In the current market environment, we have observed that the high cost of debt, combined with the effects of high inflation, has led to an increase in the probability of capital calls. There’s a lot to keep up with when it comes to capital calls, and it's not uncommon for investors to feel like they have more questions than answers. One of the most important things an investor can do is to remain informed and prepare for the possibility of a capital call in advance.
In this article, we answer some of your frequently asked questions about capital calls and how CrowdStreet addresses them.
Q1. Is it mandatory to participate in a capital call?
Generally, no. But while it is true that participating in a capital call is generally not mandatory, it's important to note that there may be consequences to non-contribution. These consequences can vary depending on the specific deal and are outlined in the investor’s operating agreement. Some common consequences can include dilution of equity, changes in distribution structure, and advancement of funds as a loan. To learn more, read our article, “What are the Consequences of Non-Contribution to Capital Calls?”
Q2. Is the rise in interest rates having a greater impact on development deals than on acquisitions?
While this depends from project to project, development deals may be affected more dramatically. This is because lender spreads, which represent the fees charged by banks to lend capital, are typically higher for development loans compared to acquisition projects. Development projects are more risky or opportunistic in nature, and the lender takes that into account before lending.
The impact of dramatic increases in interest rates and the ongoing surge in construction and labor costs may affect projects that are already operating with tight margins or ones that have long-term financing structures in place that are sensitive to these changes. On the other hand, some development deals may be less affected by interest rate increases if they have already secured long-term financing at fixed rates or if they are able to pass on the higher costs of borrowing to tenants or buyers.
Q3. Assuming existing investors in the deal do not participate in the capital call, where do sponsors typically source additional funding from?
It varies on a deal-by-deal basis, and the details of additional contributions are laid out in the operating agreement. Typically, the first order of operations is that the sponsor or operator will reach out to the existing investors or the internal partnership to give them a first look or right of first offer (ROFO). Sponsors will generally set a time frame around the additional request and then check the participation rate. Depending on the size of the remaining shortfall, any additional gaps may be filled by the sponsor and/or affiliated parties. Alternatively, if a significant gap in funding remains, then sponsors will typically seek capital from outside third-party providers (i.e., preferred equity, rescue capital).
Q4. When considering raising additional capital, what is the rationale behind choosing member loans over requesting additional equity?
The decision between structuring a capital call as a loan versus equity can vary based on characteristics that are unique to each scenario. The deal structure can also change depending on which option the sponsor chooses.
Calling additional equity resizes the ownership pie or structure of the original equity, whereas a member loan does not dilute the ownership but rather inserts a new form of capital that is subordinate to the senior loan but in priority to the equity. In other words, member loans can “skip in line” in front of equity in terms of repayment priority - the partnership swaps equity for debt until the debt is repaid.
A sponsor may opt for loans over equity when the funding needed is anticipated to be short-term in nature, for example, under 18 months. Choosing a member loan may also make more sense than requesting additional equity if the project has the ability to pay current interest on it (i.e. there is enough net cash flow currently in the project to pay interest on the member loan).
Ultimately, the decision to pursue member loans or equity will depend on the specific circumstances of the investment and the goals of the sponsor and investors involved.
Q5. When a property's initial debt maturity has been reached, and the interest rate has been reset to a level that results in negative net cash flow, why wouldn’t sponsors use the capital call to cover the shortfall instead of buying a new rate cap?
The short answer is that sponsors typically don’t have the option to choose. Lenders, more often than not, require a debt-to-service-coverage ratio of the deal (“DSCR”) of 1.2x or higher to approve an extension. Absent paying down a substantial amount of the outstanding loan, the other way to achieve a positive DSCR is to purchase a new rate cap that is “in the money,” meaning you’re capping the all-in interest at a level that is feasible for the project.
Q6. Do capital calls solve the project's problems?
Additional capital may help address some or all of the project’s problems. When a sponsor calls for additional capital, the exit timeline for the project is often extended because more time is needed to stabilize the investment. In our experience, we've seen deals with capital calls exiting with returns that are above proforma, and we've also seen deals with capital calls where all equity was lost, including original equity and the capital call.
Every project is unique, and the success of capital calls in addressing the project's challenges largely depends on the primary reason(s) behind the capital call. As an example, if a project is dealing with, let’s say, 50% budget overruns and tight margins, it may be difficult for the project to recover to its originally projected performance. However, if a project is exceeding proforma operationally but needs additional cash reserves for a new rate cap, for example, it may ultimately help boost the project's performance.
Q7. What is CrowdStreet's involvement when a sponsor issues a capital call?
CrowdStreet’s involvement is case-by-case dependent. Sponsors are not obligated to run a capital call through CrowdStreet and sometimes do issue and fund them independently. However, we encourage sponsors to use our platform and services for a better investor experience.
CrowdStreet has recently built out additional functionality to help facilitate capital calls through the CrowdStreet portal. However, given this may not be a requirement per the agreement sponsor has executed with CrowdStreet, a sponsor may elect to run the capital call process independently when it deems more appropriate to do so (i.e., when CrowdStreet investors only represent a small portion of the equity in the deal, etc.).
We are tracking investor feedback related to capital calls and anticipate continuing to improve the investor experience in this regard going forward.
Q8. Does CrowdStreet vet capital call proposals?
CrowdStreet encourages full transparency and collaborates with sponsors to ensure Marketplace investors can access all relevant information to make informed decisions. However, for Marketplace investors, CrowdStreet’s duty is to help facilitate the delivery of information, but investors must then make their own decisions regarding participation.
As for CrowdStreet Advisors (CSA) funds or privately managed accounts (PMA), CSA has a fiduciary responsibility and conducts additional analysis to determine whether or not it is advisable to participate and either makes that decision on behalf of investors (CSA funds) or advises clients to help them arrive at a decision (PMA).
Q9. Does CrowdStreet charge sponsors for raising additional capital from investors for a capital call?
CrowdStreet does not charge fees on the funds raised from capital calls or the project. Our agreement with sponsors does not compel them to run capital calls through CrowdStreet, meaning sponsors technically have the autonomy to conduct capital calls independently of CrowdStreet. However, CrowdStreet encourages sponsors to run the process through our platform to create an investor-friendly experience.
With that said, CrowdStreet directly charges sponsors an administration fee to run the capital call process through our platform, as there are costs associated with running that process.
Q10. Am I "throwing good money after bad" by participating in a capital call?
A challenging reality for some investors to realize in a capital call scenario is that, in some cases, your original investment is now a partially or fully 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 you believe it meets your investment criteria to participate, 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 will unlikely 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 led 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 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.
CrowdStreet cannot provide investment advice or 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 before making a decision, and consider working in consultation with legal, financial, and tax advisors.
Disclosure: CrowdStreet, Inc. (“CrowdStreet”) offers investment opportunities and financial services on its website. Advisory services are offered through CrowdStreet Advisors, LLC (“CrowdStreet Advisors”), a wholly-owned subsidiary of CrowdStreet and a federally registered investment adviser. CrowdStreet Advisors provides investment advisory services exclusively to privately managed accounts and private funds and does not otherwise provide investment advisory services to the CrowdStreet Marketplace
This article was written by an employee(s) of CrowdStreet, and the contents of this publication are for informational purposes only. Neither this publication nor the financial professionals who authored it are rendering financial, legal, tax, or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to any person constitute an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. The views and statements expressed are based upon the opinions of CrowdStreet. All information is from sources believed to be reliable. This article is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance or success. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. CrowdStreet assumes no liability in connection with the use of this publication.
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