On the Exaggeration of Dry Powder

Dry powder has become a major concern for many private equity firms, with 28% of deal professionals recently identifying dry powder as their primary concern for 2013. They fear that excess capital will drive competition, raise valuations, and serve as a red flag for future investors.

But, are these concerns misplaced? Mark Gaffin, founder of the Gaffin Group and the Head of Equity Sponsor Group of a middle market investment bank, believes that the dry powder situation is not nearly as dire as described. He explained, “While dry powder is a widely covered issue, I feel there has been a fair bit of mischaracterization and exaggeration about its impact on overall PE investing.”

By identifying and understanding some of the core misconceptions around dry powder — like its universality and its importance to investors — GPs can overcome some of the hype and begin to think intelligently about closing their funds.

Dry powder is a top-heavy problem

According to Gaffin, many private equiteers have forgotten the large imbalance of the dry powder distribution. The idea that the capital overhang is an industry-wide problem is a result of analysts and journalists — like Andrew Ross Sorkin — describing the uninvested capital in one summary statistic.

Gaffin believes, “You lose all interesting variation (e.g. across vintages, across fund sizes) by using one summary statistic.” Because firms vary based on investment criteria and funds vary based on desired investment sizes, it is extremely difficult to find one appropriate number to capture the dynamic nature of the capital overhang.

“If you peel back the dry powder onion, it becomes evident that most of the overhang is concentrated in the bigger funds,” says Gaffin. “Recent PitchBook analysis of the dry powder distribution explained that only 15% comes from funds less than $1 billion raised over the period of 2007 – 2010. Across the same vintages, funds greater than $1 billion account for 38% of the dry powder.”

LPs consider more than just dry powder

Many GPs are unduly fearful that  LPs will view uninvested capital as a black mark. As it turns out, the distaste for dry powder may not be as important as some think. “According to a recent report from Duff & Phelps and Mergermarket, LPs seem less concerned about dry powder and more concerned about transparency into the investment process, clear investment theses, etc.,” says Gaffin.

“I don’t think LPs would want to see GPs sacrificing quality investments simply to reduce overhang,” he continued. “There are much more important factors that predict a fund’s success and fundraising ability: delivering cash-on-cash returns through exits, showing strong relative IRR (supported by reasonable valuations of unrealized investments), articulating clear investment theses for portfolio companies, answering transparency concerns of LPs, maintaining a strong bench and track record, etc.”

However, not all LPs are the same. Instead of assuming what LPs want, it is better to simply ask. “One of the most important things GPs seem to be doing is having serious conversations with their LPs to gain a better understanding of where their concerns lay,” says Gaffin. “In fact, 98% of the LPs responding to the Duff & Phelps/Mergermarket survey report that they are seeking more communication with their respective GPs.”

Gaffin explained that if firms rely on strong investment tactics and proven best practices, the temporary concern over dry powder will have minimal impact on their LP’s satisfaction. “Middle market firms should focus on having a robust overall investment strategy, maintain good asset selection, and demonstrate capability to execute on deal-level theses. Firms with that core strength and performance standard will be less impacted by the dry powder question.”

He added, “It is not terribly difficult to find funds with 2006 and 2007 vintages that posted good cash returns and solid IRR where, instead of throwing cash out the door as some folks feared, they stuck with their strategy and deal theses. In many cases, LPs have rewarded them by re-investing in a subsequent fund.”