Understanding and navigating capital calls

Private funds typically invest money very differently than public funds, such as mutual funds. They invest the capital you commit (your “committed capital”) to their fund over time at their discretion.

In effect, this spreads your investment out over several years. This has a couple of major advantages:

1. It allows you to continue to invest the money you committed while awaiting capital calls (as long as you can mobilize enough capital to respond to these calls when they are made - more on this below).

2. It means your investments are diversified across different economic and business environments, which reduces overall fund risk related to the timing of investments.

Investing your money

The way private funds typically work is that the money you agreed to invest in a fund is not actually transferred to the fund manager immediately. Instead, it is “called” by the manager when it is actually required to make investments. 

The chart below illustrates just how gradual this process can be across a variety of private strategies, showing the median pace of capital calls of funds in the 2008 “vintage” (i.e., that first called capital in 2008).  An investment in a 2008 fund in reality means you invest over several of the following years.

Private fund managers cannot say in advance precisely when they will make a deal, which means capital calls are fairly unpredictable. You know the maximum amount of capital that can be called, but not when that will happen or how much will be called. However, as the chart above shows, most strategies deploy the majority of their capital in the first four years (16 quarters) of a fund’s lifecycle.

Making capital calls

When a capital call is made, you are sent a notice by the fund manager detailing the specific amount of the capital you committed to the fund that is being called. You are given a date by which you need to wire the money to the fund. The following is a hypothetical example of a capital call document:

Capital calls typically have relatively short notice periods - sometimes as little as ten days, occasionally as long as two months.

The challenges of capital calls

This underscores the importance of thinking carefully about your liquidity before committing to a private fund.

On the one hand, you must be sure that you can accept some illiquidity in your portfolio, because once capital is committed it can take many years for returns to start filtering back to you. On the other hand, you need to make sure that you have enough liquidity to cover capital calls on an ongoing basis.

Before committing to a fund, you should decide which strategy to use to meet capital calls. Investors typically meet them in one of two ways: 

1. Liquidate existing investments: The simplest and most frequently used approach among individual investors is simply to sell some existing assets to cover each capital call. This obviously means ensuring enough of your portfolio is liquid, which is typically not a problem for most retail investors, who have traditionally held all of their portfolio in liquid assets. The only problem this presents is that capital calls are unpredictable, which means you may be forced to exit certain investments at a less than optimal time, such as during a market downturn.

2. Establish a line of credit: Mainly a choice for larger, institutional investors, this may still be an option for certain individuals. This would allow you to borrow from a bank at low rates to cover the capital call, with a period of time (often six months) in which to decide how to pay it back, potentially allowing you to sell other assets at more opportune times at more favorable prices. These lines of credit would need to be established well in advance of the potential capital calls.

In the highly unlikely scenario of finding yourself unable to cover a capital call, you might be tempted to try to exit a private investment early. This is sometimes possible, but is never advisable. These are long-term, buy-and-hold investments. Secondary markets for shares in traditional private funds do exist, but are illiquid and you will typically be forced to accept a big discount (or “haircut”) to your holdings’ value in order to secure a secondary sale. It is therefore much better to have a clear strategy to cover capital calls than to rely on a secondary sale.

Should you fail to meet a capital call there are penalties, which are laid out in the initial investment agreement. These can include:

• A fine

• Forfeiture of your rights to the investment

• Dilution of equity or total loss of that share in the fund

• A mandatory high interest rate loan from the fund to cover the cost

• The forced sale of your existing equity back to the manager at a discount rate

While this may all sound daunting, such extreme outcomes are very rare and highly avoidable. The right partner will be able to help you navigate liquidity management for your private investments. And the bigger picture is that, for most investors, we consider the slight logistical challenges associated with the private market fund model to be outweighed by the diverse portfolio benefits the various strategies can potentially offer.