Capital Call: A Complete Guide for Investors

Data released by investment research firm Investec at the beginning of June 2022 that capital calls made by private equity funds dropped to a 10-year low.

However, with the global economy now looking like it’s headed for a reset, we’re likely to see a significant uptick in capital calls.

In this article, we look at them in more detail, understanding what they are, and their importance to investor-funded companies.

What is Capital Call?

A capital call sometimes referred to as a ‘draw down’ is the process of collecting stipulated funds from investors when the need arises.

Companies and Investment funds usually permit investors to keep their funds until they’re required, thus enabling the investors to keep those funds in money market accounts or other liquid assets and gain interest. A capital call means that the company should have access to the funds on demand.

Example of a capital call

Capital calls are most common in venture capital and private equity and function the same way in both cases. Suppose that you’re impressed with the investment track record of a particular VC firm in silicon valley. You recognize several of the companies that they’ve brought to unicorn status and you can see that they’ve made extremely high returns on most companies they’ve invested in. So you commit $500K to a $50M fund.

Now, suppose that the VC firm starts the due diligence process on several interesting startups, and decides to invest $10M in two particularly promising fintechs, which it has agreed to deposit within a week. It now issues a capital call to all its investors who have to pay funds out on a pro-rate basis (i.e. $10M/$50M or 20%), meaning you’ll receive a capital call amounting to $100K or 20% of the money that you invested.

Importance of a capital call

Capital calls are important for two reasons.

First, they enable investors to gain interest on their own funds, rather than enabling the investment fund to do so. Otherwise, an investment fund with a large cash pile could remain looking for businesses for years, while continuing to enjoy the proceeds of the money invested. In the case of funds with billions pledged by investors, the interest would be considerable, and a disincentive to invest.

The second reason that capital calls are important is that they provide transparency.

When the private equity or venture capital fund makes the capital call, all of the investors see what they’re investing in, and the reason for the capital call. If the money had been given to the investment fund at the outset, it could potentially lead to a situation where the investors had no idea what the status of their capital was.

What happens when an investor fails to issue capital?

In the unusual event that an investor fails to issue capital within an agreed timeframe after a capital call, they will probably be contacted by the investment fund and provided an extended grace period to make the payment.

In the event that the payment is not made within this period, the investor is considered in default. Once in default, there are several possibilities, depending on the nature of the default and the investment fund’s policy.

These possibilities include:

Forfeiture: Whereby the investment firm maintains the right for the investor’s interest in the fund to be forfeited or redeemed. Again, depending on the terms stipulated in the investment agreement, this could involve any number of compromise scenarios where the investor has to either forfeit their investment or forego some part of it.

Forced sale: Whereby the investor has to sell to the investment fund or a third party at pre-agreed terms (e.g. the lesser market or book value of the underlying investments). Invariably, the investment fund maintains the right of first refusal in the case of a forced sale.

Litigation: An option that needs little explanation that involves the investment fund taking the investor through the legal system for breach of contract.

When is a capital call used?

As outlined above, a capital call is used when an investment has been identified, and the funds are required from investors to secure the investment.

The process through which a capital call is issued is sometimes referred to as the ‘capital call notice’ as it gives the investor a period of around 10 working days (the notice period), during which they are obliged to transfer the proportion of the capital that they’ve committed to investing with the fund.

Putting in together

DealRoom works with private equity and venture capital firms from all over the world on every stage of their process, from investor roadshows and deal origination to closing transactions with target companies.

This process also takes in the capital call process. Whether you’re a GP or an LP, talk to FirmRoom about how we can bring a value-creating solution to your process.