Capital Calls Explained: A Must-Know for Every Investor

A recent Gallup poll found that 37% of US adults consider property their most favored investment for generating consistent returns over time. Things have not really changed much over the years. Back in 1930, Andrew Carnegie, reportedly the world’s richest man and a noted philanthropist, famously said, “90% of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined.”

However, as with all investments, you need to tread carefully in real estate, too. A winning proposition could quickly drain your resources if you are not careful enough. In this article, we will take an in-depth look at capital calls in the context of commercial real estate investments from the investor’s point of view.

Capital Calls: Ground Rules

General Partners (GPs) can call on investors to provide additional funds if the Limited Partnership Agreement (LPA) permits. Most of the time, the demand is for a positive reason and will provide long-term benefits to investors. For example, funding could be required to capitalize on a lucrative opportunity.

However, not all capital calls are good news. GPs may make a capital call when the property incurs losses and needs additional funding to stay operational. Here are some points that will help you understand what capital calls are all about:

1. If the LPA includes a capital call clause, it is compulsory for investors to contribute funds when a request is made.

2. When a capital call is made, you will get an email asking for payment. The notice will also appear when you log on to your page on the investment company’s software portal.

3. Typically, you would get 7-10 days to pay.

4. Your money would be used for a specific purpose. For instance, the amount needed for a new project could be collected in stages. Sometimes, capital calls are made to meet unforeseen expenses.

5. Capital calls are usually not made at regular intervals. The GPs ask for funds on an as-needed basis.

How is the Capital Call Amount Determined?

The ownership share in the fund determines the amount an investor must pay. Let us dig a little deeper into this rule with a simplified example. Consider a fund with the following structure:

• Total committed capital of $20 million.

• Limited Partner A has committed $2 million.

• Limited Partner A’s ownership share is 10%. ($2 million is 10% of $20 million).

Now, if the GP makes a capital call for $5 million, Limited Partner A will need to pay $500,000. (10% of $5 million). There is another crucial point to remember. GPs cannot ask LPs to pay more than their committed capital. In the example above, Limited Partner A could be asked to contribute a maximum of $2 million.

What You Should Ask Before You Pay

We have already mentioned that if the GP calls for additional funds, the LPs have a legal duty to pay. You can consider it a fait accompli–the obligation is binding and is not subject to negotiation. However, you do have the right to ask questions, and it is a good idea to do so. What are the types of queries you should raise? Here are some that you could consider asking:

• What prompted the capital call? Was it part of the original investment plan?

• If the call has been made to raise funds for a new project or an unplanned upgradation, you should ask for details.

• At times, a capital call is made to fund operational expenses. The project could face unexpected repair costs, or a market downturn may lead to rising vacancies and a consequent fall in cash flows. The money could even be required to meet debt obligations. It is essential to understand the reason for the capital call and inquire about the precise manner in which the funds will be used.

LPs must also monitor the total committed capital per the terms of the LPA vis-à-vis the funded capital.

What if You Do Not Participate in the Capital Call?

The offering documents will describe the consequences of not meeting a capital call. In most instances, LPs will see a reduction in their ownership stake. There could be other repercussions as well. Investors who do not meet their commitments may lose certain rights, such as voting rights. That is not all. Here are some of the other possible adverse outcomes that LPs could face:

1. LPs could lose out on future distributions.

2. Interest charges may be levied on the unpaid amount.

3. The outstanding amount could be converted into a loan.

4. The GP may start legal proceedings.

5. The GP could admit a new investor to provide funds. This would result in the dilution of the defaulting LP’s interest in the investment.

At times, a capital call could put LPs in a difficult position. If there is a market downturn, or even worse, you suspect mismanagement by the GP, do you sink more money into the venture? Or do you renege on your commitment and face the consequences? In such a situation, it may be best to arrive at a decision after seeking legal advice from an experienced and trusted attorney. 

The Bottom Line

A capital call clause in a Limited Partnership Agreement gives the GP the right to ask investors to contribute additional funds. While you are legally bound to pay, you should take some precautions before transferring money to the investment firm.

Check whether the demand is per the agreement’s terms and understand how the funds will be used. If, for any reason, you decide to withhold your contribution, bear in mind that the consequences could be serious. You could face financial penalties and even legal action.