Capital calls and what declining costs

What a capital call actually is

A capital call is a request, or in some structures a requirement, that limited partners contribute additional money beyond their original subscription. It is the single feature of private real estate that most surprises investors, because the mental model most people bring is that of a share purchase: you pay once, and the worst case is that the investment goes to zero.

In a partnership the worst case is not zero. It is zero plus whatever you contributed afterwards. Whether that can happen to you, and what occurs if you decline, is determined entirely by the operating agreement you signed, and it is set out in a clause most investors do not read until it becomes relevant.

It is worth separating two situations that get the same name. A planned call is contemplated at subscription, where you commit a total amount drawn down in stages as a renovation proceeds. An unplanned call arises because the deal needs money it did not expect to need. The first is a cash flow schedule. The second is news.

Why they happen

Unplanned calls have a small number of recurring causes, and knowing them lets you assess the probability before you invest rather than after.

Debt service coverage. Floating rate debt reprices, income does not keep pace, and the loan's coverage covenant is breached or approaching a breach. The lender requires a paydown or a reserve deposit to cure it.

Rate cap replacement. An interest rate cap purchased at acquisition expires, and replacing it at current pricing costs a multiple of the original. Lenders commonly require a cap to be in place, so this is not optional.

Refinancing shortfall. A loan matures, the property no longer supports the same amount of debt at current rates and values, and the gap between the maturing balance and the new loan has to be filled with equity.

Capital expenditure overrun or an event. Renovation costs more than budgeted, or an uninsured or underinsured loss occurs, or insurance itself reprices sharply, which has been a live issue in several coastal markets.

Notice that three of the four are capital structure rather than operations. This is the same point made in how to vet a sponsor: deals rarely fail because the apartments stopped renting.

Mandatory, optional, and the remedy in between

The critical question is what the agreement says happens if you do not participate, and there are three broad answers.

Mandatory with a legal remedy. Rare in retail syndications and serious where present. The partnership can pursue you for the unpaid amount as a debt. If your agreement contains this, you should know it before you subscribe, because your maximum exposure is not the amount you wired.

Optional with dilution. The common structure. You are not obliged to contribute, but if you do not, your ownership percentage is reduced in favor of those who did. Your downside remains capped at your original investment plus any voluntary contribution, and the cost of declining is a smaller share.

Optional with a preferred instrument. Contributing partners receive their money back with a preferred return ahead of everyone, sometimes at a high rate, before the ordinary waterfall resumes. This can be more punitive than dilution even though it is not described as such, because it inserts a new tier above the existing preferred return.

The word to find in the document is not "capital call" but the sentence describing the consequence of non-participation. That sentence is the one that determines your exposure.

How dilution actually works, and when it is punitive

Straight dilution recalculates ownership on the new total capital. If the partnership had $10 million and raises $2 million more, a partner who contributes their pro rata share holds the same percentage, and one who does not holds less. That is arithmetic, and it is fair in the sense that the contributed dollar buys what it is worth.

Punitive dilution multiplies the effect deliberately, so that non-participating partners lose more than the arithmetic requires and participating partners gain more. A two-to-one or three-to-one penalty factor is not unusual in agreements that contain one.

The argument for it is real: without a penalty, a partner can decline to fund and free-ride on the rescue capital of others, and a rescue that nobody funds is worse for everyone. The argument against is equally real, because the penalty falls hardest on the investors least able to write another check, which is not the same set as the investors least deserving of protection.

What is not defensible is a punitive factor that was never explained. Ask before you subscribe whether the agreement contains a penalty factor on dilution, at what multiple, and who decides the terms of a call.

What a sponsor should do before calling

A capital call should be late in the sequence rather than early, and a sponsor who reaches for one first has told you something about their planning.

The ordinary order is: suspend distributions to conserve cash; defer non-essential capital expenditure; negotiate with the lender for a forbearance, an interest-only period or a covenant waiver; defer or waive the sponsor's own fees; seek rescue capital from third parties on terms disclosed to existing partners; and only then call on limited partners.

The fourth item is the one to ask about specifically. A sponsor asking limited partners for money while continuing to collect an asset management fee is asking you to fund their compensation. That may be justifiable and it should be raised and answered rather than left unstated.

The order in which a deteriorating deal should be handled is set out at greater length in what happens when a deal underperforms.

What to do when one arrives

A capital call notice usually carries a short deadline, which is exactly the condition under which people decide badly. The questions are the same every time and can be asked in one message.

What specifically is the money for, and what happens if it is not raised. Is this a cure or a bridge, meaning does it fix the problem or defer it. What is the total amount, is it the full requirement or a first tranche, and could there be another. What are the terms for contributing and the consequence of not contributing, quoted from the agreement. Is the sponsor contributing pro rata in cash. What has changed in the model since the last report, and may I see the revised projection. Has the lender agreed to anything in connection with this.

Then a separate decision, which is not about the deal at all: whether you should be adding money to an illiquid position that has already disappointed. Additional capital into a struggling deal is a new investment decision, and the fact that you are already exposed is not a reason to increase exposure. It is also not a reason to refuse, since a well-structured rescue can be the highest-returning capital in the deal.

The honest position is that both mistakes are common: throwing good money after bad, and refusing to fund a genuinely sound rescue and being diluted for it. The way to tell them apart is whether the money fixes something specific.

The tax side, briefly

A contribution increases your adjusted basis in the partnership interest, which can matter more than it sounds. Basis is the first of the four limitations a loss must pass before it becomes a deduction, alongside the at-risk, passive activity and excess business loss rules, and losses suspended for lack of basis can become deductible once basis is restored.

Dilution changes your share of future allocations rather than triggering an immediate taxable event in the ordinary case, but a restructuring can also change your share of partnership liabilities, and a decrease in that share is treated as a deemed distribution which can be taxable. Whether any of this applies to you depends on the specific transaction and on your own basis, which per the K-1 instructions is your responsibility to track rather than the partnership's.

None of this is advice and the variations are wide. Take the notice and the revised documents to your CPA before you fund, not after. The mechanics of the form are in reading your Schedule K-1 and the passive rules are in IRS Publication 925.

Our position

We think capital calls should be rare, disclosed clearly in advance as a possibility, and structured without punitive penalty factors. We also think a sponsor should exhaust their own fees before asking investors for money, and should contribute pro rata in cash when they do ask.

What we will tell you before you subscribe is whether the agreement permits a call, whether participation is mandatory, exactly what happens if you decline, whether any penalty factor applies, and what circumstances in our own model would make a call more likely. We will also tell you whether we have ever made one.

What no sponsor can honestly tell you is that a call will never happen. Anyone who does is describing a certainty they do not have. Size your position on the assumption that it might, which is the same conclusion reached in liquidity and hold periods.

What to establish before you subscribe

1. Does the agreement permit a capital call, and is participation mandatory or optional?
2. Quoted from the agreement, what happens if I decline to participate?
3. Is there a penalty factor on dilution, and at what multiple?
4. Will the sponsor contribute pro rata in cash, and will sponsor fees be deferred or waived first?
5. Is this call a cure or a bridge, and could there be a further tranche?
6. What has the lender agreed to in connection with this, and may I see the revised model?
7. Have you ever made a capital call before, on which deal, and what was the outcome?

What this is built on

1. Internal Revenue Service, Publication 541, Partnerships
2. Internal Revenue Service, Publication 925, Passive Activity and At-Risk Rules
3. Internal Revenue Service, Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits
4. Investor.gov, Private placements under Rule 506(b) and 506(c)
5. U.S. Securities and Exchange Commission, Rule 144, selling restricted and control securities