How do Capital Calls work?

A capital call is a tool used by private fund managers (commonly referred to as “general partners” or “GPs”) to collect capital from investors (referred to as “limited partners” or “LPs”) when the fund needs it most. When an LP buys into a private equity fund, they will often agree to pay a portion of their investment up front, and to have the remaining balance held to be used at a later date. Capital calls allow firms to limit the capital under their management to that which is actively being invested, and to attract new investors with relatively low initial buy-ins.

Private equity strategies are inherently “drawdown” vehicles, meaning investors make a commitment to provide capital to the fund after the fund manager identifies investment opportunities. The capital that an investor commits to a fund but is not yet required to provide is known as “uncalled capital”. When investors are “called” to provide capital as investment opportunities become available or as required by the fund, the “called capital” is the money that investors must deliver to these funds. This process is also known as a drawdown, which refers to the drawing of capital from reserves over time.

Private Equity Terminology

Once a GP has found a target investment and determined the amount needed, GPs will issue a capital call notice to request money from their LPs to complete it.

While there is no standard capital call notice, some common terms seen throughout the industry are:

• How much is being requested, expressed in $ and/or % of investment
• The amount that LPs have already paid into the fund (paid-in capital)
• The total that LPs have committed to the fund (committed capital)
• Wiring details of where to send your money
• Due date of when the funds must be received by

As mentioned earlier, these capital calls are legally binding and follow the terms laid out in the capital call agreement. The capital call agreement is typically found within a fund’s Limited Partnership Agreement or LPA for short and has the following standard terms.

• The time an LP must complete the capital call upon receiving notice, typically 7-10 business days
• The drawdown period, usually the initial 2-3 years after making the investment
• Legal repercussions for failing to pay the capital call, typically resulting in the LP being in default

To illustrate these terms, let’s use an example of an investor or LP that has decided to put $250k into a venture capital fund with a 2-year drawdown period. The LP can expect the fund manager or GP to request the $250k commitment over the next two years.

If the GP makes an initial 10% capital call request, the LP has invested $25k out of the $250k commitment, leaving the remaining $225k to be called over the next two years.

After the initial capital call, the GP sends a capital call notice for 20%, resulting in the LP sending $50k by the notice’s due date, which was defined as ten days after the notice is sent.

At the end of year 1, the GP sends another capital call for 30%, so 60% of the investment is called. By the end of year 2, the GP issues two capital calls, one for 30% and the final capital call for 10%, which means the LP has completed its $250k commitment to the GP.

Sources:
AngelList, April 2022, How Do Capital Calls Work?
Investopedia, November 2021, Learn the Lingo of Private Equity Investing

You might be asking, what is the point of having this commitment called? Can’t I just give all the money to the GP and call it a day? Capital calls benefit the LP and GP by investing the money over a defined period.

For the LP, the capital call structure allows the investor more flexibility when making a fund commitment. Rather than parting with $250k at the onset, the investor can break that commitment down across a period. This period also provides the LP exposure to deal flow across the drawdown period, compared to if the whole lump sum was invested when the commitment was made.

Using the previous example, the $250k investment is invested across two years, which provides exposure to companies across the two years and allows the GP to be opportunistic. If the funding followed a mutual fund where the investment was called and invested at the time subscription was made, the LP would only have exposure to the deal flow when the investment was made, concentrating risk on the current market environment.

For GPs, the issue of cash drag comes up if excess capital is sitting on their balance sheet. Cash drag is the effect of carrying a large cash balance since cash often brings little to negative real returns, especially when factoring in inflation. If the GP were to call the LP’s total commitment at the onset and still invest over the targeted investment period (ex. 2-3 years), the GP would be carrying a large cash balance as they source investments. This cash balance would lower the portfolio’s return due to the cash drag.

Additionally, private equity and venture capital funds typically have defined investment periods (e.g., 5 years to make investments, followed by 5 years to realize those investments). A common question investors ask is: will all my committed capital be called? While typically a fund aims to deploy all capital investors have committed, if by the end of the investment period not all the capital has been called by the GP, under the terms of most funds, further uncalled capital cannot subsequently be called.

There are risks and drawbacks associated with capital calls. The cash drag problem now rests with the LPs to solve. During the drawdown period, the LP needs to have the cash readily accessible to meet the capital call requirements. The current low-rate environment makes this harder to find a stable, high-yielding investment to park the money. At times, the manager will not fully call an investor’s commitment due to the terms set out in the capital call agreement, which would leave money on the table for the investor. It’s common for GPs to call ~80-95% of an LPs commitment.

For GPs, the fund is at risk of whether the LP will make its capital call payments. However, if an LP does not meet its payment, the LP will be in default, which will trigger legal ramifications. Each fund has its own set of consequences for defaulted LPs, but typically, a defaulted LP will be barred from investing with the GP in the future.

Sources:
AngelList, April 2022, How Do Capital Calls Work?
Investopedia, April 2021, Performance Drag

To conclude our discussion of capital calls, the structure is typical for investing in alternative investments. The system allows GPs only to invest capital when investments are ready to be made while giving LPs the flexibility to break up a commitment over time. While this type of funding structure is generally designed to better align the interests of the GP and LP within the fund, some of the drawbacks include legal ramifications for defaulting LPs and a cash drag for the LP portfolio.