Private capital dry powder share dips as AUM surges

The balance of cash held by funds is down as managers put capital to work amid higher costs of entry

As private capital assets under management (AUM) climb, the amount of dry powder is growing to record levels. With the recent run-up in both fundraising and performance, private capital managers are holding the largest pool of capital in their history. Low interest rates and public equity volatility have made their strategies more appealing, particularly to institutions under pressure to perform. 

What is the right amount of dry powder?
Managers, likewise, need to put that capital to work. Dry powder, or the cash waiting to be deployed, is a necessary account for funds who need to move quickly as opportunities arise. But too much can hint to investors they are short on opportunities and may make unwise investments at elevated prices.

In absolute terms, the amount of dry powder is at a new high, but its share of AUM has fallen to a low.

North America-focused funds held $1.85tn in dry powder as recently as September, 2021. Proportionally, however, that is at its lowest point since Preqin began tracking industry AUM data in 2002 at 28% (Fig. 1). Private equity drove much of the decline, however all other asset classes also had a drop in dry powder as a percentage of AUM over the nine months since the end of 2020.

The last time dry powder slipped below the 30% mark was in 2011 and into 2012, the years following the Global Financial Crisis (GFC). While there are indeed similarities between the periods following the GFC and the brief –and increasingly more distant – COVID-19 driven downturn, the most recent cycle has been more pronounced. Both periods were characterized by low interest rates and rising, but volatile, equity markets. However, the 2021 deal activity was comparatively more aggressive.

Post-pandemic deal activity
Indeed, the price of admission has risen in the past 15 months. Most notably for PEVC (private equity /venture capital) funds. For venture capital funds the average deal value nearly doubled from $22mn in 2019 to $42mn in 2021 (Fig. 2). Private equity funds, generally buyout-focused, rose 40% over the same period. Competition for deals certainly played a part in this, as has the capacity to complete larger deals. As LPs demand has only gone higher, the supply of funds has adjusted to meet it, but so has the demand for deals to invest in. Even as the effects of simple supply/demand economics have worked out here, the role interest rates have played can’t be overlooked.

At the end of 2021, central banks began to increase base interest rates to combat 40-year high inflation numbers. In turn, the US Treasury eventually began raising its base interest rate in March of 2022, but long-term rates already anticipated the move. The impact was felt in deal valuations as 2022 average deal pricing dipped in both VC and PE deals as higher discount rates crept into the equation.                                                   

What will increased deal prices do to performance?
The effect on performance may need to wait to be fully evaluated, but history has shown that low interest rates are kind to private capital – or kinder than high rates. Using the 10-year US Treasury yield as a proxy, private capital, as well as PE/VC perform better in low-rate environments, particularly at the extreme ends of the spectrum (Fig. 3). This year’s rise in interest rates has put the 10-year near its averages from the past decade which could revert performance back to the mean as exit values fail to keep pace with higher costs of entry.

A rising rate environment shouldn’t sour private capital demand. Private capital’s record of boosting returns and adding stability to a portfolio is well documented. But an increase in dry powder, or a slowdown in the amount of capital going into the market, is likely on the horizon as discount rates hang on deal valuations and a period of slightly more risk-off behavior is ushered in.