There are times when a private equity or venture capital fund investment requires an infusion of fresh capital. It’s usually when the fund is about to sign off on a project, or when it must address an unexpected and temporary market downturn. Whatever the reason, when more capital is a necessity, the fund will typically perform a capital call.
Let’s take a closer look at what happens when an investment fund needs additional capital.
Tell Me More About Capital Calls
Funds employ this tool when needed to collect committed capital from investors. When investors first join a fund, they are typically only required to make a portion of their contribution. But sometime in the future — often within months — the fund will “call” for the balance.
Both parties tend to favor this arrangement since the investor gets to put the capital in a low-risk account where it can grow, and fund managers don’t have excessive capital around that’s not being invested.
How Big a Deal Are Such Calls?
Put it this way: funds depend on capital calls to thrive and grow. They cannot rely on “scheduled” investor funding when a deal is imminent; funds are needed right away. What’s more, PE funds tend to operate on a just-in-time basis, meaning that they don’t have a lot of excess capital handy.
Having said that, it’s not a great look for funds to be perceived as being too dependent on capital calls, as that can signal a liquidity problem.
What Do Such Calls Entail?
Funds don’t usually make a capital call to just one investor. In fact, such calls typically go out to an average of 20 investors, who are first notified that such a call is coming. When it does, payment is usually due within a week to 10 days.
The investor will know what the terms are because they’re spelled out at the beginning in the limited partnership agreement (LPA).
In the “call” — a document, really — investors will see the amount of capital called for in addition to the commitment amount, plus the amount already contributed. The document will also note the amount the investor will have contributed post-call, as well as any remaining uncalled capital, what the additional capital will be used for and when the capital is due.
Are There Risks Involved?
The main risk is that the investor can’t come up with the money when the call comes. And that does sometimes happen, often because it can be difficult to verify someone’s stated financial position.
Funds can seek to lessen their risk by working primarily with institutional investors or those who have a history of coming through. Some managers strategically time such calls to distributions so that they know capital will be available.
If an investor can’t comply, the fund does have options at its disposal. It can, for instance, reduce the investor’s partnership equity or interest or force the investor to sell their interest back to the firm. The fund can also choose to turn the committed capital into a loan, which means that the investor must pay interest plus the committed amount.
In general, the fund manager will decide which of the penalties outlined in the LPA will be applied. Usually, before a noncompliance is declared a default, the fund will give the investor a chance to make things right.
In summary, when an investment fund needs additional capital, they usually make a capital call, the terms of which are set forth in the limited partnership agreement. Risks to the fund include non-compliance, which can often be mitigated with robust due diligence. Investors who cannot comply risk their reputations as well as financial penalties. The best way for them to avoid that is to put their committed capital in the bank, let it make money, and do not touch it until the call comes.