Some terms in private equity may sound mysterious to those not immersed in the field. One such term is 'dry powder'. Although the name may bring to mind military terminology, the concept plays a significant role in private equity investing. Understanding its mechanisms enables a better grasp of how private equity (PE) and venture capital (VC) funds operate and why some perform better.

What is Dry Powder?

It is money that an investment fund has already raised from investors but has not yet used. It can be held in the fund's bank accounts, or investors (Limited Partners) may be legally obliged to deposit it when the fund calls for it (via a capital call mechanism).

In other words, dry powder is money that can be utilised by the fund at any time.

The term comes from military terminology, where 'dry powder' was essential for combat. If the gunpowder is damp, the weapon won't work. In business, it's a metaphor for a willingness to act. If you manage a fund and have dry powder, you can make investment decisions quickly and fund deals swiftly.

The importance of dry powder for private equity funds

How can dry powder help to avoid financial constraints?

These are situations in which a company or investment fund does not have access to capital when it is most needed. This can be due to:

• Lack of liquidity in the market.
• Rising interest rates on loans.
• A decline in investor confidence.
• Tranche delays or capital calls.

In such circumstances, most players are forced to abandon profitable deals or sell assets at a discount to generate spare cash. Dry Powder helps to avoid these scenarios. Specifically:

• Respond quickly to the needs of your portfolio companies (e.g. provide bridge financing during cash flow gaps).
• Avoid high-interest external financing, especially in times of crisis.
• Do not depend on the vagaries of the market, banks or public investors.

When a portfolio company requires additional capital and the fund does not have dry powder, it must turn to third-party investors or take on debt. 'Dry powder' avoids the need for outside 'rescuers' and remains the company's main partner in times of turbulence.

It is worth noting that financial strain affects not only companies but also the fund team. A lack of available capital creates psychological pressure.

• Executives are forced to prioritise finances over strategy when making decisions.
• Investing in challenging yet promising companies becomes less appealing.
• The quality of risk management diminishes.

Dry Powder removes these constraints, allowing you to focus on long-term value rather than the short term.

What impact does Dry Powder have on deals and investments?

In the world of private equity, deals are not made solely because of analytics, market conditions or the desire to invest. Their success is often determined by a fund's ability to mobilise funds quickly. In this sense, dry powder — the fund's uninvested but available financial resources — becomes a critical factor.

If a fund has access to dry powder, it can:

• Offer a shorter closing date.
• Avoid lengthy fundraising procedures.
• Perform due diligence in parallel with financial mobilisation.

A fund with dry powder also has a stronger bargaining position because it can immediately demonstrate:

• Confirmation of the availability of funds.
• A plan for a deal without external contingencies.
• Quickly respond to a changing situation.

Strategic use of dry powder in private equity

Examples of dry powder use in private equity

At the start of the pandemic, most investors froze as markets fell and uncertainty increased. However, funds with Dry Powder acted aggressively and strategically.

For instance, the US-based Silver Lake fund invested its dry powder in companies that had temporarily lost value but had long-term potential, such as Airbnb and Waymo. The deals were made on favourable terms and, within one to two years, had already generated significant returns for the fund.

How does dry powder affect competition in the private equity market?

A fund with accessible capital has a competitive advantage over other players who are just starting to raise funds for new deals.

Accelerating the transactions

Sellers of businesses are often looking for buyers who can close the deal quickly. The availability of Dry Powder allows the fund to proceed without raising additional financing. This significantly reduces the time taken to sign a contract and increases the fund's credibility as a trusted partner.

Deal interception

Funds with dry powder can enter deals late in the negotiation process, offering better terms or faster closings. This creates an 'intercept' effect, whereby less prepared players miss out on the opportunity to complete the transaction.

Price pressure

When there are many Dry Powder funds in the market, competition for quality assets increases. This drives up the prices of target companies and reduces expected returns. Conversely, funds without capital or those with a slow fundraising process drop out of the race.

Active presence in times of crisis

In times of instability, most players freeze activity. However, dry powder funds take up more market space, buying up cheaper assets and building a position while others wait for conditions to improve.

Building a reputation

A fund that remains active during a downturn thanks to dry powder builds a reputation for confidence. This attracts future sellers and partners. Consequently, the fund gains access to more exclusive or closed deals.

Risks of Excess Dry Powder

While dry powder is a strategic advantage for the fund, excessive accumulation also creates serious problems and risks. If the money doesn't perform well, it loses its value. In the case of funds, this also creates reputational, strategic and financial pressure.

Why excessive dry powder can hurt a fund?

Falling expected rate of return (IRR)

Idle investments reduce a fund's IRR. For example, if a fund raises $1 billion but only uses $300 million in the first three years, the IRR automatically falls.

Pressure from LPs

Excessive accumulation of dry powder raises questions from limited partners: Why isn't the money being invested? Are there difficulties accessing deals? Or is the fund losing momentum? In the worst cases, LPs may choose not to back subsequent funds, thereby losing confidence in the management team.

Price overheating

A fund with a lot of dry powder may pay inflated prices for assets to invest within the planned timeframe. This can lead to an overheated market, lower return multiples, and potentially bad deals.

Reputational risk

A fund that 'sits on the money' for a long time and shows no activity may appear unprofessional or indecisive. This can affect its position during negotiations with sellers, other funds or advisers.

How to overcome the risks of extra dry powder?

The fund's objective is not only to raise capital, but also to utilise it in a timely, efficient and strategic manner to prevent additional risks.

Clear planning of the investment period is essential

Even before launching the fund, you should set a realistic investment schedule and decide goals that align with the amount of capital available. Overestimating market opportunities is one of the main causes of excess dry powder.

