Progressive capital calls for investment funds
Fund managers with investment strategies dependent on target assets being identified or acquired over time are generally reliant on a strong capital call structure. The right to progressively call committed capital is a common mechanism across private equity and private credit funds and is becoming increasing more common in real estate and other asset classes.
We have described common structuring options and considerations below.
Need to know
- The right to progressively call committed capital is an increasingly common mechanism used by fund managers across an expanding range of asset classes where capital is to be progressively deployed.
- There are various structuring options for fund managers seeking to progressively deploy capital, with the appropriate mechanism being driven by investor requirements and outcomes, and the manager’s ability to hold undeployed capital under an interim investment strategy.
Undeployed capital retained by the investor
Two of the most common structures used to lock in binding capital commitments that are at call from investors are:
- the issue of partly paid interests, with paid calls increasing the paid-up amount on the interests; and
- investors entering into binding subscriptions for fully paid interests up to their total committed capital, with the fully paid interests being issued to the investors once the calls are paid.
In each case, a specific investment or deployment period would generally be imposed as a sunset date on any further drawdowns of committed capital. Some of the key terms and features that generally attach to these call structures are set out in the table below.
Partly paid interests | Fully paid interests | ||
|---|---|---|---|
| Interest issued and call mechanism | Partly paid interests, generally units, are issued in the fund at the issue price determined under the trust deed. The total number of interests are issued to the investor upfront but are only paid up to the extent of the initial capital call (not the total issue price). As capital calls are paid, the dollar value and proportion paid up on each interest are increased accordingly. Capital calls can continue to be made until the full issue price per unit is paid. | Fully paid interests, generally units, are issued in the fund at the issue price determined under the trust deed. Additional units up to the full commitment amount will be issued at the time calls are made on those amounts. | |
| Rights of investors | Each investor’s rights to income, capital and voting will generally align with their ‘paid up proportion’. For example, if an investor holds 100 units paid up to 50% their rights would generally be the equivalent of holding 50 fully paid units. | Each fully paid unit has the full suite of rights attaching to it, subject to any suspension of those rights in an event of a default (as described below). | |
| Issue price | Determined on a ‘per interest’ basis under the constitution, payable in instalments when validly called by the trustee. | Determined on a ‘per interest’ basis under the constitution, payable in full at the time interests are to be issued. | |
| Default on capital calls | In circumstances of a default, the partly paid units in respect of which the default arises may (in some cases subject to the elapsing of a cure period) be subject to forfeiture. During the period of the default, the voting, distribution and other rights attaching to the partly paid units would generally be suspended. Interest (often at the target return rate) will often also apply, and the trust deed may provide mechanisms (such as funding from a related party of the manager) to bridge the period until calls are paid. | Similar default consequences to those that would apply to partly paid units can be applied on the basis of a default on the total committed capital, rather than unpaid amounts, such that if an investor has defaulted on a capital call for new units, the right attaching to their fully paid units may be suspended. Similarly, interest (often at the target return rate) will often also apply, and the trust deed may provide mechanisms (such as funding from a related party of the manager) to bridge the period until calls are paid. | |
| Documentation | Investors enter into a subscription deed or application form subscribing for the total number of interests that will be issued to them for their total committed capital. The trust deed needs to expressly provide for the issue of partly paid units and the rights and obligations attaching to them. | Investors enter into a subscription deed or application form that commits their total committed capital, without the units all being issued upfront. | |
As reflected above, the consequences of a failure to pay a call for capital under either structure are onerous, given the potential consequence for the fund and manager of needing to obtain bridging finance to settle on investments sourced on the basis that a certain level of additional capital is available to the fund.
Undeployed capital held by the manager
Multi-stage deployment
Where a manager does not have assets locked in to deploy the full amount of committed capital, but wants to hold it in the meantime, some utilise a two-staged investment approach, with capital held in a relatively passive, liquid asset class until it is deployed by the manager into the principal investment strategy. Under this option:
- the manager takes all commitments upfront for the issue of fully paid units, meaning investors are fully invested from day one; and
- capital in the ‘passive’ portion of the portfolio is generally not subject to performance fees (and may, depending on the assets in the passive portfolio, not attract the same management fee).
This option is a feature of the fund itself, and so would apply to all investors across the relevant class, rather than being at an investor’s election (which is different to the reserve account mechanism described below). It needs to be disclosed in the information memorandum and agreed to by investors, particularly given that returns will be impacted. This includes sufficient information to allow investors to assess whether the short-term liquid investments meets investors’ requirements where they have portfolio allocation limits, given they are in a potentially different asset class to the key investment strategy.
Reserve accounts
Under either capital call structure (partly or fully paid units) it is possible, and becoming increasingly more common, for investors to have the option to pay the full committed amount upfront, into a ‘reserve account’ where undrawn capital will sit until called. The mechanics, rights and obligations relating to the reserve accounts are generally set out in the trust deed for the fund, and generally provide:
- The investors deposit their full commitment into an account managed by the manager or a member of its group, which is then invested into liquid assets (generally listed securities). The account is held in the name of the trust, and generally holds all reserve account commitments (ie in an omnibus structure).
- Any return resulting from the investment of the reserve account funds is held for the benefit of the reserve account investor.
- The manager draws commitments from the reserve account in the same manner (time and proportions) as other draw downs, with the manager drawing directly from the reserve account and paying it into the trust account for the fund. The liquid investments of the reserve account are realised to the extent required to meet the call. If the relevant investor’s reserve account balance is insufficient to meet the draw down, the manager can issue a draw down notice in the ordinary course, requiring payment directly by the investor.
- While funds are held in the reserve account, the manager operates such that:
- it is not a directed investment account or similar, and investments are at the manager’s discretion, subject to the restrictions under the trust deed;
- the investor is not entitled to withdraw from the reserve account; and
- the manager is entitled to deduct its costs in managing the reserve account (but may not always charge a separate fee for management of the account).
- An investor can also request to have distributions paid into the reserve account.
- Any remaining amounts to the account of a reserve account investor at the time that they cease to invest in the fund (whether by transfer or redemption) are paid to the investor.
Depositing into the reserve account is not an option that needs to be taken by all investors in the fund for it to be available and is a useful option to have in investment documents even if it is not the manager’s intention to make it available (in case investors down the track may have different deployment requirements).
This will generally be elected by investors whose mandate requires that capital be immediately deployed, in circumstances where the manager has the capability and resources to invest what would otherwise be an undrawn commitment in liquid assets. When utilised, it provides the manager with certainty that there will not be a funding default on capital calls (unless there is a decrease in the value of the reserve account value below the undrawn commitments), but also involves them managing an asset for generally no fee in circumstances where fees are only payable on deployed commitments.
The importance of allocation policies for undeployed capital
Where a manager is operating several funds across an asset class, investors committing to an investment strategy with progressive calls and without the portfolio confirmed from the outset will generally want to understand their protections in relation to the fund’s access to certain assets available to the manager. To address this, managers will generally need to have a robust asset allocation policy in place and may need to provide side letter commitments to key investors regarding compliance with that policy.
If you would like to discuss how best to structure your funds to meet your capital draw requirements, please contact Vanessa Murphy, James Morvell or a member of the HW Funds team.
