What is Dry Powder in Finance?
Dry powder in the financial world refers to a couple of things – financial reserves and highly liquid assets that are readily available for investment or deployment. Investors or companies often hold this with the intention of using it to take advantage of investment opportunities as they arise. Therefore, the term is often used in the area of personal finance, corporate environment, and venture capital or private equity as well.
The term “dry powder” comes from the idea that the cash or assets are “dry” and ready to be used when needed. This is in contrast to assets that are already invested and therefore not easily accessible without incurring transaction costs or losses.
History of Dry Powder
The term ‘dry powder’ roots its origin in the 17th century, when loose gunpowder was in use for military battles. At the time, it was essential to keep the gunpowder dry to keep the guns and cannons firing. So, the military has to maintain reserves of powder in dry form. The same concept came into the financial world that reserves help the company to operate efficiently or make an investor’s portfolio look efficient.
What does Dry Powder mean for Reserves?
In the context of reserves, “dry powder” refers to the portion of reserves that is readily available and not committed to any specific purpose or obligation. So, a company or an individual builds up this to prepare for the unexpected downturn. A company with a lot of such liquid assets gets a financial advantage over others.
Such types of investments come in handy during a steep decline in the market. During a decline, investors can easily sell such assets to get cash. Also, the investor can use the cash from selling such investments to buy the stock at low prices during the decline.
What does Dry Powder mean in Liquidity?
When talking of liquidity, the term relates to investment in liquid assets, like money market funds. It is a wise strategy not to invest fully in the stock market. Instead, some portion should be invested in the “dry powder” assets. By holding a portion of their reserves in highly liquid form, organizations can better manage their cash flows and respond quickly to unexpected financial challenges.
What is Dry Powder in Private Equity or Venture Capital?
In the context of private equity or venture capital, “dry powder” refers to the capital that has been raised from investors but has not yet been invested in portfolio companies. This includes committed capital that has not yet been drawn down or deployed, as well as any uninvested profits or proceeds from previously realized investments.
Venture capitalists or private equity funds require adequate cash on hand to invest in a new opportunity. They also require cash to refund the companies in the portfolio. Therefore, the majority of venture capitalists prefer keeping dry powder on hand. It also leads to high valuation multiples and increased deal-making. It means ready capital to take advantage of a high-quality target offering massive growth opportunities.
Also, when a high-net-worth individual connects with a private equity fund, they examine the levels of dry powder the fund maintains to support future growth initiatives. Moreover, it is also a good indicator of the fund’s investment strategy.
A point to note is that the private equity funds that keep high levels of dry powder do not always mean they are anticipating better deals ahead. Sometimes, it also means the lack of attractive deals to invest in. For instance, a September 2017 report from Preqin Ltd notes that the private equity funds were holding $963.3 billion of the powder. This was due to investors’ more money into the private equity funds and a lack of high-return portfolios to invest in.
What does Dry Powder mean for a Company?
For a company, higher levels of such assets give more bargaining power when it comes to negotiating credit terms. A bank or any credit institution will inspect the borrower’s dry powder levels to ensure that the borrower has enough reserves to meet the debt obligations. Moreover, a satisfactory level of it results in favorable credit terms for the borrowers, including a low-interest rate.
Along with the bargaining power, keeping the dry powder also acts as a buffer against unforeseen financial crises. For instance, if a company expects a slow demand for its product in the near time, it would raise its dry powder levels to ensure it has assets that can come in handy during distress times. A company without such assets or lower levels of it may not enjoy such flexibility.
Also, a company must not keep too much of its cash as dry powder. It may lower their ability to expand. In case of too much reserve, the company blocks the money and thus prevent is from using in other productive purposes. So, it is imperative for a company to maintain it at the right levels.
What does Dry Powder mean for Individuals or Personal Finance?
Similar to companies, for individuals, keeping dry powder helps to meet unforeseen emergencies and obligations. If a person keeps their reserves, it means they are holding at least some portion of their personal net worth in assets (cash or marketable securities) that can quickly be converted into cash as and when needed.