The Dealmakers Dial: Decoding Capital Calls

Over the years, Private Equity (PE) and Venture Capital (VC) sectors in India have proven their resilience and adaptability in attracting substantial capital inflows into the industry even when there has been global uncertainty and continued fluctuations of market cycles. PE and VC investments in the year 2024 alone saw a 5% annual growth, touching US$56 billion bolstered by a notable rise in buyout transactions and a thriving pipeline of high-growth enterprises across sectors. The maturity and growth of the market can be seen in the record domestic fundraising, where fund managers such as Kedaara Capital closed a fund on US$1.74 billion indicating a strong level of confidence in the domestic institutional investors and family offices. For sustaining this growth, it depends not just on the appetite of investors but also on the efficient internal mechanics that guarantee capital is deployed in a timely manner. One of these significant tools, yet often overlooked is the capital call, which is a critical component for cash flow management, liquidity alignment, and to instil confidence in the investor.

A. Understanding the Nomenclature of Capital Calls

The terms "capital call" and "drawdown" are frequently treated as synonyms within both pooled fund structures such as Alternative Investment Funds (AIFs) and direct PE or VC transactions. In essence, both terms describe the mechanism by which a General Partner (GP), or an investment manager, or a company/entity, requests and obtains committed capital from Limited Partners (LPs) or investors.

A capital call is the formal notice or contractual request made by the investment manager, while drawdown is the actual process of capital being remitted by the investor in response to that request. It is equally important to distinguish a "capital call" from a "capital commitment." While the latter denotes the total capital that investors have contractually agreed to contribute over the fund's life, a capital call refers to the formal request to draw a portion of that commitment for immediate usages (e.g. investment in an early stage or mature company depending upon investment type).

In contrast, a "Capital Commitment Facility" or "Subscription Line of Credit" may also refer, in certain contexts, to an arrangement of credit extended by an individual investor to a company, whereby the committed capital is disbursed in stages. This kind of capital commitment facility often bears a nominal interest charge on the drawn amount, reflecting its nature as a structured financing tool.

The workings of such facilities model the capital call framework commonly used in AIFs, wherein the company issues periodic notices to the investor requesting drawdowns of capital under the agreed facility. These notices operate similarly to capital call notices in fund structures, and investors are contractually obligated to disburse funds upon receiving such requests, subject to compliance and absence of default.

B. Demystifying Capital Calls

A capital call refers to a formal procedure in which an investment manager request funds from their committed investors to finance the intended investments or to support the functioning of the funds. Instead of raising all the committed funds at once, the managers use a just-in-time funding system which enables them to release funds as soon as it is necessary in order to eliminate the risk of having excessive dry powder ultimately leading to capital inefficiency, which reduces the Internal Rate of Return (IRR), as capital deployed without immediate investment use, generates no yield and diminishes the overall performance of fund or deal efficiency.

It is a process of converting the unfunded commitments into a form of paid-in capital, by binding ownership with law, that inevitably must be met in a given time-limit of usually 10-15 days. This process is what makes a private financing system that circulates money, by ensuring that capital flows precisely when and where it is needed, with the right amount deployed at the right time.

Capital calls form an intrinsic part of the structure of closed-end funds, enabling GPs or investment managers to call capital from LPs or investors in different tranches. A phased deployment model helps to balance the timing of investment opportunities and operational costs with the availability of funds. While this mechanism is institutionalised in pooled vehicles such as AIFs, its functional equivalent is often embedded through milestone-based disbursement clauses or deferred subscription schedules.

In VC transactions that involve convertible notes or milestone-linked tranches, the unpredictability of capital inflow timing can cause liquidity constraints for a company. Additionally, investment managers must navigate the precise timing of drawdowns in an environment where transactional urgency often collides with compliance friction. Tools such as capital calls/lines of credit though are increasingly being used in India remain a double-edged sword, offering speed but at a cost to both financial efficiency and regulatory simplicity.

