Finding a better investment model
Rethinking Conventional Fund Structures
in a Resource Equity and Infrastructure Context
A SUSTAINABLE FRAMEWORK FOR SUSTAINABLE INVESTING
Matching Board Level Commitments to Sustainability
with CIO Level Commitments to Improved Investment Returns
Providing affordable energy, water, food and other material goods to a growing global population wanting ever better lives is challenging. Conditions, such as climate change – symptomatic of stretching our use of natural resources too far -- make that challenge more difficult. Addressing the challenge requires a mix of technology, capital of global scale and temporal patience, human leadership and effective policy and regulation. Global pension and institutional funds are increasingly making commitments to these objectives; but often without a plan to accomplish them consistent with other fiduciary investment mandates – such as financial return.
In addressing water, food and other material needs, energy is the master resource. It enables us to do the work to solve the other problems. Energy is also at the center of the divide between those who cling to the old order – an extractive fuel industry – and those taking us to a more sustainable future – an advanced energy economy. That divide, and its impact on keeping global carbon dioxide at levels conducive to our lifestyle, has fueled its own political movement – urging institutional investors to divest from fossil fuels. Divestiture is a very blunt instrument for a complex problem that cuts across many players and constituencies.
A far better strategy is to selectively off and on-ramp investments that reflect an achievable pace of change, a closer alignment of investor/manager interests, partnerships between newcomers and incumbents for scale and staying power, and investment structures more closely aligned to sought after outcomes.
The energy and water industries in particular are accustomed to 75-year change cycles. We have far less time than that to affect necessary changes. Most institutional investors are just now assessing their portfolios for systemic risk regarding resource and energy productivity. The changing nature of those risks is just now being priced into coal, oil and gas resources and has not yet been priced into a range of asset classes much broader than just energy production – for example industries that are large consumers of fossil fuels or those particularly susceptible to climate change consequences. Further, such risks are typically not addressed by conventional diversification strategies, but fall into the category of systemic risks to which our financial systems are particularly vulnerable.
Shortfalls of the Venture Capital Model
Venture investors began actively investing in clean energy technologies at the turn of the century and clean energy venture investing peaked in late 2008. After the recession, clean energy was slow to recover and the rise of tight oil and shale gas from fracking further slowed its recovery. Competition by China's active investing in wind and solar rapidly drove down costs of those technologies in the post 2008 period, but also created a level of competition that drastically cut profit margins and weeded out hundreds of venture-backed companies. Only by late 2012 had the carnage ended and a much smaller, but also much more capital efficient, solar sector began its turnaround. Other clean energy sectors are still progressing through these challenges.
By then, several painful lessons had been learned about the shortfalls of venture investing as applied to the clean energy sector. Most of these lessons apply broadly across the sustainability sector and do not differ materially from lessons learned earlier in investing in semiconductors, computer memory and tele- and data-communications equipment – all industries that required inventions of new technology, development of manufacturing processes, scale-up of manufacturing and development of global supply and distribution channels. Venture returns from those hardware-centric technologies all have disappointed compared to the returns achieved from investing in enterprise software, Internet and mobile telephony software and applications and the new business models enabled by those technologies – all better suited to the conventional venture model.
Better for mid-term focus. The current venture model traces back to the 1970's. It found its stride in the growing tech boom and the success first of enterprise software companies, then Internet companies and currently social networking companies. Typically, a company absorbed $50-200M in getting from startup to IPO or other positive liquidity event. In a $200-400M fund, a dozen investment professionals would put that capital to work over a three to four year period. They generally reserved about a third for follow-on investments. With the ability to see liquidity from M&A or IPO's within 5-7 years, and thereby "complete" an investment cycle in roughly 10 years, the current model is ideal. For their work, the investment managers typically received a 2% management fee and 20% of the upside they produced. Unfortunately, the typical 2/20% and ten-year fund model is not an optimized vehicle for the task at hand if that task is building the underpinnings of a clean energy infrastructure for the planet.
First, the $200-400M scale is simply too small to invest in a diversified set of companies each taking $300-500M to get to liquidity. Yes, one can build massive syndicates of a large group of smaller investors, but history indicates that only investors with 10-15% or larger positions in companies effectively and actively manage those investments through Board seats and broader fund involvement in a portfolio companies partnering, finance and exit activities. Smaller investors can often cost effectively "go along for the ride," but absent a strong lead or two, most such companies struggle in difficult times. So larger funds are called for in technology, manufacturing and global scale industries, such as clean energy infrastructure.
Second, the compensation structure of the venture model requires investing in companies that can either grow at greater than 50% per annum growth rates or generate high product gross margins (i.e. 75% or better) to cover the 2% management fee and 20% carried interest typical of those funds.
The current venture capital model was built for capital light, shorter-term outcomes based on deal-flow, market inefficiencies and preferential access. It was loaded with fees and carry only possible with technologies that met the capital, timeline and outcome expectations for which the model was built. The ramp-up period required to develop a new hardware technology, develop a pilot manufacturing process, scale that process and obtain attractive financing for scaling up production and sales in a global market provide neither the growth rate nor the gross margin needed to make the venture economics work.
