What is Dry Powder? What is its impact on valuation levels?
In the 2022 edition of its annual global private equity report, Bain looks back at a Dry Powder that has increased for the seventh consecutive year. While it was only $1.4 trillion in 2014, by the end of 2021, it stands at $3.4 trillion globally.
In this article, we explore the concept of “Dry Powder,” its definition, the benefits of maintaining pockets of uninvested cash, and the risks that excessive Dry Powder can pose to the market.
I. Dry Powder: An Asset for Seizing Investment Opportunities
The term “Dry Powder,” originally derived from the military world, referred to the supply of gunpowder that soldiers brought to the battlefield to reload their rifles. They had to ensure they always had enough powder to defend themselves or take advantage of an opportunity to hit their target.
Similarly, in Private Equity, this term refers to the capital investors have entrusted to the funds but has not yet been invested.
The amount of uninvested cash is specific to each fund, depending on its market segment and investment strategy. Small and mid-cap funds do not have the same interest in maintaining as much cash as some large-cap funds, which must disburse large sums on each investment.
The fund may also choose to intentionally reduce its Dry Powder to maximize the amount invested and increase the return for its investors.
An appropriate level of Dry Powder allows the fund to maintain liquidity to seize potential investment opportunities. This liquidity also allows investment funds to adjust their offers or match a competitor’s proposal for certain promising transactions.
Over the past several years, the global amount of Dry Powder has consistently increased from $1.4 trillion in 2014 to $3.4 trillion in 2021 (an average annual growth rate of 13.5% per year).
II. The Drawbacks of Large Dry Powder
Nonetheless, an excess of uninvested cash can pose a risk to the fund’s appeal and total return. If resources are under-allocated due to the lack of opportunities, returns will decline.
Each team must regulate its liquidity stock to invest in order to avoid the critical risk of non-allocation of funds. This risk increases as the number of private equity players grows. As more funds are interested in the most promising investment opportunities, growing pockets of liquidity may indicate a challenge in investing the amounts raised from Limited Partners (LPs).
III. Upward Pressure on Valuation
The general increase in Dry Powder, combined with the growing number of players in the market, inevitably leads to higher valuation multiples. This is the conclusion of the Bain study, which reveals an average multiple of 11.9x EBITDA for European companies in 2021, compared to nearly 10x in 2017.
The need to invest this Dry Powder thus appears to be driving up the valuations of target companies.
Moreover, a large Dry Powder can create pressure on fund managers. They are responsible for investing these pockets of cash entrusted by the subscribers (the LPs). The funds are therefore competing for a limited number of target companies. In certain situations, they are willing to pay a premium to gain a stake in some of these companies.
According to the Financial Review, Private Equity funds pay an average premium of 45% for European companies and 42% for American companies.
Conclusion:
Fund managers face the constant challenge of striking a balance between the need to preserve a liquidity cushion to capitalize on investment opportunities and align with competitors’ offers, and the need to allocate the maximum amount of funds to optimize returns. This balance is especially crucial as the increase in uninvested cash can lead to an upward trend in valuation multiples.