What is Dry Powder?
Dry powder refers to cash reserves that corporations and private equity funds have available to deploy when an attractive investment opportunity arises, or to weather a downturn. The cash reserves give their holders an advantage over other firms who do not keep reserves since they can be used to capitalize on opportunities or to help them meet debt obligations when they come due. Most organizations, especially venture capitalists and private equity funds, maintain a dry powder in anticipation of tough economic times.
History and Current Usage
The term “dry powder” originated from the ancient days in military battles when soldiers used dry powder in their guns and cannons. The soldiers needed to keep it dry for it to work effectively during the war. The term is now used in various contexts. For example, in the corporate environment, dry powder refers to the cash reserves that organizations set aside every year from the annual revenues in anticipation of harsh conditions ahead. In reference to investors, dry powder refers to the liquid assets and cash reserves that investors set aside for investment purposes. In mergers and acquisitions, the term refers to the amount of capital available to financial buyers for investment in portfolio companies, strategic acquisitions, and add-on acquisitions.
Advantages of Dry Powder
Maintaining a dry powder puts businesses at an advantage over their competitors who may be holding less in cash reserves. For example, if a business owner predicts that the market will be turbulent in the next six months, she may maintain some buffer capital to help in paying monthly operating expenses during the period. If comparable businesses do not keep cash reserves, they may be unable to meet their obligations, and they may be forced to close shop. Similarly, if an investor expects the IPO market to gain, he may keep some capital on hand to provide additional funding to his portfolio when the need arises.
Dry Powder in the Corporate Environment
Organizations often face urgent needs for funds to finance new expenses and pay their debts. In the absence of liquid capital such as cash reserves and current assets, the organization may be unable to fund its working capital needs. If the economy experiences a sudden downturn, the company may be unable to sell its illiquid assets immediately to pay its monthly operating costs. Holding enough dry powder can keep the company afloat during periods of financial distress.
Maintaining high levels of dry powder gives companies an advantage when negotiating for credit facilities. When advancing credit to corporations, financial institutions assess the firm’s ability to meet the debt obligations in the future, even during economic hardships. If the company has adequate dry powder, then the bank may be willing to advance it the credit facilities it requires. However, if there is inadequate dry powder or the company has exhausted its cash reserves, the bank may be hesitant to offer loans to the company. If the financial institution has to provide loans to such a company, then the interest rates must be punitive enough to cover the risk of default.
A high level of dry powder also protects the company when it anticipates the demand for its product and services to fall. This means that the company will experience a decline in the annual revenues and, hence, net profits. The company will need additional funding to sustain its marketing, distribution, and production costs. The funding may either come from the accumulated cash reserves or from disposing of its liquid assets.
Companies should not hold excess reserves, as this reduces their ability to expand. Instead, they should strike a balance between the amount of money they set aside as reserves and the amount of money they allocate for investments. When the company keeps too much dry powder, the funds will remain idle within the company, and this will limit the value of investments that the company makes.
Dry Powder in Private Equity Funds
High net worth individuals invest in private equity funds with the hope of getting high yields and speeding up the pace of inflows. The private equity funds then use these funds to either invest in new investments, buy off existing companies, or provide additional funding to their portfolio companies to increase their growth rate. These private equity funds, as well as venture capitalists, choose to keep a sizeable portion of their funds as dry powder so that they have ready capital as and when it is needed.
Maintaining high levels of dry powder leads to high valuation multiples and increased deal-making. A fund can deploy the ready capital when it finds a high-quality target with a huge potential for growth. When investors are looking to partner with private equity funds, they often assess the amount of dry powder that the fund has and its ability to support future growth initiatives. Also, the size of a fund’s dry powder is a useful indicator of its future investment patterns.
Although private equity funds hold a dry powder in anticipation of better deals, sometimes they may hold excess dry powder when there no attractive deals to invest in. According to a Preqin Ltd report in September 2017, private equity funds held $963.3 billion of dry powder. The increase was attributed to the high amount of funds being pumped into private equity funds by investors, while fund managers were unable to find high return portfolios to invest in. Asset prices were generally high, as the stock markets stayed in the bull market and the high-interest junk bonds and emerging marketing debts were seen as overvalued. Due to the reduced profitability of their investments, investors turned to exchange-traded funds in a bid to achieve additional returns, pending the normalization of the markets.
To learn more and advance your career, see the following free CFI resources: