Friday follies

Some random links and observations on a Friday:

• Apparently not every reader picked up on the fact that my last post was tongue-in-cheek.  Guess you had to be there.  Fortunately, Scott was in fact there...

• David Gold wrote recently on some of the same issues, wondering why solar and the like have gotten so much attention from VCs while technologies like geothermal have gotten much less attention.  His answer is that in large part "much of the bias has to do with the fact that not many VCs have strong networks of geologists, drilling technologists, heat pump engineers and steam turbine power generation experts to build great geothermal companies".  I'm directionally in alignment with David's take -- obviously I agree that VCs need to broaden their horizons into other sectors of cleantech, and acknowledge it's easier said than done when it requires learning new markets, new technologies, etc.  However, I'm not sure geothermal is the best example for this.  VCs going into solar and biofuels are following the few available examples of good exits in the sector, geothermal plays are often challenged in VC eyes in terms of their capital intensity and lack of opportunities for new intellectual property, and it's not yet a fast-adopting market.  Same challenges for VCs looking into other sectors like ocean power, grid-scale storage, etc.  Like it or not, not all attractive market opportunities are a good fit for the venture capital model.

• Not a lot of optimism out there right now about either the passage of a cap-and-trade bill, or that it would have much of a positive impact on individual companies.

• On the other hand, Deutsche Bank Asset Management is advising their clients to put their money into investments outside the U.S. in part because all the on-again, off-again support for green technologies is creating a lot of uncertainty.

Conventional wisdom and cleantech venture capital

I had the pleasure of speaking as part of a panel this morning at the Mid-Atlantic Capital Alliance's conference in Philadelphia.  Here's a taste of what I told them:

1.  Cleantech only happens in Silicon Valley and MIT.  If you look at the dollars flowing into cleantech from venture capitalists, and read the sunday NYT, that's the natural conclusion you would draw.  So my apologies to everyone in Philly (or the rest of the country outside of northern California and Boston), there's clearly very little good entrepreneurial activity in cleantech in your region.

2.  Cleantech is really only solar, "smart grid", biofuels and electric vehicles. 

3.  Cleantech is really only about capital intensive business models. 

4.  Cleantech startups are only for whiz-bang PhD researchers who have earth-shattering innovations.  Business models like energy efficiency services, and other implementation efforts, need not apply.

5.  The only good cleantech startups are those backed by VCs.  The fact that only 1% of startups get their initial capital from VCs simply means that 99% of new businesses are bad ideas.

I was supposed to describe what I like about being an investor in this market right now.  And I told them that what I like about this market is that many people actually do believe the above points.

Friday folderol

Some random items, including some administrative housekeeping:

1.  If you haven't seen it, it's worth reading DOE Secretary Chu's op-ed on weatherization and all of the governmental support being thrown toward that part of energy efficiency.  Heady times for residential and commercial energy efficiency efforts.  Side note:  The Secretary of Energy is publishing his op-eds in the Huffington Post now?  Wow, this Internet thingy might actually be catching on.

2.  How the government "picks winners and losers" is a topic of much conversation these days, re: cleantech and otherwise.  It's especially a topic given the structure of some of the programs being used to accelerate commercialization and adoption of clean technologies -- such as the DOE loan guarantee program, etc.  See, for example, this interesting editorial in the Washington Post that a colleague pointed out to me today, and the very good discussion we had on the PE Hub panel on the topic here in Boston this week (note: link may disappear behind subscriber wall soon).  It's tough, though, to come up with strong alternative solutions to what's being done.  There are gaps that need to be specifically addressed, especially at the seed / very early stage (where ARPA-E is intended to aim) and at the "first of a kind" project finance stage (which is where the loan guarantee is intended to aim).  There isn't enough funding to support every deserving effort, nor would we necessarily want that (define "deserving"?).  I've seen proposals to do it more hands-off, by having the money go in some form to private sector investors who would make the decisions, perhaps as matching funds to provide leveraged returns for private LPs in the fund, to fix the risk v. reward imbalance that created the capital gap.  Some of these ideas have merit, but even then some government body needs to be determining which funds would receive the leveraging support and which wouldn't.    Broader market-based systems (including cap and trade, carbon taxes, ITCs, PTCs, etc.) are more diffuse in impact and harder to target at specific capital gaps.  And doing nothing is not an option.  So I'll let the debate go on, but my feeling is that you simply have to design the best policy you can, hope the DOE can attract the best decision-makers that they can (and I've seen some really smart people go into the DOE over the past year or so), and accept a necessarily imperfect process.  Easy to say, hard to stomach. 

