The Perils of Dry Powder: Exploring the Risks in the Venture Capital Sector

Having seen an explosion in activity coinciding with the outbreak of Covid-19, venture capital (VC) investment activity has been registering a significant decline in the years since the pandemic. According to data from S&P Global, the value of VC funding rounds globally dropped 34% year-on-year to $14.09bn in November – the lowest November total since 2020 – while the number of rounds declined by over a quarter.

This decline in fundraising activity is coinciding with a time in the market when unallocated VC capital – otherwise known as dry powder – is at a record high. The National Venture Capital Association reports that US VC firms ended 2023 with $311.6bn in dry powder, much of it belonging to funds that were formed in 2021 and 2022.

Although dry powder may seem harmless in principle, this accumulation of capital poses in fact poses significant risks to both investors and the broader startup ecosystem.

In this piece I’ll take a look at the perils of dry powder – and how those risks can be mitigated.

Excess dry powder can lead to the misallocation of capital

As the excess capital available to VCs beyond their current investment commitments, dry powder serves as a financial cushion, enabling firms to capitalise on investment opportunities swiftly. But while on the one hand it can reflect financial strength and flexibility, excess dry powder can also have detrimental consequences.

One of its primary risks is the potential for misallocation of capital. When VCs hoard excess funds, there is a temptation to invest hastily in suboptimal ventures merely to deploy the capital. This rush to invest can lead to poor decision-making, resulting in investments in ventures lacking long-term viability or alignment with the firm's investment thesis. Such misallocations not only jeopardize the returns for investors but also impede the growth of genuinely innovative startups.

What’s more, if capital is misallocated VCs can be accused of mismanagement of funds, which could open them up to allegations of management or investment failures. These so-called “portfolio risks” can expose VCs to anything from regulatory fines to wider lawsuits.

The risk of distorted valuations

Abundant dry powder within the sector can also distort market valuations. As firms compete to deploy capital, they may engage in bidding wars, driving up the valuations of startups beyond their intrinsic worth. This artificial inflation of valuations creates a bubble-like environment, wherein startups may struggle to meet the unrealistic growth expectations set by overzealous investors. Ultimately, when the bubble bursts, it can lead to significant losses for investors and widespread market instability.

Furthermore, with more capital chasing a limited number of high-value investment opportunities, VCs can experience overcrowded investment rounds, reducing the potential ownership stake for each investor.

Reduced accountability and the erosion of innovation

Dry powder can inadvertently foster a culture of complacency and reduced accountability within venture capital firms. With ample reserves at their disposal, firms may become less inclined to rigorously evaluate investment opportunities or actively support portfolio companies’ post-investment. This lack of scrutiny and hands-on involvement can diminish the quality of investments and undermine the success of startups, thereby eroding investor trust and damaging the reputation of the venture capital firm.

The accumulation of dry powder within the venture capital sector also has the potential to stifle innovation. As capital remains idle, it is effectively withheld from being deployed into promising startups that could drive technological breakthroughs and disrupt traditional industries. This capital hoarding deprives innovative ventures of the financial resources needed to scale and thrive, hindering the overall pace of innovation and economic growth.

How can VCs mitigate the dangers of dry powder?

There are a few proactive measures that VCs can consider taking to mitigate some of the risks associated with dry powder.

• Invest strategically: Firms should prioritize strategic deployment of capital based on thorough due diligence and alignment with their investment thesis. Rather than succumbing to pressure to deploy excess funds hastily, firms should maintain discipline and focus on quality over quantity. 
• Support portfolio companies beyond investment: Post-investment, VCs should actively support portfolio companies through mentorship, networking opportunities, and strategic guidance. By fostering strong partnerships with entrepreneurs, firms can enhance the likelihood of success and maximize returns on investment. By having close ties to portfolio companies, VCs are also better placed to spot and action follow-up investment opportunities.  
• Maintain transparency regarding the deployment of dry powder: By providing partners with regular updates on investment activities and the rationale behind investment decisions, firms can build trust and confidence among investors, thereby mitigating concerns about capital allocation. 
• Diversify beyond traditional VC: Diversifying investment strategies beyond venture capital can help mitigate the risks associated with dry powder. Exploring alternative investment avenues such as growth equity, secondary markets, or direct investments in late-stage startups can provide additional avenues for deploying excess capital effectively. 
• Ensure the right risk protection is in place: Because the accumulation of dry powder exposes VCs to portfolio risks, it is more essential than ever to have the right financial protection in place. A specialist insurer can provide VC asset protection that can respond to a variety of claims. An example of which is a GBP 4m claim against the directors of a portfolio company that we previously oversaw, which arose from the shareholders making allegations of mismanagement against the directors. The allegations were first made in 2018 and settled in 2023 highlighting the time delay it often take to achieve a resolution. 

While dry powder offers venture capital firms the flexibility and firepower to capitalize on investment opportunities, its excessive accumulation poses significant risks to investors and the broader startup ecosystem. By understanding the dangers associated with dry powder and adopting proactive measures to address them, VCs can navigate this challenge effectively, unlocking the potential for sustainable growth and innovation within the sector, while minimising the chances of a claim from investors. 

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Tom Woolcott is a Broker in Financial and Professional Risks at BMS

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group