What Is A Capital Call?
A capital call in the realm of private equity signifies a crucial phase in the investment process. It entails the investment firm exercising its contractual right to demand the funds that investors have previously committed to the partnership or fund.
Investors who have pledged capital to the private equity fund are bound by the terms and are expected to fulfill their financial commitments as outlined in the agreement. These commitments are generally not required to be provided upfront, allowing investors to maximize the utility of their capital in the interim.
Table of contents
- A capital call definition describes it as a procedure in private equity and venture capital funds where the investment firm or the general partner requires the investors or limited partners to transfer the funds as promised by them towards the project.
- This requirement is born out of the fact that since funds are not required upfront in most large-scale investments, limited partners can make the most out of their money until they are demanded to pay the committed capital.
- Failing to transfer money after these calls can have severe repercussions until an understanding is reached.
How Does A Capital Call Work?
A capital call facility is also called a drawdown or committed capital. It is common in venture capital funds, real estate, private equity, etc. Let us understand how this works. Consider an investment firm or a fund manager. This entity or individual is the general partner. They manage funds and investments. They invest directly, collect funds from investors, and do most of the groundwork.
Limited partners are investors who support the general partners in their projects by pooling funds. Their commitment extends only up to their investments. The limited and general partners enter into a legally binding agreement containing the terms of their relationship, goals, returns, use of funds, reporting, etc.
Once a project is finalized, the required funds are communicated to the limited partners. These partners will have funds invested in liquid assets, such as shares, bonds, etc. This amount, explicitly invested for a particular project, is the committed capital. They yield returns as long as the general partner gives a call. It ensures maximum utilization of funds.
Meanwhile, general partners will be busy laying the foundation of a project or researching alternatives. Throughout the project, at different stages, they will require capital infusion. Then, they will send a capital call notice to the limited partners. Based on the project requirement, the funds invested in liquid assets will be withdrawn and transferred to the general partners, either in lumpsum or installments.
In cases of non-payment, penalties and legal consequences specified in the agreement can be enforced, although amicable resolutions are possible based on the relationship between partners. Large investors, with substantial capital and higher risk tolerance seek greater returns than traditional investments like stocks and mutual funds can offer. It leads them to favor capital-intensive ventures such as real estate, private equity acquisitions, and startups.
Here are a few examples to understand the concept better.
Suppose GX is a private equity firm that specializes in acquiring underperforming businesses and implementing restructuring strategies. They are currently in the process of acquiring a startup called Cloud9 for $1 billion. The project involves four limited partners: Michael, Pam, Jim, and Andrew, with respective committed capital amounts of $500 million, $300 million, $600 million, and $200 million.
Michael and Jim have their committed capital prepared and are ready to invest in the project. The first capital call will be issued to Pam, followed by Andrew, as per the project’s financial requirements. In conclusion, this hypothetical scenario illustrates a typical private equity investment process with varying committed capital amounts and capital calls based on specific financial requirements.
An affiliate of Ion Group, the Irish financial software giant that experienced a hack in its derivatives trading arm earlier this year, is facing a lawsuit from its partner. S3 Partners LLC, a provider of data related to short-interest, holdings, and securities finance, alleges that Ion-owned Fidessa Corp. owes them $6.25 million.
The lawsuit claims that Fidessa Corp. is reneging on the payment, arguing that its extensive debt burdens make it financially unable to fulfill its commitment. This situation resembles a form of a capital call, where S3 Partners is effectively demanding that Fidessa Corp. provide the agreed-upon capital. Still, the latter is allegedly unable to meet the obligation due to its financial position.
Capital Call vs Distribution vs Contribution
Capital Call, Distribution, and Contribution are distinct financial terms that play essential roles in the world of investments, partnerships, and business finance. Each of these concepts represents a critical aspect of how funds are managed, allocated, and contributed within various financial arrangements. Let’s understand the difference between them.
|Request for additional funds from investors by the investment firm as needed.
|It is the allocation of investment returns to partners based on their contributions and duration.
|It is initial funds provided by investors to the company in exchange for equity.
|Flow of Funds
|Funds flow from the investor to the investment firm in response to a call.
|Funds flow from the investment firm to the investor as returns.
|Funds flow from the investor to the company as an initial investment.
|It occurs when the investment firm requires additional capital for specific purposes.
|It happens after the investment has generated returns and is distributed among partners.
|It focuses on the initial financial commitment of investors.
|Typically used by limited partners in investment partnerships.
|It involves all partners distributing returns based on their contributions and tenure.
|Mainly applicable to shareholders in a company.
|Primarily about collecting funds as needed.
|It is concerned with sharing investment returns among partners.
|Focuses on the initial financial commitment of investors.
|Usually, it takes place at regular intervals as investments yield profits.
|Typically occurs periodically as investments generate returns.
|It is a one-time event at the start of an investment or company formation.
|Investment firm calls upon limited partners for additional funding for a new project.
|Investment returns are distributed among partners based on their contributions and tenure.
|Investors provide cash and assets to a startup in exchange for equity shares.
Frequently Asked Questions (FAQs)
No. Investors in hedge funds usually invest in one go. Capital calls are demanded on an as-and-when-required basis, sometimes in installments. Such a procedure is available primarily in private equity and venture capital funds.
No, a capital call is not a loan. It is a request for investors, typically in private equity or venture capital, to fulfill their pre-agreed financial commitments by contributing additional funds as needed. It is a contractual obligation rather than a borrowed sum, ensuring that investors provide the capital they committed to the investment or partnership.
The rules for capital calls are typically outlined in the legal agreements or contracts governing an investment or partnership, such as Limited Partnership Agreements (LPAs) or Operating Agreements. These agreements specify the conditions, timing, and procedures for making capital calls. Investors or partners are legally bound to adhere to these rules, and failing to meet their financial commitments as per the agreement can result in penalties or legal consequences. It’s essential for all parties involved to carefully review and understand the specific terms and requirements detailed in these agreements.
This article has been a guide to what is a Capital Call. Here, we explain the concept along with its examples, and comparison with distribution and contribution. You may also find some useful articles here –