Sub-scale for industry. The last decade in sustainable investing has been focused on building wind power companies, solar companies, battery companies, biofuels and biochemicals companies, waste to energy companies, smart-grid companies, electric car companies and LED lighting companies. Every one of these involves a highly inventive early period, followed by building a demonstration scale manufacturing facility. If successful, that is followed by building a full commercial scale manufacturing facility. The output of that full scale facility must then be field tested, trialed, demonstrated, piloted, and ultimately acquired at scale. Before scale can be achieved, companies must typically accomplish "bankability" for their product, meaning that commercial lending can be used in the manufacturing process and in product deployments. Last, because these companies are all competing to provide a unit of output (ie. electrons) at the lowest possible cost, they represent convergent competition; there will be a small, not large, number of winning players.
Getting a company from startup through that invention, scaling, manufacturing and commercialization process requires from several hundred million to several billion dollars. For investors who typically target holding 8-15% positions in mature companies in the normal venture model, that means the ability to invest from $40M to $300M in a company over its pre-IPO life. Multiply that by 20-25 mature investments in a diversified fund and you require fund sizes of from $1Bn to $7.5Bn in size. Even at that size, you need 5-7 funds to team together to get an investment to the finish line. In a competitive industry, with downward margin pressures, where a few players are likely to dominate, access to large amounts of affordable capital can mean the difference between success and failure – more so even than better technology. The massive amounts of low cost capital provided by the Chinese government in the wind and solar industries is an excellent example of using capital to "win" an industry. In that environment, venture-backed U.S. and German solar companies simply could not keep pace and the result for their investors was accordingly disappointing.
So, if we still must invent or scale new sustainable technologies, potentially including new nuclear plants, carbon capture and sequestration or other technologies, we would suggest that someone first must solve the scale of capital requirement vis-a-vis current fund structures. Most of the biofuel and biochemical companies funded by the cleantech venture industry remain trapped in a "valley-of-death" where they have exhausted the capital supplies of their venture backers, but have not yet achieved the market scale to obtain lower-cost financing for building additional manufacturing capacity and bringing new products successfully to market. Given the current low costs of oil and natural gas, many will remain stranded in that valley for several more years. To get out, they need access to larger and more patient pools of capital than have been available to them. Yet younger technologies, such as several nascent nuclear technologies, face similar daunting challenges even before they approach that scale-up valley-of-death.
Fortunately, we have now finished building quite a number of "bankable" clean energy technologies. These technologies, such as wind power, solar PV and electric vehicles are being purchased in ever greater numbers and are continuing to drive down the equity and borrowing costs needed for their large-scale manufacture. A number of these businesses have become relatively large publicly-traded companies with access to lower cost capital and staying power in the market. They may represent attractive investment opportunities for those willing to hold them long enough to see the full growth of the clean energy industry play out over the next 20-30 years. Unfortunately, for the Limited Partners (supporting investors) of the venture funds that backed these companies, most of the shares have long ago been distributed and sold.
We have, however, arrived at a time where new "applications and solutions" technologies are now being built to market, sell and manage wind, solar and battery deployments, EVs, LEDs, etc. These technologies involve business model innovation, software and networking capabilities. They bring us back within more traditional venture investment models. To the extent GPs and LPs understand this distinction and focus appropriately, these types of investments are well positioned to produce attractive venture returns from the more traditional venture investment model.
Controversial fee structure. Much has been written about the fees paid to venture and private equity managers. In comparing investment outcomes it is only appropriate to make those comparisons net of fees paid. Fees, however, need be broken down between management fees paid annually to support the operating costs of the fund – which are largely paid irrespective of performance; and carried interest – which is the portion of capital gains or distributions the manager may keep as profits.
As fund sizes increase and holding periods lengthen, a 2% management fee becomes much harder to justify given actual workloads. There is a strong and appropriate desire not to allow GPs to "get rich on management fees." These concerns are well dealt with by funds moving to a budgeted fee structure in which appropriate compensation ranges and overall staffing levels are agreed upon annually or in advance. This doesn't mean paying below-market salaries, it just means making sure that a) the fund can recruit the high level talent while b) making sure incentives are properly aligned so both GPs and LPs are focused on making money from long-term capital gains.
The second component of venture capital compensation that receives a lot of scrutiny is the level of carried interest paid on fund returns. Typically this represents 20% of profits generated over the life of the fund, but it can get higher, approaching 40% for funds with outstanding track records whom LPs believe will continue to produce at that level. A number of articles have been written suggesting this level of compensation produces net returns to LPs that are lower than could be achieved by the LPs making such investments directly and with their own teams. (See Note 1). A closer examination suggests these complaints may have merit as applied to Hedge Funds and some Infrastructure Funds, both typically investing in asset classes designed to produce S&P beating, but lower than private equity expectation, levels of return. Two recent studies have come to the exact opposite conclusion when looking at private equity and venture returns (net of fees) as compared to net of fees returns from other asset classes (see Note 2). These studies suggest that the private equity class, at least for the largest LPs, still outperforms other asset classes.
