Estate Planning for Principals of Private Equity and Hedge Funds

“Estate Planning for Principals of Private Equity and Hedge Funds,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Natalie Perry, ACTEC Fellow from Chicago, Illinois. ACTEC Fellow Marissa Dungey from Greenwich, Connecticut, will share her thoughts on what principals we’ll need to keep in mind regarding carried interest of private equity and hedge funds. Welcome, Marissa.

Great, thank you, Natalie. I’m happy to be here today to talk about carry planning for hedge funds and private equity principals. My plan is to take you through my approach when I have a client interested in planning with their carried interest. First off, what do I mean when I say “carry planning?” Carried interests, sometimes called a promote or incentive fee, is an interest in the profit earned on someone else’s capital. In a typical hedge fund or private equity structure, third-party investors- or limited partners- will contribute capital to a fund and  the fund will pay a management fee to a management company based on AUM 1% or 2% to cover operating expenses- and then there’s a general partner. The GP receives the incentive fee allocation, for example, 20%  on the profits of the fund, often after a threshold rate of return is achieved for the limited partners. So, from a planning perspective, carry is a really ideal asset to plan with because of the profit’s interest, it’s necessarily not worth much in the beginning, because you haven’t actually earned the profits.

And especially with the potential threshold rate of return, so you have very limited value upfront, but potentially exponential upside. A complicating factor is that the general partner or the principals individually are expected to have skin in the game and invest their own capital. And it’s the existence of these two types of equity that make carry planning complicated because it implicates Section 2701 of the tax code.

2701 applies its own valuation rules to transfers of an interest in a closely held business where there’s more than one type of equity- in this case, capital and carry- from a senior generation family member to a member of that transferrer’s family- typically a child or a trust for the benefit of the child- where the transferor or an applicable family member holds an applicable retained interest after the transfer. That’s kind of a mouthful, break it down quickly. First, the transfer: it’s not just gift planning. It could apply where the transfer is for full and adequate consideration, without taking into account the valuation rules of 2701. So, a sale, for example. This section is aimed at this kind of senior generation family member to a member of the transferrer’s family. The section is aimed at preventing perceived abuses where senior family members are shifting value to junior family members through kind of artificial means. So, certainly not the hedge fund or private equity structure, but nonetheless the section is broad enough to kind of capture that. So, applicable retained interests, what is the interest that you have to hold onto? There are two different types.

Applicable Retained Interests – Extraordinary Payment

One is this extraordinary payment right. And those are kind of like bells and whistles, where the senior generation has, for example, rights to non-cumulative dividends or rights to kind of discretionary that they may or may not exercise, and then in a family context are kind of assumed to not exercise those to benefit the other stakeholders. That’s not really the issue in the fund interest. It’s really this separate idea of a distribution right.

Applicable Retained Interests – Distribution Right

A distribution right is where, just basically, the right to receive distributions with respect to an equity interest. Really broad.  Necessarily includes your right to a profits interest, your right earnings on an equity interest. It only applies where there’s control. So, one,  if you have a principal who owns the general partner, necessarily, you have control. Kind of a given in the fund context, and, interestingly, the way they define “control” basically says more than 50 percent of the capital or profits interest, or any equity interest as a general partner and in a fund context, usually what you have is a general partner.

And so, there is an open question as to whether or not general partner includes just being the general partner or an interest in the general partner, but with that kind of ambiguity out there, because there’s a general partner in the fund context, we assume we’ve met the control requirements. And there are certain things, again, kind of keeping with the idea that these are discretionary rights that a person might have that could easily be shifted to a different interest. There are certain things that are not considered distribution rights.

Not Considered Distribution Rights

Rights to guaranteed payment, mandatory payment rights, this idea of, “You are required to get X,” and that includes in this context, liquidation participation rights. This idea that a distribution right where you can get back your capital is not going be considered a distribution right for these purposes. Remember, what we’re valuing is the value of the distribution rights. That’s the impact of 2701 is, okay, what are the value of the applicable retained interests, or what is the value of the distribution rights? And the consequence of coming under 2701 is that those applicable retained interests, or that distribution right to be valued at zero. In the fund context, if you’re going to make a gift and hold onto a portion of your carry or capital interest to make a gift of it: if your interest that you retain is going to be valued at zero, that could be a substantially larger gift than you’d intended on making in the first instance. So, you really do have to pay attention to 2701 when you’re doing fund planning.

