I am writing this column while en route to a meeting of LPs on the subject of “impact investing.” Last week, I also attended a meeting of family office investors on the same subject. Impact investing is a growing trend and discussion topic. Can it make a difference for cleantech entrepreneurs and markets?
First of all, what is impact investing? As always, different people have different interpretations and uses. But at its most general level, it’s the idea of directing investments into projects and startups that are expected to generate positive returns and (wait for it) impacts on some key issue or another, such as habitat preservation or climate change, to pick two examples, but also in non-environmental domains like education, health, gender equality, etc.
Different people in the impact investing community have different expectations about what the financial returns of such investments should be. Some seek risk-adjusted returns at or even above market benchmarks. Others view impact investing as likely generating sub-market returns, but still preferable to a grant in many cases, because the money deployed does largely flow back to the investor, and because of other factors.
Importantly, from the perspective of many investors, the impact investing concept is differentiated from other related concepts like ESG (environment-social-governance) in that it involves proactive investments designed to make a positive difference. ESG and other approaches often got interpreted primarily as “negative screens,” taking some investment areas (arms manufacturing and tobacco are classic examples) off the table, but otherwise leaving most of the investment portfolio the same as before.
So there’s something in all the vagueness of "impact investing" to interest and/or turn off just about anybody. But can it make a difference for cleantech entrepreneurs?
The answer is that it can, but only if done with an eye toward scalability, and if done collaboratively with the broader private sector. And right now, this is a rarity.
Impact investing could play four very powerful roles in cleantech markets.
First of all, as many often point out, there are lots of clean technologies that necessarily require a long gestation period from lab to commercialization -- for example, small-scale fusion power, to pick just one among many. These days, and probably on an ongoing basis, the long holding periods necessary for the early-stage investors in such technologies is a big turnoff. And the capital requirements are too great for angels alone. Government grants can fill some of the gap, but there’s still an early-stage funding gap for such long-gestation, capital-intensive efforts. If and when successful, however, such efforts could end up being huge financial winners. Impact investors with more patience and risk tolerance than today’s VCs could fill that gap and see it pay off over time.
Another oft-discussed capital gap is the “first plant” for such capital-intensive technologies. More precisely, the first few commercial-scale facilities are often too capital-intensive to be appropriately funded with venture capital, and yet not proven-out enough to be appropriately funded with project finance. Some corporate dollars have gone into this gap, but it’s clearly not enough. The risks at this stage can indeed be managed fairly well, however, if the investor is good enough at their diligence processes. Impact investors with flexibility and knowledge to play an “early-stage project finance” role here can not only address this gap, but can also generate pretty attractive returns by doing so, at least as compared to traditional project finance.
Clean technologies are often released into markets that are mispriced in favor of incumbents. And furthermore, the new technologies are initially more costly because of disadvantages of scale. As the experience with solar and wind power have shown, over time the “experience curves” of new technologies drive down costs significantly, and winners end up beating out the incumbents on an even-playing-field basis. However, that early period of cost disadvantage is very tough for early entrants to survive. Impact investors could play the role of promoting implementation in early phases, by both providing working capital for the initially low-margin producers and directly funding implementation projects that may start out justified via other impact metrics (putting solar on rooftops at disadvantaged schools, for example) so as to kick-start the scale-driven cost savings. This would require a flexible hybrid approach in some cases.
The fourth role is in simply unlocking follow-on capital into new business models by funding the “prove it” phase. This is similar to the “first plant” role discussed above, but with more of a services/ financing bent. Big banks would love to find opportunities to put lots of relatively low-cost capital into new financing platforms, similar to what’s taken place with rooftop solar, but only once the specific platforms have proof points of success. Growth-stage investors would love to find compelling expansion-stage companies they can back, but only once such companies have shown they can successful expand into new territories and/or new offerings. So there’s tons of capital just waiting for proof points to give them the permission to jump in and scale up really impactful efforts. Impact investors could fund the proof points -- and again, generate compelling returns when successful in doing so.
So, great, impact investors are going to solve all of our problems! Except that a lot of what’s happening under the “impact investing” banner right now doesn’t accomplish much of the above.
In my opinion, to truly have impact, such investment activities should be designed to be highly replicable, collaborative, and therefore scalable, ideally by the larger pools of purely financially-motivated investors waiting in the wings. If you want to fund an early-stage tech development effort that VCs will eventually back, you need to build a VC-style company in terms of management, IP, structure, governance, etc. If you want to fund the first commercial plant and have project finance types fund subsequent plants, you have to make sure Plant 1 looks just about identical to Plant 2 through Plant 20. If you want to unlock Wall Street dollars to fund the next, much larger implementation pool for financing distributed wastewater treatment systems, for example, you need to make sure that a) the overall market will be big enough to justify billions of dollars in implementation; and b) the financial structure, operational plan, etc. are identical to what Wall Street will be asked to fund.
Instead, right now “impact investors” are too often doing a lot of one-off, disjointed efforts, from what I’ve seen. They are often well-meaning projects done by individual investment entities, across a highly scattered set of “priorities,” with insufficient effort put into designing the projects so that private-sector dollars could easily replicate them -- and would want to. A big reason for this gap, as far as I can tell, is that the cleantech entrepreneurial/investor community and the impact investor communities actually rarely get together in person to figure out collaborations. The VCs and entrepreneurs often dismiss impact investors as too scattered and naive and slow-moving. The impact investors often don’t seek out the company of rapacious venture capitalists and the aggressively ambitious entrepreneurs they work with. They’re all wrong and they’re all correct -- it’s simply a clear culture clash, and I often find myself suffering severe cultural dissonance as I go from one such group to the other.
I think cleantech VCs, cleantech entrepreneurs, and impact investors (foundations, family offices, university endowments, and a few forward-thinking pension funds) should get together in specific topic areas of interest (cleantech/ climate change being just one of them) -- on purpose, and frequently -- in order to identify where there’s overlap that could be pursued. It would have to be made a safe setting for the impact investors, who understandably shy away from situations where shameless VCs and entrepreneurs can track them down and treat them like dumb money, which happens far too often.
But some initial brainstorming sessions to discuss meshing the traditional VC/startup model with the goals of impact investing with the shared objective of changing the world for the better might yield some really cool and impactful collaborations, hopefully providing some replicable models for future collaborations as well. So it would be great to see more events that specifically seek to bring these overlapping and yet disconnected worlds together.