What is Dry Powder?
Dry Powder is a term referring to capital committed to private investment firms that still remains unallocated.
Under the specific context of the private equity industry, dry powder is a PE firm’s capital commitments from its limited partners (LPs) not yet deployed into active investments.
Dry Powder in Private Equity
Dry powder is unspent cash currently sitting in reserves, waiting to be deployed and invested.
In the private markets, usage of the term “dry powder” has become commonplace, particularly over the last decade.
Dry powder is defined as capital committed by the limited partners (LPs) of investment firms – e.g. venture capital (VC) firms and traditional buyout private equity firms – that remains undeployed and remains sitting in the hands of the firm.
The capital is available to be requested from the LPs (i.e. in a “capital call”), but specific investment opportunities have not yet been identified.
There are currently record levels of capital sitting on the sidelines for the global private equity market – in excess of $1.8 trillion as of early 2022 – led by institutions such as Blackstone and KKR & Co. holding the most undeployed capital.
Bain Private Equity Report 2022
“After 10 years of steady growth, dry powder set yet another record in 2021, rising to $3.4 trillion globally, with approximately $1 trillion of that sitting in buyout funds and getting older.”
Impact on Private Equity Asset Class Performance
Typically, mounting dry powder is perceived as a negative sign, because it serves as an indication that prevailing valuations are overpriced.
The purchase price of an asset is one of the most important factors that determine an investor’s returns.
But the competition in the private markets from the sheer number of new investors and capital available has caused valuations to inflate, and competition tends to be directly correlated with increased valuations.
Further, the most frequent reason for subpar returns stems from overpaying for an asset.
In times of rising dry powder, private market investors are often forced to patiently wait for valuations to fall (and for purchase opportunities to appear), while others may pursue other strategies.
For instance, the “buy and build” strategy of consolidating fragmented industries has emerged as one of the more common approaches in the private markets.
Unlike strategic acquirers, financial buyers cannot directly benefit from synergies, which are often used to justify paying substantial control premiums.
But in the case of an “add-on” acquisition, since an existing portfolio company is technically the one acquiring the target company, higher premiums can be justified (and financial buyers can, in these cases, compete with strategic acquirers in auction sale processes).
From a risk standpoint, dry powder can function as a safety net in case of a downturn or a period of significant volatility when liquidity (i.e. cash on hand) is paramount.
But while certain people view dry powder as downside protection or opportunistic capital, it also signifies mounting pressure for investors that raised capital to earn a certain threshold of returns on it, rather than sit on it.
