Agency costs of dry powder

The amount of assets under management in the private equity industry that is left uninvested (called dry powder) has raised numerous concerns from the public. We model the fee collection of private equity sponsors and show that funds that accumulate substantial amounts of dry powder at the end of the investment period will tend to underlever future deals. Building on agency theory and the discipline induced by optimal leverage, we investigate whether this situation is associated with investment distortions and poorer performance. Our empirical analysis covers 386 funds sponsoring 1,812 US LBO deals over the period 1980–2021. Our paper provides evidence that late deals executed by funds that accumulate excess cash at the end of the investment period tend to be larger, more expensive and have less syndication. We moreover show that these deals display significantly lower cash on cash return. This drag on performance is also found at the fund level. Our interpretation is that funds with high levels of dry powder at the end of the investment period are subject to pressure to spend the dry powder and, without the discipline of leverage, this gives rise to agency costs between the investors and the fund manager.