Investors may encounter a degree of doubt when they are committing capital, whether to an alternative investment fund or directly to a company through a structured credit line. However, there is unpredictability and uncertainty which often arise from the irregular cadence of capital calls and the potential liquidity constraints at the investor's end, and evolving expectations around the nature of the investment arrangement. Investors may not consistently obtain prompt disclosures, such as how an AIF's capital is being deployed by the investment manager, or how a company or its founders are utilising a committed credit line for operational or developmental purposes. In certain cases, the actual usage of funds may deviate from initial expectations, potentially straining the investor's confidence and affecting the long-term viability of the relationship. So, if there are capital calls at the fund level or direct investor-company credit lines, these kinds of arrangements must be carefully negotiated and made operationally enforceable to ensure that there is alignment, accountability, and sustained investor trust.

Additionally, regulatory authorities like the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) have emphasized the need to conduct adequate due diligence on LPs before bringing them into an AIF structure. This purpose of review is crucial to judge the financial strength and reliability of the investor, with a view to minimizing future risks of default on committed capital.

C. Functioning of a Capital Call: An Example

The table below shows how an investor's Rs. 1,00,00,000 (Indian Rupees One Crore) commitment toAB Fund – I was drawn down over a period of four years through capital calls. The investor doesn't give the entire capital commitment up front. Instead, the fund manager calls for the money at different intervals: Rs.25,00,000 (Indian Rupees Twenty-Five Lakhs) in the first year, Rs.30,00,000 (Indian Rupees Thirty Lakhs) in the second year, Rs.20,00,000 (Indian Rupees Twenty Lakhs) in the third year, and the last Rs.25,00,000 (Indian Rupees Twenty-Five Lakhs) in the fourth year. In this manner, the fund manager is able to efficiently mobilize capital which in turn are aligned with the prospective investment opportunities and operational needs of the fund. This enables the fund manager to increase the cash flow efficiency and reduce the risk of having excessive dry powder.

D. Key Legal Documents that envisage Capital Call

The operational framework of a capital call maybe seen in the following documents mostly:

1. Investment Agreement (IA): In PE/VC transactions, the IA often taking form of a standalone investment agreement or a combination of a shareholders agreement coupled with either a share subscription agreement or a share purchase agreement, has detailed terms governing the investment. Wherein the investment maybe structured in various tranches, such agreement often contains milestone-linked disbursement mechanisms, which operate as de facto capital calls triggered upon the fulfilment of agreed conditions, thereby ensuring alignment between investment and economic performance. The nomenclature could differ, but these agreements essentially serve the same underlying function by ensuring that capital is deployed only upon the satisfaction of agreed conditions, thereby aligning the timing of fund infusion with regulatory, operational, or financial performance milestones.
2. Private Placement Memorandum (PPM): It is the fundamental document that illustrates the investment blueprint of the fund, risk factors, governance, and key terms, including the capital call mechanism or drawdown. A PPM describes the purpose of investment, and how capital contributions are handled as consideration for unit issuance and notice period for drawdowns. Additionally, it outlines the rights of the investment manager in managing uncalled capital as well as the consequences of not complying with drawdown requests. APPM must align with the terms of a Contribution Agreement to make sure there is legal clarity and operational consistency.
3. Contribution Agreement: A Contribution Agreement dictates the rules for the legal and financial relationship between a Contributor and an AIF. This agreement includes the entire capital commitment of the investor along with the conditions for drawdowns and the obligations of the contributor to remit funds as and when they receive a drawdown notice. Drawdowns may be made for investment into portfolio entities, to meet the expenses of the fund, to repay loans and for other purposes that are permitted under SEBI (AIF) Regulations, 2012. Contribution Agreement also includes the consequences of default interest penalties, dilution of interest, and legal remedies, making it central to the enforceability of capital calls.

Both PPM and Contribution Agreement govern pooled fund vehicles, but bilateral investment deals rely heavily on the Investment Agreements and side letters to ensure that capital inflows in a similar manner that is legally binding.

