Capital calls to pay off a GP loan

Welcome back and happy Monday!

I just posed the question below on Twitter and LinkedIn, but wanted to take a minute to give you my own perspective at length after seeing this dozens of times.

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First, let’s set up the case that I’ve seen time and time again:

• Total equity at 2021 purchase: $20mm

• Capital call in 2025: $5mm (25% of original equity)

• Capital call Sources and Uses:

• Sources:

• $5mm in proceeds from (usually only or at least mostly) LPs

• Uses:

• $2mm rate cap purchase

• $0.5mm working capital

• $2.5mm GP loan payoff (loan made in 2023 or early 2024)

Now you’ll notice that the GP loan payoff above is stated clearly - of the cases I’ve advised on, I’d say that an overwhelming majority of GPs don’t make it this clear.

Having said that, let’s assume for a second that the GP did state the loan payoff clearly … at which point is the above proposal ethical from the perspective of an LP and - conversely - when is it concerning?

First, I’d like to explain why this topic is so intricate, from both sides:

• Let’s assume for a second that the GP payoff was clearly stated in the uses

• Then, all else equal:

• From the perspective of a GP: “How could it NOT be ethical to ask for my money back - I didn’t have to fund it in the first place and only did it because we’re partners.”

• More on “partners” soon, hang on to your seatbelts 😊

• From the perspective of an LP: “You’re asking for more money after the project didn’t go according to plan. I’m fine with considering such an ask, but why should half of my proceeds go to you when the project is struggling and I didn’t know you were funding such a loan in the first place?”

I hope you can now see how this case gets a bit more complex than “it’s obviously fine - the GP is just paying themselves back.”

Two clarifications before we move forward:

• A major exception to the following discussion is when the loan and capital call are weeks apart - in other words, if the GP lent the money and issued a capital call a few weeks later then they simply had to put in emergency funds into the property to give LPs time to wire their cash

• This isn’t amazing by the way, but it happens - if you have a clear understanding of cash flows at your properties and a decent cash reserve things shouldn’t be that urgent .. but let’s be fair for a minute - everyone makes mistakes and we can’t be everywhere (i.e. deep in the weeds on every investment) at all times, so let’s let it slide - the GP is trying their best.

• We are NOT discussing capital calls that are planned (e.g. a fund that has several planned calls for capital every quarter and uses a credit facility to fund a capital need prior to the expected LP funding). Rather, we’ll be discussing a case where all the necessary capital was funded day 1 (which is the case for most real estate syndications), then there was an unexpected capital need, the GP funded a loan for the shortfall, and then a year later (for example) a capital call was issued to the LPs.

Now, here comes the not-so-politically-correct section - the edge cases

(I’m on a roll by the way - quite a few people didn’t like what I had to say in Can you teach me to become a GP? but, as always, I’m here to share what I see as the truth and always open to your feedback - sticks and stones in the comment section may break my bones, but unsubscribes can never hurt me 😉):

• If you recall, above the GP response was “How could it NOT be ethical to ask for my money back - I didn’t have to fund it in the first place and only did it because we’re partners.”

• The key here is partners, and my friends, I have news… partnership goes both ways

• Just like you felt it was necessary to provide the LP with an update when the project needed capital, the LP deserves an update when you loaned the money in the first place

• If the loan was a tiny bit of cash, and two weeks later things stabilized.. fine.. but if two weeks later the GP loaned more cash, perhaps it’s time for an update? I think so…

• I’m sensitive to the fact that sending bad news as a GP sucks, but you know what’s worse? An LP assuming things are going great, only to realize their investment was wiped out - and I hope we can all agree that THIS is not how a partnership functions

• This is an intricate topic - and likely controversial - but we’re in this section, so let’s do it. The GP said in the capital call email that they lent money to the project in order to help the LPs, right? Well - let’s think - are there circumstances where this could be a half truth?

