What are the Consequences of Non-Contribution to Capital Calls?

Imagine you have just received a "capital call" notification on your investment. For planned capital calls, these notifications would be expected throughout the investment period. Investors follow the guidance outlined in the operating agreement and relayed by the Sponsor before chipping in.

Scenarios for unplanned calls, however, can be unexpected. Though investors may not have anticipated an unplanned capital call, it does not necessarily signal disaster for a property. Unplanned capital calls typically stem from unforeseen circumstances like operational shortfalls, changing financing requirements, or budget overruns.

It is important for investors to understand their options when it comes to capital calls—and the consequences of not contributing. Investors who do not contribute are considered to be in 'default,' and are often referred to as 'non-contributing members' in the operating agreement (as opposed to 'contributing members' for those who fund their share of the capital call).

Your investment's capital call structure and the consequences for non-participation are generally outlined in the operating agreement under 'additional capital.' Below are a few common scenarios that can generally occur if an investor decides not to contribute:

Dilution of Equity

Investors who do not provide additional capital may find their ownership share of the limited partnership is diluted. This can happen in two common ways:

1. Standard Dilution: To understand standard dilution, consider a simplified hypothetical example where you have invested $100,000 in a deal. The Sponsor's capital call requests 20% of original equity or $20,000 for your share. If you decide not to contribute this amount, your equity share would be diluted by 17%.

$100,000/$120,000 = 83% (or 17% dilution)

Essentially, if you do not contribute to the capital call and other investors do contribute, you own the same dollar amount of a larger pie which, by default, means you own a smaller percentage.

2. Punitive Dilution: In some cases, non-contributing investors can be further penalized by the Sponsor through additional or 'punitive' dilution, over and above simple dilution.

Consider the same example as above, but with a 1.5 times punitive dilution provision. For non-contributing members, the punitive dilution is calculated in two steps. First, the amount called is multiplied by 1.5 ($20,000 x 1.5 = $30,000). The difference ($30,000 - $20,000 = $10,000), is then deducted from the original equity contribution of $100,000 to determine the punitive dilution percentage:

$90,000/$120,000 = 75% (or 25% dilution)

If you decide not to contribute in the above scenario, your equity share would be diluted by 25%, as compared to 17% in the simple dilution scenario. The difference (8%) is allocated to the investor(s) who contribute(s) on behalf of the non-contributing member.

Changes in Distribution Structure

Contributions to capital calls rebalance the equity ownership stakes for all investors in the deal, whether they elect to contribute or not. This can change the share of any potential future profits or distributions (however, it's important to remember distributions are never guaranteed). For example, contributing members will typically receive a larger percentage of potential distributions because they now own a larger stake in the investment, whereas non-contributing investors may see their equity stake, and therefore their potential future distributions, reduced.

Advancement of Funds as a Loan

In certain scenarios, Sponsors can also opt for what's often called a 'loan remedy,' whereby they convert up to all of the called capital into a loan. The details, including repayment and interest on any potential loans are laid out in the operating agreement.

As is typically the case with debt, a member loan would be paid off (with interest) first before any potential proceeds are paid to equity holders. These loans sometimes come with an option for contributing investors (or for the Sponsor) to fund on behalf of non-contributing investors providing those who participate an opportunity to 'step in,' and take on more than their pro rata share of this loan.

Why would a sponsor choose to convert the requested capital into a loan? Often this option can potentially provide a fast and simple solution for Sponsor to fund the capital call. Additionally, instead of punitively diluting non-contributing investors, a loan remedy can provide a viable solution to meet short-term capital needs, such as funding a closing on a refinance.

Throwing Good Money after Bad?

A challenging reality for some investors to realize in a capital call scenario is that, in some cases, your original investment is now partially or fully a sunk cost. A capital call might resurrect some or all of the original equity, but that is not the main reason investors should decide to participate or decline. Instead, by separating potential sunk costs and maintaining an objective perspective, investors are freed up to assess whether or not a new investment into the project makes sense, given the current circumstances.

Ultimately, the old money might be good, or it might be bad. But while the new money may have some correlation to the future status of the old money, it is not necessarily a causal relationship. In essence, if the new money is deemed good money in the deal (meaning that you believe it meets your investment criteria) then it may be viable regardless of whether it's you or a new party contributing.

Consider that a brand new investor to the deal participates in the capital call. This investor is unlikely to contemplate how their investment can benefit the original equity.

Instead, the brand new investor would likely be interested in satisfying the following criteria:

• Is the sponsor still solvent and capable of executing the business plan?

• Is it plausible that fresh capital can improve the property's performance going forward?

• Were the root causes of the issues that lead to the capital call largely outside of the direct control of the sponsor, and not a function of poor decision making?

• Is the new investment presenting a compelling investment thesis with an investor-friendly structure?

These are some factors that many investors may consider—regardless of whether they participated in the deal from the start.

In capital call situations, Sponsors are often highly motivated to raise the additional money necessary to fulfill the business plan. This typically means they may offer above-market terms in order to obtain the additional capital, and your past investment is what entitles you to a first right to participate in any new investments into the project.

Crowd Street cannot provide investment advice or otherwise recommend participating or not participating in a capital call. Please carefully review the operating agreement and all of the information provided to you by the Sponsor prior to making a decision, and consider working in consultation with legal, financial, and tax advisors.

Check out our capital calls FAQs to learn more.

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