6 steps to a successful capital call decision

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6 steps to a successful capital call decision

Welcome back! 👋

Today we will unpack capital call decisions from start to finish. My goal with this article is to give you a 6 step guide that helps you think through these decisions in the most independent and unbiased way.

Before we dive in, one reminder - don’t be the person who YOLOs on a capital call. This is an investment decision and it’s time to do DD (due diligence). One might even argue that you should do more DD now than you did at the outset, since circumstances have changed both for the deal and the real estate market at large.

This is not a time to make emotional decisions, or give in to scare tactics such as “if you don’t invest we will be forced to foreclose.” In the vast majority (if not all) of cases, you’re not the only LP and, besides that, LP capital isn’t the only available option for capital needs for a GP. Try your best to make a logical decision - I hope the below will help you get there!

Alright, let’s dive in.

Our agenda for today:

• Do you have the cash?

• Will this capital call solve the issue?

• What happens if you don't do the capital call?

• Status of existing position

• Does the investment make sense relatively to other investment opportunities?

• Communicate and take down some lessons

**1) **Do you have the cash?

This one sounds so basic, but it's extremely important. I've heard of LPs pulling on their retirement accounts, HELOCs, and even credit cards to fulfill capital calls.

There are two reasons why the source of the cash matters.

First, if you are borrowing the money that presents another hurdle to cover on the investment. In other words, if you borrow $100,000 at 7% to fund the capital call you now need to subtract 7% from whatever returns this capital call marginal investment is supposed to make you. As an example, if you invested $100,000 to earn 7%, but the source of that $100,000 was a loan at 7% you essentially haven't made any progress. This gets a little bit tricky since you have an existing investment at risk, but we will get into that codependency later.

Second, you simply don't want to over expose yourself to a given sponsor or a given strategy. This is a concept that I talk about often and it's nothing more than diversification for your personal capital. No matter how much you like a given strategy or a GP, you should be mindful of overexposing yourself based on your own knowledge of your liquidity, net worth, and the risk that you're willing to take given your set of circumstances/goals. In the context of the capital call decision, if the marginal cash that’s being requested from you takes you into the “overexposed” bucket, you should be weary to continue - and notice that’s without looking at anything else .. we’re still at step 1!

**2) **Will this capital call solve the issue?

There are many reasons to do a capital call, but the very simple motivation behind it is a lack of cash. The partnership is lacking enough cash for something and your goal should be to figure out not just what that “something” is, but also whether there’s a “something else” down the road that will require more cash!

As an example, let's say a GP has issued a capital call as a result of an expiring rate cap. To put this in simple terms, the higher rate on the debt of the property was previously hedged leading to lower debt service payments, but now that the hedge has expired the partnership does not have enough cash from operations to cover the increased debt service payment (since the interest rate on the loan was variable, has moved up, and is no longer covered by the counterparty of the rate cap hedge).

It is always a good idea to ask for a sources and uses when analyzing capital calls (or any deal for that matter). In our example, the source will most likely be your cash* and might include a third party (for example a preferred equity investment, or a debt investment), while the uses would be the capital reserve that will be able to fund any shortfalls for a given amount of time. Notice, that understanding the shortfalls (and being conservative about them) is critical because otherwise the contributed capital call cash might run out far before the expected timeline … which would trigger another - you guessed it - unexpected capital call!

Further, you might find in the information presented by the GP that the debt on the property is expiring in 9 months. For the sake of example, let's assume that you funded the capital call and the reserve is meant to last 9 months of increased debt service payments.

Now, what happens at in 9 months at maturity? This is not always the case, but in many situations today properties are faced with cash in refinances. In other words, the partnership needs to bring additional equity to make the existing lender whole on their investment because the incoming lender is not willing to lend as much. This would be another unexcepted capital call that might catch you by surprise!

So, to reiterate, your job is to ensure to the best of your ability that the capital call lasts until the property is sold for all capital needs. Needless to say it’s not a great sign if you uncover in your analysis that there's a certain event in the future (such as the cash in refinance we discussed above) that will require a capital call, and this was not disclosed by the GP in the current capital call communications.

