Unethical capital calls

Happy Sunday!

I’ve written before on the fact that not all capital calls are created equal, and have a fairly deep “library” of articles on the topic:

• Two part series:

• Is my investment distressed?

• My deal is distressed, now what?

• 6 steps to a successful capital call decision

• Do sunk costs matter in capital calls?

• Will a rate cut(s) save distressed investments?

• Minimum Viable Capital Call

• Criss cross rescue sauce - (if you haven’t read this one in particular, you should.. I keep seeing it play out weekly; my article title didn’t do the article justice, but you’ll understand why I chose it #noregrets ☺️)

• Capital calls to pay off a GP loan

Today I’d like to venture into a somewhat controversial zone: the ethics of making a capital call.

You might reasonably say “what do you mean ethics - GPs are free to do whatever they want!” This is certainly true, but I think we can all also agree that there are some bounds that would deem a capital call request deceptive, unreasonable, or even simply not in the best interests of the LP receiving it.

The underlying issue typically stems from the fact that GP/LP alignment shifts deeply during distress and this is typically where the divergence of incentives begin.

In short (would recommend reading the below article prior to continuing), a GP starts shifting priorities to cover themselves in a distressed scenario - often at the expense of the LP or their best interest. That’s precisely what we’ll discuss today because this is particularly common during capital calls.

I’ve advised on hundreds of capital calls now and talk to LPs all the time. While some LPs didn’t know that a capital call is even possible, many understand that sometimes they make sense for all parties involved. GPs, on the other hand, are essentially battling a fight of “do I cover for myself” vs “doing the right thing by my LPs at my expense.” As you can imagine, this is a tough balance and oftentimes mistakes are made.

The question for today, though, is how often are capital calls issued where even the GP knows with fairly deep certainty that the assumptions aren’t realistic? Here’s an actual example that I come across ~weekly:

For what it’s worth, the above describes well over 50% of capital calls that come across my desk. One simple way to view this is that the GP is stuck in a corner with no way out … and the only way out (usually to avoid a track record loss, litigation, etc) is an attempt to kick the can down the road. Is the “can” investable for the LP though? Perhaps not, but that’s the only option the GP has at this juncture, so they click send on the email.

In my (hopefully not too) controversial opinion, as an LP I would actually prefer the GP to tell me that they’ve done some math, share that math, and let the property go instead of issuing what I would call an unethical capital call. There are a few reasons for this:

• Many of these capital calls make the LP think there’s value left in their investment today or in the future, when 75% + (perhaps more) of the time the answer is that there’s none. Every part of the transaction (lender/GP/pref provider) realizes this EXCEPT for the LP - don’t be that person please!

• Your best LP is your existing LP, and I think kicking the can down the road with a fairly high chance of failure is so much worse than just being honest about the situation today

• Following the promote will lead everyone astray - as I wrote in the spotting GP/LP misalignment article, a GP will naturally follow the money and 90% of the time by the time a capital call is issued the GP is OUT of their promote.

• This means that they’re effectively working for free (many times the property can’t pay for management fees either) - while this may sound attractive to the LP in practice it probably means that your investment is getting the least amount of attention in the portfolio since there’s no money to be made! And now compound this with the fact that you plowed more money into the investment…

• Distressed situations turn into headline risk plays for many GPs - the question should be “what’s in the best interest of my LPs” but oftentimes in practice becomes “what should I do in order to stay out of the newspapers/social media while also avoiding a loss on my track record.”

So, to summarize, while it’s true that you could put any sort of deal in front of an investor (no matter how shady) I think the standards for capital calls need to increase - particularly so because you’re dealing with individuals who have already lost some (if not all) of their initial investment.

Unfortunately this becomes more an ethical question, rather than a securities law one … but I do hope that as the industry becomes more transparent LPs have more information at their fingertips to spot the well intentioned capital call from the rest. More on this soon.

When you’re ready, I could help you in 3 ways - simply reply to this email if one is of interest:

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If you’d like to speak on the phone, you can reach me at aleksey@centriocapital.com.