Picture this: a private fund manager or a general partner (“GPs”), as they are commonly referred to, identifies a great opportunity to invest in a startup or venture. They put together a deal, do their due diligence, and ultimately decide to invest $10 million into the company.

 

However, the balance sheet of the GP shows that they only have $5 million cash on hand. To close the deal, they need to raise additional capital from their limited partners (“LPs”).

 

What do they do? They send out a capital call to their LPs requesting the additional $5 million needed to complete the deal.

 

 

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What is a capital call?

A capital call is when a GP sends a notice to their LPs requesting additional capital to complete an investment. GPs usually make capital calls when they have identified an investment opportunity and do not have the necessary capital to complete the deal.

 

For more clarity, let’s define some common terms:

 

Committed Capital

Committed capital is the amount of money that an LP has agreed to invest in a private equity fund. However, they only put up a fraction of this amount when the fund is first created.

 

For example, an LP commits $100 million to a fund. The initial drawdown might be $10 million, with the remaining $90 million to be called upon as needed. This is also sometimes referred to as “dry powder.”

 

The initial drawdown amount depends on the investment strategy of the GP. For instance, a buyout fund might have a higher initial drawdown because they tend to make larger investments that require more capital.

 

Uncalled Capital

This is the portion of an LP’s committed capital that has not yet been called upon by the GP. So the LP technically owes this money to the fund.

 

Paid-in Capital

This is the portion of an LP’s committed capital already paid to the GP.

 

Let’s say an LP has committed $100 million to a GP. The GP might have a 20% initial drawdown, meaning the LP would pay $20 million upfront. The $20 million is the paid-in capital.

 

 

Capital Call Example

Private equity firm Blackstone Group is looking to invest $10 million in a tech startup. However, they only have $5 million in available cash. They send out a capital call to their LPs requesting the additional $5 million needed to close the deal.

 

Assume they have five LPs, each with a different commitment:

 

A – $50 million

B – $40 million

C – $30 million

D – $20 million

E – $10 million

 

How will they decide who will send what amount? If they request each to contribute $1 million, then A would be over-allocated at 20% of the deal, while E would be under-allocated at 10%.

 

One way to mitigate this is to pro-rata the capital call so that each LP contributes an equal percentage of their overall commitment. In this case, it would be 5% for each LP. This would result in the following contributions:

 

A – $2.5 million

B – $2 million

C – $1.5 million

D – $1 million

E – $0.5 million

 

Deciding what to request from each investor is crucial because it can impact a GP’s relationship with their LPs. If an LP feels over or under-allocated, it could create tension and strain the relationship.

 

When making a capital call, GPs should consider the following:

 

  • The size of the investment
  • The amount of committed capital
  • The investment strategy of the fund
  • The relationship with the LPs

 

Things to Consider to Make a Capital Call Successful

  1. Timing

 

LPs usually invest uncalled capital in other short-term investments, so the timing of a capital call is important. If an LP has already invested their uncalled capital, they need to sell their investments to meet the capital call.

 

It’s, therefore, important for GPs to give their LPs enough time to free up the capital. A good rule of thumb is to give at least two weeks’ notice, which may vary depending on the LP’s investment strategy and terms.

 

In addition, if the GP is investing in a deal that is time sensitive, they need to make sure their LPs can meet the capital call in time. Otherwise, they might miss out on the opportunity. This would result in the GP being left with uninvested capital, which could impact their Internal Rate of Return and Total Value to Paid-in.

 

Internal Rate of Return – This is a metric used to measure the performance of a private equity fund. It measures the “time value” of money and considers the cash flows from private equity investments. Simply, this metric estimates how the funds are performing across the years.

 

Total Value to Paid-in – This metric analyzes how much an LP has earned on their investment. It takes into account the total value of the fund’s investments and the amount of paid-in capital (TVPI = Total Value / Paid-In Capital). If the TVPI is above 1, it means the LP has made a return on their investment.

 

  1. Sending Informal Notice to LPs

 

GPs can send an informal capital call notice in advance to avoid surprising LPs with a capital call. They can do this when they get wind of an upcoming investment deal. This will give their LPs a heads-up that a capital call might be on the horizon and give them time to prepare.

