As the formerly exclusive and sophisticated realm of private equity (PE) investing becomes more mainstream, everyday investors are increasingly interested in how they can potentially tap into the potentially high returns often associated with PE ventures. But as with charting any new territory in the finance world, investors must first understand some key terms and how they might be relevant in the context of their very first PE-backed investment. One such term that will almost always be of critical importance is capital call.
Fortunately, as a standard practice among PE and venture capital (VC) funds, capital calls are fairly straightforward and their various applications can ultimately be grasped with little difficulty. Let’s go ahead and take a closer look at what a capital call is and answer some frequently asked questions related to the term.
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 PE 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. The LPs upfront payment is referred to as paid-in capital, the total committed amount is referred to as committed capital, and the difference at any given point in the fund’s lifecycle is referred to as uncalled capital.
For example, an LP might commit to invest $100K into a PE fund, while only making an initial investment of $25K. In this scenario, the remaining $75K 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 a transfer of the additional $75K (or a portion of that amount) into the fund.
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. This is an agreeable arrangement for many LPs, who are often allowed to hold their uncalled capital in low-risk investment accounts to earn modest returns until the capital call is made.
VC funds use capital calls for the same reasons as PE funds, but by investing in small businesses and start-ups with high growth potential, VC funds have earned a unique reputation for making the right investment at exactly the right time. For this reason, potential VC investors usually understand and accept the necessity of capital calls, and trust their GPs to make the best decision as to the use of their uncalled capital over the lifecycle of the fund. VC funds also commonly offer their LPs preferred returns, allowing them to realize profit from the overall activity of the fund before the need arises to use the entirety of their committed capital.
A capital call is the action taken by the GP to receive additional or uncalled capital from investors. Once collected, the capital becomes an active contribution into the fund.
Generally, an LP is notified that the fund will be making a capital call in advance, at which point they will prepare to transfer the requested amount into the fund. If the LP is not prepared to transfer the funds at the designated time of the call, they will be in default and subject to penalties.
GPs typically don’t want to be asking their investors for additional funds on a regular basis, therefore 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 be made unexpectedly due to unforeseen complications related to an investment.
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 LP at the time of their initial investment, and can include loss of equity in the fund, interest fees, sale of debt to third-parties, and legal compensation for resulting damages.
A capital call notice is a notice sent to LPs to let them know that a capital call is about to be made. Notices are 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 will typically inform the LP of the amount they owe related to the call, provide a formal due date for submission of the capital owed, and disclose banking details on where the capital should be transferred.
This refers to any payment made by an LP to a fund related to a capital call.
Understanding capital calls and how they work is essential for anyone looking to try their hand as an investor in the realm of private equity or venture capital funds. 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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