The mirage of dry powder


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Are VCs really sitting on record amounts of cash waiting to be deployed into new startups? I wish. But if it sounds too good to be true, it probably is. — Anna

Record levels, but…

A recent guest post on TechCrunch+ wondered whether “record levels of dry powder [will] trigger a delayed explosion of startup investment.” The question relied on a postulate: That venture capitalists have raised plenty of funding that remains to be deployed.

The idea that dry powder has reached record levels is commonly shared, and it is backed by data.

“Venture capital investors in the United States, for instance, are sitting on a $290 billion powder keg that’s ready to ignite a new wave of tech startups,” Picus Capital’s Raphael Mukomilow and Pierre Bourdon wrote in the post.

The co-authors also noted that this cumulative overhang is “dwarfing the $117 billion of capital that was raised but had not been invested back in 2017.”

I won’t dispute their findings: It is true that more funds have been raised than have been deployed, and by an exceptional margin. But thinking that all of it will translate into funding new investments is likely misguided. Let’s explore why.

Failed capital calls

Not every startup founder knows this, but the money raised by venture capitalists doesn’t sit in the bank from day 1. Instead, their limited partners — those who invest in a fund — commit to wiring a tranche of capital upon request. The process of pinging them for money is known as a capital call.

Capital calls are usually straightforward, but not always so in a recession: If the LPs have invested in other asset classes, which they typically do, they might have lost a substantial share of their wealth. Even if that’s not the case, they may simply decide to readjust their strategy.

Failed capital calls are rarely made public, but Forbes confirmed that they are happening, and they’re hitting emerging fund managers particularly hard.

“Eunice Ajim, who is raising her first fund to back seed-stage startups in sub-Saharan Africa, says that when she attempted to conduct her first capital call — in which VCs ask for LPs to wire over a portion of the money they committed— more than half of the money did not arrive. As a result, she’s been forced to make $25,000 to $50,000 investments into startups in which she’d previously been hoping to invest $100,000 to $150,000,” Forbes’ Kenrick Cai reported.

Fund managers don’t want to endanger their relationships with their LPs, so when LPs try to wiggle out of their commitments or wire smaller checks than planned, we rarely hear about it. We only know how much a fund announced having raised in the first place, which means everyone might be overestimating the actual amount of dry powder. But there’s more, a prominent VC told TechCrunch.

Dry powder, wet powder

VC fund Lux Capital argued in its Q3 2022 letter to LPs that much of the “dry powder” will prove to be “wet.” I asked co-founder and managing partner Josh Wolfe to expand on these thoughts, and here’s what he said:

“Much of the cash that people consider ‘dry powder’ is presumed to be for fresh new companies and fresh new financings. I say it is ‘wet’ because if 2023 resembles the dot-com bust, all the money raised at valuation peaks will get spent propping up ‘walking dead’ zombie companies that can’t raise outside money and instead have to turn to insider rounds.”

In other words, many VC funds will likely be spending money supporting ailing portfolio companies instead of investing in new ones. They could choose not to, but they would face a dilemma, Wolfe said.

“The more insider rounds there are, the more punitive terms there are for non-participating investors. This in turn creates a cycle where funds that thought they had ‘dry powder’ in reserves have to make a difficult choice: Either risk losing everything and abandon existing investments (by force of other investors’ punitive terms on inside round financings) or reluctantly and begrudgingly support their existing companies not thinking they needed to have so much more reserved than initially anticipated.”

If you are a founder, this isn’t necessarily bad news: When you choose a VC, you also expect them to be there for your company during hard times. But if you are fundraising or hoping to do so any time soon, take what you are hearing on “dry powder” with a grain of salt.