Question

What is meant by the term capital call? Under what circumstances might a capital call occur, and how does it affect partners?

Answer 1

A capital call is described as an act of a firm collecting funds from it's investors (Limited Partners) when it need for it arises. When an investor invests an amount under capital call model, he agrees to provide them when the need for it arises. Doing so, instead of paying for it on Day 1, the investor is able to invest it somewhere else safely and let it grow. Real estate firms usually use it but nowadays Private Equity firm use it aswell as they have realised the advantages of it. They enter an agreement and then later ask for the money when the deal is coming close.

Capital Call agreements may be done under various circumstances. They may be required to bridge the gap between needs of shareholders and lenders. Let's say a lender requires a firm to keep a leverage between 3 to 1. A way to do that would be to decrease initial borrowings and rely more on equity. This will decrease the shareholders wealth. To solve this problem, shareholders might agree to commit to future capital requirements. They are also popular tools in loan restructuring. In cases of default, a lender's grant on forbereance depends on a shareholders capacity to provide funds in the future. They may also be used when lender's and shareholders underwriting criteria are different. For example in the case of a facility of future acquisitions, a shareholder may require lender to provide funds on precorporate overhead basis while lender would want to do it conservatively. In this case, a lender may be comfortable signing a capital call.

The capital call agreement is beneficial for the Limited Partners as it helps them enchance their IRR. If the capital was all given on day 1, there would be a lost opportunity to keep them invested elsewhere and give them when demanded later on. Thus, LPs benefit from this. However, this method is comletely reliant on LPs obligations to pay when requested. Although defaulting is rare, it happens. In a case of lack of liquid funds to meet these requirements, the LP may face interest charges. He may be forced to sell off other assets quickly to meet these obligations. If he continues to default, they may sell of his stake and exclude him from future commitments.