This is one of the worst situations for a VC fund to find themselves in and, although we haven’t seen it happen yet, it is something worth reviewing given the current economic downturn.
The fundamental purpose of a venture capital fund is to invest money into startups and small businesses. Therefore, if a VC can’t deliver the money they promised, they are in real trouble. In order to deliver the money to their chosen startup, the VC fund’s limited partners (investors) have to supply it, and this means VCs have to ensure their LPs are incentivized to do so.
If a limited partner doesn’t provide the funding, then that means they have missed the capital call. They have not provided the capital. This would cause numerous issues and word will spread very quickly that the VC fund is unable to honor its promises. Venture capital is a very competitive industry, so when other VCs find out there is a weakness within your partners you could be in real trouble as a fund.
Limited partnership agreements
So, how do VCs make sure LPs don’t miss capital calls? All of the terms and conditions between a VC fund and their general partners and limited partners (investors, foundations, endowments and pension funds) are governed by a limited partnership agreement. Both sides of the party sign the agreement and it is heavily negotiated.
Often there will be a “favored nation” principle in this agreement, which ensures the limited partners get some big benefits, such as fee concessions or a place on the advisory board. There will also be clauses that will make sure those benefits cannot be taken from them. These things will be extensively negotiated, but there are some fantastic lawyers that put these documents together and so they are binding.
The penalties for missing a capital call is one of the areas that is covered by the limited partner agreement, and severe penalties will be established.
Why would limited partners miss a capital call?
Broadly speaking, limited partners aren’t going to miss a capital call because the penalties are so severe. However, at the moment, in early 2023, there is a lot of pain in the investor community. A lot of people made commitments to VC funds when they were riding high on their big investments in crypto currency or high value stock, and it was the same with pension funds, endowments, and foundations. They all had a great deal of money. But in 2022 the stock market went down along with the value of crypto and so everyone has taken a haircut on their assets.
Here at Kruze we haven’t seen it happen yet, but given the downturn in the economic climate there is a higher chance of a capital call being missed.
What happens if an LP misses a capital call?
The general sequence of events goes like this:
- First, a venture capital fund will send out a capital call document to their limited partners. The LPs will then usually have 10 business days to send the money in by wire.
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If some capital calls are missing, the VC fund will typically contact the limited partners to give them a warning, remind them of any grace period, and check and see what is going on. It is possible the capital call may have been lost or ended up in a spam folder.
- After that, if the LP still hasn’t sent in the money, the VC may start charging interest or impose a very minor financial penalty to incentivize them to make the capital call. Remember, the VC needs that money to function and preserve their reputation, so they have to do whatever it takes to get the limited partners to provide funding.
- The next step is the big one; it is the “nuclear bomb” option. If an LP doesn’t respond to a capital call, it’s called an LP default. In most limited partner agreements, not all, there is a clause that says if a limited partner continues to not fund their capital commitments, they will forfeit all of their prior capital commitments. This means by missing one capital call they are actually walking away from a large amount of money.
LP defaults aren’t common
Because of the severe penalties, LP defaults are pretty rare. When a new VC fund is raised and goes live, they usually draw down a significant amount of capital at the very beginning. This will be around 10% of the total fund and the “nuclear bomb” clause is one of the reasons for that happening. The VC firm wants that money to serve as a penalty if someone decides to not hit their capital calls in the future.
VC firms are very focused on internal rate of return; the amount of time that money is outstanding is a big factor in IRR. However, this is one area where they will draw down a big chunk of it right at the start, in order to make sure that the LPs will honor their commitments.
For example, say you are a limited partner in a VC fund and you’re putting in $50 million. You’ve already put in 25% ($12.5 million). If you miss a capital call and your agreement has this clause, you could lose all of that investment. So missing a capital call becomes very unappealing.
The reason why we call this the nuclear bomb option is because you can imagine how upset the LPs would be if the VC fund actually invoked those clauses. It is completely justifiable for the VC firm to do so, but it’s more likely that the LPs would work with the VC funds to give them a longer grace period.
Slowing down capital calls
Although we haven’t seen any LPs miss their capital calls, they are likely to want to slow them down given the current climate. To fund their capital calls, the LPs generally have to sell othr assets. If the markets are down, the LPs don’t want to sell at the bottom and lose money. This means they will try to “slow roll” their capital calls.
The VC funds all know this, and it is one of the reasons why you are seeing VC funds slow their pace of investment right now. There is a lot of talk about how the VC funds have raised a lot of money, but it is no coincidence that the VC funds are investing at a much slower rate than they did in 2021 and 2022. It’s because no one wants to sell stock or other assets in a down market.
Managing the risk of LP default
As already noted, this really doesn’t happen that much. However, we are writing this in early 2023 and there is a lot of economic uncertainty. It’s more difficult for investors to provide funds for capital calls, and that means capital calls are more likely to be missed now more than ever. That’s one big reason that VC funds might choose to work with institutional investors or LPs that have a reliable track record for capital calls. And the VCs will try to be sensitive about the timing and frequency of capital calls.
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