Posted on April 13, 2024

Hedge Funds And Profits Interest In An Illinois Divorce

The term “hedge fund” implies an elite financial institution. In reality, there are more hedge funds than there are Burger Kings.

A hedge fund is “a specialized investment group usually organized as a limited partnership.” Black’s Law Dictionary (11th ed. 2019)

The operators of hedge funds claim to be able to see into the future with great accuracy…yet they get divorced as consistently as the rest of us.

The profits of the hedge funds are divided between the fund owners and the fund operators. The operators of these hedge funds get paid in a very particular way called “profits interest” or “carried interest” which, purportedly, aligns their interests with that of the people whose money they are managing.

Carried interest is “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)

Today, “carried interest” is largely used as a tax term to identify that profits from such carried interests are taxed at the capital gains tax rate. Part of why hedge funds are so lucrative is that they are structured to have payouts years later (at least 3) which reduce the capital gains tax rate even further. 26 U.S.C. § 1061.

This ownership/income derived from hedge funds is more commonly referred to as “profits interest.” Profit interests are inchoate ownership by members and/or employees of the hedge fund that vest upon the sale of that interest.

A hedge fund will be governed by an agreement which specifies that there are limited partners (which is always an entity) who provide all the capital for the firm and a general partner (which is, also, always en entity) who manages the money. The general partner only gets paid if they meet contracted-for goals.

For example, if the fund achieves 10% returns, anything above the 10% return is shared between the limited partners and the general partner. The interest the general partner holds in the excess return is the unvested, unrealized profits interest.

When an employee/owner/member of a general partner in a hedge fund is getting divorced, the unvested profits interest will be paid out months or years in the future…after the divorce is over. Unvested profits interest can be deemed a marital asset by an Illinois divorce court…but it all depends on the written agreement between the general partner and the limited partners.

In fact, the spouse of a hedge fund partner is likely to have signed a consent to also be bound by the hedge fund’s partnership agreement.

Normally, assets which are acquired after a divorce is complete are deemed non-marital assets and, thus, are non-divisible.

“For purposes of distribution of property, all property acquired by either spouse after the marriage and before a judgment of dissolution of marriage or declaration of invalidity of marriage is presumed marital property.” 750 ILCS 5/503(b)

Property earned during the marriage but paid out after the marriage may still be deemed a marital, and thus divisible) asset….whether it is vested or not.

“For purposes of distribution of property under this Section, all stock options and restricted stock or similar form of benefit granted to either spouse after the marriage and before a judgment of dissolution of marriage or legal separation or declaration of invalidity of marriage, whether vested or non-vested or whether their value is ascertainable, are presumed to be marital property.” 750 ILCS 5/503(b)(3)(emphasis mine)

There is literally zero case law in the United States about how to specifically divide a hedge fund’s profits interest in a divorce. In England, however, there is a case which is precisely on point. The English court correctly points out that the carry is marital but there is only a marital portion for when it was earned during the marriage.

“It is [the court’s] decision that for each fund the marital, and therefore shareable, element of the carry should be calculated linearly over time. The calculation will be A ÷ B = C where A is the period (measured in months) from the establishment of the fund to October 2021 (the date of trial); B is the number of months from establishment to first close plus 108 months (i.e. 9 years from first close – see para 12 above); and C is the marital fraction of the husband’s carry, expressed as a percentage. The projected value of the husband’s carry is then multiplied by C to give the marital carry.” A v M [2021] EWFC 89

This English decision dovetails nicely with the Illinois’ law concept that all assets acquired before the actual dissolution of marriage are marital and divisible.

Again, the agreement that created the hedge fund controls how and when the profits interest will be paid out to general partners. That hedge fund agreement may include a vesting schedule which further delays the final pay-out of the profits interest. That vesting language has no impact on the possible marital character of the profits interest.

[A]n employee spouse’s contractual right to a…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” In re Marriage of Hunt, 397 NE 2d 511 – Ill: Appellate Court, 1st Dist. 1979

The hedge fund agreement is likely to include language that forbids the transfer of the profits interest to a non-partner (such as a spouse). This clause remains valid even in divorce court.

