The Hidden Cost of ‘Dry Powder’ in Private Equity, According to Lee McCabe

In a recent LinkedIn post, Lee McCabe challenges the conventional wisdom surrounding “dry powder” in the private equity industry, arguing that the term often masks a significant, compounding cost for limited partners (LPs). McCabe, associated with Claymore Partners, highlights how the practice of holding large amounts of uncommitted capital, while presented as a sign of prudence and discipline, actually erodes net returns due to ongoing management fees.

McCabe points out that the industry’s focus on the virtues of patience and disciplined deal-making during fundraising can obscure the financial reality for LPs. He emphasizes that management fees are typically levied from day one on committed capital, regardless of whether that capital has been deployed into investments.

“Every year you sit on committed capital, your IRR math gets worse.”

This “ticking fee clock,” as McCabe describes it, represents a silent drain on potential returns. He illustrates the impact with a concrete example: a $500 million fund with a 2% annual management fee amounts to $10 million per year. If it takes three years to fully deploy this capital, that’s a $30 million reduction in the fund’s potential value creation before any investments are even made.

The Erosion of Net Returns

McCabe argues that this is rarely a topic of discussion during fundraising meetings, where the emphasis is on the General Partner’s (GP) commitment to discipline and avoiding overpayment. The narrative presented to LPs is one of careful stewardship of their capital.

“The pitch is always about discipline. We will not rush. We will wait for the right opportunities. We will be patient with your capital.”

However, McCabe counters this by stating, “Patience costs money when someone else is paying the carrying costs.” He suggests that the perceived benefit of waiting for the perfect deal can be a costly illusion when LPs are bearing the management fees during the entire period of non-investment. This slow bleed, he contends, can significantly impact the fund’s performance, particularly in challenging market conditions.

Vintage Capital in a Slow Market

The post further delves into the current market environment, where GPs who raised substantial funds in 2021 and 2022 are now facing a dilemma. Valuations in the market have not declined sufficiently to align with the original investment theses for many of these funds. As a result, the capital remains uninvested, the fee clock continues to tick, and the net returns for LPs are quietly deteriorating.

“The GPs who raised massive funds in 2021 and 2022 are now sitting on vintage capital in a market where valuations have not corrected enough to make the original thesis work. So the capital sits. The fee clock ticks. And the LP’s net return quietly deteriorates while everyone waits for a market that may never arrive in the shape they underwrote.”

McCabe concludes by reiterating that while patience is indeed a virtue in investing, its value diminishes significantly when the costs are being borne by another party. His analysis provides a critical perspective on how industry standard practices, like the management of “dry powder,” can have substantial, often unacknowledged, financial implications for investors.