The best venture capital firms pride themselves on finding business opportunities in the gray zones between established and adjacent industries in a value chain. It is in these gray zones where promising startups satisfy unmet market needs and accrue significant value to their investors.
Similarly, there appears to be an unmet capital need between venture capital and private equity in the world of energy technology and cleantech investing: a dedicated secondary fund.
A secondary fund is typically one in which a new pot of money buys out the limited partnership interests in a venture capital or private equity fund (and also assumes the obligations for additional funds that have yet to be invested) from the original investor, usually an endowment or pension fund. Where I see an opportunity, however, is for a new fund to turn over direct investments from existing venture funds that have held their investments for a while and are looking to cash out -- essentially a buy-out fund at the end of venture funds’ lifecycles.
A secondary fund would help alleviate several of the problems plaguing the cleantech venture investment industry right now. The fund would provide early- and growth-stage venture funds with sorely needed exit opportunities, delivering limited partners desired liquidity and having the side effect of raising the attractiveness of venture capital as an asset class.
The fund would remove a growth-at-all-costs burden from the management teams and provide the shelter needed to reorganize in anticipation of eventual acquisition. The fund would offer specialized asset management for limited partners, a very important feature where industry and technical expertise is required. A secondary fund with industry focus would also have a good sense of how to best allocate growth capital and thus would be able to arrange for new cash injections where needed. The fund would lack diversification and therefore be subject to idiosyncratic risk, but that risk can be managed through conservative (rather than speculative) investing. Regardless, diversification ought to occur at the limited partner level rather than at the fund level.
Just like any innovative business venture, a cleantech secondary fund would meet resistance from incumbents in the market. Many venture capital firms will not like the idea of selling out their holdings at a bargain price to another fund (unless, of course, liquidity is sorely needed). Doing so may disappoint expectations on their fund’s performance, and would decrease the asset base from which management fees are drawn.
The management of the portfolio companies might see this as simply a transfer from one set of owners to another, or might be put off by the difference in the objectives of the new fund. But in some cases, management will appreciate a focus on preparing for eventual acquisition by a larger company that would provide stable, long-term ownership. Alignment between a secondary fund’s partners and company management on objectives is thus critical to the fund’s success.
A successful secondary fund would also look to address a common challenge associated with well-funded, venture-backed companies: when examined by potential acquirers, the acquirers find that the companies would be difficult to digest. This is often because managerial attention at the acquirees-to-be is focused not on shaping a company that would be easily integrated, but instead on building a corporation that would hopefully reach IPO. In doing so, the companies often internalize activities that, though seemingly necessary to scale the business, an acquirer will have to dismantle upon post-merger integration, ultimately depressing the acquisition price.
For example, having a vertically integrated business model might force potential acquirers to gain the agreement of two different divisions in order to execute the acquisition. Often, the companies have themselves made acquisitions that have not been fully integrated. Strategic acquirers are generally better at scaling sales of portfolio additions than they are at restructuring small companies, a fact long known to private equity funds specializing in restructuring.
The management of a well-run secondary fund would focus on potential acquirers of its portfolio in a similar way that it guides management teams to be customer-centric, and focus the management teams on activities that make their companies as appealing as possible to a select group of potential acquirers. Implicitly, the secondary fund managers would either have enough influence over the management teams to realign their strategies, or find companies with management teams that share the strategic direction. The secondary fund must therefore pick and choose targets carefully to ensure that they buy the right amount of ownership and influence, and do so without overpaying.
Why a cleantech secondary fund?
Many venture investors entered or expanded in the cleantech space in 2005-2008 with the hope that the sector would produce blockbusters in the same way that Amazon, Google and Facebook created tremendous returns for their early investors. However, companies such as Amazon, Google and Facebook established industries (online retailing, online advertising and social networking, respectively) where none existed previously. These were truly radical innovations in their creation of new business models, and so they captured a tremendous amount of previously nonexistent commercial opportunity.
Energy technology, on the other hand, does not generally function in this way. Nearly every innovation in the energy sector is either a complement to an existing technology or practice, or is inherently competing against something that currently exists and has worked well for quite a while. Whether in power generation, fuels substitution, or lighting, the sub-market has strong incumbents and incremental innovation tends to be the rule, with radical innovation the rare exception. To reach sustainable profitability in an incumbent-dominated market, the time to market can be long, the infrastructure required quite big, and battling the status quo an endless slog. The growth challenge is simply too large to deliver the returns required by most venture funds.
As a result, with a few exceptions that will eventually IPO or be acquired at significant premiums, the cleantech companies that were funded five to eight years ago are collectively underperforming their investors’ expectations. Most of these underperforming companies can be divided into three groups: the liquidators-in-waiting, the stable privates, and the uncut gems.