Studies that have focused on these questions suggest that the "best" private equity and venture funds appear to: a) have access to preferential deal flow as compared to the rest of the market, b) may, by their recognition and prior track records, attract enhanced valuations for their portfolio companies in both private and later public rounds, c) may have preferential access to potential management team recruits, potential strategic partners, and to better media and PR coverage for their companies, d) may provide more sophisticated and experienced Board members to oversee their portfolio investments, and e) may provide a range of other portfolio company services simply not possible at smaller or less successful funds.
These distinctions are real and they justify the spread in carried interest compensation and provide meaningful differences in results made possible by the venture capital and private equity model over direct investments in the same asset class.
Note 1: http://www.economist.com/news/finance-and-economics/21629560-big-pension-and-sovereign-wealth-funds-are-cutting-out-middleman-house ; http://www.top1000funds.com/wp-content/uploads/2015/07/Re-intermediating-investment-management.pdf; and Fang, L. H., V. Ivashina, and J. Lerner. (2015). “The Disintermediation of Financial Markets: Direct Investing in Private Equity.” Journal of Financial Economics.
Note 2: Calpers’ Private-Equity Fees: $3.4 Billion (chart shows that CalPERS Private Equity investments, net of fees, has outperformed all other asset classes by more than 4% per annum), http://www.wsj.com/article_email/calpers-discloses-performance-fees-paid-to-private-equity-managers-1448386229-lMyQjAxMTE1MjIzNTgyMTUxWj Robinson, D. and B. A. Sensoy. (2011). Do Private Equity Fund Managers Earn their Fees? Compensation, Ownership, and Cash Flow Performance. Dice Center Working Paper ("Overall the data offer little support for the view that private equity management contracts allow GPs to charge excessive compensation for the performance they deliver."); The Alpha and Beta of Private Equity Investments∗ by Axel Buchner†; University of Passau, Germany; October 24, 2014;
More than one asset class. Investing in the transition to clean energy and to a more sustainable global economy means straddling several conventional asset classes, specifically venture/private equity/public equity and project finance/infrastructure. Because these changes involve replacing a centralized energy generation, transmission, distribution and management infrastructure with a new distributed and real-time managed infrastructure, the investment opportunities include not only the invention and development of the technologies but also the finance of the manufacturing facilities for and the deployment of these technologies. Developing the technologies but lacking the capital to manufacture or deploy them at scale is a fool’s errand -- yet one pursued by most clean technology venture funds over the last 15 years.
Several funds tried to address this problem by combining technology and infrastructure investments into a single multi-purpose fund vehicle. These proved disappointing, because they mixed a focus on current yield with one on long-term capital gains and under-produced in both regards; because the underwriting decisions of the two asset classes are different and require different skills; and because the timelines, and the return profiles involved, failed to sufficiently overlap. A better alternative would have been to keep the asset classes and underwriting decisions separated into individual funds, but align them closely in having each understand and work with the other in terms of deal flow, company and technology assessment and understanding of overall capital needs.
To develop the desired technologies and deploy the needed infrastructure, we will need ALL of these types of financing (in each case we have provided target return levels to compensate for the level of risk taken):
1. early stage high risk technology development R&D and venture funding (20-30% IRR target);
2. growth equity to support the scale up of the technologies and development of initial manufacturing facilities (15-20% IRR target);
3. a viable public equity market to support the further growth and market penetration of the leading technologies (5-7% IRR target);
4. project capital to support the building and scaling of manufacturing facilities (such as provided by DOE in its loan guarantees)(12-18% IRR target, with current yield);
5. pre-bankability project and infrastructure finance to fund the earlier deployments of the new technologies (8-12% IRR target, with current yield);
6. post-bankability funding through instruments like Green Bonds and YieldCos to drive deployment to mass scale (4-6% IRR target, with current yield) Successfully making the transition will involve the development of the full finance ecosystem.
There are indications family offices and corporate investors are increasingly willing to pursue category a) of early-stage funding. We expect that as technologies mature and markets develop, a healthier public equities and IPO market will develop for these technologies. Similarly, the Green Bond and YeldCo markets, while far from mature, have expanded greatly over the last five years and seem capable of continuing to absorb additional capital over years to come. The still underrepresented segments, but as a result also those with the potential to provide the most attractive returns, are growth equity and earlier stage project and infrastructure capital. It is the lack of capital in these asset classes that today creates the deepest "valley-of-death" for clean energy and other sustainable technologies companies.
It is also these asset classes we feel are most in need of business model innovation to create investment institutions and contracting models that provide attractive risk adjusted returns from those willing and able to pursue these investments.
