Private equity investing involves knowledge of certain key terms, one of which is “capital call.” PE managers employ this legal tool whenever they need to draw down committed funds from investors, and it’s important that you understand what it is if you’re planning to enter the potentially high-return arena of private equity or venture capital. So, just what is a capital call transaction? Let’s discuss.
Private equity investors typically contribute just part of their contribution initially, which works for them since they get to place the balance in a low-risk account and let it generate cash until “the call” comes. This also works for PE funds, since they don’t want to have a lot of capital around that’s not being invested or being used to attract new investors who seek low buy-ins.
Once the capital is collected, it becomes an active contribution into the private equity fund.
Each fund has its own capital call terms, by the way, which are spelled out in the limited partnership agreement, called the LPA, that you sign when you make your initial investment.
Impact of Capital Calls
Beyond allowing firms to get the funds they need, when they need them, capital calls are essential to funds’ growth because they’re used to get involved with new investment ventures. Because most equity firms are run on what’s called a just-in-time schedule, such calls get them the capital they need when they need it. Scheduled investor funding, by definition, doesn’t allow for such flexibility.
Making Capital Calls
As we say, funds make the calls when they need capital. And why do they usually need it? They typically do when a deal is about to be sealed on a new project. Or, when there are temporary but unexpected market changes.
When shouldn’t such calls be made? Well, you don’t want to use called funds for operational costs; it’s not a good idea to rely on such funds for that. You also want to avoid making a call if it looks like the investor in question is not in position to comply. While such situations don’t happen that often, they do happen.
If a capital call comes and for whatever reason you default on your legally binding investment commitment, there will be consequences beyond damage to your reputation if you don’t make things right, which you will usually have an opportunity to do. Such consequences can include:
- Forfeiture. Your investment could be forfeited.
- Conversions. Your interest could be changed to “nonvoting.”
- Interest sale. You may need to sell your interest to the fund or third parties at a reduced rate.
- Commitment is called. If the board makes this move, you’ll be charged a penalty interest rate.
- Lending of the commitment. Your contribution may get lent through another investor, more capital calls to other investors, or securement of a third-party loan.
Call Time Frame
Investors typically get notice that a call Is coming around 10 days before it does. The notice is to help investors prepare to make the transfer into the fund and to avoid strained relationships.
Capital Call Composition
Remember that details regarding capital calls for your investment firm are in your LPA. But each call will generally be comprised of the fund’s name, a listing of total commitments, and the called-for percentage of unfunded capital.
As we say, it’s essential that you know the ins and outs of capital call transactions since such calls are an essential part of private equity investing. Now that you do know, you can continue to learn other terms that are essential to PE investments.