In general, when you see a lot of smart investors unable to make decent returns off some of the world’s fastest growing markets, you have to blame the investment strategy and not the markets.
And yet, in the water, alternative energy, and food markets (these days much less frequently referred to as “cleantech”), for years now we’ve seen the opposite. Ten years ago, innovation opportunities in these resource-efficiency sectors were treated as predominantly a commodity-manufacturing opportunity. And yet when that approach didn’t work within a VC context (most who track the sector have shown cleantech venture capital doing only slightly better than returning capital net of fees, overall), venture investors and their backers have tended to blame the markets for being too difficult, too slow, too under-appreciative of innovation.
The word got out among the large backers who typically provide much of the capital for private equity firms: Cleantech is “a noble way to lose money”, in the words of one. “Just because it’s a good idea doesn’t mean it’s a good investment,” declared the CIO of CALPERS in 2013.
Critics have pointed to a host of reasons why these markets and strategies have yielded such underwhelming returns to venture capitalists. Many are valid reasons which should inform investors about the need to change their tactics in capturing these opportunities. But with such broadly negative statements so often bandied about, these investors are collectively blaming the markets themselves, not the investment strategies. It doesn’t help that so much of this massive potential economic transformation has been defined as a venture capital play, versus other asset categories – VCs are pretty good at getting attention, after all. And so with that strategy the center of focus while underperforming, and broadly negative pronouncements being commonplace, it's unsurprising that many institutional investors have backed away from “cleantech” altogether.
It's a shame VCs have backed away from cleantech, because these markets are booming.
This is a shame, because these markets are booming. The third quarter of 2016 was an all-time record for solar power deployments in the U.S., for example. Microgrids (onsite power generation, batteries plus intelligent power control) are poised to become a major disruptive force in the electric utility market. LED lighting plus intelligent controls is already a multi-billion dollar, fast-growing market and is about to disrupt the overall building controls market (as every light fixture can now also be a little data-gathering computer). Market opportunities related to the water sector are expected to reach USD 1 trillion by 2025, according to GWI and RobecoSAM.
If your investment strategy can’t take advantage of such rapid growth opportunities, don’t avoid those opportunities. Adjust the investment strategy. But most haven’t done so.
A venture capital hangover
To me, this confusion and avoidance reflects more than anything else the hangover from a historical over-application of the venture capital funding model to these market opportunities. To be clear, there are some vital roles for venture capital in scaling up cleantech innovations. But too many startups in the sector have raised too much of their broader capital needs through this specialized financial structure.
It’s understandable. At the end of the day, solutions in these markets typically require deploying physical assets, actual projects. Even many of the software startups in the sector require being implemented into physical deployments, and so are eventually dependent upon someone financing and deploying hardware. This would seem to be a role where project finance would step in. But traditional project finance and venture capital haven’t been able to fill the gaps between them very well. Traditional project finance doesn’t go comfortably into the first (or even the fortieth) applications of new technologies, and it doesn’t scale down well into the kinds of distributed, smaller-size assets as with many of these new solutions.
And so, lacking an alternative, most often entrepreneurs have had to finance such asset deployment by raising even more venture capital. More venture capital means higher valuations, which means higher expectations, which means narrower exit paths and greater risk. Which leads to the underwhelming results to date.
Ironically, in today’s global low interest rate environment, where renewables do intersect with the traditional project finance model (such as with big wind farms, or big solar power plants out in the desert), the performance there has also been underwhelming recently. But that’s because investors have been so hungry for such opportunities that they’ve poured in capital and competed down the returns.
So we have the entrepreneurs at one end of the resource-efficiency market who are forced to use increasingly scarce venture capital to inappropriately fund project deployments, and at the other end we have tons of project capital desperate for new deployment opportunities. Clearly, there has to be a solution here.
And we certainly aren’t the only ones who have started seeing success in these markets by thinking outside the “venture” box.
And quietly, I’m seeing several groups of investors working on these solutions. Rooftop solar has given us a good example to follow in this regard. Developing ways for third party investors to pay for panels on rooftops (so: “no-money-down solar”) helped launch an explosive growth path for the solar industry. That’s because such financing is often necessary to make the value propositions of these innovations truly compelling. Customers for resource efficiency innovations are interested in good paybacks, sure. But are you asking them to pay a lot up front for those long-term efficiency gains? Are you asking them to bother their CFO and re-open a capital budget that has otherwise been a non-issue for years? Are you asking them to take on the brain damage of trying to piece together various technology pieces, paying for all of them up-front, when all they want is to save money while keeping the lights on, and to not have to worry about the details?
The early movers into deployment capital for rooftop solar made really nice returns, while unlocking dramatic market growth. And so we need more such investors, especially for the coming wave of other distributed (i.e., small scale), resource-efficient innovations.
For example, a few years back my own team was able to unlock a chicken-or-egg growth problem for a community-solar startup, Clean Energy Collective, by applying a hybrid venture capital plus early project finance approach: we gave them both, simultaneously. This not only helped provide the corporate equity they needed, it also gave them the development capital they needed to start putting projects in the ground, further accelerating their growth. So far, it’s worked out quite well for the company.
And we certainly aren’t the only ones who have started seeing success in these markets by thinking outside the “venture” box. Quietly, several groups of investors are exploring and launching new efforts to bring new investment strategies to energy, water, food and transportation markets. It’s just not getting nearly the attention that the latest social media startup gets, or even that old-style venture capital investments into these markets still get. But it’s happening.
Nevertheless, among much of the institutional investor community--the pension funds and endowments and sovereign wealth funds that are the traditional backers of venture capital and private equity--the word is still out that “cleantech” investments are bad investments. So the capital is scarce even for new investment strategies tackling these massive market opportunities.
Bill Gates is frustrated
This is frustrating to many of my friends in the venture capital community who quietly share with me their desire to figure out new ways to invest in resource-efficiency solutions, even while their firms feel forced to distance themselves from these markets. And who would love to have project capital available to help accelerate growth at their startups.
This is frustrating to many of the wealthy individuals and family offices out there who want to access and make an impact on these global challenges--hence Bill Gates and several others banding together recently to launch a new independent, billion-dollar effort. This is phenomenal to see, but it’s notable that it came to this.
This is frustrating to resource-efficiency entrepreneurs, of course. A decade after the “Green Wave” of cleantech venture capital funding launched a lot of technology invention, these innovations are increasingly ready for prime time. And so entrepreneurs have changed their tactics. Many have shifted from a focus on new “deep tech” to a focus on business model innovation: fewer breakthrough microbes, and more breakthroughs via microchips. They’re taking advantage of the last wave of such technologies, trying to figure out how to put actual commercialized, economically attractive solutions out there into the market at significant scale. To build successful companies, in other words, and to make an immediate impact on the urgent challenges of climate change, food and water scarcity, etc. And yet these entrepreneurs, now with revenue in hand and good growth prospects ahead, still have a frustratingly hard time raising venture capital.
And it’s frustrating to many of my friends in the limited partner community as well. The traditional investment models haven’t produced great results, yet they see the clear megatrends around resource efficiency and distributed assets. However, capturing these opportunities requires embracing new investment models and new investors, which is typically uncomfortable for such conservative institutions. And while individual managers at these institutions often see the long-term opportunity here, they may face organizational headwinds from negative perceptions about these markets.
What happens next
Shrewd investors will begin to cut through the lingering fog of negativity surrounding cleantech markets.
The good news is that sooner or later this logjam will break. The global opportunities are clear and massive. The frustration is almost universally felt among all the important stakeholders, and that’s unsustainable. What is needed are early examples of success from new investment strategies, which will embolden shrewd investors to cut through the lingering fog of negativity surrounding these markets. We’re now starting to see such successful case studies emerge. And the capital thus unlocked could be much larger than the last VC-centric wave. BloombergNEF estimates of distributed solar financing are many times the size of venture capital financing into the sector, for example.
The next wave of resource-efficiency investments will soon be here. And it’s going to be huge.
