How Dry Powder Transforms Investment Opportunities
Key Takeaways
- Such reserves could allow a private equity firm to leverage its dry powder to buy out a financially troubled company or restructure it to return it to profitability.
- Dry powder generally refers to the amount of committed, but not yet allocated, capital or highly liquid securities a firm has available to use when an opportunity or need arises.
- Generally, firms and companies that have ample dry powder on hand have a leg up on rivals that do not, particularly during protracted turbulent periods.
Investors as well as companies employ “dry powder” in global capital markets for a myriad of reasons, including to achieve financial success or mitigate financial stress. But exactly what is this term that conjures images of muskets and dusty battles?
The following is everything investors should know to understand dry powder.
What is Dry Powder?
Known mostly in private equity and venture capital circles, the informal term dry powder generally refers to the amount of highly liquid securities or committed capital a firm has available to use when an opportunity or need arises.
In other words, the highly liquid asset that is dry powder is an unspent cash reserve yet to be invested that investors and companies can use strategically. The available cash may be requested from limited partners via a capital call.
Note that the term “dry powder” originated in the 17th century when armies at war employed gunpowder to fire cannons and guns. For the substance to be effective in combat, they had to keep it dry.
Why is Dry Powder Important?
Looking at dry powder from a macroeconomic perspective, a significant amount of dry capital can, depending on conditions, signal high valuations or a strong economy.
Overall, it chiefly allows PE and VC firms to benefit from investment opportunities that come their way, which subsequently reverberates throughout economies.
How Dry Powder Can Influence Financial Trends
Notwithstanding heightened volatility, lofty interest rates, and other disruption, private equity and venture capital firms have almost $2 trillion in dry powder, according to S&P Global Market Intelligence. In fact, such assets, as widely anticipated, are propelling ventures this year.
Dry Powder for Personal Finance
Individuals may also have dry powder as part of their personal finance strategy. This entails holding a portion of one’s net worth in cash or assets that are easily accessible for surprise expenses or investment opportunities.
Dry Powder for Venture Capitalists
Dry powder can provide VCs with the capability and flexibility to take advantage of new opportunities. After all, venture capital funds globally have an estimated $580 billion in dry powder.
A venture capital firm could, for example, use a portion of its cash reserves to take a position in a promising health-tech startup.
Dry Powder and Corporations
Companies also stand to benefit from dry powder reserves. Perhaps, for example, a corporation decides to hold onto its stockpile to prepare for an add-on acquisition.
Businesses also often make sure they have sufficient dry powder reserved for lean times or during any kind of downturn.
Dry Powder for Private Equity
Dry powder for PE around the world totals around $1.3 trillion, some of which could be leveraged, for example, by private equity firms to either buy out financially troubled companies or restructure them to restore profitability.
Firms may also hold onto dry powder for use as emergency funds to skirt liquidity issues should there be a loss or economic downturn.
Note, though, that having stockpiles of dry powder on hand is sometimes perceived in a negative light, since it can indicate overpriced valuations. Investors that raise capital also often face pressure to earn returns on the idle cash.
Three Ways Investors Use Dry Powder
Just three years ago, VC and PE fund managers globally had more than $1.5 trillion available overall. With such unprecedented sums of cash on hand, they had to figure out both how to use it and the impact it would have on returns.
Primarily, there are 3 ways investors can leverage the asset known as dry powder:
- To back growth for portfolio companies. Competition gets heated among bidding investment firms, and the amount of dry powder possessed could make the difference. Investors commonly use their cash reserves to support growth in needed areas, Care is needed, though, because keeping too much of a stockpile could inhibit growth or limit investments’ value.
- To help when cash is king. Dry powder is commonly viewed, in the case of an economic downturn, as a kind of safety net. Generally, firms and companies that have ample dry powder on hand have a leg up on rivals that do not, particularly during protracted turbulent periods. Oftentimes, a company that needs near-term liquidity will first turn to dry powder.
- To take advantage of distressed debt opportunities. During periods of market volatility, opportunities tend to abound for distressed debt investors. Some $66 billion of the $273 billion that private debt funds had available in 2020 was held by managers focused on distressed debt. Such debt involves riskier investments in financially troubled companies with potentially larger returns.
VCs, PEs, and Diversification
Dry powder notwithstanding, there are ways for investors to access venture capital and private equity offerings, which also serve the essential purpose of diversification – constructing a portfolio comprised of various types of assets to mitigate risk.
One way to get into VCs or PEs is through Yieldstreet, an alternative investment platform on which nearly $4 billion has been invested to date. Increasingly, investors have been adding alternatives such as art, real estate, and transportation to their holdings since they have less correlation to public markets.
Yieldstreet has the broadest selection of alternative asset classes available, a selection that includes private equity opportunities, which could be a safer choice particularly for those who are not as knowledgeable about the stock market. With a PE fund, management falls to an investment firm, which controls the fund. Yieldstreet provides a curated selection of PE investment opportunities, with early liquidity options and accessible minimums.
Yieldstreet has also launched a venture capital program that offers retail investors exposure to private companies that are shaking up current sectors or establishing entirely new ones. Over the past 25 years, returns on VC have averaged 32%, and in 2020 alone, exceeded 50%.
Along with private equity, venture capital can diversify one’s investment holdings, which also reduces overall portfolio volatility, helps protect against inflation, and can improve returns. Risk-reducing diversification is a pillar of long-term investing success.
Alternative Investments and Portfolio Diversification
Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments.
This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.
However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.
Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.
Learn more about the ways Yieldstreet can help diversify and grow portfolios.
While there are a number of ways in which dry powder can be used — including to take advantage of opportunities — deciding how and when to do so can be fraught. Investors should choose wisely.
And remember, there are other ways to get involved with VC and PE that can potentially provide steady returns while diversifying portfolios.
What's Yieldstreet?
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.
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