If you’re going to be a player in private equity or venture capital, you’re going to have to fully understand what a “capital call” is and what it will mean to you as an investor. After all, the term will likely be broached in every limited partnership agreement that’s put before you. But just what is a capital call? Okay, we’ll get right to it.
Explain Capital Calls
A capital call is basically a legal tool private fund managers use to get committed capital from investors when a need arises.
The Necessity of Capital Calls
When you enter into an agreement with private fund managers (also known as general partners), the investor (or limited partner) must forward to the general partner, when it calls for it, the balance of your committed contribution. We say “balance” because as part of the investor’s agreement, you’re only required to initially give the fund part of your commitment.
In the following scenario, for instance, an investor puts down $75,000 on a $200,000 buy-in pledge. The $125,000 balance is now what’s called “uncalled capital,” at least until the general partner requests it in the form of a capital call.
The Importance of Capital Calls
For society at large, capital calls are meaningful because they allow private equity firms to thrive. And besides, the way such firms operate, they cannot grow if they must rely on scheduled investor funding. At times, they need cash right away. They can get it through capital calls.
Capital Calls Allow Investors to Make Money
With capital calls, it’s not as if general partners sit around issuing directives — and whenever they want to – and doing all the winning.In fact, most investors appreciate the opportunity to temporarily put that uncalled capital in an investment account that can make them money.
So, it’s more of a win-win: capital calls give private fund managers the agility to swiftly change gears if the market changes or if a project’s costs are getting out of hand. In addition, the existence of such calls enables funds to woo investors who do want to contribute but who appreciate the opportunity to complete their obligation later.
The Timing of Capital Calls
Fund managers usually make such calls when they need cash to back a project. When the deal is close to being closed, the general partner will make the call and the limited partner has a certain amount of time, usually up to 10 days, to turn over the funds. After the transaction is made, the funds then become the investor’s capital contribution.
Beyond needing funds for a project, managers also make capital calls for other reasons. Those can include to satisfy bank requests, to deal with an undercapitalized fund, or when going forward with a project while costs are rising. In addition, other reasons can include a lack of liquidity, to satisfy new financing requisites, or to help cover projects that are over budget.
Capital Calls Limitations
There are some down sides to capital calls, including the risk of default. While they don’t happen that often, they do occur. And there are times when a manager knows that a capital call is futile because the investor simply isn’t in position to answer.
There’s also a danger in a manager being perceived by an investor as being over reliant on capital calls. That’s not a good look, since these firms don’t have as many liquid assets. It’s also why capital calls should not be used for speculative deals or operational costs. Besides, that’s defies the purpose equity funds, which is to create profit and value for investors. The only times capital calls should be used is when funding investments or dealing with unexpected market changes.
There’s also such a thing as suddenly having excess funds on hand if a capital call Is made too early, and before a deal is sealed.
When Capital Calls are Made
You don’t know when such a call could some, so you must always be prepared. Still, funds usually let the investor know that a call is forthcoming. They want to give the limited partner time to get the funds, of course, but they also don’t want to hurt the business relationship by catching the investor completely unawares.
Defaulting Has Consequences
If somehow the investor can’t answer the “call,” that investor is in for some penalties. Most of those will be detailed in the limited partnership agreement, but the general partner has wide discretion in terms of how he or she handles the situation. In any case, before the investor faces consequences, they typically are afforded an opportunity to fulfill their commitment, plus penalty interest.
If the investor still can’t make it right, though, the fund manager can take steps including vacating the entire agreement, declaring forfeiture, canceling the investor’s right to further contributions, requiring the investor to share their fund interest to other limited partners, restricting the limited partner’s share of future contributions, and seeking legal remedy for damages to the fund because of the investor’s noncompliance. In certain situations, other equity fund members will lend the investor the money to fulfill the commitment.
So, what is a capital call? You know all about the term now, and more. The fact is that the capital call is part and parcel of the private equity fund and venture fund world. Since you’re just starting out, one of your takeaways should be the importance of thoroughly understanding what your obligations are in any limited partnership agreement you’re considering entering, so that you’re ready when the capital call comes. After all, reputations are at stake.
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