Houston, We Have a Problem
5 Step Guide to Navigating Unforeseen Capital Calls
First of all, I’m sorry you’re in this situation. Capital calls can be stressful, but you have options. At this point, you must decide whether to participate or not. In this post, I’ll walk you through five key steps to help you make this decision.
📌 The vast majority of capital calls happening currently are due to maturing floating-rate debt. You’ll find a section dedicated to this scenario at the end or the article.
Note: for the purpose of this discussion, we will only focus on unforeseen capital calls (AKA cash calls) that occur after the initial capital was deployed (for instance, mid-hold in a single asset syndication, or after the fund closed its investment period).
Overview
A capital call (or additional capital contribution) is a legal right of the managing entity to request additional capital from limited partners (LPs) on top of their initial commitment. Capital call rights vary vastly among offerings, and are generally outlined in the LLC Operating Agreement. Investors who choose not to contribute might face dilution of their ownership stake or other penalties. The severity of this dilution can vary, and some agreements are more punitive than others.
While punitive consequences may seem investor un-friendly, they are typically in place to ensure a higher success rate for the call, and could provide a lifeline during unforeseen circumstances, preventing a fire sale of the property at a bad time.
Some common reasons for unforeseen capital calls include:
Budget overruns: construction delays, unexpected deferred maintenance needs, environmental issues, etc.
Operational shortfalls: unexpected drop in occupancy, increased expenses (taxes, insurance), natural disasters that result in lost rental revenue, etc.
Interest expense: this is the most common reason for capital calls we are seeing at the time of writing this article. Please refer to our earlier post for some background on how we ended up here.
Refinance: the property qualifies for a new loan, but the payoff amount for the existing loan is higher than the new loan balance (aka cash-in refinance).
5 Steps to Consider when Evaluating a Capital Call Decision
Please note, this is not investment advice. We always recommend consulting with a legal professional.
Below are some considerations when evaluating whether to participate in a capital call. The decision must be made rationally, as painful as it may seem. REMEMBER: you hold the cards! Your capital retains optionality: you can choose to fulfill the call, or you can hold onto these funds.