Capital calls are an essential instrument of private equity, and occur with regularity between investment firms and their limited partners. In essence, they are mobilizations of capital prompted by the firm and funded by the investors. Historically, they have been used primarily by real estate funds, but they are becoming more commonplace across all types of private equity.
As with any private equity transaction, capital calls require that multiple parties have access to documents containing a good deal of sensitive information. Here we will discuss the basics of capital calls, some potential risks to consider, and strategies to ensure that any capital calls you need to make will be completed in a safe and secure manner.
How Do Capital Calls Work?
When investors become limited partners with a private equity firm, both sides agree to a maximum investment amount (also known as committed capital). Let’s say Investor X commits $10 million to a firm. The firm retains the right to all of that $10 million, but in almost every instance, Investor X will not be expected to pay it out all at once. Instead, the firm will identify investment opportunities and make capital calls accordingly, only withdrawing however much cash they need at the moment. If the firm makes a capital call for 10% of total commitment from all limited partners, Investor X has to come up with $1 million.
Typically, by the time a capital call is made, the firm will already have decided where they want to allocate the money, so although years may have passed between the initial pledge and the capital call, investors have to provide the specified amount within seven to 10 days.
Funds raised from a capital call will not necessarily be put into an investment, at least not directly. Sometimes — particularly in the case of real estate funds — the firm will borrow however much money it needs from a bank and make their investment. Once the returns on the investment reach a certain level, place a capital call to its limited partners. The cash from the partners in this scenario would go toward paying off the loan from the bank, rather than into the original investment. This is a beneficial setup for the firm, because in establishing committed capital from its partners, the firm secures cash flow equal to or greater than the loan, making a default very unlikely.
Other common reasons for a capital call may include projects going over time or over budget, or accommodating changing financial requirements.
What Differentiates Capital Calls from Other Types of Investment?
In short, timing. When investors decide to put their money in mutual funds, for example, they have to commit the entire sum all at once at the outset. The mutual fund manager will then put all that money to work increasing existing positions of the fund or pursuing new ones.
Under the capital call model, however, investors are allowed to do what they please with the money they have committed, as long as it is available in short order when the firm requests it. This is an appealing arrangement for investors who prefer to retain a good amount of liquidity.
Risks and Drawbacks of Capital Calls
Relying too heavily on capital calls suggests that a firm has a chronic lack of liquidity, which can be a red flag for investors and make it harder for the firm to find limited partners over the long term. Just as firms assume that the investors’ cash will be available when they need it, investors expect to see returns on their investments, and if their committed capital is drawn down too quickly, it probably means the firm is not making gains.
The capital call model also carries inherent risk for equity firms in that the total sum that is committed on paper is not deposited right away. This means that between the time the agreement is reached and the time the call is made, investors can do what they like with their money, and may find themselves unable to pay when the time comes. Should this happen, there are steps a fund can take to offset the cash loss, such as the following:
- Diluting the investor’s partnership interest or equity
- Turning the committed capital into a loan, so that the investor has to pay interest on top of the original amount
- Forcing the investor to sell their interest back to the firm
In the very worst cases, a firm may decide to file a lawsuit against an investor in order to collect the committed funds.
Notices and Documentation
Ahead of a capital call, a firm will send out a notice to all its investors, informing them of their upcoming commitment. Details included in these notices are the following:
- The amount of capital needed
- The amount the investor has committed to
- The amount the investor has already contributed
- The total amount the investor will have contributed after the call
- The remaining uncalled capital
- Why the additional capital is needed
- An itemized list of how the funds will be used
- The due date
That’s a lot of data, especially when you consider that the average fund has 20 different investors, meaning there are at least 20 different potential opportunities for a breach if the necessary precautions are not taken.
Virtual Data Rooms as a Solution for Capital Calls
Virtual data rooms, like Caplinked, are the ideal solution to the potential hazards of a capital call. With world-class data encryption, quick setup times, and end-to-end user control over who can see what and when, VDRs are the safest possible venue for capital calls or any other kind of major transaction. If you would like to learn more, get in touch today about a free trial.
Rafael Carillo is a writer, editor and tutor living in Brooklyn, NY.