For many people, the term “hedge fund” conjures images of Wall Street billionaires and elite investment firms. Although hedge funds may seem mysterious, the divorce issues they create are familiar: determining what property belongs to the marital estate, what constitutes future income, and how to value an asset whose ultimate worth is uncertain.
This article references “hedge funds,” but the compensation structure discussed below is more commonly associated with private equity and venture capital funds. Regardless of the label, the same legal issues arise whenever a spouse has a contractual right to receive a share of a fund’s future profits.
Unlike a traditional salary or bonus, a carried interest may not generate any payment for years. Its value depends on future investment performance, the terms of the governing partnership agreement, and whether the fund generates sufficient profits. So, carried interest often becomes one of the harder assets to classify, value, and divide in an Illinois divorce.
How Hedge Funds (and Similar Investment Funds) Actually Work
To understand how carried interest works, it is first necessary to understand how investment funds are organized.
Black’s Law Dictionary defines a hedge fund as “a specialized investment group usually organized as a limited partnership.” Black’s Law Dictionary (11th ed. 2019). This definition reflects the structure of most investment funds talked about in this article, where limited partners contribute capital while general partners manage the fund.
Most investment funds consist of two main groups:
Limited Partners (LPs) contribute most of the investment capital but generally do not participate in the fund’s day-to-day management.
General Partners (GPs) manage the fund. They oversee portfolio companies, discover investment opportunities, negotiate acquisitions and sales, and make decisions meant to increase the fund’s value.
The general partner is usually compensated in two different ways.
Management Fees
First, the general partner receives an annual management fee. This is generally calculated as a percentage of the assets under management. Unlike carried interest, the management fee is dependable; it is earned regardless of whether the fund ultimately performs well. Management fees function a lot like ordinary compensation for managing the business.
In an Illinois divorce, management fees are typically treated as income.
Carried Interest
Second, the general partner can receive a carried interest, which is sometimes referred to as a profits interest.
Black’s Law Dictionary defines carried interest as “the share of any profits produced by a partnership’s investment, paid to a general partner as compensation for managing the investments…the partner’s interest is ‘carried’ with the property until it is liquidated.” Black’s Law Dictionary (11th ed. 2019).
Carried interest is not guaranteed compensation. Rather, it is a contractual right to receive a percentage of the fund’s investment profits after investors recover their invested capital and any required preferred return (also known as a “hurdle rate”). Once those obligations are satisfied, the general partner participates in the remaining profits under the fund’s distribution agreement. It is intended to align the general partner’s interests with the limited partners’ interests.
Because carried interest combines characteristics of compensation for services and an ownership interest in future profits, it can be difficult to address in a divorce.
Why Carried Interest Is Different
Carried interest is often called a single asset. However, it is better understood as a bundle of contractual rights whose value depends on multiple contractual and economic conditions. It may never produce a payment at all. Several features distinguish carried interest from more traditional marital assets.
Hurdle Rates
Most carried interest arrangements require investors to first recover their invested capital and receive a minimum rate of return, also known as the preferred return or hurdle rate. Once that threshold has been satisfied, the general partner begins to share in the remaining profits.
Distribution Waterfalls
Even after the hurdle rate has been met, distributions do not occur at the same time. Partnership agreements usually establish a distribution waterfall that determines the order in which profits are allocated among managers and investors. Although every partnership agreement is unique, a waterfall generally proceeds in four stages:
- Return investors’ contributed capital.
- Pay investors their preferred return.
- Allow the general partner to “catch up” by receiving an agreed-upon portion of profits.
- Divide all remaining profits according to the carried-interest percentages established in the partnership agreement.
Because every fund has its own waterfall provisions, two carried interests that appear identical may have completely different economic values.
Vesting and Future Services
Many partnership agreements require the general partner to stay with the fund for a certain period before fully earning the carried interest. Sometimes, agreements condition distributions on continued management of the fund or successful completion of future investment exits.
