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Estate Planning for Private Equity Partners

Since the introduction of carried interest, Private Equity principals have been able to benefit from the favorable capital gains tax treatment by making gifts or estate planning transfers. The benefits of making transfers during the fund formation stage is a very important factor for a variety of reasons.

The main reason for making gifts near or about the time of formation is that the value of the carried interest is considerably lower than making the gifts at any time during the private equity lifecycle for the following reasons:

as time passes, there is greater certainty as to the capital commitments, invested capital, the expected returns, the expected harvesting dates and therefore the projected cash flows of the fund. 
as the fund nears the end of its lifecycle – such as nearing the harvesting stage – the period for discounting cash flow is limited to the remaining life of the fund.  This is very critical, since most of the cash inflows or future positive net cashflows are towards the end of the fund, resulting in greater values.
Valuation done at the early stages of any fund formation will reflect greater risk and uncertainty, and therefore greater discount rates that would affect the value.

Over the years, I can recall several  times where I have been challenged by the principals that there is no value to the carry at the time of formation.  I have to say that from my experience in dealing with the many principals in the field of private equity and given their knowledge of finance and the markets, those who suggest that their investment is worthless seems highly improbable.  This is simply because if what they believe that was true, I am certain that none of the principals would be happy to sell me their interest for even a dollar.  Similarly, presenting this same position -- that these gifts are worthless -- at the gift dates will likely be unsustainable when challenged by the Internal Revenue Service (IRS). Furthermore, poorly documented or unsupported valuations of such gifts transferred would be viewed by the IRS as inadequately disclosed and such valuations can be challenged at any point during the donor's life even through the settlement of the estate. 





Rather, principals who wisely adopt qualified appraisals that are well supported and adequately disclosed will benefit from the three-year statute of limitations.When choosing an appraiser, consider those who have appropriate experience in valuing these special interests. Given the nature of private investments and their complexities, specifically in relation to carried interest/incentive fees, selecting an appraiser with the depth and knowledge of the industry, the experience of having worked with major private equity firms and law firms in the area of expertise, as well as someone who understands the markets and their vagaries can be a good investment.

For more information on proper tax planning, consider reading the article co authored in November 2009 by Bradley van Buren and David Scott Sloan of Holland and Knight LLP.  This article is an excellent primer on planning techniques for private equity principals interested in transferring their carried and capital interests in the general partnership of the private equity fund.