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Companies, such as venture capital and private equity firms, attract capital from investors for new strategies being pursued and funds being launched. Investment conditions are not always at peak levels, and as a result, the investment firm may receive commitments or financial promises by investors without getting any funds upfront. Then, the venture capital or private equity firm can pursue opportunities as they arise. When that time comes and the firm uncovers those opportunities, it issues a capital call to investors. In turn, investors must provide the money that was promised to the fund.
Venture capital firms provide financing to compelling start-up companies that are looking to grow. Private equity firms are in the business of acquiring assets or businesses it seeks to improve upon and eventually sell for profits. Both types of investment firms may begin raising money for a new fund that has a particular direction but may not have designated actual opportunities yet. Investors that make capital commitments to these funds might include pension funds, wealthy individuals, and financial institutions.
The investment firm might alert its investors to a capital call by sending a letter. In the communication, the firm will outline the reason for the capital call, such as an acquisition target has emerged or another investment opportunity is ripe. This is when the investor must make good on its financial promise so that the investment firm has the money it needs to invest and generate profits for all involved.
Agreements between investors and investment firms are binding, but sometimes there is flexibility. If an investor, such as a pension fund, commits a certain amount of capital to a new private equity fund, it may have every intention on following through with that promise. Economic times change, however, and that pension fund may not have access to liquidity, or cash, at the time of the capital call. If the investment management firm is cognizant of the fact its investors are strapped for cash, it could decide to work with them. The investment firm may send a letter indicating that a capital call is forthcoming but that investors have a window of time to reduce their financial commitments.
When an investment firm reduces a requirement for a capital call, it may appear to be extending a break to investors. It is worse for an investment firm if an investor defaults on a commitment instead of investing less money, however. This is especially true if one large institutional investor has committed to support a majority percentage of the new fund being launched; the investment firm may very well be acting in its own interest to allow a reduced commitment when it's time for a capital call.