Consequently, carried interest may reflect work already performed during the marriage, as well as services that will not occur until years after the divorce. This is a reason why Illinois courts may struggle to determine what portion, if any, should be treated as marital property.
Clawback Provisions
Even distributions that have already been paid are not always final. Some partnership agreements contain clawback provisions that require the general partner to repay previously distributed profits if later investments perform poorly or investors receive less than the agreement guarantees. Today’s distribution may not represent the fund manager’s final economic benefit.
Partnership Agreement
These rights are often defined by the fund’s partnership agreement. The partnership agreement likely governs when carried interest vests, when it is distributed, whether previously distributed profits may be clawed back, and whether the carried interest may be transferred. Thus, two carried interests that seem identical may be subject to completely different rights, restrictions, and payment schedules.
Carried interest rarely fits neatly into traditional categories of property or income. The next question then becomes how Illinois courts should classify and divide such an unusual asset.
Is Carried Interest Marital Property in Illinois?
Currently, Illinois courts have not addressed whether carried interest should be classified as marital property. Still, the Illinois Marriage and Dissolution of Marriage Act contains a framework that can analyze the issue.
Section 503(a) states that “‘marital property’ means all property, including debts and other obligations, acquired by either spouse subsequent to the marriage,” unless it falls within one of the statute’s enumerated exceptions. 750 ILCS 5/503(a). Applying this principle to carried interest is not straightforward because the first question becomes: When is a carried interest actually acquired?
Carried interest is often earned over an extended period. It may compensate a fund manager for services already performed, reward future investment performance, encourage continued management, or accomplish all three objectives at once. So, the economic value of a carried interest reflects both marital and post-marital efforts in many cases.
Illinois law further recognizes that not every employment-related benefit fits squarely into the categories of either marital or nonmarital property. For instance, Section 503(b)(3) specifically provides that “all stock options and restricted stock or similar form of benefit … whether vested or non-vested or whether their value is ascertainable, are presumed to be marital property.” The statute also tells courts to consider “all circumstances underlying the grant,” which includes the vesting schedule, “whether the grant was for past, present, or future efforts,” and whether it was meant to promote future performance or continued employment. 750 ILCS 5/503(b)(3).
Carried interest is not explicitly addressed in Section 503, but the statutory framework provides a useful analogy. Like stock options, carried interest can serve multiple purposes simultaneously. Part of the interest may reward work already completed during the marriage, whereas another part may work as an incentive for the fund manager to stay with the fund and continue creating value after the parties separate. Thus, the proper classification of carried interest may depend less on whether distributions have been received than on the purpose the carried interest was meant to serve.
In re Marriage of Hunt Provides the Closest Illinois Analogy
Although Illinois has not addressed carried interest directly, it has addressed similar questions involving deferred compensation. The leading decision is In re Marriage of Hunt, 78 Ill. App. 3d 653 (1st Dist. 1979).
In Hunt, the appellate court considered whether an employee’s pension and profit-sharing interests constituted marital property even though portions of the benefits had not yet matured or vested. The court rejected the argument that uncertain future benefits were simply expectancies. Id. at 658-62.
Rather, the court held that “[a]n employee spouse’s contractual right to a pension or profit-sharing interest is ‘property’ under section 503 of the Illinois Marriage and Dissolution of Marriage Act . . . regardless of whether the interest is matured, vested or nonvested, or contributory or noncontributory.” Id. at 659.
The court further explained that “[a]ny part of such pension or profit-sharing interest earned by the employee spouse while married is property ‘acquired’ during marriage . . . and is, therefore, marital property.” Id.
The court also rejected the notion that valuation uncertainty prevents an asset from being marital property, reasoning that “difficulties in valuation are not an insurmountable barrier to including a pension or profit-sharing interest . . . as marital property.” Id. at 663.
That principle is especially relevant to carried interest. Its ultimate value may remain uncertain or may never result in a distribution, but that uncertainty does not automatically prevent the underlying contractual right from constituting marital property. See id. at 659, 663.