- Liquidators-in-waiting: Companies that will not be able to reach scale because the business is simply too capital intensive, the market for their product will not exist soon enough, or the transaction costs are too high. The electric vehicle industry’s value chain has been the site of unfortunate recent examples.
- Stable privates: Companies that have found a profitable business model and market niche but will not scale quickly or profitably enough to meet the returns sought by the early-stage investors. Plenty of solar developers and service companies with homegrown technology fit this description.
- Uncut gems: Most often, these are product-based companies where the product itself is commercially promising (or will be with some additional development), but the idea isn’t big enough for one company to scale around due to sales channel challenges, the reliance on downstream manufacturing partners, or other barriers to entry. In short, there's a good product, but with insufficient market traction. Many solar technology, battery, LED lighting and industrial technology companies fit this description.
A cleantech secondary fund could go after either stable privates or uncut gems. Stable privates can be acquired, levered, and amalgamated in order to find economies of scale. However, investing in uncut gems is where a cleantech secondary fund could generate the best returns. By realigning a portfolio company into a target (or targets) that can be integrated in a reasonably short period of time, a secondary fund could add significant value quickly and then leave it to a strategic acquirer to scale the business.
Executing a cleantech secondary fund
By my count, there are over 200 funds that are holding investments in over 700 different energy technology companies (a mix of cleantech and more traditional oil & gas and power generation industry companies). More than half of these funds have fewer than half of their portfolio in energy technologies, and many are holding three or fewer energy technology investments. As a result, these funds are not focused on this segment, and diversification is not serving them well.
Though a few of these funds, such as Barclays Ventures and Mobius Venture Capital, have publicly indicated that they are in wind-down mode, most appear to be simply holding on to the companies, hoping for the best and no longer actively investing in the energy technology space. As there have been perilously few IPOs and only the occasional acquisition, many of these funds would no doubt entertain a discussion about an early exit to focus on other sectors and objectives. As a group, their energy technology investments comprise a ready-made hunting map of secondary fund acquisition targets.
Secondary transactions have traditionally been the realm of private equity firms that focus more on financial engineering and cost-cutting companies with stable cash flows than on realigning the strategy of technology-based companies that have yet to achieve scale. The best examples of uncut gems being polished in the right hands come from this world of alternative asset ownership.
Vector Capital nearly doubled its money in less than two years through its sale of intelligent gas detection system maker RAE Systems after taking the company private. Oaktree Capital Management took advantage of the growing market for energy-efficient data center cooling through its ownership of Wright Line, selling the company to Eaton once it achieved $100 million in revenue. Eaton, a world leader in energy management solutions, is not known for air cooling, but seeing as its power distribution sales force calls on data centers anyhow, Wright Line’s portfolio and data center operations expertise is a natural adjacency for Eaton to better serve some very important customers.
These transactions, though well executed by the private equity firms, were opportunistic when the companies were originally purchased. Buyers such as these firms care far more about market inefficiency and risk-leverage optimization than they do about energy or clean technologies as focus sectors.
To successfully execute an energy technology and cleantech secondary fund, an investment firm will have to build a hybrid team with expertise in distressed company restructuring, corporate strategy, technology commercialization, and a laser-focus on select industries, technologies and potential acquirers as customers. Discussions with potential acquirers over how best to mold acquisition targets should frequently occur at such a fund.
For a venture capital firm that is thinking about raising a secondary fund, the easiest way to get started would be to build a track record through synthetic-secondary investing in its current growth funds. For example, the tactical acquisition of an adjacency to a current portfolio holding, the buyout of another fund’s asset, and the deliberate restructuring of a company in preparation for acquisition would all build the track record and skill set needed to raise a large secondary fund from what will no doubt be initially skeptical limited partners. By combining the required skill sets, a secondary fund would be able to identify and execute on opportunities that venture capital firms would otherwise pass on and that the private equity firms would otherwise ignore, not find out about, or fail to identify.
The energy economy has reached an interesting turning point. There is more certainty today on medium-term availability of capital and on general economic direction than there was in 2008-2009 (which, granted, was one of the most uncertain periods in recent history). More importantly, there is much more certainty around the regulations governing the subsectors of cleantech and the role of cleantech companies in a future of enhanced domestic oil and gas production.
With original investors looking to cash out, cash-heavy corporations looking to make tactical acquisitions and limited partners seeking more conservative and also more certain investment yield, now is the right time for a savvy firm to seriously consider some horizontal market expansion into the secondary market for energy technology and cleantech companies.
Daniel Kauffman, President of TerraCel Energy, is an energy technology entrepreneur, investor and consultant based in the Research Triangle area of North Carolina.