Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is a capital call.
Over the past decade, private equity has become an ever-popular asset class. One term that private equity investors will eventually come into contact with is “capital call”. In this episode, Charles discusses what capital calls are, and why they are an important tool for both private equity firms, and investors.
TALKING POINTS
Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is a capital call.
Charles:
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Charles:
A capital call is how a general partner, the dealer fund operator collects capital from their limited partners. The passive investors general partners make capital calls when the dealer fund requires more capital.
Charles:
Capital calls typically happen when a fund plans to make a new investment or if the fund or deal requires more capital in order to pay expenses, different types of capital calls for different situations. In most real estate syndication deals and funds, limited partners will commit a specific amount of capital and then invest this total amount on day one. For example, you commit to an investing $50,000 into an apartment complex syndication deal, you’ll wire this $50,000 into the deal immediately. The general partners utilize the majority of the capital immediately during the purchase and the beginning of the renovations. There is a minimal percentage of capital compared to the total raised still sitting in the, in the bank account for the deal. However, it’s very minimal when compared to the amount that was raised in other types of funds such as venture capital funds. It is common for the limited partners to commit a specific amount of capital, but only put up and wire in a portion of their committed capital at the beginning of the fund’s life.
Charles:
This is also referred to as the initial drawdown. Now there’s no set rule or amount for the initial drawdown. It varies greatly from general partner to general partner and fund the fund. In this type of fund setup, the general partners might be raising 100 million to invest in the companies. However, on day one of the fund, they only have 10 million of the a hundred million allocated to specific companies and deals. Commonly they will do a capital call, may be of 25 or 33% of the toll committed capital from limited partners. Since there’s no need to have 90 million sitting in the bank. Instead, they might have 20 million sitting in the bank for the next year of investments in deals. When this 20 million dwindles due to investments and expenses, the general partners will make another capital call. Now, the amount of money that limited partners, uh, put into the fund, um, is called the paid in capital.
Charles:
And the difference between committed capital and paid in capital is referred to as uncalled capital. So for example, an investor commits $75,000 to a venture capital fund. The initial drawdown is 33% or $25,000. The investor will wire this in. Their paid in capital is now 25,000 and their uncalled capital is $50,000. The amount the investor still owes to the fund. And when the second capital call occurs, the general partners will send out a capital call notice to limited partners. This notice will outline the amount due, the portion of committed capital, the bank wire information, and the capital call due date, usually within two weeks. For example, I recently passively invested into an angel investment fund for the purpose of investing into early stage tech startups. The initial drawdown was 33% and I was told to expect a second one in about 12 to 15 months, and then the third one, 12 to 15 months after that.
Charles:
As a limited partner, I have to make sure I had the funds readily available for these capital calls. Now, the benefits of the capital calls model for limited partners, specifically for venture capital funds are it allows passive investors the ability to possibly earn higher returns than capital that is not being utilized by the fund manager. It offers the limited partners the ability to commit funds to a fund while utilizing cash flows from other investments to fund the capital calls. It minimizes the time that the investor’s money is unavailable. The benefits for general partners, the fund operators is that it minimizes cash drags on fund performance from uncalled capital. It helps general partners raise funds. Since a limited amount of total capital is committed, is required upfront, there is no rush for fund managers to invest. It allows general partners to invest when and only when they identify good deals.
Charles:
Now since our show is based mainly around real estate investing, I wanna break down some specific real estate capital call situations and that are considered unforeseen one compared to the venture capital. Capital calls that are are just explained and understand from the beginning. Now, unforeseen capital calls are very detrimental to a real estate syndicator’s business. It shows that the operators do not understand the current market dynamics they’re under capitalized and they’re unable to continue operating the property in business plan without additional capital. If I was limited partner in a real estate deal with an unforeseen capital call, I would be very concerned with what is happening with the funds that are being called. I would really wanna see a different general partner or key principle take over the deal. Now, a capital call may be initiated when there is an unexpected drop in occupancy, uh, economic occupancy or collections.
Charles:
If the drop to levels that are closer below breakeven, they’ll be risking the entire asset if they did not recapitalize with a capital call. Now, if the operators continued on this path, they’ll be unable to make normal property repairs and improvements and no one wants to work if they’re not getting paid. And this will lead to good, good tenants leaving the property and fewer good tenants wanting to move in, which is a recipe for disaster. Now, a capital call might be made if a renovation or development project goes over a budget. For example, the project initially thought that 10 roofs, uh, needed to be replaced after purchasing the complex. 20 roofs needed to be replaced within the next six months. The sit cares did not correctly perform due diligence, and now they need to find money for 10 more roofs in the next 180 days.
Charles:
Now, capital call might take place if financing and debt terms change on a property. And this is a big one that can happen to not only new investors, but also experienced investors alike if they misjudge interest rates for floating rate debt. If they’re paying interest rate of 4% on your debt and interest rates spike 2%, when you readjust, they do not have an interest rate cap, your debt payments will dramatically increase. That is why floating rate debt is only for experienced investors. If you’re interested in learning more about this topic, you can check out, um, SS one 15, SS one 17 and SS one 20. Or worse yet, the mortgage loan is coming due and the property has decreased in value since it is in recessionary times. Most banks are not lending at the same loan to value in order to refinance operators and limited partners need to make up the spread between the previous loan to value and the lenders new loan to value.
Charles:
So let me give you an example here. So you purchase a property for a million dollars with interest only debt, 80% loan to value, and it has a three year term and the property drops during recession to a value of $900,000. Well, however, lenders are now lending at only 65% loan to value. So now you need to refinance an $800,000 loan with loan pre proceeds of only $585,000. So 65% of the new value, which is $900,000. So the operators need to sell and lose a hundred thousand dollars because the property has dropped 10% from their initial purchase price, plus all the capital they invest in or ask investors for $215,000 to be able to refinance. It’s not an easy decision and it’s gonna be very difficult when you’re going back to those investors. Now, some passive investors might feel that since there there is a capital call, the property is can completely lost and there’s no hope for it.
Charles:
Uh, this might be true in some situations, but it could also be, you know, faults because if you are, it depends on really how the operators handle the problems at hand. Now, most operators will put in their own money into the deal at 0% interest in order to write the ship, and others might not have that money or might not wanna do that. So it really shows you how important it is that the sponsors that you’re investing with are really financially stable. Now, if you find yourself in this position, there are several questions you might want to ask yourself As a sponsor or as a limited partner, how and why did the capital call become unavoidable? What specific events led to this situation and were they out of the sponsor’s control? What could have been done differently to avoid all of this? What happens if the capital call fails?
Charles:
How will additional capital contributions be used? How much additional capital are the general partners putting into the deal? Which is a great one. I’d want to know that. How will asset management and property management change also very important and how are the general partners going to reduce and waive fees in order to compensate limited partners? Another great point. Now, most good operators will decrease or fully pause distributions when the first sign of something negative happens. For example, interest rates go up 5% if you have floating or fixed rate debt. Either way, this could dramatically damage the economy and which will damage your possible collections and your your tenants, uh, livelihood and financial livelihood at the property. Right now, now renovations are going over. Budget or other repairs have recently appeared that were unforeseen that need to be addressed as soon as possible. Either way, good operators will usually be able to notice small issues. Now that might turn into big issues on the road. A pause and distributions is much better than an unforeseen capital call. The main goal with real estate’s syndications is not the distribution but the equity multiple when the property is ultimately sold. So I hope you enjoyed. Please remember to rate where you subscribe, submit comments on potential show topics, global investors podcast.com. Look forward to two episodes next week. See you then.
Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.
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