In recent years, the world of private equity has moved from a niche topic in the financial industry and into the mainstream. Despite the outsize attention that private equity has received, however, many people still aren't certain about the ins and outs of the field, including terms like "capital calls."
Capital calls are a highly useful tool in private equity, but one that should be used with caution and a good idea of the consequences. Read on to learn more about this important technique.
What Is a Capital Call?
A capital call, also known as a "draw down," is the act of collecting funds from limited partners whenever the need arises. When an investor buys into a private equity fund, the firm makes an agreement with the investor that these funds will be available when the firm requests them. In turn, investors are able to hold onto their funds and keep them in a favorable investment account, such as a mutual fund or retirement account, so that the investment can continue to appreciate until the firm needs it.
Private equity firms typically issue capital calls when an investment deal has been reached and is nearing close. Investors have a predetermined amount of time, which is usually between a week and 10 days, to provide the funds. Once investors provide the funds they are repaid later on with capital contributions.
When Should You Use a Capital Call?
Historically, capital calls have been frequently used by real estate funds. Because the firm may spend some time on finding an attractive real estate investment before buying, it may not need access to investors' funds right away.
However, more and more private equity funds are taking advantage of the tactic for a number of reasons. Capital calls provide increased flexibility and can be useful for attracting investors who want to benefit financially from that flexibility. Because the investment may be spread out over a period of months or even years, investors can maximize their return on investment while they wait for their funds to be requested.
In general, by giving you access to more funds on a short-term notice, capital calls improve your ability to deal with surprise changes and shifts in the market as well as investment projects that unexpectedly go over budget. You may also be requested to perform a capital call by banks or other institutions in order to secure financial agreements.
What Are the Dangers of Capital Calls?
Capital calls are not without their risks, however. Because you don't actually have access to the funds until they arrive in your bank account, you may be unable to obtain all of the funds that you were initially promised from investors, which can lead to a default. Private equity firms use a number of strategies to discourage defaults, including sanctions against the investor and withholding future income distributions.
In addition, if you issue a capital call too early, without having a deal in place, you may receive too many funds. You should only use capital calls to fund investments on which a deal has been reached, not on speculative deals or on operational costs.
Finally, relying too much on capital calls can make your fund appear too unstable for many investors. This is because firms that frequently use capital calls typically have fewer liquid assets available.