Diversification and liquidity can safely kindle the performance of institutional investors’ dry powder assets while they wait for private markets to call.
In fact, a diversified, highly liquid portfolio that provides the highest return for the risk taken can balance the shortfall risk, which is the potential for having insufficient capital when private market managers call capital, and opportunity cost, which is the risk of returns forgone by being away from the desired allocation.
This dynamic dominates traditional approaches such as leaving dry powder — capital that is committed to private markets but not yet called and invested by private market managers — disbursed throughout the strategic asset allocation, or holding dry powder in cash or public market assets that attempt to replicate the private market, according to a recent report titled “A New Approach to Dry Powder Investing,” by Wells Fargo Asset Management.
“We know all the reasons why institutional investors look for illiquid or private investments,” said Daniel Morris, chief investment officer and head of systematic investments at Wells Fargo Asset Management. “But they end up with a structural challenge about how to invest while they’re waiting for their dry powder assets to be put to work, and it’s testing a different part of their mindset. It’s no longer about looking at private investment, it’s about thinking about liquid investments again.”
While the challenge of investing dry powder has been an issue as long as there have been private markets, the response to that challenge requires a fresh look, according to Kevin Kneafsey, senior investment strategist multi-asset solutions, at Wells Fargo Asset Management.
“What has changed is that there [are] now over $2.3 trillion in global dry powder assets, [an amount that has] grown 2.7 times over the last nine years. [It] now impacts a much broader swath of investors than it used to and impacts them at a greater scale,” Kneafsey said.
Unique characteristics, unique portfolio
The three characteristics specific to dry powder investing, according to Morris, include:
1) It’s funded with a future fixed-dollar commitment that’s legally binding;
2) The size and timing of the capital calls are uncertain; and
3) The time horizon for capital calls can be up to five years.
The first characteristic gives rise to shortfall risk, the second eliminates the possibility of cash flow matching and the third creates potentially meaningful opportunity cost of forgone returns. This trade-off between shortfall risk and opportunity cost creates the dry powder dilemma, Morris said.
According to the report, holding dry powder in cash and/or equities carries its own risks with a potential for varying negative impacts. For example, while cash can minimize shortfall risk, with its low risk of capital loss, it has high opportunity cost because expected cash returns are less than those of other asset classes. Meanwhile, replicating private market assets with public equities, for example, can significantly lessen the opportunity cost with higher expected returns, but it can present greater shortfall risk because potential market losses could lead to insufficient capital when calls are made.
“Few investors can play the extremes: ‘I want to solve the opportunity cost problem, so I’m going to invest in equity’; or ‘I’m going to solve for certainty and avoid shortfall, so I just want to invest in cash,’” Morris said. “And you can’t say, ‘I want take half of one and a half of the other’ and think that you get a better outcome. It’s just a scaled version of the risk — so you’re basically trying to make two wrongs into a right. You need to think, ‘How can we optimize the trade-off between these two and actually build a better portfolio that starts to minimize shortfall risk, minimize opportunity cost, with sufficient liquidity, and meet that need without having an actual hedge available?’ That’s exactly where the dry powder portfolio comes in.”