Venture capital’s record dry powder has its limits

In recent weeks, a debate bubbled up among the venture capital and startup crowd on Twitter about a normally benign financial metric. Dry powder, an estimate of the capital available for VC firms to invest, briefly became the talk of the town.

The dry powder debate is fundamentally about whether we should be optimistic or pessimistic about our outlook for startups. This anxiety over available capital is understandable, since startups rely on new investment.

In an economic downturn, mountains of cash mean that fewer startups will fail than would otherwise. But if the accuracy or importance of dry powder is overstated, market actors may be blind to the specter of a tighter funding environment.

On one side of the argument are dry powder optimists: those who believe the estimated $290.1 billion available to VC firms, according to PitchBook data, is enough to outlast any downturn. Moreover, startups attract gobs of funding from investors other than traditional VCs, money that isn’t captured in dry powder estimates. In a LinkedIn post, Decibel Partners founder Jon Sakoda argued there’s enough dry powder to keep the industry humming for three years.

The naysayers respond that the impact of dry powder levels on future behavior is overstated and that the figure is more of a lagging indicator than a bellwether of the market outlook. Speaking on the “All In” podcast, Craft Ventures co-founder David Sacks warned against “overly optimistic, overly rosy” projections based on the state of dry powder.

So will dry powder save startups from a capital drought—if it ever comes?

Reasonable people can disagree, but high levels of dry powder are no guarantee of venture’s unstoppable growth. Moreover, data collection delays and uncertainty over investor behavior make predicting the amount of dry powder both an art and a science. The indicator’s importance may also be exaggerated, since VCs have broad leeway over how and how quickly to invest.

There are plenty of reasons for dry powder optimism. VCs have been riding out stormy economic seas in style, setting a new fundraising record this year with $150.9 billion raised, according to preliminary data from the Q3 2022 PitchBook-NVCA Venture Monitor First Look.

This windfall is largely owed to the recycling of money from last year’s exit bonanza, according to Zane Carmean, lead quantitative analyst at PitchBook. “Many LPs have reupped with GPs at a faster pace out of necessity,” he said.

LPs received plenty of distributions last year that had to be put to work, and there’s an incentive to maintain relationships with GPs by allocating to new funds. VC as a strategy also remains attractive to investors. The number of investors in the ecosystem continues to set fresh records, and LPs have steadily grown their allocations to the strategy. As a result, today’s fractured market shows median valuations continuing to climb even as the largest startups struggle to justify their former worth. Most of the market remains quite healthy.

Another cause for the Pollyanna outlook is that the dry powder figure only counts traditional VC dollars. Huge amounts of capital in the ecosystem come from nontraditional VC investors such as hedge funds, corporate venture firms and PE investors—capital that won’t make its way into the dry powder total.

Data delays

Now for the killjoy’s dose of reality.

At a basic level, dry powder is calculated by adding up fundraising and subtracting the capital that has been deployed. This average capital deployment pace is extrapolated from data PitchBook gathers from LPs whose investments tend to be concentrated in the largest funds.

Data on both fundraising and fund deployment suffer from lag effects. The fundraising figures are recorded when the fund closes, but investors can and do start investing well before this date.

Fund deployment is also delayed: GPs typically report to LPs on a quarterly basis, and it takes time for PitchBook to gather data from pension funds, endowments and others to know how much capital has been called.

In short, it’s not clear how fast money is being invested at any point in time, so PitchBook analysts make projections based on historical data.

In normal times, that historical pace is a good predictor of the current pace. But we’re in abnormal times, and there’s plenty of anecdotal evidence that dry powder was used more quickly than usual in the boom. In an extreme example, Tiger Global closed a $12.7 billion VC fund in March but had invested nearly all of that money by May, TechCrunch reported.

Clearly, some of the fundraising that makes up the current dry powder total has already been invested. If the largest VC funds deployed capital much faster than normal, the dry powder estimate could meaningfully overstate the real figure, Carmean said.

Tourist trouble

Perhaps a larger question to consider is how much the dry powder figure really tells us about investor activity.

As mentioned above, dry powder describes the money available to traditional VC firms, and nontraditional investors add heaps of dollars to the ecosystem. This money often isn’t strictly committed to VC, so there’s a risk that it comes and goes depending on the economic climate.

“Crossover investors are pulling back from early-stage investing and leaving a void. Insider rounds will therefore become more prevalent, which will take up a lot of the dry powder,” said Pamela Aldsworth, head of venture capital coverage at JP Morgan Commercial Banking.

Those investors won’t flee overnight, but they do have different options and motivations than traditional VC firms. Corporate venture capital investing may be scaled back in lean times, and hedge funds may go hunting for stocks instead of startups.

It’s hard to overstate just how important these investors are to the hundreds of unicorn companies in private markets. The largest VC-backed companies raised $194.3 billion in 2021 across 842 mega-rounds of $100 million or more. That same year, VC firms raised $147.2 billion.

“VC funds can’t fully support the late stage if there’s more being invested in that market than was raised in a record year.” said PitchBook senior analyst Kyle Stanford.

Future fundraising

What matters to startups more than the current levels of dry powder is the behavior of investors, which is far from certain. VC firms can adjust their pace of deployment in order to satisfy their LPs needs and get the best deal possible.

Investors have the option to sit on recent capital commitments, possibly in expectation of lower prices. LPs may also insist on a slower pace if, say, their portfolios are overallocated to VC following stock market declines. And those LPs can expect few distributions in 2022 due to low numbers of exits—therefore having a limited amount of money to recycle into new funds next year.

There’s no guarantee investors will proceed with caution. Late-stage valuations have come down, and investors have cash on hand, more time to do due diligence and increased negotiating power to add preferential terms to deals. Those factors combine to make the present day a more attractive time to put capital to work.

Founders should be rooting for VCs to keep doing what they do best: finding startups that deliver outsized returns. That’s what led to today’s record dry powder and will determine how much money is available in the future.

Featured image by Jenna O’Malley/PitchBook News