Wednesday, June 18, 2014

Two Kinds of Dry Powder: Private Equity

Two Kinds of Dry Powder: Private Equity

In the world of private equity, the amount of cash committed to funds but not yet drawn is known as dry powder.  According to Prequin in The Wall Street Journal[1] there’s $1.1 trillion in dry powder waiting for money managers to find deals.  This figure includes private real estate funds.  Since many private equity strategies employ leverage, PE managers are going to have to find something like $1.5 to $2 trillion worth of deals in order to invest their investors’ capital.  Amazingly, the amount of dry powder is likely to continue to grow, since managers are continuing to raise funds more quickly than they can invest the capital.

The rise in dry power isn’t always a bad thing.  In times of extreme uncertainty and financial upheaval, a rising stash of cash can lead to outstanding investment opportunities.  Typically, dry powder increases in time of crisis because PE managers find it difficult to obtain financing.  However, valuations are usually falling during this period, so when credit eases and a bit of confidence returns, managers are able to invest at very attractive prices.  We’re seeing this phenomena bear fruit in the returns of funds that invested in the years immediately following the credit crisis.

Unfortunately, those attractive returns are encouraging institutional investors to make increased commitments to the asset class.  As a result, dry powder is rising, but for a bad reason.  You might think that institutional investors are far too sophisticated to chase investment returns.  They aren’t.  They fall for the same marketing pitches used to woo retail investors into mutual funds.  The only difference is that everybody around the conference room table pretends to be savvy.  The money managers are always able to come up with a compelling case to invest when they are marketing a fund.  Institutional investors, particularly public pension plans, need to believe their PE managers because it is the only way to make sense of their overly optimistic expectations for the returns of their pension plans.  The Prequin data shows that institutional investors are piling into the asset class.

In the end, the returns from private equity over the next five to seven years are likely to disappoint, because too much capital is chasing too few good investments.  However, many of the trustees, politicians, and staff that approved this growing pile of dry powder won’t be around to sort out the mess and take responsibility when these funds fail to perform.  There will be a new crop of institutional investors, and the PE managers will be able to repackage the same old story and build an even bigger stash of dry powder.


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