If you’re interested in private equity, one of the first terms you must master is “capital call.” The legal tool is crucial in that it’s used to collect committed funds from investors whenever such capital is needed. Capital calls help keep PE funds going – and growing – and enable them to secure investment projects.
With that in mind, here’s information that will help you understand the ins and outs of capital calls.
What Exactly is a Capital Call?
Initially, PE investors usually make just a portion of their pledged contribution to the fund. This usually works for all parties since investors get a chance to temporarily hang on to their capital and even make money on it through a low-risk account. The fund, meanwhile, benefits from not having a lot of capital around that isn’t being invested or put to work to bring in new investors with relatively low up-front buy-ins.
The white elephant in the room, though, is that when the fund calls for the balance of the contribution – which can take many months — you must come through.
Why are Such Calls Important?
As we say, funds need them to thrive and grow. Why? Because most private equity firms operate on what’s called a just-in-time basis, meaning that when they need capital, they do need it – now (well, investors typically have a week to 10 days to deliver the funds). They don’t have the luxury of awaiting “scheduled” investor funding because that’s not how opportunities or sudden needs work.
When are Such Calls Made?
A capital call is made whenever there’s a need, which typically is for project funding or to address unanticipated and temporary market challenges.
It should be stated that it’s never wise to rely upon capital calls to cover operational expenses, though, and such calls probably shouldn’t be made if compliance seems unlikely, since that could trigger an investor default, hurt reputations, and damage relations between the fund and the investor. Now, there are financial consequences for noncompliance, but firms generally want to first see whether things can be worked out.
If an investor is unable to remit the capital when the time comes, however, a fund may:
- Demand that the investor sell back to the firm their interest
- Make the committed capital a loan, so that the investor must pay interest in addition to the pledged amount
- Reduce the investor’s partnership interest or equity
Are There Any Downsides to Capital Calls?
It’s not a good look for funds to overly depend on capital calls; investors can view that as a liquidity problem and may be hesitant to participate. After all, quick drawdowns – capital calls — may be a sign that the firm is not making gains.
There’s also the risk of investor default, which we’ve cited. The main problem is that it’s difficult to substantiate, in a timely fashion, investors’ ability to comply. However, fund managers can mitigate their risk by working primarily with institutional investors or individuals who have a track record of hitting their marks. Some fund managers attempt to time their calls to distributions to be certain that funds will be available.
How Do Capital Calls Work?
Before a call is made, the fund will notify investors, of which the average fund has around 20. The notice will usually include:
- The amount of capital being called for as well as how much the investor has pledged
- The amount the investor has contributed already
- The total amount, post-call, the investor will have contributed
- The remaining uncalled capital
- What the additional capital will be used for
- The due date
Now that you know the ins and outs of capital calls, you’re that much closer to being able to participate in one with confidence. The main takeaway for you should be that you simply must have the balance of your contribution ready for when – not if — the call comes.