When Too Much Money Poses a Problem

The world of private equity (PE) runs on huge amounts of money. From the most minor capital injections for seed-series venture capital (VC) start-ups, all the way to the leveraged buyout (LBO) deals of mega-companies such as Twitter.

A very simplified way of how PE firms work is that they raise money from a bunch of interested investors (mostly institutions) and deploy that money according to their fund mandate. The money that flows into these deals is in stark contrast to the public market, which is more liquid with short turnover periods. Stocks listed on the public market are known as public equities. The private market mostly operates on a closed-end limited partnership model, where the contributors (known as limited partners) to a particular fund will have their capital locked up for a period of 10 years (and possibly an extension of 2 years) subject to the capital requirements of the general partner (GP) and the investment manager. Both the GP and the investment manager work in tandem to ensure the capital received is put to use throughout the first few (3–5 years) of the fund’s life cycle, allowing them to reap the juicy returns which average out among 15–20% in the remainder of the fund’s life cycle. The GP draws money from the limited partners through capital calls.

However, most PE firms do not deploy all of their capital at once, with some choosing to spread it out over multiple investments, such as PE giant KKR, which has more than 100 portfolio companies under its belt. On the other end of the spectrum, there are firms like Thoma Bravo, who invested the majority of their newly minted 2021 fund into two main companies Proofpoint and Realpage in a $22.5 USD billion all-cash deal. Furthermore, not all funds specialise in buyouts, with some more focused on growth equity, and some on venture capital, both of which tend to take on higher risk and require more nimble and smaller tranches of cash.

Now that you have a generic idea of how the world of private equity works, we can examine why the record amounts of dry powder, otherwise a fancy term for unused cash or capital sitting on the sidelines, poses a massive problem for the private equity industry going forward.

Few GPs will complain about having access to mountains of cash. Cash is the most important instrument at a firm’s disposal, as it demarcates the limitations of their choices and puts specific parameters on their investment thesis. Analysts have attributed the reason for so many cash inflows to low-interest rates, hedge fund underperformance, and lower expected returns from public markets. It is not hard to find figures on the sheer size of the mega-cap funds. Hellman & Friedman Capital Partners X successfully closed a US $24.4 billion fund in July, and The Carlyle Group Fund XI has targeted to raise a US $27 billion funds in 2022, which will become the largest PE fund ever raised if it goes through. However, this could be topped by Blackstone, who according to insiders, is seeking to raise as much as US$30 billion for its next flagship fund. Such market trends only illustrate how a bulge bracket deal in today’s market can be a middle market in the next year.

According to data from Preqin and Mergermarket, global PE and venture capital dry powder hit a record level of nearly US $ 2 trillion in 2020. The monetary and fiscal tools that have been employed to counteract the pandemic have caused public equity markets to constantly break through their previously established highs. This leads to the denominator effect, which is also another key reason why there is so much circulating dry powder in the industry. The effect prompts LPs to raise their absolute PE allocations across asset classes as the increasing value of public equities would mean their PE allocations would gradually become underweight. Thus, to restore the balance in their portfolio, LPs are forced to channel more capital into PE. Evidence of this is the staggering amounts raised by PE funds outside of traditional giants such as Blackstone, KKR, and Carlyle.

However, the chief problem with having so much dry powder is that it could alarm some huge institutional investors who retain close tabs on the market. It could concern them as cash sitting around in the vault is unproductive and does not generate value. Holding cash in a highly volatile macro environment is definitely a good idea, but this comes at the risk of not being able to capitalise on attractive valuations when they materialise, especially taking into account the prolonged period of deal structuring and deal formation that underlies LBOs. This could point to tailwinds that the industry is saturated or that there are lesser and lesser attractive opportunities out there.

Moreover, even if investment managers reassure investors that the amount of dry powder they are holding is pegged at an ideal ratio compared to their assets under management, this would still have knock-on effects on deal valuations. Knowing that there is so much dry powder in-store would only force sellers of companies to negotiate more aggressively for more valuable buyouts, allowing them to receive a greater windfall in the process.

The pressure to deploy dry powder could also force GPs and investment managers into subpar deals, which would lead to poorer investor returns and result in an exodus of capital — a vicious cycle that would be hard to stop. However, it is important to bear in mind when contemplating a GP’s chase to deploy dry powder that terms are set in a fund operating agreement outlining a limited investment period. PE funds are permitted to enter into new investments only during this set time, typically around four to six years from the closing of its first investment or final close of the vehicle. After this defined window, the firms lose access to the funding. It is possible for the firm to request extensions from its investors, though this could be perceived as unfavorable to the GP’s reputation and can even negatively affect fundraising efforts in the future.

In conclusion, the PE industry has continually shown its ability to take on more capital while achieving a return much higher than fixed income or public equity asset classes. Moving forward, my prediction is that PE will continue to be a resilient asset class, but this would rest on the investment managers’ abilities to be creative, which would entail seeking out opportunities beyond the technology, media & telecommunications (TMT), and pharmaceutical sector to look for opportunities to deliver more outsized returns.