Jul 16, 2023|Education- 3 min
What is Dry Powder
The unlikely origins of “dry powder” date back to the 17th century when military battles were fought with guns and cannons that used loose gunpowder, which had to be kept dry to engage in battle.
In private equity, dry powder refers to the capital raised from investors that has yet to be invested. These funds are available for acquisitions, buyouts, etc.
Dry powder is an important indicator in private equity. It represents the financial firepower available to pursue investment opportunities. Over the years, dry powder has grown significantly. Bain & Company estimated that the global dry powder in the private equity industry increased from $1.5 trillion in 2020 to a record of $3.7 trillion in 2022.
Interpreting Dry Powder Levels
Available dry powder is simply the difference between the capital raised and the capital invested over time. Market sentiment and valuation dynamics are influenced significantly by dry powder. Abundant dry powder signals increased competition for deals, leading to higher valuations for target companies. Conversely, limited dry powder implies less competition and more favorable valuations for investors. Dry powder levels are influenced by several factors such as:
Slowdown in Deal Activity. A slowdown in deal activity means fewer opportunities available for investment, pressing firms to deploy their dry powder under suboptimal conditions at higher valuation multiples.
Longer Hold Periods. Shorter investment hold periods increase the flow of distributions to investors, availing more capital for reinvestment. In an unsettled market, private equity owners may hold their investments longer awaiting more favorable market conditions. This reduces distributions and limits the cash available for reinvestment into new funds.
Economic and Geopolitical Factors. Macroeconomic events, such as global economic slowdowns, geopolitical tensions or major political changes, can influence investor sentiment and confidence, constraining fundraising activities and consequently dry powder levels.
The Limitations of Dry Powder as a Metric
Dry powder alone does not indicate the ability of a firm to execute successful investments or maintain disciplined investment strategies.
The most successful private equity firms prioritize rigorous investment processes and maintain discipline, regardless of uninvested capital. Even without dry powder, such firms can raise funds quickly if a compelling investment opportunity arises.
The Bottom Line
Understanding the role of dry powder is just one consideration when making informed investment decisions.
Record dry powder and fewer deals many simply indicate an imminent flurry of dealmaking. Investors should be mindful of the changing dynamics of dry powder and align their strategies accordingly.