 

The notice doesn’t need to be formal or legally binding. It simply gives LPs time to get their affairs in order to meet the capital call when it comes.

 

  1. Use Capital Call Lines of Credit

 

Another way to avoid straining relationships with LPs is to set up a capital call line of credit.

 

A capital call line of credit is a short-term line of credit that can be used to cover the costs of an upcoming investment. GPs can use this line of credit to fund the deal until they receive the capital from their LPs.

 

This alleviates the pressure on LPs to meet the capital call in a timely manner. It also gives GPs the flexibility to make last-minute investments without worrying about having the capital on hand.

 

The downside of a capital call line of credit is that it can be expensive. The interest rates are usually higher than what LPs pay on their investments.

 

This is why GPs need to weigh the costs and benefits of a capital call line of credit before deciding to use one.

 

  1. Call for Capital After Paying Distributions

 

Fund distribution is when investors receive cash or securities after the private equity fund exits an investment in their portfolio—also called a liquidity event.

 

GPs typically distribute 70-80% of the profits to their LPs and reinvest the remaining 20-30% back into the fund. Calling for capital at this time is recommended, as the LPs can use their distributions to pay for the capital call.

 

What Are the Benefits of Capital Calls?

As an LP, you might be wondering why would I want to give my GP money on a pro-rata basis. Why not give out the whole amount at once?

 

And as a GP, you might be wondering why would I want to go through the hassle of calling for capital on a deal-by-deal basis? Wouldn’t it be easier to just raise a big fund and have all the money upfront?

 

The answer to both these questions is that there are benefits to both the GP and the LP regarding capital calls.

 

For LPs:

  • Investing the uncalled capital in short-term investments – This ensures their money is working for them and generating a return even when it’s not being used to fund private equity deals.
  • Flexibility in meeting the capital commitments – Contributing a lump sum of big amounts can take a toll on an LP’s liquidity. But with capital calls, LPs can spread out their contributions over time, making it easier for them to meet their commitment.
  • Ability to distribute risk – Unlike in mutual funds, where all funds are invested in the same market environment, in private equity firms, investments are made over a period of at least three years when capital calls are made. This ensures funds are invested in different market environments and reduces the overall risk.

 

For GPs:

  • Avoiding cash drag – “Cash drag” is the term used to describe the situation when a GP has more cash than what is needed to fund current deals. This “idle” cash earns no return and drags down the fund’s overall return. By calling for capital on a deal-by-deal basis, GPs can avoid this situation.
  • Attracting LPs with low initial drawdown – Many LPs are put off by the high initial investment required to enter a private equity fund. By calling for capital on a need-to-need, GPs can attract these LPs by requiring a lower initial investment.

 

Do GPs Call for All Committed Capital?

Private equity funds have a defined investment period—usually five years.

 

During this time, GPs can call for capital as and when they need it. However, they are not obliged to call for all the committed capital.

 

If the GP has not called for all the committed capital at the end of the investment period, the uncalled capital can not be called afterward. But this depends on terms agreed upon by the GP and LP—the fund terms.

 

GPs call for approximately 95% of the committed capital over the fund’s life.

 

What Are the Penalties for LPs Defaulting on Capital Calls?

LPs who default on their capital call commitments may be subject to penalties. These penalties depend on the fund’s Limited Partnership Agreement (LPA).

 

These penalties can take the form of:

 

  • A loss of carried interest – LPs will not be entitled to any carried interest on future profits.
  • A reduction in distributions for the LPs.
  • An increase in management fees.
  • Forcing the LP to exit by selling their current interest in the fund.
  • Seeking compensation for any losses incurred by the fund as a result of the LP’s default.

 

These are just some of the possible penalties that may be imposed. It is important to consult the fund’s Limited Partnership Agreement to see what penalties apply in the event of a default.

 

LPs who default on their capital call commitments may also find investing in future private equity funds difficult. Many GPs will not accept an LP who has defaulted on a previous fund as it is seen as a sign of bad faith.

 

Conclusion

As a GP, mastering the art of the capital call is essential to ensure the success of your private equity fund. And for LPs, understanding how capital calls work is key to ensuring you can meet your commitments and avoid penalties.

 

Both parties should remember that the capital call process is a two-way street—it’s important to ensure that the interests of both the GP and LP are aligned.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

 

 

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