The job of a GP is present you with all the information necessary and there’s nobody that should know the project as well as them. If the GP decides to split the capital call requests (e.g. half now and another half in 6 months), but still communicates both, that’s great - in fact it might be marginally better for you since you’re able to “spread out” the risk and might have a choice to not invest in the next one if you’re not seeing the progress you expected.

*- It’s generally a good idea to ask how the GP is contributing to the capital call as well, whether that’s through cash or another mechanism to align interests. I will write on the concept of misaligned incentives in a future article, but for now you should know that in many capital calls the GP is no longer expecting a promote (which is how they make money) so it’s a difficult situation for everyone involved - LPs are trying to get their money back while the GP is not extremely money motivated any longer.

**3) **What happens if you don't do the capital call?

The title says it all, but you would be surprised how many times I have seen cases where the answer to this is not clear. The GP/LP agreements don’t always define these terms on the front end of the transaction and therefore you should never be afraid to ask the GP what the terms are .. hopefully you don’t have to ask and they already tell you as part of their proposal.

Generally speaking, there are punitive measures such as dilution or capital call proceeds having a more senior position to you in the capital stack (i.e. when the property is sold their claim would be paid in full first before the next part of the waterfall takes place). You should know exactly what these terms are before you proceed. The more “harmless” the capital call request is (e.g. no dilution other than a pro rata share of equity that someone else brought in), the easier it becomes to say no since you have “less to lose” from the perspective of dilution.

The connection between the capital called investment and your existing investment is important to understand and it was the topic of this article. It's important to realize that although the original investment is a sunk cost to you (you already invested that dollar amount and there’s not much you can do to liquidate the position today) and shouldn't influence your decision making, things can become tricky when investing a small amount in marginal capital call can, with decent probability, get your cash back on the original investment (as a result of not getting heavily diluted out). I dive more into this in the aforementioned article using a model and really recommend you taking a look.

**4) **Status of existing position

Simply said, what is your position worth today? There are essentially three ways to figure this out:

• Ask the GP

• Do your own research

• Ask a third party resource

Asking the GP is helpful, but obviously you have to keep in mind that you might be getting a somewhat biased response. Some are honest of course, but not all. So it’s hard to do this without 2 or 3 above.

In terms of doing your own research, you might be surprised at how much you can accomplish on your own. If you go to this article and search for “3 ways to spot distress:” it’ll take you precisely to the section where I go through the steps to get an estimate of how much your equity is worth.

Accuracy here is helpful, but getting a decent ballpark number (or a range as I speak about in the article) is the true focus. You’re not trying to get a number down to the dollar, but rather figure out whether your investment is worth more, the same, or less than your original investment amount. This alone can give you a lot of information because it's a marginal data point about how your GP has performed to date. Remember that when you originally invested you had less information than you have now, and you should use all of that information to your advantage when making the capital call decision.

**5) **Does the investment make sense relatively to other investment opportunities?

This one’s important. A capital call decision is just another investment decision. Yes you have money at stake, but at the end of the day your decision should come down to logic and not emotions.

In a previous article I presented a model of how to think about this. Your fundamental question is what return are you able to generate with the capital call cash - and I hope you know by now that the answer is NOT (1) the preferred rate stated by the GP or (2) the IRR presented on the capital call deck .. those are just expectations. This has to be your calculation and it’s a decision between placing that cash back into this investment or taking the same cash and investing it elsewhere. The decision is in your hands, and I don’t see a way of making it without doing some math.

If the returns are slightly less than or similar to opportunities elsewhere (while also adjusting for the risks you’d be involved with), it might make sense to stick around and support the GP. This is a relationships business and if you think they’ve truly done right by you and your investment (as we discussed in #4 above) is doing alright, then it might be better putting your capital with someone you’ve already gotten to know rather than starting a brand new relationship… grass may be greener on the other side, but at least here you know your counterparty and have a lot of information to make a great decision.

**6) Communicate and **take down some lessons

From a communication perspective, I would recommend reading the below article to understand what you should do once you realize that your deal is in some form of challenges (which could certainly include a case of a capital call request).

Last but certainly far from least, don’t forget to stop and think about the things you’ve learned from this experience. I recommend going back to the original deck to see whether some of the issues you could have foreseen, and how. These lessons might be worth multiples of any investment loss today over the rest of your life.

For more on this topic, check out my Twitter and LinkedIn posts.

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