Risk or lose: The liquidity trap and Dry Powder in the middle market

"Fortune is at the side of those who dare."

The title of the article may seem exaggerated, but for high net worth that have a lot of liquidity it is not.

Account balances are currently highly penalized, to a point where the investor has to assume a devaluation of his assets, unless he takes risks and invests in profitable assets.

What are the factors that tax liquidity and erode equity?

On the one hand, we find negative real interest rates. Null or negative nominal interest rates combined with the arrival of inflation mean a loss of purchasing power for money in the medium term. Estimated annual CPI inflation in March 2021 stands at 1.3%. Furthermore, Eurostat has asked the INE to review the basket of products and weights of the CPI, which with the new calculation basis aims to be even higher. In the US the short-term inflation expectation rose in March to 3.1%, its highest level since July 2014. We can foresee a loss of purchasing power of 2% per year of money in real terms.

On the other hand, the Wealth Tax has risen to 3.5% in its highest bracket and is applied to both individuals and companies, in the later to assets not assigned to the activity.

Another factor arising from the low interbank rates is the taxation of cash on account by the bank. The rate that the European Central Bank is applying to commercial banks for ease of deposit is 0.5%. It is becoming increasingly difficult to persuade our bank not to charge for liquidity. In the best of cases, they propose fixed-income funds or structured products that pose a certain risk and end up charging a hidden management and depository commission of more than 1%.

All this draws a gloomy horizon for those who have idle or uninvested money. An equity of € 50 M that does not rent and pay taxes, in 2033 will have half that today in constant euros and in 24 years it will have a third, that is, € 24 M in current euros or only € 15 M in constant euros , and without having had a single euro. If inflation rises to 3% and the IP increases somewhat, as Minister Montero threatens, the assets of € 50 million will have become € 25 million in constant euros in 9 years, an accelerated impoverishment.

What to do about this situation?

Faced with this situation, it only remains to invest, either in the recurring brick, with a discreet profitability, in funds and listed companies, which are very expensive both in the US and in Europe and Spain, their prices are volatile and do not allow control to the majority of investors or buy medium-sized companies, either directly or through a joint vehicle (PE funds, club deal). Another more minority option includes alternative assets: gold, jewelry, art, patents, bitcoins, etc.

When the investor, whether it is a private individual, Family Office (FO), corporation or venture capital fund, decides to invest directly in companies with a significant controlling stake, he or she finds a shadow enemy: Dry Powder.

What is Dry Powder?

This term originated in the military battles of the 17^th century, when soldiers used dry powder in their guns and cannons. They had to keep their weapons dry in order for them to function correctly whilst in battle. It is a concept that takes us to a war scene in which it was necessary to have resources to shoot and win the war.

Nowadays Dry Powder refers to the amount of cash reserves or liquid assets available (treasury, short-term financial investments, lines of credit, etc.) that companies, institutions, funds and individuals have for use in asset investments. Therefore, the term can be used in personal finance situations, in the business environment, and in venture capital or private equity investments.

Its amount has grown in recent years due to market dynamics, low interest rates, the emergence of financing instruments and entities, etc. But this growth was remarkable over the last year due to the latest expansive monetary policies as a result of COVID-19.

Can we estimate the amount of Dry Powder in Spain for middle market operations?

The discrepancy in the figures regarding this indicator is bewildering. This is partly because each source understands it in their own way.

Some sources reduce it to money in the hands of Private Equity funds with a finalist orientation, that is, constituted only to invest in Spain in medium-sized companies.

Others understand it as money in the hands of corporations.

There are even those who equate it to fundraising or new money from funds aimed at Spain.

The truth is that Dry Powder can be used both to drive portfolio company growth and to acquire new companies, or even to repay debt.

One way to get an idea of the minimum size of Dry Powder for intermediate market operations is to find out the volume finally disbursed / invested each year in this type of operation in Spain.

Datasite gives us an indicator: in Spain € 32 B were invested in 2020 in 375 operations within the range of € 10 M to € 500 M per deal; they were € 42 B in 2019 in 508 operations and € 36.5 B in 2018 in 407 operations.

Thus, we can say the minimum Dry Powder is from € 30 B to € 40 B for 400 to 500 middle market companies. And it is the minimum because it is obvious that many of the target companies offer themselves to many candidates (competitive process), several of whom stay out and don’t invest, that proprietary processes do not abound (One to One) and that there is much more money than that invested which is or would be willing to buy if there were more opportunities (more Dry Powder in sideways).

Those who want to buy in France, Germany, the United Kingdom, etc. will also find themselves with a much higher Dry Powder, since there are more local funds, they have more money and large economies attract more resources.

Do we have an idea of the number of companies and funds looking for middle market operations?

The candidates to buying the 400 to 500 companies previously mentioned range from FO, funds and companies to wealthy individuals.

Speaking only about funds, there are 238 entities registered with the CNMV as Venture capital, of which 32 announce average tickets of more than € 10 million, that is, they compete for companies in the middle market. Many of the remaining 206 would like to or could buy medium-sized companies through joint ventures.

The FO and great wealth, being opaque by nature, also act as competitors. According to the annual study on the richest people in Spain by El Mundo newspaper, in Catalonia alone there are more than 80 assets with more than € 100 million, most of them of business origin. It is obvious that a good part of them is part of the Dry Powder.

There are 5,938 people in Spain with more than $ 30 M and will reach 8,233 in 2025. Many of these rich, and not so rich, also want to invest in quality medium-sized companies, either alone or among several, buying majority, minorities or 5%. And they will do it just to avoid having their wealth halved in two decades, as seen in the above example.

The Spanish FOs manage between € 150 M and € 750 M on average, intending to invest 18% in alternative assets. 60% of them prefer to invest directly or in the form of a club deal, that is, becoming competitors for classic funds and buyer companies.

And we have not yet taken into account the companies with the intention of diversifying, the mixed credit institutions, etc.

Where does all this take us?

Dry Powder pushes up the prices of target companies with its almost endless supply of money.

Punishing liquidity further encourages investors to buy companies.

There are hundreds, if not thousands, of legal entities (and individuals) in search of the profitable opportunity in the middle market and with resources to buy.

These three factors reinforce the vicious or virtuous circle: Money is not a scarce resource, but quality operations that make money and avoid losing purchasing power are. It is obvious that in the coming months there will be an increase in prices of the target companies and a fierce competition to win the deal, even more so that before.

In light of this situation, the following reflection would prevail for any bright investor: "Rather than fighting to find without any help something of quality in the Dry Powder arena theater, against hundreds of competitors, while I pay the bank each year up to 0.5%, to the Treasury up to 3.5% and I lose close to 2% due to inflation, I am better off paying an advisor a one-time fee to help me get a good deal”. But not all investors always think that way, far from it. "The heart has reasons that reason does not understand."