“Dry powder” is it good or bad for you?

Written by Louis-Tchine Pickering, Director of Research

The phrase “dry powder” has been used more frequently in the past year, denoting a lot of cash committed to the industry that has not been invested. If PE firms do not invest this money, they would not be able to charge fees for it and, thus, create no revenue. Eventually, they will have to consider doing deals, even with poor economic and market conditions impacting the return of a deal. However, with interest rates increasing, it affects the IRR (internal rate of return), where the projected exit for a PE firm needs to meet the standard of a 20% or higher IRR.

The quantitative analysis completed by Daniel Davis (2023) showed that the IRR would go below 20% with higher interest rates, leading to an unfavourable deal for PE firms. However, it was found that if a deal can be struck at a lower entry price, private market investors can decide on the timing of divestments and sell at a better multiple than they bought. Thus, this would lead to a reasonably high IRR- seen in many previous deals over the past decade of cheap finance.

Overall, it is hard to say how the “dry powder” can best generate the IRRs that PE firms want, consistent with the new rising interest rates environment. In my view, it relies on the fact that prices have to fall to reach similar IRR levels in the past and showcases a cycle that plagues investment bankers and PE investors alike.

US buyout multiple growth has leveled off (FT.com, 2023)