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Key Takeaways
Capital calls are when private asset managers request pre-committed capital from investors with relatively short notice, to deploy into investment opportunities. Options for getting out of capital calls are limited and expensive.
Capital calls provide the opportunity to prevent cash drag, by only requesting capital when it will actually be used and allowing investors to invest in other assets in the interim.
Most investors have to meet capital calls via asset liquidation, meaning they need to invest more than the amount they’ve committed to private funds in highly liquid assets.
What is a Capital Call?
Commonly, firms do not take the capital committed to them by investors immediately nor all at once. They wait until they find investments they’d like to make, then have capital calls, requesting that a portion of the amount of money investors have committed be transferred, typically with short notice (~2 months). This occurs in private markets, but not in public markets (such as mutual funds), where markets are very liquid and investor capital can be deployed immediately.
In effect, this spreads the investment into private assets over several years, meaning investors have the flexibility to access and invest their money in other assets until it is time to put that money explicitly to use in a private investment. This flexibility can help them maximize returns by avoiding cash drag -- but if managed poorly, capital calls can be a source of both confusion and potential return loss.
What is the Capital Call Process?
Investors are sent notice from the general partner that a specific amount of the capital they’ve committed to the fund is being requested. They are given a date by which they need to wire the money to the fund.
The following is an example of a capital call:
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Problems with Capital Calls
Capital calls can be unpredictable - The maximum amount of capital which can be called is known, but the timeline over which it will be called is unknown. It generally happens in the first several years of an investment, but investors are not given very much notice. If investors do not have cash on hand, they may be forced to exit existing investments, which can be particularly painful during a down market (and many private investment strategies find better entry points during these periods). Today, there are software solutions to help model out the cash flows of fund investments to try to mitigate this problem.
There aren’t many ways out of a capital call. If investors do not transfer the agreed upon capital, they can be forced to pay a fine and forfeit the rights to the investment (terms in a capital call agreement). The secondary market for shares in private funds also are not very liquid so do not offer a great alternative for exiting a position before capital is owed.
What Happens if You Don’t Have the Money to Meet a Capital Call?
Terms are laid out in the capital call agreement, but firms may employ any of the following against an investor if the investor fails to meet a capital call (and is unable to trade shares on the secondary market to meet it):
Dilution or loss of equity - The fund may dilute the equity owned by the investor, sue for the equity, or buy back the equity at a very discounted rate.
Loan at High Interest Rates - The fund may offer a loan at very high interest rates to the investor, to cover the capital call share.
Preparing for a Capital Call
When first approaching investing in a private asset fund, investors should decide which strategy they will use to meet capital calls. Investors typically meet them in one of two ways:
Borrow from a bank line of credit: This option is mostly available to large institutional players. This allows investors to borrow at very low rates and liquidate existing investments to pay back the line of credit over the following 6 months, exiting positions when prices are more favorable. If investors opt for this course of action, they need to make sure they have lines of credit set up well in advance of any capital calls.
Liquidate existing investments: Selling existing assets to meet capital calls is an option available to every investor. When going with this option, investors should make sure enough of their portfolio is in liquid assets that they can easily meet the capital call requirements - which means investing more than the committed capital (to account for risk of loss) if holding in non-cash instruments. This shouldn’t be a problem for most investors transitioning into alternative investments, coming from 60/40 or 70/30 portfolios. The allocation investors choose for the capital they’ve precommitted should take into account diversification, return and liquidity in order to maximize the benefits of the capital call structure, and ensure the investor’s availability to meet the capital call.
After receiving notice of a capital call, investors either tap their credit line or liquidate existing assets then wire money to the private asset manager.