Capital Calls

A capital call (also called a drawdown) is an investment firm’s legal right to request a portion of committed capital from a limited partner (LP) at their discretion in order to make one or more underlying investments, or to pay fees and expenses.  

At a high level, the investment period defined in the limited partnership agreement (LPA) dictates when a general partner (GP) can invoke a capital call for new investments. In practice, the GP will need to create a strategy that balances the flexibility to make time-sensitive investments with the need to provide LPs adequate notice. Ultimately, GPs should set clear expectations via a regular cadence of capital calls.  

Here are several points to keep in mind as you determine your capital call strategy: 

Capital calls affect internal rate of return (IRR)

When you call capital, you effectively thread the needle between risk and return. If you hold a lot of uninvested capital on your balance sheet, it does not accrue toward your IRR. On the other hand, if you collect and quickly deploy a disproportionate portion of the fund in the first few months of your fund cycle, your risk may not be well dispersed. What’s more, you may miss out on companies later in the cycle when you have less dry powder.  

Focus on cash-on-cash returns rather than IRR

Many emerging managers overcomplicate their process by focusing too heavily on IRR. “Smaller funds (especially those under $25 million) should focus on cash-on-cash returns over IRR, and therefore should primarily optimize for cash flow simplicity,” cautions Jim Marshall, head of Silicon Valley Bank’s Emerging Manager Practice. “Get on a regular capital call schedule — quarterly or every six months — to create a regular pace that you and your LPs can rely on across the fund’s life.” 

Offer advance notice

No one likes a last-minute request for cash. And capital calls can involve a lot of cash, which means inadequate advance warning about them can frustrate LPs unnecessarily. “The more institutional your LP base, the more institutional the cadence they expect,” Marshall says. “Also, smaller investors like high-net-worth individuals and family offices, simply may not have the infrastructure to provide capital on short notice. We recommend at least 10 and up to 30 days notice for all LPs.”  

Fund size is negatively correlated with drawdown rates

As a general rule, smaller funds tend to “execute fewer deals per fund, which translates to large checks relative to the fund size, quicker drawdowns and more concentrated portfolios,” according to PitchBook. Factor check size into your capital call strategy to ensure you’ll have the capital reserves you need throughout the cycle.  

The early years matter

As a benchmark, PitchBook has found that the average fund calls 5% of its commitment size until 75% of the fund is invested, after which the average tapers off. There is typically a ramp period in the first three years of a cycle, during which funds deploy cash most quickly. “More than 80% of venture capital (VC) funds call capital during any given quarter” in those first three years, according to Pitchbook. 
 

Consider your reserves ratio

Depending on your investment strategy, you may need to hold quite a lot or very little for future follow-on investments. When it comes to setting your initial capital to reserve ratio, Marshall offers this guidance: “There is no objective right answer here for all emerging managers, but the trend we are seeing is a higher percentage of the fund invested via first checks. In 2021, a good benchmark might be a 70:30 initial to reserve ratio, while it used to be more like 1:1.”

Smaller funds should focus on cash-on-cash returns over IRR, and therefore should primarily optimize for cash flow simplicity. Get on a regular capital call schedule — quarterly or every six months — to create a regular pace that you and your LPs can rely on across the fund’s life. Jim Marshall Head of Emerging Manager Practice

Rebalance as you go

No matter how well you plan your cash flows at the beginning of a fund cycle, you will need to recalibrate. “Every month remodel the pace of your investment and rebalance your needs accordingly,” Marshall advises. “You and your back-office team should be constantly updating your fund accounting model so that it matches your reality.” 
 

Venture capital cycle speed is increasing

While most emerging manager fund investments happen over the course of a few years, the pace continues to quicken in the current environment as check sizes balloon and the time between rounds shrinks. While it’s important to be thoughtful about the pace and cadence of your specific industry (e.g., a crypto fund will deploy much more quickly than a hardware-focused fund), you should also follow broader economic trends closely and share notes with other GPs throughout the cycle. 

What does a capital call notice contain? 

LPs expect your capital call notice, often sent on your behalf by your fund administrators, to include three elements: 

1. A cover letter with the net amount due, the intended use and the LPA clause it falls under. 
2. A detailed written description of the transaction that includes deeper details regarding any specific investments and management costs the capital call will cover, plus a display of the LP’s funded and unfunded capital amounts. 
3. An Excel spreadsheet including all financial details of the transactions. 

Resources

Review these Capital Call and Distribution templates

• Capital Call & Distribution Notice Sample Cover Letter and Description by Institutional Limited Partners Association (ILPA)

• Capital Call & Distribution Notice Excel Template by ILPA