• I’m here to tell you, that the answer is yes… here are some simple examples:

• GP is in the middle of another raise where they expect existing LPs to participate… on the other investment (that’s struggling and in need of capital) the GP is faced with 3 options:

• Option 1: issue capital call to LPs

• Option 2: self fund the capital need and don’t say anything

• Option 3: self fund the capital need and disclose the challenges/loan

• Notice that both 1 and 3 could make the new raise less successful, so GP opts for Option 2 and sells it as "I did it for you" a year later

• If the GP has said “we don’t do capital calls,” they might be funding the loan to continue that image/brand even though it might NOT be in the best interest of LPs

• A similar situation to the above unfolds if the GP needs (for whatever reason) to say that they’ve never done capital calls - to be abundantly clear, in both of these cases the GP might be putting their own interests ahead of the LP interests

• I’ve also seen variations of the following statements in capital calls, let’s discuss how they’re intricate:

• “We’re not taking any fees for this capital call transaction”

• That’s true.. but (1) half of my money is going to pay you back, (2) you didn’t tell me there was a loan to begin with

• “We’ve stopped taking management fees to align our interests with yours”

• What the statement sounds like: “We no longer get paid for our work and therefore we’re more aligned to you!”

• What the statement actually means 90% of the time: “We’re not currently collecting cash payments for our management fees. However, we ARE accruing those payments.. and those payments are an accounts receivable that is senior to your equity. In other words, we are guaranteed to make our fees back, before you make a dime on your equity investment or capital call contribution.”

• By the way this is suuuuper complicated, because - in the eyes of an LP - the worst thing that can happen is having a GP that’s not incentivized

• In many capital call scenarios the promote is already deep out of the money (i.e. upon sale there’s a very slim to no chance of the GP getting paid a material sum of cash for their work to date); you can see then how not receiving fees doesn’t necessarily make things better for the LP in terms of alignment…

• More on the GP business model here and more on spotting GP/LP misalignment here

• “We’re investing alongside you in this capital call”

• What this actually means (in most cases) is that a portion of the $2.5mm (which was funded by LP cash to payoff the GP loan) will be reinvested into the property - but let’s be clear, the money (today) came from the LP

• Putting aside ethics and “what’s fair” for just a section, I just want to make the point that in some cases it’s actually better for LPs to not payoff the GP loan - the GP is more incentivized to work through a solution when they have more cash in the project at stake. In other words, by cashing them out (and let’s remember - their promote is already out of the money in most cases) you’re likely decreasing their alignment with you in making the property work.

• Now - before you yell at me - I know this is controversial! They deserve their money back.. I agree. But I am simply stating the reality, which - to be clear - should be abundantly clear to the GP as well when they’re extending such a loan. You don’t have to fund a loan, it’s not a requirement… but if you decide to extend the loan, do it.. but do it for a short time and disclose to your partners what you’re doing.

And now we get to the conclusion - at which point is paying off a GP loan ethical as part of capital call proceeds?

• When the GP clearly communicated that the loan was being made in the first place

• During this communication, the GP clarified that there are challenges with the property … the more transparency, the better

• A few weeks of a delay here is fine, people get busy - but if you learned about the challenges and the loan when the capital call was issued a year later, you can clearly see how that’s a problem

• The loan terms are disclosed (remember, it’s a partnership)

• Many times the loan terms are dictated in the documents by the way, and sometimes there’s an order that the GP must follow that might contradict the GP’s action to fund the loan (e.g. the GP must first ask LPs for capital, and only then can inject their own cash)

• Some may ask, is a balance sheet update on the related party loan enough of a notification to LPs?

• It’s certainly better than nothing, but if there's a serious need for capital (regardless of how its funded) .. I think your partners in the project deserve a quick note on what's going on… right?!

• When the use of the cash in the capital call (to payoff the GP) was clearly stated

• This means it wasn’t hidden, and wasn’t confusing either (it’s not so hard to say “we’re getting paid back for money that we previously lent, as we explained in our email update to you dated YYYY.MM.DD”)

• As a reminder, if a Sources and Uses isn’t presented to you in a capital call… you should request it - there’s no way to make a decision without it - you can read more on that topic in 6 steps to a successful capital call decision

• Were the updates between loan and capital call transparent?

• In a capital call, you’re essentially being asked to trust someone who hasn’t performed to expectations

• To be clear, sometimes it wasn’t their fault.. things happen, but at the end of the day, the investment isn’t going according to plan

• The best way to rebuild trust in any challenge is communicate transparently

• If the reporting updates at/after the loan was funded have been transparent and the capital call wasn’t a surprise, that’s a good sign; if the oppose is true, well then… were you partners in the first place or are you only partners when the GP needs you?

As always, would love your feedback! Have a wonderful week.

I advise LPs on existing and potential positions and write articles here weekly on what I see in the marketplace that could help you invest better. You can find me on LinkedIn or Twitter.

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