Capital calls are when an investor in a private equity or venture capital fund is required to contribute additional capital to the fund. This typically happens when the fund’s managers have identified an investment opportunity and need more capital to fund it. Capital calls can also occur if a portfolio company in which the fund has invested requires additional capital to fund its operations or growth. Capital calls can be a regular part of investing in a private equity or venture capital fund, and investors should be prepared to meet them when they arise.
Why do capital calls exist?
The purpose of a drawdown process is really driven by the metrics used by private equity. In a liquid fund, you can invest it straight away and it can generate a return. In the private environment, if you committed capital right away you would have dormant cash sitting unused for a period of time.
The two primary return metrics in PE (and private funds generally) are IRR-based and money multiple-based. These are all about the cash put into the system and the cash that comes out. Why is this important? The real financial driver for all General Partners (GPs) is their carry. This is driven by a waterfall. Part of that is driven by IRR. So it is really core to the administration mechanics of private funds. The issue with drawdowns is they can happen at any time. And they do.
How do capital calls typically happen?
In private equity and other private market investments, capital calls typically occur when a GP needs additional funds from their Limited Partners (LP) to make investments. The GP will issue a notice to the LPs, requesting that they contribute a specified amount of capital to the investment vehicle within a certain time frame. LPs are contractually obligated to meet their capital call commitments unless they have negotiated specific terms in advance. Once the LPs have contributed the funds, the GP can use them to make investments or take other actions on behalf of the investment vehicle.
Funds mostly intend to pace the capital calls, which can be any amount up to total commitments, during the investment period. But this often does not play out at an even pace as opportunities arise during the investment period in a manner that is not uniform.
There is a structure to how drawdowns happen, although they can appear quite ad-hoc. If a fund manager has a plan to invest in 20 deals over a five-year investment period, that is roughly one per quarter, and the deal size will typically be of a similar size for their portfolio management.
It is typical, especially in venture and growth fund strategies, to ‘reserve’ for follow-on investments. This means they intend to call approximately 70 per cent of committed capital during the investment period and call 30 per cent later for these follow-on investments.
It can be more difficult to judge expected capital calls for follow-on investments as those
are truly ad-hoc. Sometimes funds do not call all committed capital as they have access to credit lines.
It is worth noting, especially with the increased frequency of family offices and investment in smaller/emerging managers, that this offers some nuance. The complexity of planning liquidity with smaller funds is higher, with first and second closes (e.g., during first close they can often draw in excess of 50 per cent of commitment, then with the second close, there can sometimes be an equalization process where they hand cash back, which can be perplexing to LPs).
Why do capital calls matter to Family Offices?
Capital calls can be an important consideration for family offices, because they represent a potential additional financial commitment from the family office. Family offices typically invest in private equity and venture capital funds as part of a diversified investment portfolio, and capital calls can be a regular part of this type of investing.
It is important for family offices to be aware of the potential for capital calls and to have the financial resources in place to meet them when they arise. Additionally, family offices may want to carefully consider the terms of a fund’s capital call provisions before investing, to ensure that they are comfortable with the potential financial commitments involved.
However, they are not giving enough focus to the “money waiting” period, when they have made commitments to investments but the funds are not yet deployed. This is an important issue for governance, as well as investment. Investors should consider how to invest their money during the waiting period, and account for the risks and experience of assets during this time. It is also important to manage cash flows across different private asset investments, and ensure that commitments to general partners are met on a timely basis.
Best practice is to adopt a dynamic investment framework, a strategy for managing investments that adjusts to short- to-medium-term projections of cash flow requirements. This means that the allocation of assets within the investment portfolio is regularly adjusted based on the expected future needs for cash.
This approach allows for a more flexible and responsive investment strategy, as it allows for changes to be made to the portfolio in response to changing market conditions or cash flow needs. A dynamic investment framework is typically used in private asset investments, but it can also be applied to a broader family office investment strategy.