The clauses pertaining to capital commitments define the total amount that each investor has to pay and distinguish between committed and uncalled capital forming the basis for drawdowns. The procedural provisions govern the terms and timing of capital call notices that include advance notice periods, contribution amounts, and payment details to ensure clarity and applicability. Several agreements also introduce deployment thresholds to cap the frequency and volume of capital calls within defined periods and impose limitation after the investment period to ensure prudent capital management.

In order to address potential defaults, agreements include certain remedies, such as interest on delayed contributions, reallocation among compliant investors, terminations of rights, dilution, forfeiture, or forced transfer of interest. These safeguards not only function as enforcement mechanisms but also as deterrents, reinforcing accountability of the investor and enabling investment managers to maintain capital efficiency and operational continuity.

E. Risks in Capital Calls

A key impediment in the capital call process is the time lag between issuing a capital call and the actual receipt of funds from investors. Such delay, while expected, can significantly be of great concern in time sensitive transactions and in business where active working capital is required and failure to invest capital on time can lead to missing out on significant investment opportunities.

An investment manager usually desires greater degree of liquidity in a fund that would be ready to close deals that require immediate execution. Similarly, company would require working capital on regular basis to keep their business without any interruptions.

Beyond timing, execution risks can arise during the capital call mechanism which the investor and investee has to sail through. In a scenario where there is more than one investor, if one of them

delays or defaults on their part of the deal whether due to internal approval cycles, lack of liquidity or misalignment can disrupt the entire timeline of the deal. Investors may experience a situation where they are in a liquidity crunch and this usually happens if capital calls are sudden or in close proximity, potentially leading to delayed participation or even default. These risks underscore the need for meticulous coordination and investor readiness to make certain that the capital call mechanism functions in an effective and efficient manner.

F. Effect of Capital Calls

Capital calls play an important role in determining core fund performance indicators, particularly the Internal Rate of Return (IRR) and the Total Value to Paid-In (TVPI) multiple. The timing of these calls constitutes a critical strategic consideration for GPs. An early drawdown, if followed by a delay in deployment, can lead to a situation of "cash drag", where idle capital diminishes the overall IRR by diluting the returns generated on invested amounts. Any default on the part of the investors in the case of capital call has a negative impact on the TVPI that is a crucial metric for the performance of a fund. It depicts the ratio of the total value of a fund's investments (both realized and unrealized) relative to the sum of capital contributed by investors. Any shortfall in contributed capital skews this ratio, undermining performance benchmarks and investor confidence. Hence, it necessitates proper forecasting and disciplined execution to ensure that capital is accessible precisely when needed without remaining unutilized.

The use of subscription or credit lines which are common in both global private equity funds and increasingly being considered in the domestic private capital market adds another dimension to the capital call strategy. Although these facilities provide short-term liquidity to bridge the time lag between deal readiness and inflow of funds from investors, but their overexposure can artificially inflate IRR if not managed with caution. Further, if there is a premature acceptance of providing credit line without readiness to provide money for the duration of the contract could ultimately result in defaults and disputes. In extreme cases, the company which was expecting such deployment for working capital or seeking regrowth may have to go through insolvency or liquidation if such facilities are not adequately implemented.

Besides affecting the performance measures, capital calls are also a structural mechanism of portfolio diversification. The capacity of an investment manager to call capital in various stages enables the fund to invest in multiple sectors, stages, as well as periods in order to disperse risk and this helps in increasing the long-term earning potential.

G. Solving the Problem: Unfunded Capital Commitment

The unfunded capital commitments pose a serious operational and transactional threat across both investment funds and direct credit line or investment transactions. If a default occurs during a capital call, the consequences can be severe for the recipient awaiting such money. Consequences would include derailing investment timelines, straining liquidity and undermining investor confidence. This the reason why the key legal documents such as Contribution Agreement in the case of funds, and credit line agreements or investment agreement if correctly structured, play key role in mitigating these risks. They largely include extensive provisions addressing instances where an investor defaults on its obligation to meet their capital commitment that was initially decided. These covenants are designed so that the investors fulfil their obligations and to prevent defaults that can have an effect on the operation of a fund or jeopardize working capital for an on-going business, directly exacerbating the liquidity challenges within pooled investment vehicles and bilateral deal arrangements.

