If you’re entering into a partnership agreement with an investment firm, you’re right to do your due diligence on private equity capital calls. Capital calls can happen at any time, which increases your risk for bad deals. However, there are benefits to capital calls, too.
In this article, we’ll define capital calls, explain how they work, go over pros and cons, and provide expert insights into what they mean for investors and investment firms.
What Are Capital Calls?
In private equity, a capital call is the legal right of an investment firm to demand a portion of the money promised to it by an investor as outlined in the capital call agreement. It is the sponsor, also called the general partner (GP), or investment firm, who makes the call for investors, also known as limited partners (LPs), to supply their portion of the investment.
More specifically, another capital call definition is: the actual transaction that moves the promised funds from the investor to the investment firm’s capital call fund.
Capital calls are also referred to as drawdowns and cap calls.
How Does a Capital Call Work?
When an investor buys into a private equity fund, they first form a limited partnership agreement (LPA). Among other things, the LPA states that the investment firm agrees with the limited partner that the promised funds will be available when the firm requests them.
They also agree that the investor can hold onto their money until the firm calls the capital. Typically, the investor will keep that money in a preferred investment account, such as a mutual fund or retirement account, until the investment firm calls for it.
A capital call is usually issued when an investment deal is reaching a close, or when there’s a problem with the property. At that point, investors have a set amount of time to provide the committed funds, often between 7 and 10 days. These terms are outlined in the LPA.
A capital call is delivered via a document called a capital call notice or capital notice. A capital call notice will include:
- The percentage of unfunded capital called
- Payment information
- The name of the investment fund
- A list of total commitments
- The due date of the current capital call
Once the investor provides the capital, they can be repaid later with capital contributions.
Benefits of Capital Calls
Capital call agreements have benefits for general partners and limited partners.
For general partners and investment firms, adding a capital call agreement can attract savvy investors who use the flexibility of capital calls to enhance their investment portfolio. Because the investment doesn’t require the total commitment all at once, the investor can maximize their return on investment (ROI) by letting the unfunded portion of their commitment appreciate in another investment account.
GPs can pair this benefit with a low initial drawdown and periodic capital distributions to attract even more investors.
Moreover, capital calls can be helpful in managing cash flow issues during tough times, Andrew Lofredo, CEO and Founder of CRE Vertical Advisors LLC, said. They can help to improve the relationship between the owners and the investors by offering a chance to show their support for the property.
In addition, GPs can use capital calls to raise money quickly to cover expenses or make repairs, and they are often tax-deductible. Lofredo added that cap calls can “help a property/sponsor avoid having to go to the debt market or raise additional capital — each of which come with additional costs.” Capital calls help to ensure the property is well-maintained and provides a good return on investment for firms and LPs alike.
Finally, capital calls help GPs avoid cash drag. In other words, GPs have less cash on hand, meaning they’ll have a better internal rate of return (IRR) and total value to paid-in capital (TVPI). These two metrics are key fund performance indicators.
For LPs, they get to hold onto some of their capital and let it appreciate in a different investment account. If they’ve signed an LPA that includes distributions, they can use those distributions to fund capital call commitments.
Risks of Capital Calls for LPs and GPs
Capital calls are not without their drawbacks, making LPs wary of them.
Moreu explained that sometimes capital calls indicate there is a problem with a property. “For example, if a property is not generating enough income to cover its expenses, the owners may issue a capital call to cover the shortfall.”
Marina Vaamonde, Commercial Real Estate Investor and Founder of PropertyCashin.com, gave these examples of common issues with commercial properties:
- Retail businesses with slow sales
- Retail center with high vacancy
- Residential development with unsold lots
But Lofredo said capital calls are generally scheduled for a planned capital improvement or for tenant improvement costs associated with the new deal. Capital calls should not necessarily be a surprise.
In less fortunate situations, however, cap calls can put a strain on relationships among GPs and LPs. For example, if a GP issues a capital call earlier or more often than the investor anticipated, an investor might have trouble providing funds or become concerned about the potentially failing investment.
Moreu added, “There is the risk of selling the property to cover the debt, which could result in investors’ losses.”
Risks for the GP include defaulting LPs. If an LP defaults for any reason, a deal can fall through completely. Now both parties have a black mark on their track record and reputation, to make matters worse.
Capital calls also have administrative costs and fees. The investment firm must send out capital call notices, collect and manage incoming payments, and handle defaulting LPs. If a GP needs to take out a capital call line of credit, or capital call line for short, to fund the unpaid portion of the capital call fund, that comes with interest and fees, as well.
Lastly, having to wait on funds from limited partners can delay deals, especially if your LPs are taking longer than the 7 to 10-day term.
What If an LP Defaults On a Capital Call?
Sometimes, an LP can’t meet the capital call. When an LP defaults, they may be subject to penalties and legal liability. The fund manager decides which penalties to apply as outlined in the LPA. Often, the LP has a unique situation and fund managers are willing to work with them to collect their commitment.
An LPA may include one or more of these common penalties:
- Limitation of the LP’s share of distributions
- Charging penalty interest on the outstanding capital call amount
- Cancellation of the LP’s right to contribute
- Capping the LP’s participation to the value of the current paid-in capital
- Creating a plan in which the LP is forced to sell their current interest in the fund to other LPs
- Pursuing the LP in a court of law for damages to the fund resulting from their default
Vaamonde added, “There are legalities involved that impact how far an investor’s interests can be diminished. However, the investor could wind up with a very small percentage of ownership that reduces their voting rights and their ability to recoup their initial investment.”
Reducing the Risk of Defaulting LPs
A few quick tips will greatly reduce a GP’s risk of their investors defaulting.
- Work primarily with institutional investors
- Thoroughly vet high net worth investors to ensure they have a track record of filling their commitments
- Offer distributions to help provide a cushion for LPs in case of a future capital call
- Write capital call terms, conditions, and anticipated dates into the partnership agreement so investors know what to expect and when
Capital Call Example
Let’s say an investor commits $500,000 to a private equity fund. At the time of signing the agreement, the investor is only required to pay $100,000.
Over a period of months or years, the fund issues capital calls until the unfunded $400,000 is paid into it. Because the project in this example went smoothly and there were no surprise capital calls, the investor successfully meets their capital call commitment.
In an example using the same figures, but the project is turning out to be more expensive than initially planned, the LP may not be able to produce the called capital. In that case, they would default.
Check Your LPA for Capital Call Terms Before Signing
At the end of the day, capital calls can be a bigger risk for some investments than others. Distributions and thorough vetting of each LP can reduce the risk of a deal going south, and instead benefit LPs and GPs alike.