3.  Speaking of policy issues, a few days back I wrote about a study which examined coal-fired generators in the U.S. and concluded that there could be a relatively low natural limit on carbon prices under a cap and trade scheme.  I mentioned a few gaps I saw in the analysis, and for you wonks out there like me, a reader wrote in and pointed out another important one:  Elasticity of demand means that some of the costs on the generators will be passed downstream, so that they would require higher carbon prices than indicated in the study before making the decision that shutting down is worth it.  Of course, generators would also be able to pass some of the costs upstream as well, in all likelihood.  It's still a very intriguing study conceptually, but between failure to address elasticities of demand in the electricity value chain, and the other factors I mentioned in the post, I'm not sure I would want to do any significant investment planning around the specific price limits they indicate.

4.  An administrative note:  Over the 4+ years of writing this column, I've attempted (not always successfully) to hew to the most rigorous of blogosphere rules regarding notification of self-interest, in that I've tried to note whenever I've mentioned a company in which I have some stake in their success.  But in my current position that's becoming impossible, due to the breadth of indirect investment activities involved.  I can't reveal self-interest in many cases without possibly revealing some fund's confidential information, and I can't mention some companies and not others because then the occasional obvious failure to mention a deal becomes an indicator by itself.  So my choices are either to never mention any companies at all ever again, or simply to ask you all to trust me that I won't too horribly pump up a company or fund where I have a significant self-interest, without noting that.  I may still mention self-interest sometimes if I can, but not always.  Is that okay?  Tough call, and I've wrestled with it for a while.  Flames, suggestions, etc. are all welcomed in the comments or via email.

5.  Another administrative note:  Yes, I know I'm horribly behind on listing deals that get announced in the sector.  Apologies, but still, no one seems to have complained yet.  Maybe I can stop that practice?  Or maybe a smart Sloan student reader wants to help me with it?

Great returns from cleantech

Did you see the Q2 venture returns report from Cambridge Associates and the NVCA (note: pdf)?  If so, you were probably as intrigued by the chart on page 7 as I was.

On that page is a chart of "US Venture Capital Dollar-Weighted Internal Rate of Return on Vintage Year Companies" broken out by sector.  They don't break out cleantech as a category, but they do break out Energy.  And the numbers are pretty noteworthy.

Energy category IRRs vs. All Companies IRRs

2002  Energy = 43.0%, All = 8.75%

2003  Energy = 46.0%, All = 12.3%

2004  Energy = 10.4%, All = 12.8%

2005  Energy = 33.5%, All = 9.66%

2006  Energy = 23.7%, All = 4.46%

2007  Energy = 20.1%, All = 0.65%

2008  Energy = 9.10%, All = (0.04)%

So what is this really saying?

On the surface, it looks like there have been great IRRs in Energy as compared to other sectors like IT, Software, Health Care / Biotech, etc.  In almost every year post-Internet Bubble, VC investments are producing pretty healthy returns in the Energy category, in all but one year beating the performance of the overall VC pool.  If energytech VCs are getting these kinds of IRRs, that looks good compared with current criticism of venture capital that it's been producing sub-par returns versus the risk level inherent to the category. 

But wait a minute, there's a big catch.

If you read the fine print in the methodology, some (and most likely, the predominant portion) of these IRRs have been calculated based upon NAVs (net asset value), not actual cash returns.  So, for example, if a company took in a Series A in 2002, and since then they've had significant up-rounds but no exit, the value of the company is pretty much* set at whatever was the valuation of the last round.  In the aggregate, 2002 vintage companies who took in money that year and later are looking at pretty significant up valuations versus where they were when the money went in.  At least in the numbers CA is tracking.

What this really reflects, therefore, is just what we've talked about here many times over.