Exceptions to Distribution Rights

There are certain exceptions, ways to plan that we know are not going to trigger 2701 in the fund context. One is the idea of the same class. We know that if you give the same thing that you have and that’s all you have, then we know that you’re not going to get 2701 because you and what you gave are the exact same interest. There’s no way to kind shift value from one interest to the other.

And so, in the fund context, this is usually achieved by using a holding company or family limited partnership or family limited liability company that can hold your carry and your capital in the same vehicle, and then you gift or you do another transfer with respect to the LLC interest. And then conceivably you haven’t actually transferred, you don’t have two different types of equity, you just have one. You have that LLC interest at the top. So, that’s one way that 2701, even though there are multiple equity interests at the bottom, you’re not going to be affected by the valuation rules of 2701.

Proportionate Transfers and Vertical Slice Planning

The other is this concept of proportionate transfers, what we all call a vertical slice exception or vertical slice rule. This idea that if the transfer results in a proportionate reduction of your interest then, we’re not going to apply 2701, because we know if you transfer 20%  of your capital and 20%  of your carry, there’s no way to artificially shift value from one to the other, because the principal continues to own 80%  of his interest in both, the transferee owns 20% of their interest.

If you’re going to shift value from the capital to the carry, then you’re both going to get the same benefit. You’re not shifting value if you do a proportionate interest. And so, vertical slice planning is probably the most common way that people plan with carried interest.

In terms of the types of planning vehicles that you could use, for various reasons, GRATs are often not the planning vehicles. And, they’re a very popular planning vehicle on their own. They often don’t work well in the fund context, and part of the reason for that is that, as you know with GRATs, you can only put in one contribution. You cannot make additional contributions and so if you’re in a new private equity fund, for example, and you’ve made a capital commitment, all of your capital is not due right away.

Use of GRATs

So, you have to put in cash in order to be able to pay that ongoing capital commitment, you can’t add anything later. And GRATs also require that annuity be paid out on an annual basis. And so, where you have a new private equity fund, it’s not just the cash flow on the way in, but also the fact that you’re not going to be getting distributions for potentially several years before you can make the annuities in cash. And as we all know, you can’t loan money back to the grantor in order to meet the annuity requirements.

So, for some of these cash flow reasons, GRATs really don’t work very well. And also, because you have to make these constant transfers, unless you actually have cash, the possibility that you’re doing another 2701 transfer and attempting to pay the annuity if you had to do so in kind. Which is another way of saying that intentionally defective grantor trusts are a very common planning vehicle in this context. Very frequently, you might see a gift, at the outset of a fund is the most ideal time because that’s when the profit’s interest is worth the least, but you could, in theory, do it at any time.

I would say, about GRATs, is that if you are in a private equity fund and you’re at the later stage of a private equity fund where you’re already in a distribution; all the capital’s been called, the distribution is already happening in cash, and you can put that into a GRAT. Actually, I do that pretty frequently in the later stage of a fund because I know I’m going to have the distributions to make the annuity payments and I already have a lot of value because I’m into the fund. I have a sense of what the profit interests are going to be and that’s a bigger risk type thing, than if I’m a brand-new private equity fund, have a commitment of $1 million, and I have a profit’s interest on top of that.

While I do have the gift component of the million-dollar capital, the carry’s not worth a whole lot on the outside because we don’t know yet what the profits interest going to be. It’s certainly worth something, but it’s at its lowest value and the outset when there’s still quite a bit of a risk and question involved as to whether or not the fund’s going be successful.

Final Thought: Using Derivatives

Finally, I wanted to mention, there’s one planning technique that is an attempt to void 2701, which is using derivatives to not make a transfer. By using a derivative, you can kind of mirror the benefits of what you would get without actually transferring the carry or the capital.

And so, that’s become a more common technique, most notably with Fellow David Handler. I think you definitely want to be conscientious of 2701 when you’re doing carry planning. As I always say, gift early and gift often, and carry is a great asset to be planning with. So, thank you, and I’ll turn it back to you, Natalie.

Thank you so much, Marissa. That was really informative. We always enjoy learning a little bit more about planning for principals in private equity and hedge funds.

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