I had the opportunity to address a group of foundation managers, investors, entrepreneurs, and DOE staff at a roundtable at MIT last week, discussing the subject of capital gaps in cleantech.
That there are capital gaps -- parts of the cleantech innovation, commercialization and adoption cycle where more capital is needed than is available -- isn't a surprise to any readers of this column. But I continue to see lots of conflicting takes on where exactly the gaps are and what causes them.
As I described to the group, we've spotted not just one or two, but five different capital gaps affecting the cleantech market. Some are more obvious than others. For a couple of these gaps, government has a role to play. But for others, a relatively small amount of foundation capital could go a long way toward getting the private sector to fill the gaps.
The first gap that I think is obvious is at the very early stage. This mostly affects innovations based upon physical sciences, like advanced materials, etc., because the reasons why not enough capital comes in early enough are that there is a lot of technical risk, it's a long gestation period, and the capital needs can be anticipated to be pretty significant over the course of the commercialization of the investment. Here's a terrible column I wrote on the subject four years ago if you want to be bored to tears.
The confusion on this issue comes from the fact that these kinds of opportunities do get funded sometimes! Some of the biggest-named venture firms have gone out there and backed very early stage science experiments across almost every cleantech sector. Seed-stage investments in cleantech wax and wane, but they do exist. So this isn't a "gap" in the sense that nothing gets funded at this stage. But it doesn't happen consistently. Some pure research doesn't get funded by the private sector to the optimal extent. VC interest in seed-stage cleantech investments was hot a couple of years ago but is suffering a bit right now as the generalists back away from the sector. And even when VCs are funding seed-stage cleantech ideas, they're not going to fund some kinds of ideas -- such as impactful innovations that are destined to be components rather than complete systems. If the VC doesn't see a way of making a billion-dollar company out of an innovation, they won't sign up to fund it at a very early stage. And there are lots of brilliant hundred-million dollar ideas.
Thank goodness for the efforts of groups like ARPA-E and the MassCEC which will fund innovative early-stage research. This early-stage gap is a critical one, and these groups play a vital role in addressing it. We also need to see more work done to help seed-stage management teams bootstrap and improve themselves, via accelerators like the Cleantech Open and others.
On the other hand, we also see too many pundits and idealists who seem to think this is the ONLY gap worth addressing -- that somehow if we just see the right early-stage innovation, everything else will work itself out. That if we see a sufficiently breakthrough idea, the world will grab hold of it quickly and efficiently. When have we seen any evidence of this in the energy or other cleantech-related markets? I would love to see it, but there's also plenty of evidence to suggest that even the oft-maligned "incremental" innovations can help push energy markets over price thresholds that lead to rapid adoption (think fracking for natgas extraction) in existing markets. And there's plenty of evidence to suggest that new markets take a lot more than just innovation to achieve rapid adoption (the need to see new channels, new financial models, etc.) if consumers are being asked to change their existing patterns.
So we move on to the other gaps.
The second obvious one is, of course, the "first project" gap. Getting that first commercial-scale project or plant built, to prove out the economics and performance well enough for project finance professionals to come in and do what they do. This gap is real. For example, at one point I was pitched by a gasification entrepreneur seeking a $30M Series C round. Why so much, I asked? "We need $10M to support our efforts, but $20M to build our first commercial-scale plant." I asked the entrepreneur if he would rather raise a $10M Series C and then a $20M project finance round instead. "Of course!" he replied, "But no one will do that." I would suggest, however, that taking in expensive venture capital through the corporate equity stack to fund putting steel in the ground is a misapplication of LP capital, and one of the reasons why venture capitalists in this sector are reeling right now. And this is a much bigger problem when that first commercial-scale plant costs not $20M, but $200M.
The private sector has run a gamut of attempts to find funders for this gap, all with limited success. Hedge funds, then large corporates, then Wall Street, and now large corporates again have all had their turn to try to make money funding these things. The DOE Loan Guarantee program and other government programs have been designed to address this gap. And the jury is out as to how effective such governmental programs can be. But even if they are effective, it's a lot of capital concentration. It requires a difficult mix of both technical and financial skillsets that we don't see very often. At my firm, we've looked at a number of opportunities to tackle this by taking on a simultaneous venture capital and project finance role, in essentially two parallel transactions. We think this hybrid approach may hold promise, but we haven't deployed it against this particular gap yet.
One model that I haven't seen tried quite yet to address this gap would be an OPIC-style approach to providing capital to funds that purposefully address this gap. Most likely, this would be a special situations fund from a project finance firm with some experience with relatively new technologies. The OPIC model is to provide matching funds in the form of leverage that makes the overall return profile to equity-providing LPs more attractive, thus enabling funds to be raised that otherwise wouldn't be. It leaves the actual specific investment decision-making in the hands of the fund managers, and by investing in portfolios as opposed to specific projects, it minimizes the chance of a binary outcome for government funders. And thus, OPIC is able to be self-sufficient as an independent, quasi-governmental body. It would be interesting to see a model like this attempted, as opposed to asking government officials to put on project finance hats and choose winners themselves.
Now we move to the less obvious gaps.
