Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Family Offices Use Private Equity Carry
Transcript
- Lucas: We talk a lot on this show about how family offices deploy capital — private credit, secondaries, real assets — but there's one area that's often overlooked, and it's actually where a lot of the real money gets made. I'm talking about private equity carry. Luna: Carry — that's the performance fee the general partner earns, right? The twenty percent of profits above a hurdle. Lucas: Exactly. And for an ultra-wealthy family that either invests in funds as a limited partner or, more likely, operates as a GP themselves, carry can be the single biggest driver of wealth creation. But it also creates a huge planning headache, especially when it comes to estate tax and succession. Lucas: Take a typical private equity fund. The GP commits maybe two percent of the capital, but they get twenty percent of the upside. If a $500 million fund doubles, that's $500 million in profit, and the GP's carry is worth $100 million. That's a meaningful chunk of change for any family office. Luna: And the tax treatment is pretty generous, isn't it? It's taxed as capital gains, not ordinary income. Lucas: Right. That's the carried interest loophole, depending on your perspective. The GP is providing services — management, deal sourcing, oversight — but the compensation is taxed at the long-term capital gains rate, which tops out at twenty percent plus the net investment income tax, versus the top ordinary rate of thirty-seven percent. That's a big spread. Luna: So it's a tax advantage for the GP, but it's also a liability in estate planning. I remember a story about a family office that had a GP who died unexpectedly, and the IRS wanted to value the carry at its full potential, not what it was worth at the time. Lucas: That's the classic 'angel of death' problem. If a GP passes away holding carry, the IRS will argue that the carry should be included in the estate at its fair market value — which, if the fund is performing well, could be enormous. And since it's an illiquid asset, the family might not have the cash to pay the estate tax, which can be as high as forty percent. Lucas: So the planning challenge is to find ways to transfer the carry to the next generation while it's still worth relatively little, and ideally before the fund has generated any carried interest. Luna: How do you do that? I mean, you can't just give it away, can you? Lucas: Well, there are a few techniques. One is to set up a grantor-retained annuity trust, or a GRAT, and transfer the GP's interest into it. Because the carry is illiquid and hard to value, you can often discount it significantly — sometimes by twenty to thirty percent — which reduces the gift tax. And if the fund performs, the appreciation goes to the beneficiaries tax-free. Luna: That sounds like a sophisticated move. But what about the family that's not the GP, just an LP? Do they have to worry about carry? Lucas: Less so, because LPs don't earn carry. But they still have to understand how carry affects their economics. When you invest in a fund, the carry is factored into your net returns. A good LP will negotiate the carry structure — the hurdle rate, the catch-up, the distribution waterfall — because that determines your effective return. Luna: So even as an investor, you're exposed to the GP's carry. That's an important point for our listeners who might be considering private equity investments. Lucas: Absolutely. And the carry isn't just a tax and estate issue — it's also a behavioral one. A GP's carry aligns their interests with the LPs, but it can also lead to risky behavior if the carry is structured with a high hurdle and a catch-up that rewards excessive risk. Luna: That's a good point. Let's talk a bit more about the estate planning angle, because I know that's a big concern for family offices. What are some of the other strategies? Lucas: One approach is to use a family limited partnership, or FLP, to hold the GP interest. By transferring limited partnership interests to the next generation, you can get valuation discounts for lack of control and lack of marketability. That's a common technique. Lucas: Another is to use a life insurance policy owned by an irrevocable trust. The trust owns a policy on the GP's life, and when the GP dies, the death benefit provides liquidity to pay the estate tax on the carry. That's a simple, effective solution. Luna: And there's also the timing issue. You want to transfer the carry early, before it's worth much, but that means giving up control and future income. It's a trade-off. Lucas: It is. And that's why it's so important to work with a team that understands both the investment side and the estate planning side. A lot of family offices just focus on the deal, and they forget about the succession planning until it's too late. Luna: I've seen that happen. A client of mine—well, a friend, actually—had a father who was a GP in a mid-sized buyout fund. He never did any planning, and when he died, the estate had to sell a chunk of the private equity portfolio at a discount just to pay the IRS. It was painful. Lucas: Yeah, that's the worst-case scenario. And it's avoidable, but it takes proactive planning. That's the message I want to get across today. Lucas: Before we go further, I want to be transparent about something. This show is completely listener-supported. We don't run ads, we don't have sponsors, and that's a deliberate choice. But it means we rely on a small group of listeners who chip in a few dollars a month through platforms like buy me a coffee dot com slash fexingo. Luna: And honestly, that support is what keeps us going. It's not a huge number of people, but it's enough to cover the costs of producing and distributing the show. So if you've gotten value from our conversations, and you want to keep them ad-free, that's the way to help. Lucas: No pressure, of course. But it's a genuine way to ensure we can keep doing this. Now, back to carry. Luna: So, we've talked about GRATs, FLPs, and life insurance. What about the tax reform angle? I know there's been a lot of talk in Washington about taxing carry as ordinary income. How would that change the planning landscape? Lucas: It would be a game-changer. If the top ordinary rate applies to carry, the tax hit on a $100 million carry jumps from around twenty-three percent to about forty percent. That's a $17 million difference per $100 million. For a family office, that's a material reduction in wealth transfer. Lucas: But it's not just about the tax rate. If carry is taxed as ordinary income, it would also be subject to self-employment tax, which is another 15.3 percent. So the effective rate could be over fifty-five percent in some cases. Luna: That would change the whole economics of being a GP. I'm surprised more people aren't talking about this. Lucas: Well, there have been attempts to address it, but the lobbying is fierce. And even if it doesn't change soon, it's something that family offices should be planning for. If the tax law does change, the strategies we've discussed become even more valuable. Luna: So, what's the takeaway for our listeners? If they're a family office or a wealthy individual considering private equity, what should they do? Lucas: First, understand the carry structure of any fund you're investing in. Don't just accept the standard twenty percent — negotiate. Second, if you're a GP, start the estate planning early. A GRAT or an FLP can save you millions in taxes. And third, stay informed about legislative changes. The tax landscape is shifting, and you need to be ready to adapt. Luna: And I'd add that it's not just about tax. It's about making sure your family's wealth lasts for generations. Carry can be a powerful tool for building wealth, but only if you manage it wisely. Lucas: Exactly. Carry is often the engine of family office returns, but it's also a fragile asset. Without proper planning, it can evaporate in taxes and litigation. With planning, it can be a lasting legacy. Luna: That's a great way to put it. Thanks for breaking this down, Lucas. I feel like I have a much clearer picture now. Lucas: Anytime. And to our listeners, if you're interested in learning more about this topic, we'll have some resources on the show notes. But for now, thanks for joining us.