Dry Powder?

The dry powder is not as dry as it looks.

I am, to be sure, bullish on the long-term prospects for private equity investing for reasons I have outlined in a paper entitled 'Rational Exuberance'. However, one of the many factors I cited in aid of my bullish outlook deserves some further scrutiny. Thus, I point to the existence of a significant amount of liquidity in the system, represented by so-called 'dry powder' under the control of private equity funds focused on venture capital. That aggregate number is, depending on the estimator, close to $50 billion and it must be spent, according to the rules set up in many (if not most) of the private equity funds, in the next couple of years or the managers' ability to invest the capital becomes severely limited… 'use it or lose it,' in other words.

One's instinct is to look on that number as a 'buy' signal if you like … a lot of money in search of private equity/venture capital deals. The point about that number, and let's call it (simply for purposes of illustration), $40 billion, is that it needs a haircut. Thus, given the way venture capital funds work, the $40 billion is not cash in hand but commitments from investors in the fund, which commitments are to be called on a 'just-in-time basis,' meaning that the calls go out if and as, and only if and as, a deal is on the horizon (neglecting for purposes of simplicity capital called to pay the management fee). The 'powder' is only 'dry,' in other words, if the commitments can effectively, de facto as well as de jure, be called; the money remains in the pockets of the investors until it is turned over, on a case by case basis, to the fund managers. And, as a consequence of the 2001 meltdowns there are a number of unhappy investors… limited partners who are trying to figure out ways to weasel out of their commitments. The fund documents suggest that Draconian penalties can be imposed on defaulting investors but it is not usually deemed in the managers' best interests to wind up in court with an unhappy investor or group of investors, in turn claiming a pitiful performance or some other excuse for reneging.

More importantly, it now appears that, since openly defiant limited partners are difficult to deal with, some of the general partner/managers are voluntarily reducing their commitments across the board and others resisting making any capital calls at all, 'cooling it' in effect until the market turns around. The problem the managers face (which are outlined in an article shortly to be published by two of my partners, Allen Weingarten and Jay Rand), is that there is no neat, easy and risk free way of dealing with a defaulting limited partner. The language in the typical agreement provides significant penalties for default. But, there can be a lot of shrapnel resulting from a blow up between the LPs in a venture fund and its general partner. Moreover, if the general partner flinches and allows one particular truculent investor to withdraw from the fund, that strategy is risky for the general partner because there is a theory that the release of one releases all. In other words, letting only one limited partner off the hook can create, in effect, a run on the bank. On the third hand, while the investors can theoretically access the secondary market for limited partnership interests, i.e., can sell out to somebody who would take over the position, somebody more enthusiastic about investing with the general partner, that window is not wide open. As my clients Dayton Carr and Brett Byers point out, there is no secondary market in the real sense of the word for limited partnership interests unless the commitment has been funded at least, say, 50%. If the investor has put up only 5% or 10% of the commitment, the proposed trade is not secondary sale but is in fact a primary sale. The fund managers and the seller are looking to somebody to take over the position as if the fund were soliciting capital ab initio, as it were.

Apparently, the thought motivating the general partners who are going slow on calling down the dry powder is either (i) the market will change and everybody will start feeling good again or (ii) a deal will come along so compelling that all the investors, when informed of the contours of the deal, will gladly honor their commitments. If that is the case, however, what appears to be a private equity fund with a $100 million in capital is really what is referred to as a 'pledge fund'. The LPs are obligated to invest on a deal-by-deal basis, but only if they like the deal. They have to fund the management fee but, beyond that, they are on their own.

All this is to suggest the $40 billion figure mentioned above has to be significantly qualified. Obviously, the commitments to the trophy funds, the ones investors fight to get in, remain enforceable; but those funds are a relatively small, upper bracket slice of the fund business. For all the others, a healthy degree of skepticism is required before this dry powder is counted in an climate of overall availability.