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The Dry Powder Question – Thoughts From The Chairman #3

Jeff Lynn

I hope you all made the most of the quarantined Easter weekend and are keeping healthy.

In my last two notes (here and here), I wrote about government funding solutions for startups and scaleups during the Covid-19 crisis. This week I am going to change tack a bit to look at private sector funding and the debate emerging around what I’ll call the “dry powder question”.

Quick Update on Save Our Startups

But first, a check-in on the Save Our Startups campaign, which I wrote about last week. We’ve been thrilled that over 5,000 people have already signed the petition, and it has gotten widespread media coverage. More importanty, it appears the Government is listening: yesterday’s Telegraph reported that Treasury is getting ready to announce a startup rescue package along the lines of what the campaign has called for, and I am hearing similar indications from my contacts in Whitehall. So hopefully there will be good news to share shortly.

The Dry Powder Question

One of the reasons why government support for startups and scaleups is so important, as I discussed in my last two notes, is that CBILS—the small business lending scheme launched by the Government at the beginning of the crisis—doesn’t work for high-growth loss-making businesses. As it turns out, there are some questions around whether CBILS is even working for the businesses for which it was intended, but that is a separate point. The key issue is that there is not yet a government support programme suitable for the country’s most innovative and high-potential young companies.

But we wouldn’t even be talking about government support if it looked like private sector investors could solve the cash problem that so many startups and scaleups will now face. And when I say private sector investors, what I really mean is venture capital firms, or VCs. Much as I believe that investors of all shapes and sizes should be able to invest in this asset class—and thanks to Seedrs and others, the capital base has diversified substantially over the last decade—by far the majority of capital that goes into startups and scaleups still comes from VCs. So the private sector’s ability to plug cash shortfalls is primarily a question of what the VCs can, and will, do.

Enter the dry powder question. In broad terms, dry powder is the amount that VCs have raised but that has not yet been invested. And there is a lot of it out there: in the UK and Europe alone, there are billions (or, depending on how broadly one defines VC, tens of billions) of pounds of dry powder that is theoretically available to support startups and scaleups during this period. What’s more, pretty much every VC general partner (general partners, or GPs, are the people who manage VC firms and the funds they raise) is saying publicly that they are fully open for business and looking to invest that dry power. There are even lists circulating that purport to show all the VCs who are investing during this period.

So problem solved, right? The cash is there to fund these businesses, and the VCs say they want to fund them. Valuations may be pushed down and terms like preference structures may get more aggressive—which is all just a part of shifting market dynamics—but there is no reason that companies should struggle to raise the cash they need to get through this period. Simple.

Well, not quite. The existence of dry powder on paper and its availability for deployment aren’t always the same thing, and the best laid plans of GPs can easily go astray. This is due to a combination of two things.

One is simply bandwidth. VCs tend to run lean operations even in boom times, and they rarely have much capacity to spare in conducting the relatively labour-intensive undertaking of investing in private companies. So now, with huge amounts of time being taken up supporting portfolio companies, and lots of their remaining time being taken up by external pressures that this crisis has created (including things like providing childcare), many GPs will face a real operational struggle in making new investments. Elizabeth Yin, who runs the well-respected San Francisco seed-stage VC Hustle Fund, wrote an excellent thread on the nuances around this issue a few weeks ago. I expect many other VCs find themselves in a similar position to Elizabeth.

The other, probably more significant, issue is in the notion of what dry powder really is. I said earlier that it’s money raised by VCs that has not yet been deployed, but “raised” is a nuanced word. In reality, most dry powder represents commitments by the fund’s investors (known as its limited partners, or LPs), meaning that the GP still needs to call on the cash from the LPs, and the LPs still need to pay it over. Hence we get into conversations like the one below from LinkedIn (which you can see in full here) between two people who know this ecosystem very well:

What are the implications of Michael Chaffe’s observation? Is it likely that LPs will simply stop responding to capital calls during this period, letting the dry powder go up in smoke? Not exactly: the penalties on an LP for missing a capital call are severe—the LP basically forfeits its whole stake in the fund—so except in the case of new funds, where there is no stake yet to lose, I doubt we will see a lot of LPs simply saying “no” when the GP comes knocking.

But that doesn’t mean LPs are powerless. The mere prospect of a refused capital call will make many GPs nervous. More than that, GPs will be thinking about their future funds. If they do something today that upsets their LPs, then when it comes time to go back to those folks for Fund 2 (or 3 or 9), they may find a lot of doors shut in their faces.

And that is the key to the dry powder question. If LPs don’t want the funds in which they have invested to be deploying capital right now, then they are able to put a lot of pressure on the GPs not to deploy capital. Are they actually doing so? Yes, although the extent is hard to tell: anecdotally there are stories of LPs exercising their power one way or the other during this time, but as we all know, the plural of “anecdote” is not “data”.

More concerning than the stories is the simple reality of LPs’ positions: most are institutions who invest across multiple asset classes, and when they make a commitment to a VC fund, they often invest the cash in a different, liquid asset—such as listed stocks and shares—until it is called by the VC. With valuations of so many major liquid assets having taken a big hit over the past two months—but with expectations of a strong rebound after the crisis is over—many LPs will be loathe to sell their holdings at the moment. There will of course be plenty of exceptions, but it is inevitable that what is happening in the global markets will mean a significant number of LPs will want to reduce the amount of cash they need to hand over to GPs right now.

And that is what leads to a private sector investment crunch. The dry powder is not exactly going up in smoke, but much of it will be locked away in the magazine until this crisis is over.

Resources and Musings

Here are a few resources and goings-on I’ve found interesting over the past couple of weeks:

Thanks very much to Jimmy McLoughlin (whose Navigating the coronavirus for business newsletter I mentioned a few weeks ago) for highlighting the last two of those.

And finally, a few tweets I thought worth sharing:

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That’s it from me for this week. As always please do let me know any feedback or contributions, and I hope you all stay well and safe in the week ahead.