Private fund managers use what are known as capital calls to get capital from investors when the fund needs it. The collected capital then becomes an active fund contribution. Investors know the call will come; they just don’t know for certain when. But do you ever wonder what would happen if you missed a capital call? We’ll explain all that – and more.
Just What Is a Capital Call?
Also known as a draw down, a capital call, which is protected by law, is basically the demand for funds from limited partners whenever the need emerges.
Why Do Such Calls Come About?
Upon buying into a private equity fund, the fund and the investor agree that the investor’s contribution will be there when the firm wants it. Oftentimes this is the balance of their contribution, since when an investor buys into a fund, they usually put down an upfront portion.
For example, an investor may pledge an investment of $100,000, with $25,000 down. The remaining $75,000, then, is referred to as uncalled capital. When the fund manager, commonly referred to as a general partner, needs the balance owed, he or she makes a capital call asking for a transfer of the $75,000 into the private equity fund.
The upside for investors is that, until the “call” comes, they can keep the funds and put them in an investment account – mutual funds or retirement, say – where the funds can make money.
When are Such Calls Usually Made?
Capital calls are typically made when a firm is about to close on an investment deal. After such a call is made, investors usually have between seven to 10 days to relinquish the funds. As we say, such funds then will become the investor’s capital contribution.
Why Do Funds Employ the Tactic?
For one thing, a capital call gives funds heightened flexibility and can help lure investors who wish to use such flexibility to their advantage. After all, depending on the period over which the investment is spread out, investors, commonly referredto as limited partners, can make a lot of cash while awaiting the call.
Private fund managers gain the ability to pivot if there are unexpected market shifts, or if a project’s costs exceed expectations.At times, banks ask managers to make such a call before signing off on a deal.
Are There Risks to Capital Calls?
There are. For funds, making the call and having the money are not always the same thing. While defaults are relatively infrequent, you simply do not have the funds until they hit your bank account.
Also, issuing an untimely capital call, one that is too early, can leave you with excess funds, which is not optimal if a deal is not in place. It’s not a good idea to call for capital to fund operational costs or speculative deals.
In addition, you, the investor, may view a fund as unstable or erratic if there appears to be a dependence on capital calls. Why? Because such firms usually have fewer liquid assets.
How are Investors Alerted to a Capital Call?
Usually, the funds will give an investor a heads up that a call will soon be made. This is business courtesy that helps the relationship, and it also gives the limited partner a bit of time to prepare.
How are Defaults Discouraged?
There are several actions private equity funds take to discourage defaults, which are subject to penalties. Those can include investor sanctions and the withholding of income distributions that were set for a future date.
Since capital calls are backed by law, investors face several consequences if they default. Such penalties are usually detailed in the limited partnership agreement the investor signed on to at the start. Such penalties can include legal compensation for resulting damages, loss of fund equity, interest fees, and the sale of debt to third parties.
What typically happens is that a fund will first give the investor a period in which to “fix” the default, although there likely will be penalty interest due on the late payment. This is usually the end of it. However, if you continue to be in default, even after you’ve been given a chance to repair the situation, the general partner has more moves he or she can make.
Those can include:
- Sale of limited partner interest. This could be a sale of the limited partner’s entire interest in the fund, or a portion of it, to other investors or third parties.
- Reallocation of capital call. Here, the fund manager, another limited partner, or some combination of the two, could instead fund the capital call. If this happens, such parties could gain a preferred interest in the investment in place of the defaulting investor.
- Compulsory redemption. The investor could be forced to give up existing fund interest, on a pro rata basis, for the benefit of any other investors. The forfeit of interest could also result in the loss of the investor’s right to vote on any issue.
- Short-term loan. Depending on what’s outlined in the agreement, the investor may be required to make a short-term loan to the fund. Or the general partner may withhold future fund distributions against the default amount.
- Liability for costs. The fund may require the limited partner to pay for all out-of-pocket expenses the default causes to incur, including the costs of facilitating any offsetting bridge financing.
Now you know what happens if you miss a capital call.While the consequences are not good, you do need to be aware of them. Fortunately, such an event is relatively rare. After all, such calls are part of the world of private equity, and limited partners expect them at some point. While such calls are a very useful implement, they should be used deliberately and with caution. And it’s crucial that you, the prospective investor, understand each fund’s obligations regarding such calls before committing yourself.