How Do Capital Calls for Private Equity Funds Work? How Do Capital Calls for Private Equity Funds Work?
Capital calls are an important tool used by Private Equity or Venture Capital funds to raise additional capital from fund partners in order to pay for new investment opportunities or to cover other fund expenses. Considered short-term loans, capital calls are initiated by the General Partner (also known as the GP or fund manager) of a fund and sent to the Limited Partners (also known as an LP or fund investor).
Key Takeaways:
- A capital call is a tool used by Venture Capital or Private Equity to receive committed capital from investors make a new investment or pay expenses.
- After receiving notice of a capital call investors will have a pre-determined amount of time (usually between 10-20 days) to come up with the required funds.
- It's not uncommon for fund managers to issue an informal notice about upcoming investment opportunities to investors ahead of making a formal capital call.
- Another way to ease the impact of capital calls on investors is through capital call lines of credit.
While capital calls vary by fund, they usually include some of the same general information for fund investors which we'll outline below. Additionally, we'll dive into how capital calls work, when capital calls are generally used by funds, some of the pros and cons of capital calls, what a capital call line of credit is, and how capital call lines can help funds eliminate the need to reserve unused cash balances to fund investments within a short period.
What is a Capital Call?
A capital call, also known as a drawdown, is a tool used by Venture Capital or Private Equity funds when the fund needs more money on hand to make a new investment or pay expenses. Generally, when someone invests in a fund and becomes a Limited Partner, they agree to commit a certain amount of money for the fund to invest on their behalf.
However, only a portion of this money is usually paid by the Limited Partner up front. For instance, if a new Limited Partner agrees to invest a total of $2 million, they may only pay $500,000 at the time they join the fund -- the amount paid by a Limited Partner up front is referred to as the initial drawdown. The remaining $1,500,000 stays with the LP for the time being and can be called upon for use by the General Partner as needed, through a capital call.
So, often a Private Equity or VC fund has more money committed to the fund than they actually have on hand to make investments with. The total amount a fund's LPs have committed to invest is referred to appropriately as committed capital and the amount that LPs have actually put into a fund is referred to paid-in capital. The difference between committed capital and paid-in capital is called uncalled capital which represents the outstanding amount of money investors have committed to contribute to the fund.
That's where capital calls come into play -- they are the primary tool used by General Partners to request additional capital owed by LPs to help make investments. Think of it as a way for funds to convert uncalled capital into paid-in capital.
How Do Capital Calls Work for Limited Partners?
The format for capital calls varies by fund, but there are some pieces of information that you can expect to see in a capital call regardless of what fund you're investing in. Delivered either by registered mail or email, a capital call notice will generally include how much of the LPs uncalled capital is due, what portion of all committed capital has been called, the banking and payment details, and the due date.
While the notice period for capital calls will also differ by fund, investors can reasonably expect to have 10-20 days between receiving notice of a capital call from their GP and when their funds are due. It's important for investors to thoroughly review their Limited Partnership Agreement when agreeing to invest in a fund for more details on how that specific fund's capital call process will work. Usually, a Limited Partnership Agreement (LPA) will go into detail on how much time an LP will have to come up with funds following a capital call, the maximum amount an LP will be expected to pay in a capital call at any given time, a general plan for when the fund will be making investments that will require capital calls (also known as a deployment period), and any consequences for LPs if they fail to meet a capital call.
What is the Capital Call or Drawdown Process?
As mentioned above, a fund manager will make a capital call when the fund needs money to make an investment or pay expenses, generally giving LPs 10-20 days advance notice to come up with the necessary capital. GPs will take a few things into consideration when determining the ideal strategic moment to make a capital call to avoid straining their investor relationships while keeping key metrics like Internal Rate of Return (IRR) and Total Value to Paid-In (TVPI) in mind.
It's not uncommon for fund managers to issue an informal notice about upcoming investment opportunities to LPs ahead of making a formal capital call to ensure they have as much time as possible to prepare their capital commitment.
Another way to ease the impact of capital calls on investors is through capital call lines of credit, a crucial tool for funds to consider when determining the most effective way to raise capital for their next investment.
How Do Capital Call Lines of Credit Work?
A capital call line of credit is a great option for fund managers who are looking for a way to mitigate the often time sensitive nature of capital calls. Financial institutions like Leader Bank will issue funds a line of credit to help eliminate the need to reserve unused cash balances to fund investments within a short period and bridge the gap between funding an investment and their next capital call.
These short-term credit lines help funds cover the money needed for any upcoming investments until they receive capital from their LPs. This helps alleviate some of the aforementioned tension that can be created by issuing a capital call at an inopportune time and putting LPs in a bind to come up with funds on a tight deadline. Investment funds will then usually pay off the line of credit once they receive LP funds from issuing a capital call at a more convenient time.
What Happens if Investors Default on a Capital Call?
Consequences for failing to meet the obligations of a capital call will be spelled out in a fund's Limited Partnership Agreement. While these penalties are different for every fund, they commonly include a loss of carried interest, reduction in distributions (return of capital), increase in fees, being forced to sell current interest in the fund, or even reimbursing the fund for any losses resulting from the default.
If you have any questions about capital calls, capital call lines, or other banking and lending solutions that can help your fund achieve its growth goals, please don't hesitate to reach out to Leader Bank's Venture Capital and Private Equity Banking team!
