LP Capital Call Mechanics and Risks: Navigating the Complexities with Evolve Venture Capital
Introduction
In the private equity and venture capital space, capital calls are a key process mechanism whereby fund managers raise the capital needed to fund their investments. This process is not always a simple one. For limited partners (LPs), knowing how the capital call process works and, most importantly, the potential traps in the capital call mechanics is important for managing portfolios and ultimately mitigating risk. In this blog, we'll walk through the nuances of LP capital call mechanics, identify some common pain points, and show how Evolve Venture Capital can help solve these problems.
The Mechanics of LP Capital Calls
A capital call occurs when a fund (private equity or venture capital) requests its limited partners’ (LPs’) proportion of committed capital. The capital call process is important so that a fund can obtain founders liquidity for either an investment or to fund expenses. The basic steps to execute a capital call are:
Commitment: the LPs committed a dollar amount to the fund during its fundraising.
Notice: the fund manager sends a capital call notice to LPs letting them know of the required capital amount and the due date for payment.
Contribution: LPs transfer the required capital to the fund by the payment due date.
Repayment: the fund then invests (or expensed) the capital and will eventually return the capital to LPs through distributions or exit events.
Pain Points and Risks Associated with LP Capital Calls
Capital calls are a normal occurrence in the industry but they come with assorted pain points and risks every limited partner should be aware of:
Liquidity Risk: Limited partners can experience liquidity constraints if they do not have the funds to satisfy a capital call, essentially when it comes due. This issue can also be amplified in bear markets when funding thus the need for capital call may be even more difficult to satisfy.
Default Risk: If limited partners default on their capital commitments, there are theoretical damages stemming from legal consequences for the limited partners or the Fund as a whole.
IRR Inflation: Capital call facilities can present the normal problem of "inflation" of a fund's IRR which makes it even harder for limited partners to assess fund performance.
Operational Risk: losses can stem simply from operational errors or fraud by the fund manager, which can be mitigated by ensuring that the manager has meaningful experience.
In-Depth Analysis of LP Capital Call Risks
To address the various risks associated with every element of LP capital call wording, let's break down every one of these pain points:
Liquidity Risk
Liquidity risk is the risk that a LP will not meet a capital call because there are not enough funds or liquidity available. Liquidity risk can be elevated during times of instability and volatility in the market, as LPs may face liquidity issues in their own portfolios. LPs can mitigate liquidity risk by engaging in cash flow management by closely monitoring cumulative and projected cash outflow (i.e. capital calls, distributions, fees) and cash inflow from their portfolios, which can assist a LP in liquidity performance.
Default Risk
Default risk occurs when an LP fails to respond to a capital call, which opens the door to legal actions taken by the fund, forfeiture of the LP’s interest in the fund, and/or the reallocation of a capital call to other LPs. Fund sponsors have many remedies in possible LP defaults. Some potential remedies are the sale of the defaulting LP’s interest to non-defaulting LPs or third parties, forfeiture of partnership interest, or reallocation of capital.
IRR Inflation
Capital call facilities can distort the IRR of a fund by postponing the timing of capital calls, making it difficult for LPs to assess a fund's performance. LPs should ask for detailed performance reports from fund managers around the usage of capital call facilities and undertake considerable due diligence around the use of capital call facilities.
Operational Risk
Operational risk is the risk of loss due to managerial or employee error and/or misconduct. A LP can mitigate operational risk due diligence in fund manager selection based on experience and length of track. As part of their due diligence, LPs should investigate the operations and governance of the fund.
How Evolve Venture Capital Can Help
Since we work with LPs, we know firsthand the complexities and risks associated with LP capital calls. However, we have a team of experts that are happy to help LPs work through the complexities and risks involved and help them optimize their investment processes. Here are some things we can do:
Risk Management: We have full risk management solutions that help LPs identify the risks of capital calls and manage those risks accordingly.
Performance Analysis: We have the metrics and analytic capabilities which gives LPs the ability to accurately evaluate the performance of their funds, LP capital calls, and make better informed financial decisions.
Due Diligence: We provide, and help LPs apply (when necessary) the same due diligence process to evaluating fund managers, and operational processes which we would expect if we were the LP so that we know we are investing in a well-managed, high-quality fund.
Customized Solutions: Each LP has varying risk profiles, needs, and approach, and we customize our solutions accordingly so that LPs achieve their investment goals while minimizing risk.
Conclusion
LP capital calls are an integral part of private equity and venture capital investing but they carry a degree of risk that LPs need to be conscious of. By understanding the mechanics and risks associated with capital calls, LPs can take actions to minimize those risks as well as achieve higher levels of success from their investment. At Evolve Venture Capital, we have a vested interest in ensuring our LPs properly navigate this terrain and achieve their investment ambitions. Please feel free to connect with us and learn more about how we can assist you on your investment journey.
