Private equity (PE) has the reputation of being one of the most lucrative asset classes in the investing world. According to Cambridge Associates, for the 20-year period ended in June 2020, PE had average annual returns of 14.65% compared with the S&P 500, which had average annual returns of 5.91% over the same period.
But this higher rate of return also comes with a cost: liquidity. Private equity investments are significantly less liquid than public equities, meaning that when an investor puts money into a private company, the investor cannot access that money until the contract matures. That’s because the average holding period for a private equity contract is between three and five years.
To address this potential liquidity problem, private equity companies maintain a certain percentage of their funds in easily accessible public stocks or a cash reserve, what the industry refers to as dry powder.
What is private equity dry powder?
In private equity, dry powder is essentially funds kept in reserve to act as a buffer against financial setbacks or a means of flexibility for quick investment. Dry powder usually consists of assets like cash and public stocks, which can be readily sold. Illiquid assets like real estate or investments in privately held companies are generally not considered dry powder because they can’t be quickly converted into cash.
The word dry powder originates from the 17th century. Back then, weapons like cannons and guns relied on dry gunpowder to function properly. Soldiers would try to maintain a certain amount of reserve dry powder on hand so they could either defend themselves or take advantage of an opportunity to attack.
How do investors use dry powder?
Different types of private equity firms may have different reasons for using dry powder. Venture capital firms—a form of private equity that typically invests in early-stage private companies—often keep their dry powder reserves in cash. Private equity funds that invest in larger companies may keep some of their reserves in liquid stocks and bonds.
- VC powder. Because venture capital firms focus on early-stage investments, new opportunities can come up relatively quickly. Venture capital funds tend to keep a supply of cash on hand to outbid the competition if a new opportunity suddenly arises.
- Distressed investments. Sometimes, a private equity firm may see an opportunity to profit off of a public company that is in financial trouble. In this case, a private equity fund might buy a struggling company’s debt or equity and restructure the company in the hopes of making it profitable again. Private equity funds have to use capital for these opportunities relatively quickly, because financial distress can arise with little notice. In this case, having dry powder on hand can allow the firm to invest with speed.
- Emergency funds. Sometimes private equity firms don’t earn as much as anticipated in a given year. This could happen for many reasons, including an economic downturn, or simply because the companies a firm invested in performed poorly. In that case, a fund might not have the ability to repay its creditors. Without having some reserve dry powder on hand, the firm might find itself in a liquidity crisis. Having dry powder can help a fund meet its financial obligations and save it from going under.
What can dry powder tell you about a private equity firm?
The amount of dry powder a private equity fund has can give an investor insight into the financial stability of the firm and how it makes use of its investment opportunities. Too little dry powder could indicate that a firm is struggling financially while too much could suggest that a firm is not maximizing its potential for returns.
According to data aggregator Preqin, money has been flooding private equity, leading to an all-time high in dry powder held by North American firms: $980 billion in September 2021. Of that total, 25 firms held more than half of the stockpile of dry powder.
The surge in dry powder numbers has also been accompanied by an increase in the total amount of assets under management (AUM) at private equity firms. Over the past two decades, investors flocked to the asset class, driving up the amount of money firms have on hand.
Dry powder has remained at about 32.5% of total assets under management during the past decade.
How can dry powder be problematic
One of the biggest concerns that investors have with large amounts of dry powder is the missed opportunity of investing in assets with higher returns. Dry powder is often held in cash, public equities, or liquid bonds—assets with low interest rates and historically low returns. Holding too much dry powder can indicate the following:
- Limited opportunities. Private equity funds may have many willing clients but nowhere to put their capital to worthwhile use. Too much idle cash will impair returns, and sometimes firms return cash to investors, such as pension funds and other institutional investors, after failing to find profitable opportunities.
- Cash loses value with inflation. Cash, in particular, can actually have negative real returns because inflation erodes its value. In the United States, inflation in 2022 was at the fastest rate in four decades.
- Lower returns. Data from Preqin has shown that on average, private equity firms achieve higher returns when they hold a smaller percentage of their funds in dry powder.
- Public equities have high volatility. Some private equity funds keep their dry powder in publicly traded securities, particularly stocks. However, while public markets are more liquid than private markets, they are also on average more volatile. This is because public equity values can change on the hour due to current events and market trends. This volatility could result in dry powder losing its value at points when it is needed.
The bottom line
Dry powder refers to the cash and highly liquid investments that private equity funds keep on hand to maintain reserve funds. Because private equity investments often are illiquid, PE firms in North America may keep about a third of their total assets in these easily accessible funds.
Dry powder is useful in case a fund manager sees an investment opportunity it wants to capitalize on quickly or if a company finds itself in financial trouble. The downside of dry powder is that it does not generate returns as high as those of a private equity investment.