reports. Thorough discovery is essential.
Valuation manipulation: Fund managers have some discretion in valuing portfolio companies. A manager facing divorce might undervalue holdings, though this also harms other investors and could breach fiduciary duties.
Strategic Considerations for Private Equity Professionals
If you work in private equity and face divorce:
Understand your fund agreements thoroughly. Vesting schedules, clawback provisions, and transfer restrictions all affect your position.
Don’t manipulate distributions or timing. Courts can see through attempts to defer distributions or minimize apparent value, and such tactics may constitute fraud.
Consider clean buyout if possible. Maintaining financial entanglement with an ex-spouse for 5-10 years through deferred distributions is often more trouble than it’s worth.
Evaluate employment implications. Divorce stress can affect job performance in demanding private equity roles. Consider whether you might leave the firm voluntarily or involuntarily, and how that would affect unvested carry.
Plan for taxes. Carry distributions can create enormous tax obligations. If you’re paying your ex-spouse 50% of distributions, ensure you reserve enough for taxes on your share.
Document separate property carefully. If you brought pre-marriage carry or separate property investments into the marriage, clear documentation is essential to avoiding characterization disputes.
Strategic Considerations for Spouses of Private Equity Professionals
If your spouse works in private equity or you have significant PE investments:
Engage qualified experts early. Private equity valuation requires specialized expertise. Don’t rely on generalists who lack PE experience.
Don’t accept blanket assertions that unvested carry is worthless. While future performance is uncertain, unvested carry often has substantial present value that should be divided or offset.
Understand clawback risks. If settlement involves receiving future distributions, recognize you may have to return money if fund performance deteriorates. Structure agreements to account for this possibility.
Consider tax implications of different settlement structures. Receiving non-PE assets instead of PE interests may be preferable to avoid complexity and tax uncertainty.
Investigate thoroughly. PE professionals often have co-investment opportunities, management fee income, transaction fees, and other compensation beyond salary and carry. Ensure discovery addresses all potential value sources.
Don’t wait too long. If major exit events or distributions are imminent, timing the divorce relative to these events can significantly impact settlement value.
The Secondary Market Option
One increasingly common strategy involves secondary market sales:
Private equity secondary markets allow investors to sell fund interests before maturity. While historically illiquid, these markets have grown substantially. In divorce, selling PE interests on secondary markets can provide:
Liquidity: Converting illiquid holdings to cash that’s easier to divide.
Price discovery: Secondary market transactions establish actual market values, eliminating valuation disputes.
Clean break: Avoiding extended financial entanglement through deferred distribution arrangements.
However, secondary sales typically occur at substantial discounts (often 20-40% below NAV) to compensate buyers for illiquidity and uncertainty. The couple must weigh the value of certainty and liquidity against the cost of discounted sales.
Some divorce settlements include provisions allowing but not requiring secondary sales—if the parties can’t agree on value or division, either can trigger a sale and split proceeds.
Case Study: The Carry Complication
A real-world scenario illustrates the challenges:
The situation: Husband is a partner at a private equity firm. During the 10-year marriage, he earned salary averaging $400,000 annually, but his significant wealth came from carry. He has vested carry in Fund I worth approximately $3 million (based on current NAV) and unvested carry in Fund II that could be worth $5-10 million if the fund performs well, though it won’t fully vest for another five years.
The husband’s position: Husband argues that Fund I carry should be valued at a significant discount (40-50%) because it’s illiquid and contingent on future exits. Fund II carry, he claims, should not be divided at all because it’s unvested and he might not receive it if he leaves the firm or the fund underperforms.
The wife’s position: Wife argues that Fund I carry should be valued at minimal discount (10-15%) because exits are imminent and value is reasonably certain. Fund II carry, though unvested, has substantial present value and represents compensation for work performed during marriage, making it community property that should be divided.
The resolution: After expert testimony, the court in Texas determined that:
- Fund I carry should be valued at 25% discount to NAV, reflecting moderate illiquidity but reasonable value certainty
- Fund II carry should be valued using discounted cash flow projections with 40% marketability discount and divided 50/50, but the actual payment to wife would occur “if, as, and when received” by husband
- Wife received other liquid assets (retirement accounts, real estate equity) to provide immediate funds rather than waiting years for all carry to materialize
- Agreement included provisions addressing clawback—if husband had to return distributions due to clawback, wife’s corresponding payment obligations would be reduced proportionally
The outcome: Wife ultimately received approximately $2.2 million in immediate liquid assets plus the right to receive 50% of future Fund II distributions up to a cap of $2.5 million. Husband retained his carry interests and career but compensated wife fairly for value built during marriage.
The Key Takeaway
Private equity ownership creates some of the most complex asset division issues in high net worth divorce. The combination of illiquidity, valuation uncertainty, extended time horizons, intricate fee structures, tax complexity, and potential conflicts makes these assets dramatically different from traditional stocks, bonds, or real estate.
In Texas, the community property framework means that private equity value built during marriage belongs equally to both spouses, regardless of who worked in private equity or whose name appears on fund documents. However, actually implementing that principle through fair valuation and practical division requires sophisticated expertise and often creative settlement structures.
Whether you’re the private equity professional or spouse of one, early engagement with attorneys experienced in complex financial divorces and valuation experts specifically knowledgeable about private equity is essential. The difference between proper and improper handling of private equity assets in divorce can easily amount to millions of dollars.
Don’t approach private equity division using strategies that work for simpler assets. The unique characteristics of these investments demand specialized expertise and customized solutions.
Additional Questions
If you have additional questions, please contact us by telephone at 832-538-0833 to schedule an appointment. Our attorneys have deep expertise in handling high-net worth-divorce cases involving private equity.
Legal Disclaimer: This article is for informational purposes only and does not constitute legal advice. Divorce laws vary by state, and every situation is unique. For advice specific to your circumstances, please consult with a qualified attorney in your jurisdiction.