1.  The aggregate dollar totals in cleantech venture capital have been dominated by a relatively small number of really huge late-stage deals.

2.  While overall economic conditions are definitely having an impact, many of those well-capitalized companies hadn't had to take in lower-valuation follow on capital through Q2 2008.  So on paper, they're still being carried at those previous high valuations.

In fact, in another part of the report they show that the actual cash distributions across all VC categories are just about nil from 2004 vintage funds onward, probably moreso in cleantech (I'm guessing).

So don't read this chart and get all excited.  These numbers will likely be revised downward in future such reports (but we can hope!).

The most important takeaway is probably that cleantech valuations have held up better than others, at least through Q2.

...Note I'm not at all criticizing the methodology used in this report.  It's great data and hard to do anything more than what CA's done with it.  Just pointing out what we can conclude from it.

+++++++++++++++++

(*it's really not nearly so simple, but let's not get too wrapped around the specifics here)

“ARPA-E! ARPA-E!”

Okay, so maybe I jokingly tried to start an "ARPA-E" chant at Obama's MIT speech on Friday, simply because I thought it might be the only crowd ever wonky enough to get it.

But acronymical joking aside, it's a potentially valuable DOE program that could end up helping one of the major capital gaps that's emerging in cleantech venture capital:  Seed stage and early stage development of ideas that are promising but will take too long to commercialize than most VCs can handle.

So it's great to see the news release today with $151M of grants to 37 efforts.  Including:

• Sadoway's liquid-metal batteries
• Low-cost LED crystals
• 1366's "mono-equivalent silicon" wafers
• FloDesign's smaller-format wind turbines
• Foro Energy's drilling technology
• And several direct sunlight-to-fuels efforts

On a completely different note, I recently re-read an old 2000 article (I can't find a direct link, but you can access it through this site) from Environmental Finance back in April 2000, where the authors (Byron Swift and Aldyen Donnelly) argued that there's enough inefficient coal-fired generation out there in the U.S. that under a cap-and-trade system there will be a natural limit on CO2 credit prices at around $5-7/ton.  I'm interested in reader reactions, critiques, corrections, etc., please email or use the comments to share with alll...

Swift and Donnelly simply look at the implied financial worth of the generating assets of companies like AEP, Southern Company, and Cinergy (remember, this was from 2000), and then divide that by their CO2 emissions in terms of earnings per ton of CO2.  And therefore, they argue, if you're AEP and you can make more money by shutting down an inefficient plant and selling the avoided emissions, you would do so, and that would be triggered at around the $5-7/ton level.  They also looked at it from another perspective -- market capitalization for each of the companies, estimating how much of that was attributable to the fossil fuel generation fleet, and then dividing by emissions to get a value for perpetual stream of carbon allowances (discounted). Both methods came out with about the same value.

Now, what they don't account for, as far as I can tell, are three crucial additional factors:  1) the shut-down costs associated with mothballing a generation facility to sell off the avoided emissions; b) the incremental cost of replacing that generation capacity with something else with much lower carbon impact, such as gas-fired generation (although they acknowledge this as an open question); and c) short-term volatility as separate from long-term average prices -- it's tougher to shutter a generation plant because of temporarily-high carbon prices, so there could certainly be significant price spikes above the limits Swift and Donnelly indicate. 

But I find it a fascinating analysis, given the policy discussions going on right now (which include possible hard caps on carbon credit prices under a cap-and-trade plan), in that it suggests there may be a lower natural price limit than many expect.  There's definitely precedent from elsewhere in the electricity business for electricity customers to curtail their demand and sell the capacity back to the utility -- see EnerNOC, or in an early example, Kaiser Aluminum (note: pdf). Why couldn't some power plants shut down and re-sell their credits for greater profit?  Whether you love or hate the idea as an electricity consumer, it does open up a new business dimension for anyone in the powergen industry to consider...

Curious to get readers' thoughts.

Thank you, Eric!

...for my nomination for Funniest Post and Link of the Year.

"When Thanksgiving day arrives, and I fill my plate... I want to be able to thank the Lord for his gift of barium titanate..."

Enjoy, all!