Insufficient track record. Fifteen plus years of venture investing into the asset class typically referred to as "CleanTech" has produced less than a handful of post IPO success stories. The names that come to mind include Tesla and Solar City. They might also include SunPower and First Solar, but those companies raised more of their money from family offices or corporate investors and are less representative of venture fund success. Some, notably Nest Labs, have been acquired for multi-billion dollar exits. But most of those that have progressed to the liquidity of an IPO continue to languish in less than rewarding levels of market return – including companies like Amyris, Codexis, Control4, Crystal Springs Networks, CREE, Echelon, EnerNOC, Goldwind, Green Plains Renewable Energy, OPower, Renewable Energy Group, Solazyme, SunEdison, and SunRun.
Virtually all (SolarCity, OPower and SunRun as exceptions) faced the difficult challenge of developing a novel technology, demonstrating it at pilot scale, building manufacturing capacity and ultimately bringing commercial quantities of product to market. Many are still very much a work in process. But at least they have progressed to a potential investor liquidity stage – albeit years later than originally expected. Most of their peers remain in the anonymity and capital starved world of private growth stage cleantech companies. Many of those have made very considerable progress with their products and technologies over the last ten years but have seen little to no valuation rewards from those gains.
Their investors have learned many painful lessons and earned no economic returns on a portfolio of these investments. Statistically, it would be difficult to show that any group materially outperformed any other on the positive side – those having both Tesla and Solar City in their portfolio being the happiest. That leaves new potential LPs with a difficult challenge, do I put my money with entirely new investors or teams (who at least have no negative track record)? Do I bet on the benefits of experience and overcome the challenge of a prior track record? Do I bet on those who have successfully invested in other energy technologies to move to clean energy? Or do I just sit on the sidelines hoping that time (or someone else) will solve these questions?
Most institutional investors have chosen this final position, but the risks of remaining on that sideline continue to mount and we would suggest that most investors must find a better answer than remaining passive.
Focus on premature liquidity. Due to the typical ten-year fund life, most investors are struggling to get their portfolio companies to sufficient valuations to justify getting an exit within the ten to twelve years that LPs typically allow for portfolio investments to mature. This is something venture investors in biotechnology companies have struggled with for decades, as successful biotech companies often require twenty plus years to get from their Series A to an optimal public exit after developing a blockbuster drug. Often investors who invest in those companies at their IPO do better, from an IRR and cash-on-cash standpoint, than investors who came in as part of the Series A but had to sell on or soon after the IPO. Similarly, most LPs in those funds sell shares received on distribution; so they too miss out on the best performance of the companies they were once meaningful investors in.
If we are building the world's energy, water and food infrastructure for the next 100 years, then investing only in the first ten years of the lives of game changing companies seems shortsighted. To some extent that can be said of each great wave of technological innovation, as companies like Microsoft, Cisco and Apple Computer were better investments for their post-IPO investors than their early private investors (over comparable holding periods). With energy, many large institutions have held decades-long positions in companies like Exxon, Chevron or major utilities like PG&E or Duke Energy. If these are being replaced by a new generation of energy infrastructure players, why should GPs distribute (or LPs sell) their ownership of these seminal companies so early in their corporate life?
In the traditional venture model, the assumption is that the greatest rates of growth (and the greatest reductions of risk) occur in those first 5-7 years post Series A investment. Where that holds true, it makes sense for GPs to "recycle" their dollars and restart the process with a fresh group of companies. But what about those situations where risk reduction and valuation don't appear to be in lock-step or where the steepest part of the valuation curve comes later in a company's life?
Those seem to call for a more deep-pocketed and patient set of investors. Frequently that can be individual and family office investors, but the scale at which they participate would best cover an earlier "valley-of-death" namely that between university research and the traditional venture model, not the many hundreds of millions of capital required to cross the manufacturing/commercial scale-up valley that most sustainability technologies become mired in.
Given an adjusted structure this would be an ideal place for larger institutional investors to participate in a more "evergreen" fashion, allowing them to establish long term holding positions in the seminal energy technologies being developed. However, the current venture structure remains challenged in providing both its GPs and its LPs the benefit of taking the early investment risk in these technologies.
Shortfalls of Institutional Direct Investment
There have been an increasing number of commitments to sustainable investments over the last several years. That is good. But these “commitments” risk falling into one of two far less beneficial categories: a) an announcement not backed by an actual requirement that dollars be spent, or b) an extrapolation of dollar flows (almost exclusively into large infrastructure investments) already occurring and therefore not reflecting any new commitment level. Pension funds and institutional investors frequently end up in the former and corporations and investment banks frequently fall into the latter. Unlike commitments to new venture, hedge or private equity funds, there is no "skin" in this commitment game. There is no delegated investment authority, no payment of salaries or fees to a team dedicated to finding or making these investments and no agreed upon economics to reward anyone for getting them done. Instead, these “commitments” are really a willingness to engage in a dialog about what types of investments might be of interest.
