Capital Commitment: How it works

Meaning of Capital Commitment

Capital commitment is defined as the amount of capital that a company has committed to spending on long-term assets over a period of time. It is forecasting of capital expenditure by the company to be incurred over its long-term assets such as machinery and fixtures, equipment, facilities, and buildings. However, the term ‘capital commitment’ may also carry different meanings depending upon the context in which it is used. When used from the perspective of the stock sale, the term refers to a number of securities that a company has committed to putting up for sale. The capital commitment also relates to investments in blind pool funds by investors that are venture capitalists. They make contributions over the period of time as and when requested by the fund manager. It denotes agreed capital that the General partner can request from the limited partner.

Capital commitment in the business world revolves rounds the fund’s designation for specific purposes including any form of future liability. More commonly, this is composed of regular operating expenses within the business enterprise such as costs associated with the property, production materials, and tools. Overall, the capital commitment regardless of the circumstances for which it is used defines the fund that is being directed in a specific manner. Future business ventures such as starting of expansion project may to lies within the capital commitment. The capital commitments are generally higher for capital-intensive industries like power generation, automobile manufacturers, oil producers, and refineries. 

How does capital commitment work?  

The structure of capital commitment differs from one circumstance to another. In the case of a blind pool fund, it means the investment amount committed by capital investors for a contribution towards the pool as requested by the fund manager. The capital commitment in a limited partnership denotes the capital amount that the general partner can request from limited partners. For organizations, it is the planned expenditure meant for the settlement of regular operating expenses as well as liabilities in the future. The amount needs to be kept aside as capital commitment by businesses is dependent upon their size and operations. It is not the same as incidental expenses as otherwise would be called contingencies.   

Risks associated with Capital commitment

There are numerous risks involved in capital commitment and the major one is the burden posed by it on business finance, especially in cases where it is not properly planned. The capital commitment can build pressure upon the company’s account although it indicates funds yet to be released by the company. It can pose a greater amount of risk especially when there are instances of overcommitment or under-commitment on the part of the organization. For example, in case if a company under-commits then it denotes that the company might not be able to meet all of its future obligations and if over-commits, then a decrease in the capital may have a large impact on the company. In order to hedge all these types of risks, the company’s capital commitment can be viewed or accessed at the time when financial statements are released. Therefore, the company should exercise due diligence while structuring its amount of capital commitment.

Capital commitment in Stock Market

A capital commitment when seen from the perspective of the stock market reflects shares held by the organization and are currently available for sale in the market. These are basically the company’s shares put up for sale in the current market. It may also pose risk because the value of the shares is connected with market conditions as shares are affected by market factors.   

Capital commitment in Private Equity

Capital commitment from a private equity perspective denotes the number of funds promised by venture capital investors to contribute towards venture capital funds whenever requested by the manager. Therefore, the investor’s commitment toward funding investment for a specific time period is termed capital commitment. This commitment can also include a contribution toward fees as requested by the fund manager. 

The private equity market comes with a much higher amount of risk as compared to public equity. This is because the returns from private equity carry higher dispersion of returns than the public equity market.   

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