The “dry powder” does not exist

VC Twitter predicts that 2023 will bring a funding avalanche. But the $290 billion they're counting on may be put on ice.

You’ve seen it on Twitter: Despite the pullback on investment by venture capitalists, there exists a treasure trove of funds waiting to be deployed. Some claim there is $290 billion sitting in idle funds and prophesy that it will fuel a strong investment environment in the new year.

The premise is that venture funds continue to raise at record rates. While public markets saw a significant sell-off in the last six months, venture funds raised an unprecedented $261 billion. The rosy picture is that this capital build-up will lead to a flood of investment activity.

I’m here to burst that bubble. The dry powder does not exist. 

Here’s why.

Follow the money

When venture firms raise investment funds from Limited Partners (LPs), the LPs commit to an allocation in the fund. The actual money changes hands in a series of capital calls.

A capital call is a legal right for these venture firms to demand a portion of the money agreed upon at the time of the fund’s raise by their LP investors. This reflects the reality that not all the capital can be deployed at once. It takes time to find the diamond-in-the-rough startups to invest in.

Typically, the funds are distributed from the LPs to the fund in thirds over the course of the fund’s lifetime. So while an endowment might commit $50 million to a fund, they would only wire a fraction of the money to the fund in the first few months. The remaining $33 million is called and wired at intervals over the next few years.

Calling capital only when required allows LPs to maintain control of their capital for longer and continue to earn returns on the capital through short-term investments. In addition, the capital call math conveniently produces a higher internal rate of return for the venture fund. 

So what does this mean for the billions of dollars raised by venture capital firms in the pandemic? Only a fraction of the committed capital is actually in the bank and under the firm’s control. Optimists are assuming LPs will actually wire the remaining funds.

They will… won’t they?

Limits to liquidity

For LPs to meet their capital call obligations, they must have the liquidity to do so. 

The question of liquidity is opaque. The world is looking pretty weird right now, with some of the biggest exchanges struggling to meet withdrawals and disappearing literally overnight.

It wasn’t that long ago when we experienced a liquidity crunch on a mass scale. Let’s look at what happened to capital calls in 2008. 

Spoiler alert—the capital was not actually there.

When the market crashed in 2008, so did many investment holdings. The S&P 500 lost more than 50% of its value from the peak. Some investments went to zero. 

Remember those LPs who still had two-thirds of their capital obligations to venture firms outstanding and decided to invest in short-term holdings to earn interest in the meantime? Their short-term holdings are now worth a fraction of what they originally expected. They may be forced to sell positions at a loss. In some cases, they simply may not have the capital to commit. 

Like venture firms, there is a spectrum of the caliber of LPs. For tier-one venture firms who have built up relationships with LPs over decades, the agreements could be more ironclad. For the 12,000+ new firms that came into existence in the last six years, it is less clear how well-managed and what pressures exist to salvage their investment positions. 

What happens next?

Of course, there is a secondary market for this. Back in the dot-com crash and the Great Financial Crisis of 2008, pawn shop investors stepped up to buy secondary holdings of venture funds or LPs themselves. However, these pools of capital are limited and prone to similar market exposure.

Other alternatives include borrowing money at soaring interest rates from banks. Or larger LPs may have the power to tell the fund not to call capital at all. Neither party is incentivized to make this information public because it makes other LPs lose confidence in the venture firm and LPs likewise don’t want to be perceived as being unreliable.

The pressure from LPs to deploy funds as fast as possible (and reduce the fees) has been replaced with patience. Fund cycles that were 18 months in a bull market could now stretch past the typical 2–3 years to possibly 4. New investment activity could continue to decline, or even freeze.

Frankly, it’s foolish to predict what happens next. All that history indicates is that some of the perceived dry powder may be more prone to evaporation than a fundraising avalanche. The question is what percentage of the publicly announced funds will remain. Continuing to extend runway from the coldest summer in the valley to ride out the possible winter is not a bad idea.

As Howard Marks once said, bull markets rhyme. Maybe prior bear markets also have something to teach the optimists. ⊞