Prepare a deal pay plan in advance

Successful funds work with a pre-deal pipeline — a list of potential deals assembled before fundraising closes. This enables you to start investing quickly as soon as Dry Powder becomes available.

Utilising co-investment

To reduce the strain on its dry powder, a fund can invite LPs to participate in large deals directly. This reduces the need for a large internal reserve and alleviates the pressure to invest at all costs.

Regular LP reporting

Open communication is critical. The fund should regularly explain to its investors why dry powder has not been utilised, which opportunities are being considered, and which approaches to deal selection remain in place.

Dry powder interaction with other market participants

How do LPs and GPs decide the dry powder allocation?

Dry powder is free capital that has not yet been invested. In the context of private equity or a venture capital fund, two key parties decide on how and when to utilise this capital: the GPs (general partners) and the LPs (limited partners).

Who controls what?

• LPs are the investors, such as pension funds, family offices and corporations. They provide the capital.
• GPs are the direct managers of the fund. They decide which companies to invest the LPs' money in and on what terms.

Although Dry Powder is legally owned by the LPs, the GPs make the decisions regarding its use. The LPs merely delegate this authority.

How does dry powder get into the fund?

When the fund raises commitments, the LPs do not transfer the money into the account yet. They commit to doing so when a capital call is made. Therefore, dry powder is often committed but not paid-in capital.

GPs call the capital as soon as a particular trade arises. This allows you to:

• Reduce the risk of holding funds aimlessly.
• Control the liquidity of the fund.
• It also enables you to reasonably plan the load of LPs.

Finding the right balance between speed and discipline

LPs want dry powder to be used efficiently, but not hastily. In turn, GPs need to demonstrate that they are not just seeking deals, but are also allocating funds carefully and purposefully.

Funds, therefore, set an investment period (usually three to five years), within which GPs must utilise the dry powder. LPs receive regular reports showing:

• What proportion of the capital has already been called?
• Which deals have been funded?
• And how much dry powder is left?

Co-investment is one way of distributing Dry Powder

In some cases, LPs can participate in specific deals directly, meaning they can invest outside the underlying fund. This enables GPs to allocate dry powder strategically: the fund covers the base amount, while LPs provide additional capital in the form of co-investments.

The impact of dry powder on the negotiation process between funds and partners

Dry powder is not only an investment resource, but also a tool of influence in negotiations. Its presence or absence often determines a fund's position when negotiating with entrepreneurs, other investors, asset sellers, and even banks.

It signals stability and willingness to act

A fund with Dry Powder demonstrates to the market that it is ready to invest. This automatically puts it in a stronger position. Company founders see that they have a ready buyer in front of them, not someone who is just dreaming.

Dry powder can be used as leverage when determining deal terms

Liquid funds have more leverage to influence the structure of the deal. For example:

• Dictate their closing date.
• Demand exclusivity.
• Negotiate a better valuation of the company.

In the event of competition for an asset, the fund that can contribute money faster has the advantage.

Advantage in co-investments

In negotiations with other funds, the fund with dry powder can act as the lead investor, while the others can only follow. This gives the leader more influence over:

• Due diligence.
• Legal terms.
• The choice of advisers.
• The post-investment management plan.

The impact of Dry Powder on the economics of private equity

Dry powder is one of the key indicators of the state of the private equity market. It influences the activity of individual funds and the overall dynamics of the industry. High or low levels of dry powder affect company valuations, competition between investors, deal structure, and even the behaviour of business founders.

It is an indicator of market readiness for investment

A high level of dry powder in private equity signals that there is a significant amount of untapped capital in the market. This suggests high levels of investor confidence (LPs) and the potential for increased investment in the coming years.

Rising company valuations

The large amount of dry powder available means that funds are competing for promising assets. This increases competition and prices. Consequently, company valuations rise, and the potential return on transactions (IRR) decreases.

However, more deals are not necessarily better

Funds under pressure to use dry powder may compromise certain standards. For example, they may invest in less prepared companies, accept lower standards of due diligence, or enter into higher-risk deals.

On an industry-wide basis, this reduces the average quality of portfolios, which can have negative, albeit delayed, consequences.

Economic inertia and cyclicality

Dry powder creates a kind of market inertia, whereby funds with existing reserves continue to invest, even in times of economic uncertainty. While this stabilises investment during times of crisis, it also postpones the natural cooling of the market.

How exactly do funds manage dry powder?

The strategies and tools for using dry powder effectively

Having dry powder is beneficial, but using it correctly is crucial; otherwise, a fund risks holding funds without income or investing them in questionable assets. Below, we'll outline the approaches funds use to ensure Dry Powder is utilised effectively.

Pipeline of deals and proactive analytics

Funds create a prepared pipeline of potential deals. This is a list of companies that have already been contacted, their financials researched, and market analyses prepared. Thanks to this, dry powder can be turned into an investment immediately as soon as the opportunity arises.

Special analytical platforms such as PitchBook, CB Insights and Crunchbase are also used to track promising companies and trends.

Capital staging

Rather than investing the entire amount at once, the fund provides the company with financing in stages (for example: $1M → $3M → $5M). This provides an opportunity to:

• Test the effectiveness of management.
• Adjust the amount invested based on performance.
• Reduce the risk of losing all capital.

Reserve funds for follow-on investments

The funds always set aside a portion of dry powder for follow-on investments in the most successful companies in the portfolio. This allows you to:

• Increase your stake in a promising asset.
• Support the company in a crisis.
• Prevent the loss of control or synergy.