Why are institutional investors in particular so reluctant to make real commitments to sustainable investing? A significant reason is the lack of track record represented by the great majority of investments made so far (see Shortfalls of the Venture Model above). Another reason is many of the funds to whom large commitments for building out energy technologies or infrastructure have historically been made are the same private equity funds that have led investments into coal, oil, gas, fracking and tar sands; not the most likely players to actively lead change. Last, several institutional investors have said that they simply do not want to take the risk of being the first to make a meaningful new commitment into an unproven and previously unsuccessful asset class. This last reason is further strengthened by the overall compensation schemes common among institutional investors, ones that discourage taking risks and reward staying close to a benchmark of behavior set by their similarly conservative peers.
How do we turn these "commitments" into action? For the reasons set forth below, it is unlikely direct investment programs by institutional investors themselves will produce a different outcome:
Reluctance to act strategically. A strategic investment commitment of the type needed to move the needle on climate change must originate at the top of the organization. Only the CIO, the CEO and Board typically can envision, craft and execute such a new strategic direction. This is a problem the corporate venture industry has similarly struggled with, as most corporate venture funds are tightly linked with various business units, often those most threatened by the new technologies, and the venture units act as technology scouts (making early small dollar investments that provide exposure to the future) but fail to act decisively to take larger positions or acquire the technologies their corporations most need. The risk/reward nature of the key decisions is such it is best left to the CIO, the CEO and the Board, but that also means there can only be a few key decisions as the time availability of those executives is highly limited.
A large institutional investor is by nature highly conservative. Maintain this level of conservancy throughout a large organization requires a system of checks and balances and limitations on authority. Those structures inherently favor the status quo over change and do much more to punish bad risk taking than reward good risk taking. To further insulate themselves from risk most institutional investors turn to outside consultants to provide support for new decisions and directions. Although these consultants can provide support for new strategic directions, they too have learned that it is better to be rewarded for conservatism than be punished for erroneous activism. Like major corporations and oil tankers, large financial institutions are much better at gradual course corrections than at showing nimble leadership into new directions.
Some institutions and governmental agencies are now beginning to recognize that these very same “conservative” patterns are those that fail to protect these organizations from “systemic risk” of the variety that we saw with the “sub-prime real estate and banking crisis. Since we first drew the analogy between that crisis and the carbon bubble that we are addressing here, a growing number of commentators have drawn the same comparison and pointed out the need to change institutional practices to better address such systemic risks.
Absent such institutional changes, to assume that investors will individually act otherwise is to assume action when there will be delay. Therefore assuming institutional investors will take the lead, not only in making direct investments, but in making them into new, risky and unfamiliar technology areas is a naive assumption by those suggesting this path.
Wrong compensation structure. Forty-four percent of the $8 trillion in U.S. equities are now held by institutional investors. The management of those equity securities is split between passive buy-and-hold strategies designed to mimic a particular index and "active management" in which internal or external managers are compensated based on how they perform compared to a benchmark, often the S&P500. The problem with that construct, at least as applied to a basket of publicly traded securities is that the active managers are collectively engaged in a zero sum game in which the gains of the winners exactly match the losses of the losers. Add in fees and the whole game becomes a negative sum game. On average, managers will not only underperform the market, but do so by a fairly large margin while a small percentage of managers does meaningfully outperform (the 80-20 rule in action).
More and more portfolio managers are being compensated on this benchmarked standard. That brings with it some serious flaws. One is that the ultimate portfolio owner cares about actual performance – did I make money; while his hired managers might make a bonus even while losing money, provided he/she beat the performance benchmark. In a world of publicly traded equities, this results in a fairly conservative set of managers who are largely incented to avoid losses more than to take risks.
Many pension schemes are underperforming the expectations of the politicians that oversee them and the pensioners who rely on them. That puts most pension funds into a conundrum for deciding how much to pay their top investment staff. Even when they want to hire the best possible staff — by paying the salaries and bonuses private sector professionals are used to — they are inherently limited by needing to meet budgetary restraints. For many of the world's largest pension funds, who are specifically looking to increase their hiring of in-house investment professionals as a way to reduce the fees paid to external asset managers, these budgetary limitations make those objectives unattainable.
Logic would suggest highly-talented investment managers, with attractive track records, are the individuals most likely to increase pension fund assets. But, not unexpectedly, these individuals require high compensation levels relative to others in their field. While politicians and taxpayers may view the role of pension fund employees as a public service, those very pension employees are often the first to realize that high compensation, particularly in incentive pay, is the norm in the investment profession and necessary to obtain the desired positive results.
All of this becomes even more challenging in the private equity and venture world. PE and VC are much less zero sum games – there is no broad benchmark and in given sectors and in given vintage years entire fund classes can greatly outperform or underperform. Nor is there a defined set of investment opportunities, managers cannot just pick from a known set of public equities or indices. Instead there is an almost limitless supply of potential investment opportunities, each with far less track record and public information to it than those public securities or indices. Often, the personal skills of senior executives are far more important than traditional measures of financial performance. Access to the best deals is often restricted to a limited group of preferred investors and investment decisions may have to be made "on the fly" or at least in very limited time frames. These are new or foreign skills to most pension asset managers. Not that they cannot be learned, but, as is often said in the venture industry: "it takes about $50 million in losses to grow a good new investment professional" – a standard few public pension executives are likely to want to expose their staffs to.
