J-Curve

According to reports, the private equity market has amassed a record-breaking level of "dry powder" of approximately $1.5 trillion. This is roughly double than what was in the market five years ago.

Private equity’s cash reserves
Available “dry powder” among global private equity firms

Source: CNBC, Jan 2020.

The term “dry powder” dates to the 1600s when soldiers in warring armies had to keep stashes of dry gunpowder to be able to fire ammunition.

Translated into today's financial sense, dry powder means a stockpile of investment capital that can be deployed for transactions. In other words, it is available capital that has not yet been utilized. Instead, it is kept in reserve for to capitalize on investment opportunities.

However, when it comes to private equity funds, dry powder refers to the committed but not yet called capital that managers have accumulated. It is unspent cash that is waiting to be invested.

Dry powder is essential for private equity funds as it allows them to competitively bid on potential transactions by providing a higher certainty of closing to the seller. Dry powder also allows private equity fund portfolio companies to weather unforeseen outcomes in the market and to deploy capital opportunistically.

For a business to survive market downturns, it needs to have adequate liquidity. Furthermore, if there are lucrative opportunities, private equity funds and their companies also need to have the funds available to capitalize on them.

However, unlike a business where holding too much cash can impair returns on capital, private equity funds call their capital commitments through time as they find attractive investment opportunities, thereby optimizing use of cash.

Interest in private equity investments has been steadily growing. This is due to the fact that private equity promises increased rates of return over publicly traded stocks, as well as low interest rates. According to a recent analysis conducted by the National Bureau of Economic Research, historically, private equity investments outperformed S&P 500 stocks by an average of 3% per year. The gains achievable through private equity investment can be even higher, depending on the funds in question.

The key to successful private equity investing is to wait for lucrative opportunities where the fund manager can add value through the implementation of a business plan.

Source: National Bureau of Economic Research.

According to a recent article in Institutional Investor, even with billions to deploy, the industry hardly invested over the last two years. That’s good for investors. In the two years leading up to the current economic crisis, private equity firms called in investor capital at record low levels. That’s one sign that private equity firms may have ultimately protected investors, according to eFront, the BlackRock-owned financial software and research company. Capital calls, measured as a percentage of the total money raised, indicate how much private equity firms have put to work.

“This may indicate that funds of recent vintage years have not been rushing to deploy capital early in a highly priced market, potentially limiting the damage caused to portfolios and also meaning that investors have large pools of dry powder available to make new acquisitions,” according to eFront.

“Unlike the previous two downturns, private market managers had been radically reducing their deployment of capital in the run up to this recession, while raising unprecedented amounts of capital. Whether this was a result of luck, judgement, or intuition, the industry appears exceptionally well placed to invest into any recovery. History suggests that those who start do so quickly, will reap the most benefit.”

Source: Institutional Investor, June 15 2020. Private Equity Sat on its Hands.

Private-equity firms have an enormous amount of dry powder, but the vast majority is held in newer fund vintages.
Below is the amount of capital left in each vintage year of private-equity funds back to 2012.

Note: Data for 2019 as of September 30, 2019
Source: PitchBook Data Inc.

Source: The Wall Street Journal, June 28 2020. Private Equity’s Trillion-Dollar Piggy Bank Holds Little for Struggling Companies.

Many would say that the current levels of dry powder in private equity are too high. The reason for this is that with an abundance of dry powder can come inferior transactions, which then impact returns for investors, thereby making the market less lucrative in some cases.

However, this pitfall largely depends on individual managers and how the private equity funds in question are managed. There is a saying in the industry that too much dry powder can burn a hole in a manager's pocket. The end result being that he "spends" freely and makes less savvy decisions.

While this can be true, fund managers who are large investors in their own funds should be less likely to invest in less attractive deals due to their alignment with LPs, making working with the industry’s most institutional, proven and focused private equity managers of the utmost importance.