Alimony plus capital calls

Breaking up is hard to do – and for private equity firms it can raise a host of issues when investors in a fund get divorced. It's also something that more firms may have to deal with as the current economic difficulties add extra stress to marriages.

“It's one more sticky issue for a GP to think about and one more complication in their life, which is already complicated enough,” says a former managing director with a private equity firm that has had to deal with a divorcing limited partner. In that instance, the LP became two half-sized LPs who both continued to pay their capital calls separately.

Not every LP divorce works out as neatly. Things can get complicated quickly with issues such as the transfer of a share of an investment to a spouse who was not a party to the partnership agreement. Sherri Caplan, a partner of Debevoise & Plimpton's private investment funds group, says that one of the main concerns when an unfunded commitment is split between two spouses is whether both sides will have the financial resources to continue to satisfy capital calls.

The firm also needs to create separate capital accounts for exspouses, so that a default by one person doesn't lead to a forfeiture of a substantial portion of the joint account.

If the goal is to split the interests so that one spouse is no longer responsible for the funding requirements of the other spouse, the fund sponsor would have to agree to the transfer of the partial interest. This means that fund sponsor would also have to be comfortable with the credit risk of the unfunded portion of the interest's being assigned to the ex-spouse.

“From the sponsor's perspective, if there is a significant unfunded capital commitment, they need to know that both spouses have the resources to continue funding, because that would provide reasonable grounds not to permit the transfer,” Caplan said. “For the investor in the fund, the real issue is about making sure that you don't have the liability in the event the spouse doesn't fund his or her share. You want to transfer the interest so it is no longer your responsibility.”

When GPs divorce
Divorce is even trickier at the GP level as questions involving the transfer of interests in the equity and carry, as well as voting issues, must be addressed. Individual GPs make capital commitments to the fund for which they are liable whether or not the ex-spouse defaults. In many cases, firm management companies only permit a transfer if the original asset holder agrees to guarantee the unfunded portion payable by the former spouse.

In addition, the GP will likely be unwilling to give the ex any say in the business, permitting only a transfer of the economic interests.

If possible it is ideal to keep any residual divorce-related issues out of the decision-making process. As Caplan notes, “You have to keep that kind of static outside of the GP level and work out an arrangement where everybody is happy so that whatever acrimony remains after the divorce doesn't filter down into the business”.

When LP or GP clients are faced with divorce, many lawyers advise trying to find some financial assets to split other than fund interests, due to the potential complications for a sponsor. “Just to get regular LPs to be current enough in this climate is one thing, but when you get locked in with some of these personal-related situations and the emotional issues that get put into the equation it gets very time-consuming,” the former managing director said, adding that additional cost on a manager's time can include having to educate and deal with increased information demands from an ex-spouse with little knowledge of the private equity business.

In order to avoid such difficulties he advises limiting the number of individual investors in a fund. Caplan says that if an ex-spouse does receive an interest in a divorce settlement, making sure there is no funding obligation, and thus risk of non-payment, will help reduce potential headaches for GPs.