Even though the current institutional direct investment model has theoretical access to scale, it rarely deploys the capital available to it. Most pension funds admittedly lack strength and depth of team for venture or private equity investments. Rather than lead investments, direct investment teams often play the role of late stage capital for still nascent venture portfolio companies they know through their existing venture fund relationships. Direct investment teams are also frequently presented not with the “A” but the “B” deals, because the venture managers were themselves able to fund their "A" deals. In an industry where only the A’s survived and only the A+s made attractive returns, getting B deals was a lousy value proposition.
For all of those reasons, we see it as unlikely institutional investors will choose venture and private equity as places to initiate internal investment teams at scale. The lower risk places to do so are in public equities and infrastructure investing and then progress over time to the higher risk categories.
Lack of adequate teams. In theory any major institutional investor could hire a full-fledged team of highly skilled venture capital or private equity investors and run its own fund to successfully compete with Sequoia, Kleiner Perkin, Andreesen Horowitz, TPG, Silver Lake, or Generation Investment Management. In practice no one has yet done it. Why? Because these institutions about more than their compensation structures, their staffs or their capital. They are about an approach to investing, to business and to value creation that involves a unique business culture and a high need for both independence and the ability to build and maintain a unique brand.
Several institutional investors have hired a handful of investment professionals who come from the venture or private equity sector. The same can be said for family offices and corporate venture funds. But when one asks the CEO of a hot new entrepreneurial technology company who they would like as their lead investor, those names do not show up on the list. The exception is family office funds run by individuals who themselves were highly regarded technology executives – Peter Thiel coming to mind as one example. Only when we talk about later stage rounds where large amounts of capital are required and a fully functional Board of Directors and lead investors is already in place do people mention the direct investment teams of these larger institutions.
That doesn't make a capable in-house team impossible, but it again suggests the odds are stacked against you and a new and difficult asset class might not be the best one in which to run a test case. Doing so would also require that you can meet the compensation needs of the team and their desire/need for both speed and autonomy in making investment decisions.
Obviously with the right level of commitment and time, the task can be accomplished. In the corporate world, Intel Capital is a good example. After being in business for over 20 years, the fund is now one of the largest venture investors in the world and seems capable of competing for some of the best deals. But we need answers that will work now, not in 20 years.
Adverse to nature of risk. Why do small entrepreneurial business outcompete large incumbent corporations in new technology markets? For the same reasons small, focused venture units outcompete large private equity shops for financing those hot entrepreneurial startups. Startups don't have as far to fall as large corporations. Call it they have nothing to lose, or call it an ability to keenly focus when everything is on the line. Either way, startups take risks that bigger businesses don't and probably shouldn't.
Historically, the venture industry is an 85/15 not 80/20 proposition. Roughly 15% of your investments return 85% of your gains. Maybe as much as half of your investments will lose you money. Many investment look like losers for years before turning the corner. Most don't pencil out if you ran a rational set of numbers reflecting the odds of success.
If you are not comfortable operating in that environment, you probably shouldn't play. Success relies heavily on pattern recognition and pattern recognition comes from seeing lots of failures and enough successes to see repeating patterns of behavior. That education isn't taught in school, it comes from yourself starting, running, sitting on the boards of and investing in these companies. Often the very people good at these types of businesses are a threat to a larger, more stable corporate environment.
That is part of the reason companies like Google (Alphabet) and Facebook are increasingly leaving their new acquisitions as independent companies rather than rolling them into the corporate parent. As the saying goes: “If you want to travel fast, travel alone; if you want to travel far, travel in a pack.” Over time scale typically wins out, but accomplishing large moves in short periods of time favor the small. Large institutional investors seeking to create a successful venture team would be wise to consider a similar model.
Lack of Oversight Skills. Even where institutional investors have formed direct investment teams, they have typically avoided taking board seats, instead relying upon GPs in which they have fund investments to act as the lead investor. By doing so, they allow their professionals to become good at two key skills – deal due diligence and investment decision (do I invest or not) – but they avoid having to become good at deal sourcing, pricing of deals, board management, corporate partnering and M&A and other exit decisions. All of those are typically learned over many decades, which is why many of the most accomplished venture funds will assign their most senior partners to the board seats of their most valuable companies.
There really is no substitute for time and experience for the board level responsibilities of overseeing entrepreneurial companies in new market segments. Can those be found in the open market? Yes, to some extent, because companies themselves frequently recruit outside directors and those same outsiders might be recruited by an institutional investor to act on their behalf. But ask most experienced venture capitalists and they will point out there is a significant difference between the mindset of an independent director and that of an investor/owner board member. It is often a level of accountability those same experienced people seeking independent Board seats no longer want when they more to an independent role.
If institutional investors are going to lead investments these broader roles cannot be assigned away – they are core to the investment outcome and must be core to the skillsets brought to bear.
