Fund structure: better investment models

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 basic materials of life to a growing global population wanting ever better lives is a challenge.  Conditions, such as Climate Change, symptomatic of stretching our use of natural resources too far, makes that challenge more difficult.  Addressing these challenges requires a mix of technology, capital of global scale and temporal patience, human leadership and effective policy and regulation.   Growing numbers of global pension and institutional funds are making commitments to these objectives, but often without a rational plan as to how 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 because it enables us to do the work necessary to solve the other problems.  Energy is also at the nexus between those who desire to cling to the old order – our fossil fuel industry – and those taking us to a more sustainable future – an advanced energy economy.  That nexus and its relationship to 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 involves informed and selective off and on-ramping of investments that reflect the pace of change that can be accomplished, closer alignment of GP/LP interests, partnering for scale and staying power, and using investment structures more closely aligned to the sought after outcomes.

 

The industries affected by these challenges are accustomed to 75-year change cycles.  We have far less than that to affect the necessary changes.   Most institutional investors are just now beginning to assess their portfolios for systemic risk regarding resource and energy productivity.  The changing nature of those risks 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 – and such risks are typically not addressed by conventional diversification strategies. 

 

Success Will Require a Different Model

 

A model for success must recognize a number of built-in biases and structural impediments and effectively face up to issues that have challenged previous efforts.  These include: 

 

  1. A strategic investment commitment of this nature 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.

  2. The typical 2/20 and ten year fund model is simply not an optimized vehicle for the task at hand.  It will require a longer term, more nimble, and more collaborative investment vehicle.

  3. Investing in this transition may straddle several conventional asset classes, rendering the traditional venture, private equity, infrastructure, and debt categorizations obsolete.

  4. The current venture capital model was built for capital light, shorter-term outcomes based on deal-flow, market inefficiencies and preferential access.  It was also loaded with fees and carry that were only possible with technologies that met the capital, timeline and outcome expectations for which the model was built.

  5. The current institutional direct investment model has theoretical access to scale, but rarely deploys it; it often lacks strength and depth of team and, as a result, frequently plays the role of late stage capital for still nascent venture portfolio companies.  It also too frequently was presented not with the “A” but the “B” deals, in an industry where only the “A”s survived and only the A+s made attractive returns.

  6. An industry that repeatedly spread too much capital amongst too many players who then distributed that to a much greater variety of companies than the capital ecosystem could support.

  7. A family office investment model that also was sub-scale in terms of capital and scale and expertise of team, and too frequently focused on individualistic investments.

  8. A corporate venture model that continues to be sub-scale in capital (typically ~$100M in size) and depth of team, isolated (each company has its own), focused on business units trying to protect legacy businesses and with an overall track record that is negative for the companies it intended to benefit.

 

Collectively, the efforts in sustainable investing by leading venture and private equity funds, by a broad range of boutique funds and family offices, by corporate funds, by pensions funds; and by family offices, have yet to establish a recognizable and repeatable model for investment success. 

 

The Timing is Now; both from a Structural and from a Team Standpoint.

 

It is virtually impossible to accomplish such changes in industries that are currently experiencing success, as entrenched positions will not be put at risk.  But industries at the bottom of a cycle, or undergoing transformational change, are well suited to also implementing new investment models.  Right now, represents a unique opportunity:

 

  • It is Possible to Assemble an All-Star team.  Due to the downsizing and reconfiguration that has occurred both 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.  We believe this opportunity has a less than 6 month shelf life. 

 

  • We are still in the “Valley-of-Death” for most CleanTech Companies, but for others the Time is Now.  Although many market segments will take years to turn up, segments driven by the proliferation of wind, solar and electric vehicles are experiencing exponential growth now.  Therefore, although this is the toughest of times to close a new fund, it is also likely the best of times to do so.

 

  • A New Team can 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.

 

  • There is Heightened Risk around Fossil-Based Energy, the Divestiture Movement is Gaining Ground and Investors are struggling with Correlation Risk in their Portfolios.  Many, if not most investors are increasingly uneasy about maintaining a “business as usual” route.  But the simple realization that change is needed does not dictate the timing or strategy for change.   Worse yet, 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.  For most, they will ride the existing classes down before they can ride the new classes up and significant value will be destroyed along the way.

 

  • Sustainable Investing is an Industry 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 completely different. 

 

  • 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, in turn, implies $1Bn plus fund sizes.  Given the scale of the energy industry a fund of that size is by no means large, yet it is something only a very few prior sustainable investment firms have accomplished – and only under very conventional fund constructs and without any participant on or off-ramps.  We believe that a larger capital pool can be de-risked by employing several carefully constructed strategies:

 

  • A focus on clearly defined investment themes able to generate returns today, each of which is agreed upon before capital is invested.  A fund structure that incents long-term participation but enables the flexibility of theme specific participation by corporates and others with relevance to a single theme.

 

  • A vastly more partnered and collaborative model in which the investment themes are vetted by the limited partners and relevant corporate participants.

 

  • A defined set of on and off-ramps to manage risk over time as the investment team proceeds against the approved investment themes. 

 

  • The Fund management exists as an independent team, in order to favorably compete with the best of current funds, but is tied to a longer-term orientation and an organizational structure that permits individual success but only to the degree it is fully consistent with overall economic performance and the longer terms interests of both its GP and its LPs.

 

  • The fee structure is designed to allow recruitment and retention of highest-order talent, but explicitly structured in a budgeted fashion.  Compensation and carried interest are structured to support long-term asset growth rather than short-term exits and cash-outs.

 

  • Lastly, the fund structure is designed to permit fund holdings to be gradually transferred from fund ownership and management to direct ownership by one of more of the constituent L.P.’s as companies mature to profitability and self-sustainability; thereby allowing for long term asset management and appreciation.