Private equity funds that need a cash infusion, usually for a new project or to buy assets, use a legal maneuver called a “capital call” to collect committed capital from the fund’s investors. But there are other considerations having to do with such a call’s usage. Let’s look at when a capital call should be used – and more.
Explain Capital Calls
When buying into a private equity fund, investors usually only turn over part of their contribution at the onset and put the balance in a low-risk account where it can make money until the fund “calls” for it. This arrangement works for the fund as well, since it doesn’t want to have a lot of money around that isn’t being invested or used to woo new investors with relatively low initial buy-ins.
Such calls are viewed as short-term loans that ensure the equity funds’ liquidity and continued growth. And because equity firms typically operate on a just-in-time basis, they must be able to secure capital … whenever. That’s not possible, by definition, with investor funding that’s already scheduled. So, capital calls are essential.
Note that the onus is on the investor to make sure, up front, that they are familiar with all the terms of their fund’s looming capital call, which will be spelled out in what’s called a limited partnership agreement.
What’s included in a Capital Call?
A capital call must include the percentage of the commitment that’s being demanded, the fund’s name, payment details, the due date, and a list of total commitments.
What Happens if the Investor Can’t Comply?
One challenge with capital calls is insufficient fund documentation; the fund can’t be 100 percent sure that the capital will be there when called for. And, at times, investors will default on their commitment, even after they’ve been given an opportunity to make things right. Such penalties can include:
- Forfeiture. The investor’s commitment could be totally forfeited.
- Conversion. If they can’t make the call, the investor’s interest could be changed to nonvoting.
- Calling the commitment. A penal rate of interest will be applied if this happens.
- Sale of interest. The investor may have to sell their interest to the fund or third parties at a discounted rate.
- Withholding against future distributions. Unless and until the capital call is met, future income distributions will be affected.
When Should a Capital Call Be Used?
Technically, a fund can issue a capital call whenever it wants. Therefore, investors should always be prepared. However, there are times when a fund should hold off on that call. That includes when it knows or suspects that the investor isn’t prepared to comply. After all, reputations are at stake all around, and the firm doesn’t want to unnecessarily strain relationships.
To skirt planning issues, investors typically get at least seven days’ notice before making the call, also known as a drawdown.
It’s never wise, by the way, for a fund to rely on capital calls for operational costs. That’s asking for trouble, especially if it isn’t certain the funds will be there.
So, when should a capital call be used? As we say, usually when project funds are needed — and even then, only when a deal is close – or to address unexpected and temporary market changes. Such calls are short-term loans that are secured against the investor’s capital commitment. This short-term borrowing makes it easier to manage the fund day to day and makes funding of the private equity firm easier.