Although Hunt involved pension and profit-sharing plans rather than carried interest, its reasoning suggests that Illinois courts may analyze carried interest as another form of deferred compensation. See id. Thus, Hunt supports treating a carried interest as property even when payment remains contingent and its value is uncertain.
Valuing Carried Interest
Determining that carried interest constitutes marital property answers only part of the problem. The next question is: What is the interest actually worth?
Unlike publicly traded securities, carried interest usually has no readily ascertainable market value. Its worth depends upon variables like future investment performance, the hurdle rate, the distribution waterfall, vesting requirements, future investment exits, continued employment, clawback provisions, and the terms of the partnership agreement. Many of these variables can remain uncertain for years, so a carried interest that appears valuable today may end up producing little or no economic benefit.
Under the Illinois Marriage and Dissolution of Marriage Act, when dividing marital property, “the court shall value the property as of the date of trial or some other date as close to the date of trial as is practicable.” 750 ILCS 5/503(f).
Valuation may be difficult, but Hunt identifies two methods for addressing deferred compensation.
First, there is the present-value method. With this approach, the Illinois court determines the present value of the deferred compensation, awards the interest to the employee spouse, and awards the nonemployee spouse other marital property to offset that spouse’s share. Hunt, 78 Ill. App. 3d at 663.
Applying that method to carried interest likely requires a valuation expert. An approach commonly proposed is a discounted cash flow (“DCF”) analysis. Under a DCF analysis, the expert projects future fund profits, estimates the portion expected to be distributed to the general partner, and discounts those estimated payments to present value.
Yet, a DCF analysis depends a lot on assumptions concerning fund appreciation, compensation, discount rates, future investment performance, continued employment, exit timing, and other uncertain variables. Different assumptions can produce completely different conclusions regarding value.
Second, there is the “if, as and when” method. When present valuation is too speculative, or when insufficient marital assets exist to give an offset, the court may reserve jurisdiction and divide future payments if, as, and when they are received. Id. at 663-64.
Those methods may be appropriate for carried interest, as well. Some carried interests may be sufficiently developed to allow a reliable present-value analysis. Other times, it may depend upon future exits, investment performance, or contractual contingencies that make a present valuation too speculative. In those cases, an “if, as and when” allocation likely better reflects the contingent nature of the asset while allowing each spouse to share proportionately in future distributions.
So, careful review of the governing agreement and an expert financial analysis will usually be indispensable in an Illinois divorce involving carried interest.
How Can Carried Interest Be Divided in an Illinois Divorce?
The court must decide how to divide carried interest once it has been classified and valued. The partnership agreement often limits the available options, as carried interests are commonly subject to transfer restrictions. Consequently, a non-partner spouse may be unable to receive the carried interest, even if part of it is marital property. Rather, the court may need to award other marital property, cash, or a right to receive a portion of future distributions.
Immediate Offset or Buyout
One option is to use immediate offset or buyout. Under this approach, the court awards the carried interest to the partner spouse and gives the non-partner spouse other marital property or cash equal to that spouse’s share of its present value.
Offset or buyout lets the parties make a clean financial break, and it leaves the partner spouse in control of the fund interest. It does, however, depend upon the court’s ability to determine a sufficiently reliable present value. This approach also can cause liquidity problems because the partner spouse may need to pay for an asset that has not yet generated any cash.
Deferred “If, As, and When” Distribution
A second option is to try deferred sharing. Under this approach, the partner spouse retains the carried interest but is required to pay the non-partner spouse an agreed or court-ordered percentage of future distributions “if, as and when” they are received.
As discussed above, the Hunt court explained that, when present valuation is impractical or sufficient offsetting property is unavailable, the trial court can award each spouse an appropriate percentage of the benefit payable “if, as and when” it becomes payable. Id.
Deferred sharing avoids forcing the court to predict future fund performance. It also lets both spouses share in the actual success or failure of the carried interest.
On the other hand, it maintains financial ties between the former spouses, potentially for a long time. The partner spouse continues to control the interest, while the non-partner spouse may have little control over the decisions affecting payment.
