What Is A Capital Call?

The private equity market has been one of the most lucrative playgrounds for entrepreneurs, founders, and financial institutions. However, the private market is a very competitive environment with limited capital to go around. Therefore, to succeed, private equity funds need to be well versed in some of the ways they can raise money, among which is known as capital calls.?

What are capital calls??

Capital calls, or drawdowns, are when a fund manager requests capital from the fund’s investors. Capital calls are usually utilized in real estate, energy, and infrastructure partnerships, in which general partners (GPs) act as operational decision-makers while limited partners (LPs) are investors of the fund. As is typical, when a limited partner wants to involve in a PE fund, there is an agreement between the fund and investors, requiring the LPs to provide capital at any given time determined by the general partner. When a manager discovers any perceived opportunity in the mentioned industries, for example, they will call on capital contributions from their investors; also, these calls are binding.

Capital calls provide flexibility and liquidity for private equity firms. Private investments and projects are very unpredictable, but also very profitable, so relying solely on the investors’ initial equity contributions is often not enough. As a result, GPs draw additional funding from investors to cover expenditures and deal with different circumstances, such as shifts in the market, over-budget projects, or short-notice deals. Since the private market can change on a whim, private equity funds demand limited partners to inject capital within a short period of time. This ensures that the company won’t go under or miss any opportunity simply because of lacking liquidity. However, relying too much on capital calls can make the fund seem unstable. Analysts would like to see a private fund can self-sustain its operations, limiting the reliance on capital calls.?

How private equity funds make sure that they have the money on time

Understanding that money is the bloodline of any business, it is of the utmost importance that a fund manager receives the funding when needed, hence penalties for any late compliance. There is no guarantee that investors will wire the funding when the time calls for one, or simply send it late, which is enough to cause trouble. So, managers can decide to withhold future incomes for any unpunctual limited partners. Or in other cases, the investor will have their ownership in the company liquidated involuntarily. However, when an investor is aware that they won’t be able to meet the call, they have the option to sell the private equity position themselves on the secondary market. While this gives them more control over how they can deal with their stakes in the fund, the sale typically occurs at a steep discount. Plus, the transaction costs are difficult to measure in this situation, so selling would be the last resort for the equity holder.?

An alternative for capital calls?

Because private market funds require accessing capital on short notice, waiting for investors to wire their commitments can be time-consuming and inefficient. As a result, subscription line financing is a viable substitute option for capital calls. A subscription line of credit is a type of loan that functions just like a drawdown, injecting capital into a leverage buyout firm when it assembles acquisition or investment plans. This type of financing is typically issued by banks or financial institutions, such as SVB Financial Group, formerly known as Silicon Valley Bank.

Instead of waiting for wire transfers from limited partners, fund managers can use a subscription line to support investment quickly. PE firms generally borrow money within a short duration, ranging from nine months or fewer. To reduce the risk of issuing a loan to private funds, banks will use the limited partners’ equity commitments in the fund as collateral. As subscription line financing can only replace capital calls to some degree, general partners still need to draw more funding from investors when necessary. However, using a credit line delays the capital call, reducing the period investors need to tie up their cash in an investment. In addition, private market funds invest in long-term projects, which means they are illiquid, so cutting the holding time short will incentivize more investors to join the fund.

Things to consider for limited partners

The obligation of a limited partner is to provide capital when it is called upon by the general partner. However, because of the fickle nature of the private market, the timing of such calls is fuzzy at best. For example, an investment manager might delay the equity drawdowns when anticipating the asset price will adjust or waiting for a suitable acquisition. Also, private equity funds involved in complex developments will make payments to contractors in tranches as the project progress, further postponing the call on capital. Yet, most capital calls are heavily concentrated during the first few years of the fund’s operation. So, investors need to consider and plan for the potential drawdowns from the commitment, as they face the uncertainty of the timing and volume of capital calls. Additionally, having capital sit idly on the side can incur opportunity costs as it could have been used to fund other business endeavors. Understanding all the nuances of the private market ensures the success of both the fund and its limited partners.?