No Clear Commitment. There is a meaningful difference between having access to a pool of capital and having accountable responsibility for investing it. Most direct investment teams have access to capital and are compensated for properly deploying it, but they are not held accountable for deploying X dollars over Y time frame, the way an independent manager typically is.
In-house teams will be more conservative, will find deal flow from amongst the venture funds they have already made LP investments in and will make later stage investments on an opportunistic basis. All are sound judgements and have typically produced a reasonably good set of results for the institutions that have fielded strong direct investment teams.
But making a commitment to invest X hundred million dollars over the next 3 to 5 years is a different proposition and is one we have seen few institutional investors willing to make in the sustainability area. Our experience has been most large pension funds and other institutional investors will negotiate hard for co-investment rights and will suggest they wish to deploy almost as much capital directly as they do through LP relationships; but when looked at years later little of that "committed capital" was ever deployed. From a conservative standpoint, that may be a good result. From the perspective of moving the needle regarding deploying a new clean energy infrastructure, it is unlikely to accomplish the desired result.
Designing a Better Sustainable Investment Model
Accelerating the transition to a more sustainable global economy means developing new ways to channel money from investors to the companies leading that transition. Although it is virtually impossible to drive investment model changes in industries currently experiencing success, but industries at the bottom of a business cycle, or undergoing transformational change, are both well suited and generally amenable to testing new investment models.
Investing is by definition a risk/reward game. We know that our failure to act upon growing CO2 concentrations, to address potential stranded assets in fossil fuels and to adopt more sustainable practices with water and natural resources generally exposes us, as investors, to systemic risk. Coal indices in the U.S. have lost more than 95% of their value over the last several years. Both oil and gas have moved substantially lower, meaningfully deflating the overall scale of the carbon bubble. Carbon Tracker reports as of November 2015 there were still $2.2 trillion of potentially “stranded assets” sitting on investor books. The recognition of these risks have fed a fossil divestiture movement that now includes investors holding $3.4 trillion of assets. It is clear that many investors are increasingly uneasy about maintaining a “business as usual” route.
The simple realization that change is needed does not dictate the timing or strategy for change. The unknowns are leading most prudent investors to engage in some level of divestment and some level of engagement with their portfolio to mitigate secondary exposures. A very few have even designed hedges to protect themselves from a further acceleration in fossil write-offs. But on a global scale, virtually no one has acquired a matching level of clean energy or sustainable portfolio assets to match the distributions and losses taken on the carbon side of their portfolio.
One reality is that the asset classes at risk are too large and the asset classes to which one might want to migrate too small to allow the majority of investors to safely make that transition. Most investors will ride their existing carbon-heavy investments down before they do anything to invest in the stuff that goes up when carbon goes down. As a result, significant global investor asset value will be lost.
A look back at the sub-prime crisis tells a similar story: investors were slow to move, when they finally moved, it was too late; almost everyone lost a lot of money. On the other side of the equation, only a tiny number of investors had bet appropriately on what would go up – they reaped extraordinary profits, but net losses far exceeded net gains. Energy is not likely to paint a very different picture, particularly as today the number of eligible upside opportunities is dwarfed by the scale of those with downside.
That makes sustainable investing ripe for investment vehicle innovation. Transformational changes are easier in a world of flux than in a world of comfortable stasis. Flux is favorable way to describe the disarray that reflects the sustainable investment community today. All agree we must go forward; all concede the previous models and practices were unsatisfactory, all acknowledge that time is running out, but few agree on how to proceed – a perfect time to take the risks of trying something different. Right now, represents a unique opportunity.
The following represents a summary of our views with regard to changes that make sense. Note that we have provided a much more detailed version of these changes to our investors at Resourcient Capital Partners (please contact us if you would like to discuss those):
Pool Capital Sources. Bringing together a meaningful number of like-minded investors and/or institutions each sharing the risk of taking this new step and each getting some political cover from including important others is an important first step. Relatively speaking, it is also the easy step. The hard step is to give one entity or a small group of entities the delegated authority to actually invest those “pooled commitments.”
It is also important that the pool be large enough to have both an impact and have the staying power to deliver investments to a happy conclusion. Individual companies of the type that need such support have already shown that some of them need to absorb as much as several billion dollars of capital before they can profitably stand alone. If you don’t have the capital to finish that journey, it isn’t clear why it would be intelligent to start it.
Create a Staged and Managed Set of Capital Flows. Although a larger overall pool is a major risk reducer, a system that draws down capital for specific focused investment strategies, or for specific “investment themes,” each a few years in duration, can further both reduce risk and provide helpful focus for delivering positive early returns.
We are of the view that success breeds success and in a world where investors are highly skeptical based upon historic disappointment, we believe it is important that early investments from the pool be particularly focused on creating nearer-term financial success. Obviously a range of technologies and stages of investment need to be supported, but if too much of the early capital goes to creating yet another crop of “hungry mouths” for later stage and expansion and deployment capital, then we have increased rather than decreased the problem.
