Capital calls allow private equity firms and real estate investment companies to gain fast access to money from their limited partners. A capital call mobilizes capital from the investors at the firm’s prompting.
Historically, real estate investment funds rely on capital calls to free up funding to cover project delays or pay closing costs as a deal is finalized. However, private equity funds in other industries also use capital calls to secure money for various reasons.
As with any private equity transaction, capital calls require multiple parties to access documents containing sensitive information. Capital calls are not without risk, but the benefits of gaining quick access to funding often outweigh the potential drawbacks.
Capital calls must follow due processes, including maintaining the privacy and security of the investors’ and the investment firm’s financial data.
What Is a Capital Call?
When investors commit to funding a private equity fund or real estate fund, they don’t typically transfer the full amount of their investment right away. They can hold the capital until the fund needs the money.
A capital call is a request from the fund for investors to provide a portion of their committed capital — known as the maximum investment amount. Investors typically must provide the funds within seven to 10 business days of the capital call.
How Does a Capital Call Work?
When investors become limited partners with a private equity firm, both sides agree to a maximum investment amount, known as committed capital. But the investors don’t provide the full amount immediately.
Instead, the general partner of a firm makes a capital call to the limited partners (investors) when the fund needs cash.
The limited partnership agreement should outline the terms of any capital calls. That includes:
- The initial drawdown amount (how much the investor initially provides)
- Remaining capital
- Capital call limits
- How quickly the LP needs to fulfill the call
- Default penalties if the investor can’t produce the called capital within the time frame
Example of a Capital Call
Let’s look at an example of a capital call for a private equity firm.
- Investment amount (per investor): $100,000
- Initial drawdown: $30,000
- Uncalled capital: $70,000
- Capital call: 20% of the initial commitment
- Capital call: $20,000
Now, multiply the drawdown by 10 or 20 limited partners in a typical private equity deal. You can see how capital calls make it easy for investment firms to acquire large amounts of capital quickly.
When To Use a Capital Call
Typically, a fund will make a capital call for one of several reasons:
- The project (typically in real estate) ran out of money and needs short-term funding.
- To obtain short-term funding to cover the time between the financing agreement and the money received.
- To secure funds for expansion.
- To purchase assets or begin a new project.
- The deal is approaching the closing date.
Equity funds want to use capital calls carefully. Issuing unexpected capital calls or a capital call without a compelling reason can strain investor relations. Likewise, making too many capital calls in a short time frame can make investors wary of the firm’s financial security.
Benefits of Capital Calls
Capital calls appeal to investors and funds for many reasons. A capital call offers flexibility; investors don’t have to pay the entire amount of committed capital at once. Instead, their money can sit in other investments, collecting interest, until it’s needed.
Capital calls give private equity firms quick, short-term access to funds. This way, the firm can:
- Adapt to shifts in the marketplace.
- Take advantage of new, unexpected opportunities.
- Pay off a loan.
- Cover funding if a project goes over budget.
By relying on a capital call, the fund doesn’t have to accept the liability of holding millions of investors’ dollars in a bank account.
Holding a great deal of unspent capital on the balance sheet could negatively affect the internal rate of return. Collecting only the money that’s necessary for a specific project keeps those excess funds off the balance sheet.
How Are Capital Calls Different from Other Types of Investments?
Increased liquidity sets capital call investments apart. When investors decide to put their money in mutual funds, for example, they commit the entire sum at the outset. The mutual fund manager puts the money to work increasing existing positions of the fund or pursuing new ones.
Under the capital call model, however, investors can hold and invest the money themselves until the general partner calls for it.
Risks and Drawbacks of Capital Calls
Capital calls are not without risks, though. Relying too heavily on capital calls suggests that a firm has a chronic lack of liquidity (or bad working capital ratio), which can be a red flag for investors. Poorly timed capital calls can make it harder for the firm to find limited partners over time.
Just as firms assume the investors’ cash will be available when they need it, investors expect to see returns on their investments. If committed capital is drawn down too quickly, it could mean the firm is not making gains.
The capital call model also carries inherent risk for equity firms because the committed capital isn’t deposited immediately. Investors hold the funds, and that means they may not be available when due.
What To Do If An Investor Doesn’t Honor a Capital Call
A capital call is a legally binding agreement, and firms do have recourse if an investor doesn’t pay. The firm can:
- Dilute the investor’s partnership interest or equity.
- Turn the committed capital into a loan so that the investor has to pay interest on top of the original amount.
- Force the investor to sell their interest back to the firm.
In extreme cases, a firm can file a lawsuit against an investor to collect the committed funds.
Notices and Documentation for Capital Calls
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
The capital call, which can be transmitted via email, mail, or — preferably — a secure link, includes:
- The total called capital due
- The limited partner’s share of called capital
- Due date
- Banking details for ACH or wire transfer
Keeping this data secure, especially with multiple investors involved, is important for the fund’s reputation, financial future, and the deal’s success.
How a VDR Supports Capital Calls
Information transparency is critical for any firm raising capital. Investors want to know how the called capital will be spent. They also want assurance their investment will appreciate and pay dividends.
If a loan was taken out, to be covered by investment capital, lenders want to know that the equity firm or real estate investor can pay the loan with interest.
A virtual data room provides you with many features for easy documentation and document management. For instance, when you upload documents to your CapLinked virtual data room, they are automatically numbered and indexed, allowing for easy navigation.
Upload files in most formats for easy reading. Use a full-text search to find the information you need quickly. A VDR secures documents through dynamic watermarks, remote shredding, virus scanning, and document permissions.
Getting started requires no plugins or new software installations. These features, and others, help make it easy for limited partners and equity firms to manage capital calls quickly and securely.
Want to learn more about using virtual data rooms to streamline and simplify the capital-raising process? Start your free trial with CapLinked today.
LevCapital.com – What Are Capital Calls in Commercial Real Estate –
UpCounsel.com – Capital Call: Everything You Need to Know
AngelList – How Do Capital Calls Work?