THINGS YOU NEED TO KNOW ABOUT A CAPITAL CALL

You’ll encounter the term “capital call” quite often as you learn more about private equity (PE) investing. In essence, it’s a tool PE fund managers use when it’s time to fully fund an investment. 

To that end, here are some things you need to know about a capital call.

Usually, private equity investors make just a portion of their contribution at the outset, which gives them an opportunity to make money through low-risk accounts until a call is ultimately made. The other side of that, however, is that when a fund manager wants the balance, it wants the balance. In the interim, the fund gets to minimize the amount of capital it has on hand that isn’t being invested. It also makes it easier to lure new investors with lower up-front buy-ins.

They basically help keep equity funds going and growing and enable them to score investment projects. The main thing here is that many equity firms operate on a just-in-time basis, so it’s critical for these firms to come up with capital when they need to do so. This is not possible through scheduled investor funding.

Capital calls are used whenever there’s a need, such as when the closing of a deal is imminent. They’re also employed to address unexpected market challenges.. 

Having said that, it’s never a good idea to depend on a capital call to cover operational costs. Capital calls also probably shouldn’t be used if it’s likely that investor don’t have the means to comply, triggering a default and likely sullying reputations.

One of the chief challenges when it comes to capital calls is insufficient fund documentation, which ultimately can lead to investor default. As one can imagine, there are consequences should a default occur. 

— Conversion. Due to nonpayment, the investor’s interest could be changed to nonvoting.

— Forfeiture. Default could forfeit the investor’s commitment.

— Calling the commitment. If the board calls the whole commitment, a penalty rate of interest is applied.

— Sale of interest. It may be necessary for the investor to sell their interest at a discounted rate to the fund — or third parties.

— Withholding against future distributions. Until the capital call is met, future income distributions will be impacted.

— Lending of the commitment. A fund manager might lend the contribution through either a non-defaulting investor, securement of a third-party loan, or more capital calls to other investors.

Generally speaking, to avoid planning issues and maintain good relations with investors, funds give a notice period of around 10 days. Every capital call must also include the fund’s name, the due date, the list of total commitments, payment details, and the percentage of unfunded capital that will be called for. 

That pretty much covers the basics of things you need to know about a capital call. What is worth underscoring here is, before you make any financial commitments, you must scour your limited partnership agreement for your capital call obligations, so that you aren’t caught flat footed. While this mechanism makes it easier to get into an investment, you need to be prepared to back it up when — not if— the capital call comes.