Dry Powder and IRR Consequence
We have heard many times over the last few years that PE firms have record dry powder, presumably this translates to that they are sitting on a lot of committed capital that has been drawn down through a capital call but that they haven't yet invested it?
If PE firms keep sitting on so much dry powder and don't deploy it, are they not at risk of massively undershooting their target IRR and investors ending up getting measly returns after standard 10 year hold period? I must be missing something, would appreciate clarification
Further, with these huge funds in the 10s of billions raised by mega funds, is it realistic that they can find enough good opportunities and successfully beat other firms to deploy all that capital take $20bn for example in the required timeframe?
That's been a concern for a while now, and we're seeing effects of that in everything from PE shops paying higher multiples to larger premiums on R&W insurance. Essentially, you've got to get better at finding undervalued businesses, successfully add meaningful value to the target's operations, or make a structure such that the economics of the investment make sense. That said, back in 2017 there were record levels of dry powder too, and we're seeing strong exit values now, so there are ways to generate appropriate returns for your LPs if you work hard enough.
A PE fund won't call capital until they're ready to invest in a deal, so your comments have no impact on the IRR.
Right so the idea is that IRR isn't affected because they equally pool the call down from those who committed so on that first deal that they do, the investors get the economics and IRR on that portion of the drawdown, the rest is irrelevant to the IRR because the LP can technically invest it in the meantime as long as they can meet the capital call when it comes?
Agree with the above posters in practice in terms of how PE firms calculate their IRRs and benchmarks, but there is a macro angle here where LPs that commit capital are foregoing other investment opportunities to commit the capital to the PE fund for a 10 year return expectation. If it takes 4-5 years to invest that capital, while the PE fund’s IRR may not be impacted on an absolute basis it sure does impact the LPs long term returns and they definitely do complain about it. One of the key diligence areas for LPs in a fundraise process is investment cadence and ability to deploy capital.
However to answer OP’s question, all in all, regarding how LPs think about this and the trends you mention, it is all a macro impact of low interest rates and “yield-seeking” behavior. With such low interest rates and yields across other asset classes coupled with high liquidity, waiting a few years and taking a bit of a hit on 10-year returns is still favorable to an LP than other asset classes which have also declined in yield.
In layman’s terms, while long-term returns for PE funds has come down a bit, so has the opportunity cost to committing that capital elsewhere as yields across the board have come down.
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