Planning liquidity for capital calls, with a worked example

A fund investor needs enough liquid money to pay every capital call on time, and no more than that. Our rule is three layers: the calls expected over the next twelve months, at a pace half again as fast as planned, in cash; the calls of the year after in instruments that mature within that time; and the remaining unfunded commitment covered by listed assets you are prepared to sell, counted at a discount to today's prices. Holding the whole unfunded commitment in cash is too expensive, and counting on distributions to pay for calls fails in exactly the years when it matters.

What a fund can call, and when

A commitment is a promise to pay up to a fixed amount when the fund asks. The fund asks by capital call, and the part it has not asked for yet is the unfunded commitment. The fund agreement decides how much notice you get. The model limited partnership agreement of the Institutional Limited Partners Association (ILPA), a published reference that investors hold their own agreements against, provides for at least ten business days between the notice and the due date. Agreements with shorter periods exist. Read yours.

The same model sets a commitment period of five years from the first closing, extendable by one year. During that period the fund calls money for new investments. Afterwards it may still call for follow-on investments in existing companies, for management fees and for expenses. A fund in its seventh year with 15 per cent uncalled is therefore not finished calling, though what remains comes slowly and may never be drawn in full.

Two details move the unfunded figure in ways a simple subtraction misses. Distributions marked as recallable increase it again: the ILPA model lets a fund redraw proceeds from investments it sold within twelve months of buying them. And funds that finance purchases with a bank credit line secured on the commitments call less often and in larger amounts, sometimes months after the investment was made. From the outside, the pattern of calls looks more irregular than the pattern of deals.

What happens if a call is not paid

The consequences are written to deter. In the ILPA model, an investor who has not paid receives a default notice; if the amount is still open five business days later, the investor becomes a defaulting partner. Interest runs on the unpaid amount from the due date, at a rate the model term sheet fills in with 10 per cent a year. The general partner may then pursue every remedy the agreement gives, up to forfeiture of the investor's entire interest in the fund without compensation. The other investors are told of the default within 30 days.

Your own agreement will differ in the figures. It will not differ in direction. A missed call can cost the money already paid in, and it ends the relationship with the manager. Liquidity planning for calls is therefore planned around the worst week, not the average one.

The two standard answers, and why we follow neither

The cautious answer is to keep the full unfunded commitment in an overnight account. It can never fail. It also means that someone with EUR 460,000 of unfunded commitments keeps EUR 460,000 out of the market for years, much of it for calls that will come in year four or not at all. The return on the fund has to carry that idle money, and nobody adds it to the fund's IRR.

The relaxed answer is that a mature portfolio funds itself: distributions from old funds pay the calls of new ones. Over a decade that can work out. In a single year it is unreliable, because calls and distributions respond to the same market in opposite ways. When exits stall, distributions stop, and calls continue. The week after 2 April was a small demonstration of how fast the liquid side can change; we wrote about it in the tariff shock and the denominator effect.

A worked example

Say you hold three commitments, all in euros.

The total unfunded commitment is EUR 460,000. Now estimate the pace, fund by fund. These percentages are assumptions for the illustration; the better source is each manager, who will usually tell you what is planned for the year if you ask.

Fund A is past its commitment period. Expect follow-ons and fees: EUR 10,000 in each of the next two years. Fund B is in the middle of investing: 25 per cent of the commitment in the next twelve months, EUR 62,500, and 20 per cent in the year after, EUR 50,000. Fund C has just started: 20 per cent, EUR 60,000, then 25 per cent, EUR 75,000.

That gives EUR 132,500 for the next twelve months and EUR 135,000 for months 13 to 24, together EUR 267,500. The remaining EUR 192,500 lies further out.

Next comes the stress. Suppose funds B and C invest half again as fast as assumed, which can happen when a manager finds more to buy than planned. The next twelve months then cost EUR 93,750 plus EUR 90,000 plus EUR 10,000, which is EUR 193,750.

Three layers

The first layer is the stressed twelve-month figure, here about EUR 195,000, in an overnight account or a money market fund. It has to be reachable within the notice period, which rules out more than people expect: a fixed-term deposit usually cannot be ended early, a notice account with three months' notice is of no use against ten business days, and the proceeds of a securities sale arrive two trading days after the trade and may then need another transfer to the account the fund is paid from.

The second layer is the rest of the 24-month expectation, EUR 267,500 minus EUR 195,000, so about EUR 72,500. It can sit in fixed-term deposits or short-dated bonds that mature within a year or so and roll into the first layer as time passes.

The third layer covers what is left, EUR 192,500, and it does not need to be cash. It needs to be something listed that you would really sell, valued at what it might fetch in a bad year. If you count listed shares at 65 per cent of today's price, you need about EUR 296,000 of them earmarked for this purpose. If your listed portfolio is far larger than that, the third layer takes care of itself. If it is smaller, you are over-committed, and the time to notice is before signing fund D.

Distributions are deliberately absent from all three layers. When they arrive, they refill the first layer or reduce what the third has to cover.

What to put in the calendar

Review the plan every quarter, when the reports arrive, and after every call. Each call shifts money from unfunded to paid in and changes the expectation for the next twelve months. A commitment in US dollars has to be planned in dollars and watched in euros: its unfunded part costs more when the dollar rises, so the first layer for such a fund deserves a margin on top.

The practical failures are rarely about money. A notice goes to an e-mail address nobody reads in August. The person who can release the transfer is travelling. The account the fund is paid from has a daily limit below the call amount. Ten business days are enough for all of this if someone opens the notice on the day it arrives, and for none of it if it is found on day eight. Name a second person who receives the notices and can pay, and raise the transfer limit before the first call, not during it.

If you cannot state your unfunded commitment per fund today, start there; the signs that a spreadsheet has stopped working begin with exactly that number.