Record Levels of “Dry Powder”

Peter Ward

Sales Analyst – VC & PE, Sales
Tuesday, Feb, 20, 2024
2mins

Why VCs Should Diversify Cash Investments

In the fast-paced world of venture capital firms (VCs), the concept of diversification extends beyond the traditional portfolio of start-ups to include the strategic management of “dry powder.” With VCs holding record levels of uninvested capital, the spotlight turns to diversifying cash investments. This approach transcends the conventional wisdom of spreading bets. It delves into optimising idle cash to enhance a fund’s resilience and growth potential.

The accumulation of substantial “free cash” during high-interest rate environments set the stage. The landscape then shifted as rising costs and a focus on unit economics challenged start-ups to grow based on the inherent value of their offerings. This shift has led to a cautious stance among VCs, who are reluctant to invest in businesses unable to demonstrate sustainable growth without continuous funding. The climb in interest rates increased operational costs for start-ups and demanded a more disciplined approach to growth, marking a departure from the era of growth at any expense. Consequently, the VC ecosystem finds itself at a crossroads, with significant capital on the sidelines awaiting opportunities that meet these new criteria for investment.

Navigating this environment requires a nuanced strategy for cash investment diversification, turning idle cash into an active participant in a fund’s success. The current state, characterised by unused capital amidst market fluctuations and uncertainties, underscores the need for VCs to ensure their cash reserves are safe and actively generating returns. By exploring strategic avenues for cash investment, this blog aims to guide VCs and their portfolio companies toward optimising their portfolios for durability and growth, making every asset, including cash, work harder for them in the ever-evolving venture landscape.

Why diversify?

Diversification protects against the investment world’s unpredictability, embodying the adage of not putting all your eggs in one basket. Diversifying cash investments serves as a critical defence against the volatility in the market. It’s about minimising risk, not just in the equity stakes of emerging companies but also with their excess cash investments.

The cash on hand for VC funds isn’t merely a static asset; it’s an opportunity to earn returns, even as they seek the next disruptive innovator. Diversifying cash investments bolsters VCs’ financial and operational efficiency, showcasing a level of fiscal responsibility that is highly attractive to limited partners (LPs), especially in a space where they’ve seen investments either burn quickly or stagnate. By strategically allocating idle capital into a variety of financial instruments, VC funds not only mitigate the inherent risks associated with their high-stakes venture investments but also demonstrate a commitment to responsibility for managing their cash and optimising returns.

By balancing the pursuit of high-growth ventures with the stability offered by diversified cash assets, VC funds enhance their operational efficiency and position themselves as prudent and attractive stewards of their LPs’ investments, navigating the unpredictable venture landscape with a strategic and balanced approach to risk and return. For VCs and their portfolio companies, diversifying cash investments is not merely a precautionary measure; it’s a proactive strategy to optimise returns across all assets, ensuring that every £, €, and $ contributes to the fund’s success.

Case Study: Working with a VC fund to diversify cash investments

Situation:

The VC fund is determined to minimise risk and maximise yield on their excess cash. To achieve this objective, the fund’s venture capital trusts (VCTs) needed a solution that would comply with their 80/20 investment rule. While 80% of the VCTs’ portfolios had to be in qualifying holdings as set out in HMRC’s Venture Capital Schemes Manual, the remaining 20% could be in highly liquid investments, easily convertible to cash within seven days. (Source)

Strategy employed:

To mitigate risks without sacrificing liquidity for emergent investment opportunities, the VC fund sought an innovative cash management solution to diversify its excess capital across several investment-grade counterparties, focusing on T-bills and secured investments within the permissible bounds of VCT-specific regulations.

Outcome:

The strategic diversification efforts paid dividends during a downturn in the tech market. By employing a balanced mix of stable, low-risk assets and exploring enhanced yield options, the VC fund maintained a crucial safety net and reported reduced risks and increased returns compared to previous deposit options and homes for its excess cash.

The success story extended beyond the VC fund, with portfolio companies adopting a similar approach to managing excess cash. This approach to managing cash enabled the VC-backed companies to extend their runway, minimise risk, and streamline their treasury operations.

Conclusion

The VC space is undergoing a transformative shift, compelling VCs to rethink their strategies and focus on sustainable growth. As “dry powder” reaches record levels, the imperative for diversifying cash investments emerges as a proactive and strategic move. For VCs, the call to action is clear: by implementing a diversified approach, VCs can minimise risks, increase returns, and ultimately drive sustained growth for both their funds and portfolio companies. Simultaneously for VC portfolio companies: by adopting a diversified approach to cash management, portfolio companies can minimise risk, extend their runway, and streamline their treasury operations.

*TreasurySpring’s blogs and commentaries are provided for general information purposes only, and do not constitute legal, investment or other advice.

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