Therefore careful staging and centralized management of cash flows and the thoughtful building of a pooled portfolio are all critical ingredients of success. Risk can be managed by limiting early investments to companies that have already completed the development and market testing of their technologies and are at the growth, deployment and scaling phase. Investment themes that fit the risk profile today include deployments of microgrids and community solar, and a broad range of smart-grid deployments focused on energy efficiency, storage management, demand management, virtual power plants, vehicle charging and integration of wind and solar.
Align Team with Task. The limited number of prior successes and current level of investor disarray means that a new team backed by sufficient capital, focused on a carefully vetted theme or strategy can readily establish itself as the category leader. Due to the combination of factors that have exhausted the capital supply of most existing players and a mediocre track record for even the best and most seasoned funds, it is actually possible for a new entrant to establish itself at the top of the food chain and obtain preferential access to the best of deals.
Given that capital is needed for R&D, for scale-up, for manufacturing and for deployment, the overall capital pool should be divided amongst these categories in a fashion that provides both for the capital needed by a company as it migrates from one capital pool to the next, but also in recognition that the skills and experience of investment managers for each of these pools differs. History suggests that it is prudent to retain separate underwriting/investment processes for each purpose-oriented capital pool and recognize that they will represent different risk/return profiles. Ideally, however, the overall pooling effort and upper level management thereof allows the underwriting decisions of each pool to guide the risk/reward assessment of the other.
Assemble and Properly Compensate Expertise. Due to downsizing and reconfiguration at pure “CleanTech” funds and at broader-based venture and private equity groups who once focused on “CleanTech,” now is the best opportunity in a decade to pull together a great team of the highest individual capabilities. So far, not a single one of the pooled commitments announced, has hired its own expert staff to manage actually making investments. Without a team charged with deploying the dollars, monies will not flow in anywhere near the needed volumes.
The companies the pooled capital will be investing in involve deep technology expertise across a wide range of fields, their manufacturing processes and scale-up similarly require deep yet different expertise and their deployment through power purchase agreements and utility-scale contracts requires yet a different expertise. Very little of this expertise exists within the internal organizations contributing to any of the capital pools. As many of these companies are operating in nascent industries, they will rely heavily on the expertise of their Boards of Directors and the experience represented by the key investors on those Boards.
Assembling one or more high caliber teams to find, make, manage and scale these investments will be a critical component of success. Although insufficient capital was a component of failure, providing such capital is by no means an assurance of success. Building that success requires finding investment managers that have, on a now global basis, the same level of expertise as the investment managers that led the transformation of the computer industry thirty years ago and the data communications industry twenty years ago.
Achieve Scale Comensurate to Task. Individual companies within the subject industries have required upwards of two billion or more to achieve sustainable levels of profitability. Most can do with less, but to assume needing less than $500 million to fully scale a wind company, solar company, industrial biotechnology company, battery company, etc. would be imprudent. Most pools would want to see at least 20-25 investments to assure diversification of risk. Given that there are few other investors to lead these deals, a pool would need to be in a position to take the lead investor role and might need to supply 25% of the total capital in a company, or more. Twenty investments at $125 million per company would mean needing a pool of $2.5 billion just to create a single portfolio. Creating a syndicate to successfully move a number of these companies forward would likely mean several pools each in the $2-$4 billion range.
In addition, the capital pool must be patient enough (or have sufficient longevity) to see these investments through to a (hopefully successful) conclusion. We have seen that ten year funds were insufficient to accomplish that with investments made in the 2000-2008 time frame. Today there are mature companies for which a smaller amount of capital (and fewer years) could get them to the finish line, but any pool seeking to make new earlier stage investments would need to set at a minimum a 15 year or longer time frame till exit.
This is best accomplished by providing access to a capital pool that is both large and patient enough to see these investment opportunities through to full scale success. Fortunately, most larger pension funds and institutional investors today desire to deploy capital in fewer larger chunks to a more trusted and smaller group of GP’s – typically in $100-$200M increments. That implies $1Bn plus fund sizes. Given the scale of the energy industry a fund of that size is not large, yet it is something only a very few prior sustainable investment firms have accomplished – and only under very conventional fund constructs.
Investor On and Off Ramps. We would suggest a defined set of on and off-ramps to allow other investors to join a pooled program over time and to recognize that some investors may need liquidity along the way. As success and learning increase, investors can form direct relationships with participating managers. New investors and teams can be brought into the construct. Ideally an evergreen fund structure with a process for creating liquidity over time, but also retaining the ability to manage investments over a longer period will be required to achieve the desired transition to a sustainable economy.
Alternative Measures of Success. Last, we would suggest that these pools examine the wisdom of substituting a more program oriented compensation structure for the normal management and carried interest construct. In particular, to the extent investments are focused on carbon reductions and efficiency gains, we believe that interesting new methodologies exist to actually compensate managers for achieving a desired mix of financial and programmatic goals and to accurately measure the programmatic outcomes as well as we historically measure financial ones.