Agency Costs of Dry Powder in Private Equity Funds

Abstract

The amount of non-invested capital in the private equity industry or “dry powder” has raised numerous concerns from public opinion. To obtain insight about the drivers of the dry powder development, we model the investment behavior of a fund sponsor as a function of their expected fees, the latter being a function of their expected returns as well as their profit-sharing agreement with limited partners (LP). Our empirical analysis is performed on 383 funds sponsoring 1,011 US LBO deals over the period 1980 – 2019. We first show that, consistently with the model, the fund management fees, the change in the fee basis computation towards the end of the investment period and the general partner’s (GP) expected return based on their track record and experience have a significant impact on the dry powder of the fund. Small funds, funds with low management fees or GP with a weak track record are more likely to have an abnormal level of dry powder at the end of the investing period. This situation leads to agency costs as we give evidence of the loss in performance for funds with abnormal dry powder at the end of the investing period. We find that high levels of dry powder lead to investment distortions where GPs focus more on maximizing their fees rather than maximizing the value for LPs. Deals undertaken at the end of the investing period by funds with a large volume of dry powder are under-leveraged, are larger and performed with less syndication to maximize the equity spent. They also present a significant lower cash on cash return.