As a result, any deferred-sharing order needs to clearly address the percentage to be paid, taxes, clawbacks, reporting obligations, notice of distributions, access to supporting records, and the treatment of later amendments to the partnership agreement.
Structured Buyout Payments
A third option is to use a structured buyout. Under this approach, the parties agree upon a value for the non-partner spouse’s share, and the partner spouse pays that amount over time instead of immediately.
This approach may reduce the liquidity problem created by an immediate buyout. It can also be scheduled around anticipated fund exits or distributions.
Still, the non-partner spouse bears the risk that the partner spouse may default. Thus, the agreement or judgment may need enforcement protections.
Option-Pricing Models
A fourth option is to use an option-pricing model. This approach uses sophisticated financial models to determine the value of carried interest by modeling it as a series of European call options that are tied to the fund’s future profits.
Because they are designed to value option-like rights, option-pricing models may better account for the contingent nature of carried interest than a discounted cash flow analysis.
However, this approach is much more complex than other valuation methods and depends upon many assumptions, such as discount rates, future volatility, and expected fund performance. Consequently, experts may reach much different conclusions depending upon the methodology and assumptions used.
No single method works for all cases. The best approach depends upon the liquidity of the marital estate, the reliability of the valuation evidence, the transfer restrictions in the partnership agreement, and the parties’ willingness to stay financially connected after the divorce.
Calculating the Marital Portion of Carried Interest
Even if carried interest is property, the entire interest may not be marital. Part of the carry may reflect efforts performed during the marriage. Another part may depend upon services performed after the marriage is over.
Although Illinois has not adopted a specific formula for apportioning carried interest, Section 503(b)(3) tells courts addressing stock options, restricted stock, and similar employment benefits to consider “whether the grant was for past, present, or future efforts,” whether it was intended to promote future performance or employment, and the applicable vesting schedule. 750 ILCS 5/503(b)(3).
In England, however, a court addressed this problem directly in A v. M, [2021] EWFC 89. The husband argued that carried interest was an earned bonus, and the wife characterized it as a return on capital investment; the court held that carried interest was a “hybrid resource” and not exclusively one or the other. A v. M, [2021] EWFC 89, ¶ 10.
The court calculated the marital portion linearly over time: “For each fund the marital, and therefore shareable, element of the carry should be calculated linearly over time.” Id. at ¶ 15.
Let’s break that down. The formula may be summarized as: A ÷ B = C
A represents the amount of time when the fund and the marriage overlapped.
B represents the total projected time when the work necessary to generate the carried interest would be performed.
C represents the marital fraction of the carried interest.
Then, the projected value of the carry is multiplied by the marital fraction to determine the portion attributable to the marriage. Id.
This formula assumes the effort required to generate carried interest happens evenly over the fund’s life. However, that assumption may not reflect reality every time. The partner spouse could argue the most important value-producing work happened after separation, such as improving portfolio companies. The non-partner spouse could argue the fund’s formation and development during the marriage created most of the eventual value.
In all, A v. M gives a useful framework, but it does not provide anything binding in Illinois. An Illinois court could instead evaluate the fund’s lifecycle, the purpose and terms of the grant, the vesting schedule, the timing of the spouse’s services, and the extent to which post-marital labor stays necessary to create future distributions. See 750 ILCS 5/503(b)(3).
Importantly, the governing partnership agreement and evidence concerning the fund manager’s actual responsibilities will be vital. A purely time-based formula can be appropriate when effort is spread reasonably throughout the fund’s life. However, if value creation is concentrated in particular stages, a court likely will need a more fact-specific allocation between marital efforts and post-marital services.
Discovery in a Divorce Involving Carried Interest
Carried-interest disputes often turn on information before valuation. The relevant financial and contractual records may not be readily available, which means the non-partner spouse may need formal discovery to determine what interests exist, how they are structured, and whether they have value.
