Tokenizing Capital Calls… What’s the Angle There?

We’ve all heard of funds, feeder funds, funds of funds, and a variety of different structures for private equity, venture capital and the like. However, they all have a common feature: Capital Calls.

Capital calls are essentially a request for additional capital by a fund manager (AKA general partner or GP) to their investors/limited partners (LPs). Typically this may occur when the fund is running low on capital and has an opportunity they’d like to invest in. There are other scenarios for capital calls such as bridging but for simplicity let’s focus on this one.

How can a GP just ask for more money?

When LPs invest into a fund, they can choose to only invest a portion of their committed amount upfront which is called “paid-in capital”. The remainder is called “uncalled capital” which the GP has the right to request at any time as per the Limited Partnership Agreement and Private Placement Memorandum.

Typically they’ll issue a notice in advance but nonetheless, if an LP defaults they may face some serious consequences such as loss of any voting rights or even a forced sale of their LP rights to either existing LPs, the GP, or third-parties which can be at lower-than-NAV.

This is because GPs may refrain from calling capital until it’s absolutely necessary such as investing in a new opportunity or as add-on capital to keep the fund’s ownership percentage in a company if they are raising another round. As one could imagine, these scenarios can be extremely time-sensitive meaning there’s little to no room for wasted time in collecting the capital from LPs, hence the consequences. In addition, this uncalled capital is a resource the GP needs to be able to rely on as the LPs agreed to it from the beginning.

Like traditional options such as calls and puts, capital calls are merely a ticket or right (and obligation) to do something:

• Call options are the right to buy a stock at a lower strike price than market price
• Put options are the right to sell a stock at a higher strike price than market price
• Capital calls are the right (and obligation for that matter) to invest additional capital in this fund

The common factor between each of these rights is that they can be bought and sold from one investor to another! Don’t have the capital to invest more? Sell off the capital call without sacrificing your investment in the fund!

Want to double down on this fund? Excited for this particular investment? Buy more rights from others rather than settling for your allocated amount!

This does come with complications though such as finding those buyers and sellers, any due diligence needed, document signatures, GP-approval (if required), etc.

So what’s the angle with tokenization?

Tokenized funds can eliminate the need for capital calls by simply raising the capital upfront. This is possible through fractionalization, making the minimum investment a lower barrier to entry and allowing a wider investor audience to participate. If all those investments are added together, the fund can fully collect the committed capital at the beginning and eliminate capital calls.

This next section specifically focuses on smart contracts in a simplified piece of code and I break down how the logic works. The article continues afterwards.

In the event that a GP can’t raise all the capital upfront, capital calls can be baked into smart contracts, essentially a list of “if this happens then do this” statements, guaranteeing timely funding without tracking down investors, while enabling trading and even checking for investment eligibility. For example,

function collectCapitalCall(address investor, uint256 amount) public {
  // Check that the investor is authorized to make a capital call
  require(authorizedInvestors[investor] == true, "Investor is not authorized to make a capital call.");
  
  // Check that the investor has not already made a capital call for the maximum allowed amount
  require(capitalCalls[investor] + amount <= maxCapitalCallAmount, "Exceeded maximum capital call amount.");
  
  // Check that the investor has sufficient funds available
  require(investor.balance >= amount, "Insufficient funds available.");
  
  // Collect the capital call
  capitalCalls[investor] += amount;
  fundBalance += amount;
  
  // Transfer the capital call amount from the investor's account to the fund
  investor.transfer(amount);
}

This function is defined as collectCapitalCall and it takes two arguments: investor, the address of the investor making the capital call, and amount, the amount of the capital call.

The function begins by checking that the investor is authorized to make a capital call. It does this by checking the value of authorizedInvestors[investor]. If the value is true, it means that the investor is authorized to make a capital call. If the value is false, it means that the investor is not authorized and the function will revert with an error message.

Next, the function checks that the investor has not already made a capital call for the maximum allowed amount. It does this by adding the amount of the current capital call to the investor's previous capital calls and comparing the result to maxCapitalCallAmount. If the investor has exceeded the maximum allowed amount, the function will revert with an error message.

After these checks, the function checks that the investor has sufficient funds available to cover the capital call. It does this by checking the balance of the investor using the balance property. If the balance is less than the amount of the capital call, the function will revert with an error message.

If all of these checks pass, the function will collect the capital call by updating the capitalCalls mapping for the investor to reflect the new capital call and increasing the fundBalance by the amount of the capital call.

Finally, the function transfers the amount of the capital call from the investor's account to the fund balance using the transfer function. This guarantees that the capital call will be collected, as the transfer will always succeed as long as the investor has sufficient funds.

Looking at one of the main value-add’s of tokenizing any asset, it’s the ease of transacting it which brings liquidity, lower back-office costs, and access to a global audience among other benefits.

If capital calls were tokenized LPs could find other investors on an alternative trading system (ATS) or exchange, funds could diversify their investor base, and other investors could receive exposure to the fund at lower minimums.

The capital call code will be embedded in the security token, meaning it’ll travel with the rights to any investor that buys it and still execute.

Because of all these benefits and more, tokenizing capital calls is the future of funds. The infrastructure is being put together now with the partnership between Inveniam and Tokeny from last year (which came with a €5m investment in the issuance platform).

While Inveniam.io focuses on trusted valuation and price discovery, Tokeny will supply the compliance and tokenization infrastructure which supports cap table management, distributions, and of course capital calls.

“Global secondary trading of private market assets in a tokenized form will transform the alternatives space, including CRE, infrastructure, private equity, and private credit. To become a reality, the market demands a high-functioning user experience, seamless technology utilization/integration with legacy systems, and underlying data that can be trusted, all within the right regulatory structures. This partnership addresses all those requirements for success.” —Pat O’Meara, Chairman and CEO of Inveniam

About the Author: Jason Barraza is Head of Growth and Operations at Security Token Market and an advisor at Security Token Advisors.

Jason comes from a consulting and entrepreneurial background. During his tenure at The Launch Pad (University of Miami’s entrepreneurship center) he consulted over 100 businesses; evaluating business plans and identifying potential avenues for change and improvement. Jason also has experience in e-commerce and web design through his past businesses and freelance work.

While preparing to become a financial advisor post-college, he quickly realized the benefits of security tokens and their potential, ultimately deciding to join the Security Token Market and Security Token Advisors teams.

Jason believes in blockchain technology, democratization of capital markets, and strives to make meaningful connections along the way.

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