What happens if you can't participate in a capital call?

Question

Hi, folks. It looks like there's a mandatory capital call forthcoming in a project I'm an LP in. I can't contribute more money at this time so have no choice but to be in "default".

Besides not being able to collect distributions, if the project goes under, will I at least be entitled to my original investment amount if there are funds left over to return investor capital?

This is the language in the company agreement:

" a Defaulting Member shall be entitled only to the return of the balance in the Member’s Capital Account without any interest thereon."

Doug Smith · Answer

It's really going to depend on what is written in the Partnership Agreement and the Subscription Agreement. That being said, the attorneys write those things to basically say "here are all the ways we're going to lose your money". This forum is great for simple things, but that's something your attorney that specializes in securities and limited partnerships is going to have to answer for you. We got out of being the General Partners of LPs long ago because I couldn't sleep. The stress was just too much. We're now fine with our simple JVs and fixed-return debt agreements with investors. I no longer feel like I have to worry about cost overruns. I would be curious to know why the GP needs more capital. Did they mismanage the project? Did they do a poor job with the scope of work? Did they not build in enough for contingency reserves? Keep us in the loop. I'm interested to hear how it plays out.

Erik W. · Answer

It kind of scares me for a person who goes into a deal like this without understanding that this could happen or being prepared with resources when things do not work out as projected. It's sort of like a homeowner who signs up for a mortgage, then loses his job and asks, "What could happen to me if I don't pay my mortgage?" The Mortgage or Deed of Trust tells you: the lender will foreclose if you don't get current. Meanwhile, late fees and legal fees will be added on, making a bad situation even worse, until eventually it spirals totally out of control and the homeowner is forced out and loses much, if not all of their equity and may owe a deficit balance even after the property is liquidated.

As you said, you're in default. It usually means you're going to lose a significant amount of money. I haven't read your LP operating agreement says, but it might say the amount of the capital call will be deducted from your original investment amount. So let's say you had $100,000 invested. If the call is for $50,000, your "share" would to drop to $50,000 for all future payouts. If there are others in your group who likewise cannot meet the call requirement, then the project may go under and you may lose most, if not all of your investment. If the other partners are able to salvage the investment and make it profitable again, your share of distributions will be less as a result because you weren't in with the people who did the heavy lifting of providing the required capital when the project was in trouble.

Not trying to beat you up too hard, but next time be sure to understand the requirements of the deal you're getting into and have the cash reserves to participate before signing up ... or don't participate. I do hope it works out in the end.

Arn Cenedella · Answer

@Asa Hunt

Check PPM and Operating Agreement.

I suspect if you don’t put up more cash your equity percentage ownership will decrease.

Say it was a $1M raise to begin with and you put up $100,000, you own 10% of the LP equity. If sponsor needs to raise say $250,000 and you don’t put up your share your equity position is reduced as follows:

$100,000/($1M plus $250,000) equals 8%.

Your equity share in the deal is now 8%.

I think you need to evaluate . Can the deal be saved? Or is it going under?

Lots of folks in your situation.

Sorry and good luck.

Erik W. · Answer

@Asa Hunt, Understood. All of us get sideswiped by the unexpected from time to time. Job losses happen, and so do major life events like births, deaths, etc.

The part I don't get is why you weren't aware of the risks / consequences of failing a capital call: that should have been researched and understood before jumping into this adventure. This stinks for sure. We've all "been there, done that", so let the pain of this encourage you next time to read the documents and consult professional advice to help clarify any confusing obligations before jumping into the next deal. In a deal like this, I'd want to know my maximum possible exposure and loss potential. Have that spelled out in the documents. If the deal provider can't do that, it's a crap deal. Don't touch it. Unlimited loss is never acceptable. This is why I never short stocks, because theoretically the loss is limitless.

On the bright side: congrats on the new kiddo coming into the family! Kids are the best, and we can use our mistakes / life experiences to help train them to avoid the pitfalls we crash into along the way. Good luck, and buy some strong coffee!

Henry Clark · Answer

@Bruce Lynn. I don’t even invest in syndicates or MFH. You almost made me cry. Losing my investment and having to pay taxes.

OP. Any investment you do, calculate and understand failure. Understand your personal situation. That is why you need to keep working in an REI strategy.

Asa Hunt · Answer

The call is for 25%, so I would expect dilution to that amount.

To your other points, much can change over lifetime of a project. I was laid off 2 months ago and our 2nd child is due this weekend. This is the only time in the last decade I've been sweating financially, so this call couldn't have come at a worse time. It'd be incredibly wreckless to send a large chunk of money out the door since I'm the primary bread winner.

Bruce Lynn · Answer

#1. You could loose your entire investment. It says this multiple times normally in the PPM. This could happen if there is not some other way to raise the capital needed to continue operations or the project. Of course you could loose both the original and the capital call too, if it doesn't prove to be enough or things continue to deteriorate.

#2. Sometimes there is a capital call, but the GP is able to add debt or borrow more money. Just saw some deals where they tried to get money from the 3rd party PM, and that was going to be at 14% interest. OUCH. That's rescue capital, but at the last minute PM pulls out...so not sure where those deals stand now. These days probably that rescue capital is expensive and will need to be paid off first before LPs get distributions or capital back.

#3. Some GPs might try to borrow money from their investor pool or if they have funds, loan in money themselves at some interest rate. Maybe 10% right now.

#4. I would guess most GPs try to over raise what they need if possible to be on the safe side and knowing not everyone has capital. Then you probably get diluted.

#5. Some chance that you get some capital back, but from what I am seeing in Texas right now it seems like when the deals go under, everyone gets wiped out.

Someone smart out there tell me if a foreclosure is a "capital event" where the GP would be able to collect their 1-2% on the backend...and if any small amounts left in operating accounts and such would get wiped out. Also wondering on these deals that go to foreclosure, do you think the GPs still pay an accountant for a schedule K?

@Asa Hunt also if I remember correctly if you do get 100% wiped out and you took bonus depreciation you may have a tax bill to consider at some point when that gets recaptured, so save back some funds to pay for that.

I'm not the authority on all this, so if someone wants to correct me or prove me wrong, I'm open to learning.

Maurice Smith · Answer

capital calls suck , sorry to hear that. Be cautious of who you invest with. I heard stories of asset managers doing capital calls , and then running off with the money. I hope you get it figured out.

Carlos Ptriawan · Answer

all CRE asset classes has worsened cap rate since last three quarters. If the GP asking for more capital call sometimes there're only three choices
(i) losing your 25k now
(ii) adding another 25k, with the risk of losing 50k
(iii) or maybe my 50k would return 60k after 4 years.

I guess depending on the "financial situation" of the GP and property,; lets say they have floating rates, and all their portfolio is due next year, I guess it's wiser to lose the 25k than lose 50k.

James Hamling · Answer

@Asa Hunt there are 2 core issues here, that (a) your not with comprehension and (b) the venture has changed.

I would focus my energies to resolving these items first.

That would mean (a) getting a legal review to tell me my options, and to have full comprehension of them. And (b) doing the analysis of venture, from scratch, as it is now. Maybe it no longer is viable, it may hold more value to walk away, maybe worth sticking it out, maybe needs' to prepare for additional capital call's, without the analysis it's just guessing so need to redefine exactly what it is now, in this updated status.

What happens if you can't participate in a capital call?

What happens if you can't participate in a capital call?

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