Cash Flow Management Component 2 of 4
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."
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