The third gap is a second project finance gap that isn't specific to cleantech, but hits it hard: funding for small (i.e., distributed) projects. Project finance transactions cost a lot. The legal work alone often runs into the six-figure level. Thus, project finance firms will mostly just look at projects of a certain minimum size. And distributed generation or building energy-efficiency projects definitely fall below this size.
This is a gap the private sector should be able to address, and rooftop solar financing has shown the way: pooling projects. It requires a different way of selecting projects, using standards and risk metrics borrowed from real estate and other financial innovations. But it can be done. The problem is that, beyond rooftop solar, it hasn't been rolled out yet. There's a need for the big capital providers to be shown for each of these types of projects that there is a market, a good financial model, and good returns to be made before they will feel comfortable putting significant capital into any of these gaps. In rooftop solar, we achieved that point. Next, I predict, will be building energy efficiency. And other distributed generation projects will roll out from there.
These financial innovations, I believe, will unlock a big inflection point in the adoption of these technologies and will presage the next big wave of cleantech. In the meantime, at my firm we're seeing opportunities to play that aforementioned hybrid role (simultaneous VC and project finance investments) by providing sponsor equity for first-time pooled project funds, to prove the model and get them to their second fund (when the big banks can step in and take over for us). We've already done one and will do more.
A fourth gap is less obvious. I describe it as customer/channel finance. This is primarily a B2B problem but can also be B2C in some circumstances. I'm still wrestling with how much of the gap here is structural, versus just an education issue. Many cleantech innovations provide lower operating costs for customers, but have higher upfront capital costs. Many customers lack budgets for this upfront cost. Financing (to support leases versus purchases, for example) can help address this issue. Confusingly, vendor financing does exist. Several of my startups have been able to identify sources for it and provide lease options to their customers. But it tends to be expensive capital, and thus the value proposition breaks down for the customers, who often end up deciding in the end that they'd rather just free up capital budget somewhere. I believe the high returns these smallish vendor financing providers are charging indicates there's a capital gap. But I don't know why it should be inherently so. I just know that the high rates of return these financial players charge startups results in dampened customer enthusiasm and thus slower adoption.
The fifth and final gap we see in the marketplace is somewhat related but I consider to be separate: Balance sheet support for startups. These markets are dominated by big vendors with big balance sheets. This skews the expectations across the entire industry. Utility payment cycles are often 90 days. Why? Because they can get away with it. But if you are a startup waiting for rebate checks or other receivables from utilities, that presents a heck of a working capital demand.
One place this hits is lines of credit and other forms of venture debt. If you are a startup that has an institutional venture capitalist on your board and you have patents, Silicon Valley Bank will happily provide you capital under lots of restrictions but at a reasonable rate. Many venture-backed companies avail themselves of this opportunity. But what about all the service companies we keep saying are critically needed, either to reinvent the dysfunctional channels or to accelerate implementation of emerging clean technologies, but which can't get VC dollars and don't have patents? SVB and its competitors are much less keen to work with them. And they can have significant working capital needs, as well. I've seen some very high rates be charged for such working capital from alternative sources. Such high rates tell me there's a capital gap, and while that may mean it's lucrative for such capital providers, it's inhibiting to the growth of such industry segments.
Here's another example: One of our portfolio companies is involved in the construction industry. The company won a couple of multimillion dollar contracts as part of a couple of green housing projects. Congrats, right? Except that the general contractors demanded that this startup provide "bonding" (or, essentially, parking capital in an escrow account until the product was delivered) that also amounted to millions of dollars. This startup was being asked to park most of its slim cash balance in a bank account for several months. There are bonding agents that will cover this capital, but they demanded significant deposits from the startup -- in one case, a bonding agent told the startup that for a first such project they would require >100% coverage! So simply to get a bonding relationship going, the startup was going to have to pay margin to a bonding agent and get no capital relief in return. Feh. Fortunately for this company, we had the flexibility at our firm to address this directly, so we just took care of it. But many other such startups won't be so fortunate.
As with the customer/channel finance gap, I don't see any real reason for the private sector to fail to address this balance sheet support gap. In fact, I've seen examples that suggest addressing this gap can provide compelling risk-adjusted returns, at least in the near term. Eventually, community banks can and should fulfill this need, if they could just get comfortable with playing that role again. Foundations or supportive policies could show them the way. But for now, the gap is inhibiting growth of the implementation side of many cleantech markets we all would like to see grow more quickly.
For many of these gaps, there's only a limited role for government or foundation support to play, but albeit limited, it can be a vital role. Particularly in the areas where there's no inherent structural reason for a gap, a small amount of foundation support or a well-designed local government incentive could go a long way to proving out the financial models that would then be rapidly scaled up by following private sector capital. Simply encouraging community banks to start lending to clean energy service firms would make a big impact, for example.
I'm therefore optimistic that these gaps will be addressed and, as a result, we could see another big wave of cleantech adoption. A little bit of capital deployed against these gaps, if matched by a lot of education to the banks about it, could go a long way to accelerating the growth of cleantech in the U.S.
Have a great Fourth of July, everyone! If you get the chance, take a moment to thank a veteran for their sacrifice.