I. Key Contractual Safeguards Against Capital Call Defaults

The efficacy of these contractual safeguards lies not only in their implementation but in their proactive inclusion in structured manner during the drafting stage itself. The following clauses play a crucial role in reducing risks that arise from defaults on capital calls:

1. Dilution of Ownership: If an investor fails to pay when a capital call is made, this clause allows their stake in the fund to be diluted. This can happen in two ways; through standard dilution wherein the percentage ownership of the investor reduces as other investors contribute or through punitive dilution, which creates an additional penalty on top of simple pro-rata adjustment.
2. Punitive Interest: If investors default, they are usually charged with a high interest rate on the amount they owe until it is paid. In cases of direct investment or credit line, there has been cases where parties agreed to forfeit to pay any interest or equity on default of remaining credit line or investment.
3. Forfeiture of profits: If an investor defaults on the capital call, they may lose their rights to future distributions or even their entire value of capital that includes the previously paid-in capital and any accrued returns.
4. Transfer of Interest: In cases of Funds, the investment manager may have the authority to sell the stake of defaulting investors, normally at a discount, to other investors or to third parties.
5. Withholding Distributions: The fund might hold back future distributions owed to the investor who has defaulted and can be used to compensate the amounts owed to the fund.
6. Loss of Participation Rights: If an investor defaults, they typically lose their right to vote on activities of the fund and their participation in advisory committees.
7. Liability for Costs: The investor who has defaulted is usually accountable for all expenses incurred by the fund directly due to their default, such as legal fees and costs linked to arranging temporary financing.

Additionally, remedies beyond the above outlined clauses are often crucial in maintaining the integrity and financial stability of the agreement. In particular, clauses for non-compliance serve as an essential tool to enforce the investor's obligations. These clauses can be structured as liquidated damages or punitive fines, applied directly to the defaulting investor to compensate the fund or the investee company for the disruption caused. Such clauses ensure in minimizing the financial impact of the default. In situations where damages are insufficient to remedy the default, the fund may pursue legal action to seek compensation for the losses incurred. This ensures that the defaulting party is held accountable for their actions.

Another critical remedy is the pursuit of specific performance, which compels the investor to fulfil their obligations, ensuring the agreed capital is provided as stipulated. This remedy is particularly useful when monetary damages cannot fully compensate for the breach or when the investor's

non-compliance disrupts the fund's operations. Additionally, dispute resolution mechanisms like arbitration or mediation provide formalized processes to address defaults and enforce remedies, avoiding lengthy litigation. These mechanisms facilitate quicker resolutions, preserving operational stability of the affected party.

Lastly, one needs to be mindful of reputational consequences, though often not explicitly included in an agreement, serve as a powerful deterrent. Investors understand that defaulting may cause severe damage to their reputation within the financial and business communities. These reputational risks, while hard to quantify, significantly impact future opportunities, reinforcing the need for compliance. Together, these remedies create a comprehensive framework that ensures adherence to the agreed terms and protects all parties involved.

H. Where Precision Meets Performance: The Road Ahead

Capital call mechanism now sits at the centre of India's private-capital playbook. From the GP who times drawdowns to match portfolio opportunities, to the VC firm that staggers milestone tranches, to the founder who relies on a committed credit line for working capital, the same message holds: liquidity must arrive exactly when the deal and the documentation say it should.

By blending precise capital call mechanisms with well-structured legal agreements and building robust channels of communication and alignment between investors and investees, the PE/VC sector can continue to thrive. The proactive incorporation of clauses that mitigate the risks that are involved when a default occurs during a capital call ensures that both funds and bilateral arrangements can withstand liquidity shocks without derailing from investment objectives. Through marrying precision in execution with foresight in structuring, the capital market of India can not only preserve operational integrity but also position itself for sustained growth, ensuring that every rupee of committed capital works exactly as intended; on time, on target, and to the maximum effect.

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