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What Investors Should Know About Capital Calls

Investors who seek to enter the private equity and venture capital world, where high returns are a possibility, you must acquaint yourself with certain industry terms. One very important one is “capital call.” As the name implies, it does involve your capital — and a call to get itfrom you – so you must learn as much as possible about it before committing yourself to any obligation. Here’s what investors should know about capital calls.

About Those Capital Calls

In the simplest terms, a capital call is an implement utilized by private fund managers to obtain capital from investors when there is a need. Use of the tool is legally binding, by the way.

Why Do Such Calls Occur?

As part of the buy-in agreement between private fund managers, or general partners (GP), as they’re known, and the investor, or also known as a limited partner (LP), the investor must provide the GP with its contribution when the GP “calls” for it. Usually, this contribution is the balance of what the investor owes, since when the agreement is made the investor typically puts down just a portion of the commitment.

Here’s an example. If an LP commits to an investment of $150,000, he or she might make an upfront payment of $50,000. The $100,000 balance is termed “uncalled capital.” That status won’t last forever, however, because at some point, the GP will want the balance. So, a capital call will be issued seeking a wire of the $100,000 into the fund’s account.

Why are Capital Calls Important?

Capital calls are important because they help private equity firms grow and flourish. Because many such firms operate on a just-in-time basis, they periodically need an immediate influx of cash that can’t happen through scheduled investor funding.

Does the Investor at all Benefit?

Yes. The good news here is that, until the capital call comes, the investor can make money off their funds by placing them in a mutual fund, retirement fund, or other investment account.

Besides Garnering Needed Funds, Are There Other Benefits for GPs?

A capital call allows private funds managers to quickly shift directions if there’s an unexpected market change, say, or if a project’s costs are piling up. Also, the ability to make such calls can help attract investors who wish to buy in but like the flexibility of a future payment.

 At What Point Are Capital Calls Made?

They’re typically made when private equity money is needed to secure the short-term funding of projects. So, the call goes out when a signed deal is near. The investor then usually has between a week and 10 days to give up the funds, which become the investor’s capital contribution.

Other reasons for capital calls include:

  • For help with over-budget investment projects
  • To deal with an undercapitalized fund
  • To satisfy new financing requirements
  • When short-term increased funding is needed when the occupancy of the real estate fund drops
  • When proceeding with an investment project despite rising costs
  • A lack of liquidity owing to client collection issues
  • When dealing with an undercapitalized fund
  • When a bank requests it to secure a financial agreement

What Are the Down Sides to Capital Calls?

 For one thing, call or no call, GPs technically don’t have the money until the funds are deposited. Defaults are possible, if relatively infrequent. In fact, because reputations are at stake, a fund manager may decide against making a call if they know a default is possible, if not likely.

Also, investors who see that a fund relies on capital calls may view that fund as erratic or unstable, because such firms typically have fewer liquid assets. That’s why managers should never depend on capital calls to cover operational costs or speculative deals. Besides, doing so is outside the core purpose of equity funds, which is to generate value and profit for investors. Capital calls should only be made to fund investments and to deal with unexpected market shifts.

What’s more, making a capital call too early can saddle you with excess funds, which is not a good idea if a deal’s not in the works.

Do Investors Know When a Call is Coming?

In general, such a call could come at any time. That’s why you’re expected to be ready and must be ready. However, general partners typically alert the investor that a call will come soon. This gives the investor enough time to get everything together — and helps the business relationship.

What Happens if an Investor Fails to Meet the Capital Call?

 If this happens, you, the investor, are subject to penalties, some of them severe, that are usually detailed in the limited partnership agreement you signed. But before consequences are put in effect, the investor usually is given time to make things right, plus penalty interest.

If the investor remains in default, the fund manager can seek release of the whole commitment, declare forfeiture, or take other steps, including canceling the investor’s right to contribute more capital, forcing the LP to sell their existing fund interest to other LPs or third parties, limiting the investor’s share of future contributions, and seeking legal compensation for damages to the fund due to the LP’s lack of compliance.

Note that there are infrequent times when other equity fund members can issue the investor a short-term loan so that they can meet their obligation.

Now that you know what investors should know about capital calls, you’re ready to handle that part of the private equity fund equation. And remember that, as the prospective investor, you first must completely understand each fund’s obligations, as spelled out in the limited partnership agreement, as every agreement is unique. If you still need more investor information on capital calls, check out the alternative platform Yieldstreet, which helps investors enter markets and generate secondary income streams that are independent of the stock market.

 

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