A capital call occurs when investors are asked to pitch money according to their initial agreement. This helps the fund get fresh capital for investments or supporting current portfolio companies. Capital calls are a part of how private equity funding works. GPs will issue capital calls when the fund requires additional capital, either for:
Private equity funds utilize capital calls to access funds from partners as needed, offering flexibility in managing cash flows. This approach provides flexibility for partners in managing their finances. The requested capital amount in a call is based on each partner's commitment to the fund. Partners are required by the partnership agreement to provide the requested capital when the general partner asks for it.
The capital call process starts when the fund manager (also known as the general partner or GP) decides that more capital is required to make investments or handle fund costs. The GP will send a notice for capital calls to all the fund's limited partners (LPs). This notice outlines the amount each LP needs, proportional to their share.
For example, if an LP committed $5 million out of a $100 million fund, their share of a $10 million capital call would be $500,000. Once the notice is issued, LPs must contribute their share of the capital call within a specified timeframe, often 10-30 days. The GP then uses this money to invest in portfolio companies or pay management fees and other fund costs.
Limited partners must fulfill their obligation to contribute funds as specified in the partnership agreement that they signed initially. Not meeting this requirement could result in consequences, including loss of managerial privileges and potentially loss of their entire investment.
In summary, capital calls are initiated by GPs but funded pro-rata by LPs at any time additional investment capital is needed during the fund's lifetime. The entire process is contractually binding based on each investor's upfront commitment.
A capital call notice usually gives investors 10 to 30 days to contribute the required funds. Nevertheless, the exact timeframe may differ depending on the terms agreed upon by the GP and LPs. In determining the duration of the notice period for a capital call, the GP must strike a balance between allowing time for LPs to secure financing and reducing any cash drag on the fund. A more extended notice period reduces the risk of LPs defaulting but can slow down deploying capital into new investments. Some considerations around capital call timelines include:
Overall, the frequency and notice period for capital calls should balance prudent planning for LPs and efficient deployment of the fund’s capital.
Missing a capital call can have severe consequences for limited partners. The three main potential consequences are:
Missing capital calls should be avoided at all costs. Before committing capital to a private equity fund, investors must understand the legal obligations and potentially catastrophic consequences outlined in the partnership agreement. Careful planning for capital calls and utilizing credit lines can help mitigate the risk. But harsh penalties await when LPs fail to pay in committed capital upon the GP's request.
A capital call line of credit is a form of revolving credit arrangement that offers support to partners (LPs) upon receiving capital call notifications. These credit lines enable LPs to access the funds required to fulfill capital calls, offering flexibility in managing their investment portfolio. Capital call lines work like a credit card - the LP can repeatedly draw down and pay back the line of credit up to a set limit as needed. The funds can then be used to finance capital contributions when required. Various financial institutions offer these lines and are explicitly structured to provide capital for investments in illiquid asset classes like private equity. They help mitigate the "cash drag" problem of capital calls, where LPs must keep significant idle cash reserves. The main benefits of capital call lines of credit include:
Some of the drawbacks to consider include:
Capital call lines of credit allow LPs to optimize their private equity investments. However, interest costs and constraints should be evaluated before obtaining one.
As a new investor in a private equity fund, I know it is important to be prepared for the first capital call. As part of the preparation, one must:
Preparing for that first capital call notice will ensure you can easily fulfill your obligation as a limited partner. With the right expectations, access to funds, and understanding of the process, you can confidently contribute capital without disruption whenever the time comes.
After investors decide to invest in an equity fund, they should anticipate receiving requests for capital over the funds, with an investment time typically spanning 5 to 7 years. Effective planning and managing cash flow are essential when dealing with capital requests from funds. Here are some recommendations for handling capital calls:
Investors should consider how much liquid cash they must set aside to meet future capital calls. Having adequate cash reserves and not overcommitting capital across too many funds is prudent. Work with your financial advisor to project capital needs for each fund and have funds set aside to cover at least two years of future capital calls.
Stagger your fund commitments across multiple vintage years to spread out capital calls. For example, rather than committing to 3 funds launched in 2022, stage your commitments over 2022, 2023, and 2024. This diversification helps avoid having too many funds simultaneously in the early years when capital calls are most significant.
Look at your general partners' historical capital call schedules to estimate future capital needs. On average, about 25% of committed capital is called during the first year of the investment period, but each fund has its own deployment pace. Understanding when capital calls are expected allows better financial planning. Proper planning and management of capital calls are necessary to uphold your legal commitments to multiple private equity funds over their life cycles. Investors can avoid potential defaults or capital crunches by planning and diversifying commitments.
Capital calls and distributions are two distinct methods private equity funds use to manage cash flows from their limited partners (LPs). While they may seem similar on the surface, there are some key differences between capital calls and distributions:
Purpose: Capital calls are made to raise additional investment capital from LPs, while distributions return money to LPs after exits or other liquidity events.
Flow of Cash: Capital calls pull cash into the fund from LPs, whereas distributions push cash out of the fund to LPs.
Frequency: Capital calls typically occur during the early years of a fund's lifecycle when investments are made. Distributions increase frequently after deployment, and portfolio companies start getting sold.
Obligation: LPs are contractually obligated to meet capital calls per the limited partnership agreement. Distributions are made at the GP's discretion as proceeds become available.
Impact on IRR: Capital calls reduce IRR early on due to the cash drag they create. Distributions boost IRR later by returning capital to LPs sooner. The timing and size of capital calls and distributions directly impact a private equity fund's cash flows and internal rate of return (IRR).
GPs must strategically balance capital calls and distributions based on the fund's investment pace and exit environment.
Over time, the nature of capital calls in the private equity sector has developed the asset class. Initially, capital calls typically happen at the start of a fund. Investors would pledge an amount of capital with funds being requested when necessary for investment purposes. As private equity expanded, capital calls became more sophisticated and structured. Deployment periods were instituted, standardizing when and how much capital could be called in the first few years of the fund. This gave investors more predictability.
Additionally, private equity funds started accessing capital call lines of credit from banks. This gave them access to capital on short notice, so they could make fewer capital calls early on. Today, most well-established private equity funds have a defined schedule of capital calls over the fund's life. Capital is called in set amounts at set intervals, allowing limited partners to plan accordingly. The process has become streamlined with clear timelines and procedures. Technology may allow for further improvements to the capital call process. Some potential innovations include:
Private equity is evolving as new technologies emerge, which could lead to a more efficient capital call process. Despite these advancements, the core function of capital calls is expected to remain consistent. It serves as a method for General Partners to seek investment from Limited Partners (LPs) when necessary. A grasp of the capital call process will remain crucial for those involved in equity investments.
Investors should always conduct thorough due diligence and ask the fund managers key questions before committing to a private equity fund. Some of the important questions to ask include:
Conducting thorough due diligence on the fund's strategy and approach to capital calls is crucial for investors to avoid surprises. The GP should be transparent about their capital call policies and expectations before committing and understanding capital calls.