The governing partnership agreement should be obtained early, as it may control the carried-interest percentage, vesting schedule, hurdle rate, distribution waterfall, forfeiture provisions, transfer restrictions, clawback obligations, and rights upon termination. Side letters, amendments, and individual award agreements may alter those terms.
Additionally, discovery should identify each relevant entity. The fund, general partner, management company, and partner spouse may possess different rights, receive different revenue, and keep separate records.
Delayed or incomplete production may force valuation experts to rely on assumptions without sufficient time to investigate discrepancies. If the expert is involved early, it helps identify necessary documents, it better tailors requests and subpoenas, and it also determines whether further depositions or motions to compel are required.
Even though fund documents can contain sensitive information, those concerns can typically be addressed through a protective order.
A carried-interest valuation is only as reliable as the information given to the expert. Absent the governing agreements, current financial records, and a good understanding of the fund structure, even a sophisticated valuation method can produce an unreliable result.
Can a Spouse Dissipate Carried Interest?
A partner spouse may have a lot of control over the circumstances that affect carried interest. That control creates a concern that the partner spouse could intentionally forfeit, reduce, or interfere with a marital carried-interest interest to prevent the other spouse from sharing in it.
Section 503(d)(2) of the Illinois Marriage and Dissolution of Marriage Act requires a court dividing marital property to consider “the dissipation by each party of the marital property.” 750 ILCS 5/503(d)(2).
The Illinois Supreme Court defines dissipation as the “use of marital property for the sole benefit of one of the spouses for a purpose unrelated to the marriage at a time that the marriage is undergoing an irreconcilable breakdown.” In re Marriage of O’Neill, 138 Ill. 2d 487, 497 (1990).
A spouse does not necessarily have to receive a direct financial benefit for conduct to be considered dissipation. As the appellate court explained, “[a] spouse may dissipate marital assets even though he or she derives no personal benefit from the dissipation.” In re Marriage of Thomas, 239 Ill. App. 3d 992, 995 (3d Dist. 1993).
Deliberately manipulating distributions, abandoning the interest, or failing to meet vesting conditions might support a dissipation claim, even if the conduct also harms the partner spouse.
However, poor fund performance, legitimate employment changes, ordinary business risk, or a good-faith departure do not necessarily constitute dissipation. It depends on whether the partner spouse improperly or intentionally reduced marital property during the marriage’s irreconcilable breakdown.
Internal communications, employment records, distribution records, partnership amendments, and forfeiture documents can help determine the difference between normal business losses from an effort to deprive the marital estate of value.
Can Carried Interest Be Both Marital Property and Income?
Let’s say carried interest has been classified and divided as marital property. Another question may actually still arise: Can future carried-interest distributions also be considered income for purposes of maintenance or child support?
Illinois courts have recognized concerns about what is commonly known as “double dipping,” which is counting the same economic interest once as marital property and then again as income. In In re Marriage of Eberhardt, the appellate court discussed the concept, stating that commentators use the phrase “‘double dipping’ to describe the seeming injustice that occurs when property is awarded to one spouse in an equitable distribution of marital assets and is then also considered as a source of income for purposes of imposing support obligations.” 387 Ill. App. 3d 226, 233 (1st Dist. 2008) (quoting Croak v. Bergeron, 67 Mass. App. Ct. 750, 758-59 (2006)).
Yet, the court did not adopt a categorical prohibition against double counting. Rather, it stated that “the judge must look to the equities of the situation.” Id. at 233 (quoting Croak, 67 Mass. App. Ct. at 759). Ultimately, the court affirmed the trial court’s consideration of the disputed retirement-account distributions under the facts presented. Id. at 231-34.
When future carried-interest distributions are received after the divorce, these principles may matter. If the carried interest has already been valued and divided as marital property, a court may need to determine whether later distributions just represent realization of that previously divided asset or instead reflect new compensation earned through post-dissolution services. That answer may impact whether treating those distributions as income would result in unfair double counting.
