Considerations When Valuing and Distributing Private Equity and Related Investments of High Net Worth Individuals in Divorce Matters
Over the last several years many individuals of seemingly average means have become high net worth individuals. Unfortunately, as the nest eggs of one’s clients grow, so does the complexity of valuing and distributing such estates. Prior to the recent bull market, the assets in a traditional divorce included a house, cars, pensions and some equities such as individual stocks and mutual funds. This picture has changed significantly in the last decade. For example, individual 401(k) accounts for individuals of modest means could approach or surpass $1 million. If this is the valuation of the account of one with modest means, imagine the size and complexity of an estate of a high net worth individual.
As a result of the recent growth of the stock market, many high net worth individuals today are less satisfied with investing their money in a well-diversified portfolio and earning an average of eight percent per year. Historically, an eight percent compounded annual return has been a good benchmark return. It approximates what pension fund administrators expect to earn on the assets they invest. However, in order to maximize their return, high net worth individuals are increasing their risk and finding alternative places to invest their money.
The focus of this article is on the investment options of high net worth individuals and discuss the impact of those options in matrimonial matters. Each case is potentially different and it is important to approach every situation individually. This article is not intended to be a roadmap for any particular situation but rather address some of the issues to consider when handling cases with private equity investments of high net worth individuals. There are many considerations that should be carefully analyzed prior to distributing these assets, probably more than when making the initial investment decision. Among the considerations are the individual circumstances of the parties, the value and marketability of the assets and, of course, tax consequences. Information gathering, valuation and distribution of these items as well as other considerations will be discussed throughout this article.
Types of Investments
Discovery is the most important, yet often the most difficult part of the process of valuing and distributing assets of high net worth individuals. It is important to ask for the right information from the initial document demand because it will be more difficult to obtain such information later in the litigation. Since high net worth individuals have many available options for investing their money, it is necessary to understand the nature of the investment. The risk and reward vary with each individual investment. Once you have received the requested information, the following items should be addressed:
The above items can form excellent interrogatory questions and a place to start when preparing for depositions.
Among the necessary documents are financial statements and tax returns for the prior three years (and, depending on the facts, five years), subscription agreements, and a listing of all contributions and distributions made by and to the investor since inception. A complete list can be very extensive, especially when valuing an operating business. After reviewing the requested documents, the most important step in evaluating a private equity investment is having a dialogue with a principal or high-level manager or director of the investment. From this conversation, you will hopefully receive a greater understanding of both the nature of the investment and its status, thereby providing more than you would receive reading through the information provided through the discovery process. This approach may not always be successful. In this instance, a more formal approach such as interrogatories or depositions may be needed to obtain the appropriate information. In this event your clients will incur additional time and expense.
Do not overlook independent research as a means of gathering information. Examples of the resources available include Lexis, Westlaw, the internet and other computer search tools. These sources provide access to records such as Dun and Bradstreet Reports, 10-K reports (annual), 10-Q reports (quarterly), proxy statements and other SEC filings. Articles referencing the other party or subject investment in trade or financial news or periodicals can also be informative.
Methods of Distribution
Once an understanding of the investment and its value has been achieved, the client and his or her attorneys and advisors must assess the available options to determine the appropriate method of distribution. For most investments, an individual has two options when determining his or her future with the investment.
One option is to distribute the investment in-kind based on equitable percentages, i.e. the “in-kind” option. This option requires (1) an actual ability to divide the asset and (2) an intimate understanding of the investment and its risk as well as (3) a determination that the client has the financial wherewithal to forego liquidity. Another option is a distribution based on the current value of the investment, i.e. the “buy-out” option. This method requires a current valuation. Valuation methodology, tax impact and other factors then become key. The decision to distribute based on either the “buy-out option” or the “in-kind” option should be carefully analyzed on a case-by-case basis. Since the issue is fact sensitive, there is no rule of thumb.
Methods of Valuation
The more common approach is the “buy-out” option, which distributes the asset based on a current valuation. This option is generally preferred by the court systems especially with on-going business because it eliminates an ongoing relationship between the divorcing parties with regard to the asset, which decreases the chance of problems in the future. While the “buy-out” method may eliminate future problems, it replaces future problems with current ones. The main focus now becomes valuation and there is not always an easy way to determine the value of a private equity investment. In some instances, it may be inequitable to force a current buyout where the potential return on investment is high but too speculative to determine at the given point in time.
The determination of value in most cases is a long and expensive process, which in some cases may cost more than the investment is worth. (Example: Valuation of a start-up Internet company). In other cases, some research could result in a reasonable estimation of value for purposes of distribution. We would caution you to disclose to your clients when relying on estimates because the actual value of the investment at the time of liquidity could be significantly different. The difference could be either lower or higher than the estimation.
Investments are typically required to submit periodic information to their investors. This information could come in the form of annual K-1 forms, tax returns and financial statements. This information is usually reported on the cost basis, which in some instances may reflect the fair market value of the investment. In most cases, however, it does not represent the fair market value. In the latter case, a valuation should be performed to distribute the asset fairly. Therefore, do not assume that the investment’s “Financial Statement” reflects the current fair market value of the asset,even if it is “marked to market.”
Depending on the type of asset, the available information and remaining marital estate, there are different valuation methods that may be appropriate for the situation. The first method utilizes the information reported on the historical financial statements and tax returns. This method, called the “book value” method, calculates the fair market value of the investment based on the book value of the investment and the ownership interest. It reflects three components: 1) the initial investment, 2) subsequent contributions or withdrawals and 3) the investor’s percentage share of reported income or loss from the operating activity. As discussed above, in most cases this does not reflect fair market value. The information for this type of valuation is contained on the K-1 form filed by the entity for partnerships and limited liability companies. For other types of entities this information could be obtained by multiplying the ownership percentage by the total equity of the entity.
When available, a better approach to valuation may be consideration of recent valuations performed by the company. Many entities have obtained valuations for many purposes, including the purchase or sale of a partial interest in the entity, funding life insurance for buy-sell or cross-purchase agreements, private offerings, estate issues, prior divorces of other owners or other litigation. The information from the prior valuations could be used for the distribution of the assets in the present divorce matter. There are some limitations to this method because valuations for different purposes sometimes result in different values. For example, the buy-out of a founder of a business may include a premium to reflect the contributions of the founder, however, a valuation performed for liquidation may result in a lower valuation. These valuations may not be appropriate for your situation even though they were reasonable for their purpose.
The third approach, i.e., “return of investment”, requires some research. This approach includes an estimate of the appreciation on an investment where the actual returns won’t be determined until liquidation. This method is based on historical returns of similar investments or the projected return on the investment at hand. In many instances, prior to making a private equity investment, the potential investor is provided with a projected return on the investment. This may or may not be ultimately achieved. A discussion with the managing director of the investment should indicate if the investment is on target with the original projections. In some cases, the projections are updated to reflect the current status of the project. The next step is to apply the current projection to the investment and discount to present value. This will provide a reasonable valuation based on the available information at the time of valuation. It is important to educate your client that the actual return may differ significantly from the estimate used.
In the absence of a projection of the rate of return for the specific investment, average historical returns for other investments managed by the same group of professionals can also be used to approximate the fair market value. Another suggestion is to utilize average rates of returns of similar