Similar to startups needing funding for growth, supporting investment funds also require financial backing. When ready to invest in a company, they make a capital call, urging their fund investors to send the committed money.
Just as a startup secures investment or backing from a major fund by convincing investors of its business opportunities, investors themselves engage in fundraising to finance their ventures.
Investment funds obtain their money through contributions from investors participating in the fund. These investors can be individuals, financial institutions, pension funds, insurance companies, or other entities. The money contributed by investors is pooled to form a common fund, managed by financial professionals known as fund managers. On certain occasions, they may require additional funds to meet their objectives or address specific operations. In such cases, they may resort to capital calls.
What are capital calls and how do they work?
A capital call occurs when a fund manager requests investors in the fund to contribute capital for making investments and thus fulfill their financial obligations. When a venture capital entity announces its entry into a high-growth company, it doesn’t mean that it already has that money in the bank, waiting for an interesting startup idea to appear. Typically, when capital is needed for investment, they request it from their ‘Limited Partners‘ (LP) in accordance with their investment commitments. This request is known as a capital call.
Its primary purpose is to provide fund managers with the necessary resources to seize investment opportunities and effectively manage the fund’s operations. By allowing investors to contribute beyond their initial commitment, it enhances the financial flexibility of the fund and optimizes its ability to generate long-term returns. Unlike general partners (GP), limited partners (LP) are not responsible for the investment strategy of the fund.
- If the limited partners (LP) do not participate in the capital call, they could experience dilution in their stake in the fund. In other words, a decrease in their percentage of ownership as a result of the issuance of new shares.
- When investors respond affirmatively to a capital call, the issuance of new shares leads to an expansion of the total fund capital. This expansion may result in dilution for existing investors, as their stakes will represent a smaller proportion of the fund after the capital increase if they do not participate in the investment round.
Therefore, dilution is a critical issue and can impact the decision to participate in a capital call. In any case, fund managers typically seek a balance between securing the necessary funds and managing dilution to maintain investor confidence, especially for those who choose not to participate in a specific capital call.
Risks of capital calls
Before making a capital call, venture capital funds must consider certain challenges:
- Non-compliance: LPs may not fulfill the request, leading to fund agreement breaches and reputation loss. Strategies like penalties or future profit retention discourage non-compliance.
- Timing: Making a capital call too early, without a firm agreement on necessary funding, may result in excessive and unnecessary fund inflow.
- Purpose: Using capital calls for operational costs is unfavorable, signaling instability. Capital calls should only finance investments or temporarily address unexpected market challenges.
If partners don’t contribute… ‘capital call lines’
Whether LPs don’t contribute or their investment is delayed, funds must fulfill committed obligations. To anticipate this, funds may turn to ‘capital call lines,’ credit lines offering immediate liquidity, such as those provided by initiatives like BBVA Spark.
It’s important to note that capital calls and ‘capital call lines’ are distinct but related concepts. While capital calls request investors to contribute the amount according to their investment commitment, ‘capital call lines’ are credit lines available to cover these calls, repaid when LPs make their committed contributions.
If capital calls emerge as a strategic tool for investment funds and, consequently, for the growth of startups, a deep understanding of the risks and benefits becomes essential. Capital calls serve as a reminder of the need to find a balance in the pursuit of funding and investment opportunities. In the quest for this balance, it is important to consider all available financing tools, such as ‘capital call lines.’