Carried interest can certainly reflect deferred compensation and future labor, meaning that Illinois courts will likely have to distinguish between distributions attributable to the marital asset already divided and distributions attributable to post-divorce efforts.
The Bottom Line On Hedge Funds, Carried Interest And Divorce In Illinois
Carried interest is one of the more complex property issues that may arise in an Illinois divorce. Its value depends upon continued employment, future investment performance, vesting requirements, contractual restrictions, and many other provisions contained within the governing partnership agreement. Thus, figuring out whether carried interest is marital property, how much of it is marital, how it should be valued, and how it should be divided requires careful analysis.
Although Illinois courts have not addressed carried interest directly, current Illinois authority provides a helpful framework. Ultimately, every carried-interest case turns on its own facts. As hedge funds, private equity funds, and other investment vehicles become even more common, Illinois courts will have to confront these issues with more frequency. When that happens, the principles embedded in Illinois marital-property law provide Illinois courts with a solid framework for classifying, valuing, and dividing carried interest in future divorce cases.
Russell D. Knight is a Chicago divorce and family law attorney with more than 19 years of experience representing clients in complex Illinois divorce matters, including cases involving high-net-worth marital estates, business interests, deferred compensation, and difficult-to-value financial assets. His practice focuses exclusively on divorce and family law in Illinois and Florida.
CASES, STATUTES, AND OTHER SOURCES REFERENCED IN THE HEDGE FUNDS, CARRIED INTEREST, AND DIVORCE IN ILLINOIS ARTICLE
750 ILCS 5/503(a) — Definition And Classification Of Marital Property
750 ILCS 5/503(b)(3) — Stock Options, Restricted Stock, And Similar Employment Benefits
750 ILCS 5/503(d)(2) — Dissipation Of Marital Property
750 ILCS 5/503(f) — Valuation Date For Marital And Nonmarital Property
26 U.S.C. § 1061 — Partnership Interests Held In Connection With The Performance Of Services
In re Marriage of Hunt, 78 Ill. App. 3d 653 (1st Dist. 1979)
In re Marriage of O’Neill, 138 Ill. 2d 487 (1990)
In re Marriage of Thomas, 239 Ill. App. 3d 992 (3d Dist. 1993)
In re Marriage of Eberhardt, 387 Ill. App. 3d 226 (1st Dist. 2008)
Croak v. Bergeron, 67 Mass. App. Ct. 750 (2006)
Black’s Law Dictionary (11th ed. 2019)
FREQUENTLY ASKED QUESTIONS ABOUT HEDGE FUNDS, CARRIED INTEREST, AND DIVORCE IN ILLINOIS
Is carried interest marital property in an Illinois divorce? It may be. Illinois courts have not directly addressed carried interest, but Illinois law typically presumes that property acquired during the marriage is marital property. A court can examine when the carried interest was granted, what services it was intended to reward, its vesting schedule, and whether it compensates work performed during or after the marriage.
Does carried interest have to be vested to qualify as marital property? Not necessarily. Illinois courts have recognized that contractual rights to deferred compensation can constitute marital property, even when they are unvested, contingent, or hard to value. The question may need to be when and why the interest was earned instead of whether it has already vested or produced a payment.
Is the entire carried interest marital property? Not every time. Some of the interest may compensate for work performed during the marriage. Another portion may depend upon services performed after the marriage ends. The court may have to apportion the interest based on the purpose of the grant, the fund’s lifecycle, the vesting schedule, and the timing of the spouse’s services.
How is carried interest valued in an Illinois divorce? Carried interest might be valued through a present-value analysis. However, if the value is too speculative, a court might instead divide future distributions “if, as and when” they are received. The method depends on the fund’s performance, waterfall, hurdle rate, vesting terms, clawback provisions, and other contractual conditions.
Can my spouse receive part of the carried interest directly? Maybe not because partnership agreements often prohibit transfers to non-partners. If a direct transfer is unavailable, the court may award the non-partner spouse other marital property, cash, structured payments, or a percentage of future distributions.
