Capital calls

Author:

The Carta Team

When fund managers are ready to invest in a private company, they usually have to make a capital call first. Learn more about capital calls in private equity and venture capital.

What is a capital call?

A capital call is a formal request by an investment fund to its investors to contribute a portion of the capital they have previously agreed to commit, typically for new investment opportunities or operational expenses. Capital calls allow general partners (GPs) to draw down capital from investors as it’s needed, rather than all at once. This process improves a fund’s cash flow efficiency by aligning capital deployment with investment opportunities and minimizing idle cash.

Capital calls are a key feature of closed-end investment funds like venture capital funds, private equity funds, and real estate funds. When a private fund is raised, its investors, also known as limited partners (LPs), commit capital to the fund, but do not immediately transfer the money they commit. Their capital commitment—also called a “subscription”—is a legally binding promise that they’ll send the money they pledged when the fund manager requests it.

How capital calls work

As the GP of a fund, when you decide to invest in a portfolio company, you might have enough cash on your balance sheet to do the deal. More often than not, though, you’ll need to call additional capital from the fund’s LP investors. The amount you’ll call depends on the size of the investment you want to make.

In practice, making a capital call means asking one or more of your LPs to transfer funds to the fund’s bank account. Rarely will a GP ask for all the committed money at once, as without a deal to deploy the funds to, this could damage fund performance metrics.

Instead, most GPs opt to make a pro rata capital call. This means that they’ll ask all of the fund’s LPs to send the same percentage of their committed capital, regardless of the amount they pledged, in order to have enough cash in total to be able to make the investment.

The capital call process

The specifics of a capital call can vary depending on the type of fund, but the general process is similar across private equity, venture capital, and other closed-end funds.

1. Commitment phase: At the beginning of the fund, investors agree to commit a certain amount of money to the fund over its lifecycle.
2. Issuing a capital call notice: The GP of the fund issues a capital call in order to fund a new investment opportunity, cover fund expenses, fund a follow-on investment, or meet other liquidity needs.
3. Funding and deployment: Investors transfer the requested funds, typically within 10 to 14 days. Once received, the GP deploys the capital.
4. Tracking capital contributions: The fund tracks the total paid-in capital of each investor so each investor meets their total capital commitment over time. The difference between an investor's committed capital and paid-in capital is known as “uncalled capital.”

Legal obligations for the GP

The LPA typically allows GPs to call capital from LPs in order to make new deals during the deployment period (or investment period). While the deployment period is usually about five years, many funds deploy their capital (meaning call commitments from LPs and use the funds) between 18 to 36 months. During the deployment period, the LPA may place limits on how much money can be committed for any one particular deal. Concentration limits can be based on the relative amount invested in a particular company, geographic limits on where companies operate, industry limits, or other factors.

Legal obligations for the LP

When a GP initiates a capital call, the LP typically has between 10 to 14 days to wire the funds for the investment. The request is legally enforceable according to the details of the LPA, but LPs rarely default because it would cause both reputational damage and have severe financial ramifications.

Capital calls in private equity and venture capital

The amount of capital, timing, and frequency of capital calls will depend on the fund’s investment strategy.

Private equity funds often invest in growth-stage companies, public companies, and other mature businesses, aiming to improve operations and increase profitability before selling at a higher valuation. Capital calls in private equity are usually tied to investment opportunities or acquisitions and are typically larger and less frequent.

Venture capital funds typically invest in startups, early-stage companies, and high-growth companies. Capital calls in venture capital may be more frequent but smaller in size to support multiple fundraising rounds.

Capital call strategies

It’s important to know how much money to call and when to call it.

Timing a capital call

If you call capital before a deal is finalized and the agreement falls apart, the money will sit in your fund’s account and drag down two important metrics: the fund’s internal rate of return (IRR) and total value to paid-in (TVPI). These metrics are used to measure a fund’s performance. IRR calculates the annual rate an investment grows. TVPI is a formula that estimates the total value of an investment portfolio, including realized and unrealized investments.

If you issue a capital call without giving the LP sufficient notice, the LP may not be able to wire the money by the time you need it to close the deal. This can cause a deal to collapse. A seasoned manager will often give their LPs informal capital call notices when they enter into discussions to invest in a company, ensuring that the subsequent capital call doesn’t come as a surprise. Usually, LPs need 10 to 14 days to liquidate assets.

Capital call lines

Over the past decade, VC funds and private equity firms have increasingly used capital call lines of credit to make sure they’ll have the necessary capital on hand to complete a deal. A capital call line of credit is a short-term loan from a financial institution that you can use to invest in a company while waiting for LPs to transfer funds.

Capital call lines have benefits for both LPs and GPs. The LP saves money on management fees, since the GP holds their capital for a shorter period of time. And the GP can legally boost IRR metrics for the same reason.

What happens when an LP defaults?

LPs rarely fail to complete the capital call. But it can happen. What happens after an LP defaults depends on the LPA. A GP may:

• Impose a penalty of a few percentage points on the capital called for each day the money is late—effectively charging steep interest for the late payment.
• Use their own funds for the investment, sell the defaulting LP’s entire stake in the fund or defaulted stake to other investors in the fund, or sell the stake to a third party, with terms dictated by the GP.
• Hold LPs accountable for liabilities incurred due to the default, potentially putting them on the hook if their payment falls through.

The penalties for missing a capital call are usually harsh. It’s important to have the consequences outlined in an LPA to prepare for a worst-case scenario.

Example of a capital call

Imagine you’re the GP of Krakatoa Ventures Fund II, a $100 million fund specializing in early- to mid-stage biotech companies. You’ve just reached a deal to make a $5 million Series B investment in a startup called Genealogy Life Sciences, but you only have about $1 million on your balance sheet. To complete the deal, you’ll need to call capital from your investors.

How Carta can help

Carta’s capital calls request tool is designed to make capital calls fast and easy.