Avoiding cash drag through capital calls

April 26, 20224 min read
Avoiding cash drag through capital calls
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Key takeaways

  • A “capital call” is a legal obligation the investor assumes when committing money – typically – to venture capital, private equity, or real estate funds, which forces them to pay into the fund when called by the general partner (or “GP”). 
  • The goal is to maintain flexibility so that the money does not sit unused while the GP vets investment opportunities – the so-called “cash drag.”
  • Capital calls can be seen as a major advantage for the limited partner (or “LP”) as well, as they allow him to keep most of his intended contribution invested in liquid instruments while the general partner scrutinizes potential opportunities.

What is a Capital Call?

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 requires it – most likely as they are ready to deploy capital to an opportunity they have already diligenced. 

Indeed, it is customary for an LP to pay only a portion of the investment up front, while committing to deposit the rest at a later stage, subject to a request by the general partner. The upfront payment is the “paid-in capital,” while the total committed amount is referred to as “committed capital.” The plug, at any given point in the fund’s lifecycle, is defined as “uncalled capital.”

For example, an LP might commit to invest $100,000 into a PE fund, while only making an initial investment of $25,000. In this scenario, the remaining $75,000 would represent the LP’s uncalled capital. When the GP decides that additional funds are needed, they will make a capital call to the LP requesting additional funds – within the limits of the LPs commitment. 

Capital calls seek to avoid low returns from idle capital, also known as “cash drag,” while making private investments more attractive, as new investors are mostly called to contribute the majority of their committed capital only when an investment opportunity materializes. Capital calls also allow LPs to keep some of their money in more liquid instruments. 

How are LPs notified of a Capital Call?

Capital calls are usually reserved for critical points in an investment deal, i.e., right when a deal is about to close. Although less common, capital calls can also be made unexpectedly due to unforeseen complications related to an investment. 

Generally, LPs are notified that the fund will be making a capital call in advance, which gives them time to come up with the required funds. To this end, a capital call notice is sent to LPs to let them know that a capital call is about to be made, which is typically received by LPs one week to ten days before the call. The content of a capital call notice will vary from fund to fund, but it usually includes the amount LPs owe, a formal due date, and bank transfer details. 

Because capital commitments are usually legally binding, LPs can face a number of penalties if they miss or default on a capital call. The penalties for defaulting are typically spelled out in the limited partnership agreement (LPA) signed by the LPs at the time of their initial investment, and can include – for instance – loss of equity in the fund. Indeed, if an LP decides not to contribute capital despite the issue of a capital call, others may choose to contribute such capital as an add-on to their total contribution, thus diluting the non-contributing LP’s position. 

Other penalties include interest fees, the sale of the LP’s debt to third-parties, or legal compensation for resulting damages. 

However, private equity firm partners are usually reluctant to initiate legal action against investors for not complying with a capital call deadline. A commonly used remedy – if contributions are delayed – is for the fund to borrow to plug the hole temporarily, or allow managers to allocate to a new investment, until they receive LP-committed capital. 

Conclusion

Capital calls can be annoying for investors, as any request for contributions is, within or even outside of the financial field. But they have clear upside for both GPs and LPs. 

To GPs, they help avoid “cash drag,” which could ruin performance and increase pressure on the managers to find suitable target firms. To LPs, it may be seen as a form of leverage – they can access potentially remunerative investments with only a fraction of the capital, and only pay the balance when the capital is effectively deployed, offering an opportunity to keep the money in potentially lucrative liquid assets in the meantime.  

Understanding capital calls and how they work is essential for anyone looking to invest in private markets. Importantly, the obligations surrounding capital calls will be unique to each fund, and potential investors should be sure that they understand these obligations as stated explicitly in an LPA before making any financial commitments. 

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