“[A] transfer of stock ordered by the court in a marriage dissolution proceeding is an involuntary transfer not prohibited under a corporation’s general restriction against transfers unless the restriction expressly prohibits involuntary transfers.” In re Marriage of Devick, 735 NE 2d 153 – Ill: Appellate Court, 2nd Dist. 2000) (citing In re Marriage of Banach, 489 NE 2d 363 – Ill: Appellate Court, 2nd Dist. 1986)

The solution is for the divorce court to order the hedge fund partner to hold the portion of the profits interest awarded to their former spouse in constructive trust for the benefit of their former spouse. When the finally vested interest is paid out to the hedge fund partner/employee/owner, the hedge fund partner/employee/owner is then obligated to distribute their former spouse’s share.

“[A] constructive trust requires any other party who receives the…proceeds, but who has an inferior equitable right to them, to hold the proceeds solely for the vested beneficiary.” Perkins v. Stuemke, 585 NE 2d 1125 – Ill: Appellate Court, 4th Dist. 1992

One final consideration is that any profits interest deemed marital property cannot later be deemed income for the purposes of child support and/or maintenance.

“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.” In re Marriage of Eberhardt, 387 Ill. App. 3d 226, 232 (Ill. App. Ct. 2008) (citation omitted)

The only counterargument to profits interest being an asset is that the profits interest is not guaranteed. Profits interest could be classified as a mere an expectancy. Expectancies are not deemed marital assets and are, thus, non-divisible.

“In order to be property within the ambit of the [Illinois Marriage and Dissolution of Marriage] Act, “the res must be in the nature of a present property interest, rather than a mere expectancy interest” In re Marriage of Centioli, 781 NE 2d 611 – Ill: Appellate Court, 1st Dist., 4th Div. 2002

“An expectancy…describes the interest of a person who merely forsees that he might receive a future beneficence, such as the interest of an heir apparent or of a beneficiary designated by a living insured who has a right to change the beneficiary.” In re Marriage of Hunt, 397 NE 2d 511 – Ill: Appellate Court, 1st Dist. 1979 (citations and quotes omitted)

The operative word is “might.” The whole point of a contract is to eliminate uncertainty, to eliminate “mights” and guarantee results for specific performance.

A non-guaranteed but nice to have payment to an employee is called a bonus. Bonuses are legitimate mere expectancies.

Profits interest is distinguished from future bonus income because the employer is contractually obligated to pay the general partner if they achieve their investment goals.

“[A] contractual right is not an expectancy but…a form of property [whereas a] bonus is an expectancy and not a property right.” In re Marriage of Wendt, 995 NE 2d 439 – Ill: Appellate Court, 1st Dist., 6th Div. 2013

Should the hedge fund partner do anything to interfere with the profits interest owed to themselves and their spouse that could be deemed a dissipation.

An Illinois divorce court “shall divide the marital property without regard to marital misconduct in just proportions considering all relevant factors, including:

the dissipation by each party of the marital property” 750 ILCS 5/503(d)(2)

“[T]he term “dissipation,” as used in section 503(d)(1) of the Illinois Marriage and Dissolution of Marriage Act, refers to 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, 563 NE 2d 494 – Ill: Supreme Court 1990

A hedge fund partner who is happy to “cut his nose off to spite his face” by not earning profits interest will still be liable for dissipation of marital assets.

“A spouse may dissipate marital assets even though he or she derives no personal benefit from the dissipation.” In re Marriage of Thomas, 608 NE 2d 585 – Ill: Appellate Court, 3rd Dist. 1993

If you or your spouse work in a hedge fund…someone is likely to get paid a LOT of money in the future which will be way past your divorce. Protecting your interest in that money requires understanding how the underlying hedge fund agreement works for the partners, the parties and the divorce court.

To discuss a hedge fund’s profits interest (or whatever that particular fund calls its payouts) with an experienced Illinois divorce attorney, contact my Chicago, Illinois family law firm today.

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Russell Knight

Russell D. Knight has been practicing family law as a Chicago divorce lawyer since 2006. Russell D. Knight amicably resolves tough cases while remaining a strong advocate for his client’s interests.

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