There’s always something to worry about, isn’t there?
At the start of the year markets reached record highs and we wondered whether the bull market might be running out of steam.
Seven months on, world leaders are bickering about trade. President Trump says he sees too many Mercedes-Benz cars on Fifth Avenue while he didn’t see any Chevrolets in Germany.
The world will have to pay for that injustice with tariffs and we’re left wondering if a global trade war will send the markets down.
Not everyone fears a trade war, though.
Private equity (PE) funds may actually be hoping for something, anything, to send stocks down.
Why is that?
Because they’re sitting on more than one trillion dollars that they can’t invest. The markets are already too high. Stocks are too expensive.
They’re now stuck with all this “dry powder” as the technical term for “money raised but not invested” goes.
How did this happen? What are these funds doing about it? And could this unused cash be a blessing for the markets?
Let’s have a look.
A whole lot of dry powder
Private equity and venture capital funds are sitting on more than 1 trillion dollars. That’s $1,000,000,000,000.
Nothing’s happening with that money. Just picture a huge Ikea with money piling out from under every mattress.
That’s a whole lot of “dry powder” as the cool kids on the street call it. Dry powder is money raised by investment funds that they don’t invest (read: can’t invest yet against good returns). And isn’t that the whole point?
How did these funds end up with so much cash on their hands? For that we have to wind back the clocks almost ten years.
Central bankers found themselves at a loss during the global financial crisis. They cut interest rates like they always did, but this time something more was needed.
That’s when the Federal Reserve, Bank of England and the European Central Bank came up with “quantitative easing”. Central banks collectively bought up trillions worth of government bonds and other financial assets.
What happens when asset prices go up? It lowers the yield on investments.
Funds had to change tack, take more risk, and put more money in stocks in their quest for good returns. Needless to say, this “money printing in disguise” policy blew up the stock markets.
PE now finds itself with all this dry powder, mattress money, or whatever you want to call it.
That’s bad because fund managers only get paid for the money they have invested. Sitting on all that spare cash isn’t good for business. It means they miss out on a lot of income.
What are these funds doing about it?
PE funds are so desperate to invest that money that they’re now putting it in exchange-traded funds (ETFs).
That’s crazy. They wouldn’t normally consider ETFs. Their gains are too pedestrian and you have to pay a management fee to boot.
But low returns are better than sitting on all that money with no returns at all. As I said, not investing $1trn they have lying around is a costly business.
Where most investors are hoping that threats of a global trade war blow over soon, fund managers might actually be praying for one.
A stock sell-off would allow them to finally put their dry powder to good use and snap up stocks at more reasonable prices.
Safety net or drop in a bucket?
While all that uninvested capital could be keeping fund managers up at night, other investors may sleep better because of it.
US stock markets are worth about $31 trillion in total. So knowing there’s $1 trillion in reserve, with fund managers aching to invest it at the earliest opportunity, could make investors a little less anxious.
“This $1 trillion acts as a virtual backstop for the market,” argues Zach Scheidt in the US version of the Daily Reckoning.
“Whenever stocks pull back, you can bet your life that the Ivy League managers at these private equity firms are pouring over the market looking for places to put their capital to work. And the farther stocks potentially fall, the more money these guys will put to work.”
Hey, that’s pretty cool! If that’s the case then now could be an excellent time to buy into the markets.
I mean any market pullback would be short lived. Rather than a panic, it’ll be a relief. Finally a chance for fund managers to put all that dry powder to good use!
It’s a “$1 trillion safety net” as Zach calls it. In fact, if these firms start using their dry powder, it might push up stocks even higher than they are now.
Tariffs, schmariffs! This bull still as some distance left to run!
But not everyone is convinced.
“Over the decade prior to 2015, PE has held around $600bn (it needs to keep some cash in case its own investors ask for it back). So the ‘extra’ cash now retained by PE amounts to about $400bn,” says Strategic Intelligence editor David Stevenson.
$400bn is a huge sum, David concedes, but it’s also only about 1% of that $31 trillion that makes up the US markets.
So if all that spare PE money got injected into the US markets, it might not make all the difference.
And that’s assuming all of it will be invested in the US…
Fund managers could just as easily look at other markets for their investments. With a world market cap of about $100 trillion, an extra $400 billion would have even less impact.
Hmmm, that doesn’t sound like a safety net at all. More like a drop in the bucket.
But wait, it gets worse…
“What happens to the PE stash if equities crash and there’s a ‘dash for cash’? Backers of PE could ask for their money back, leaving PE managers with much less firepower than they expected,” David warns.
“As we saw in the great financial crisis 10 years ago, buyers evaporate if the stock market collapses. Why should it be any different next time around?”
Just when we thought we could invest free of risk or worry…
Oh well, the world has bigger problems. At least we’re not managing $1 trillion of other people’s money with no clue what to do with it.