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Cleantech Investing Is Back. Will This Time Be Different?

A decade and a half ago, “cleantech” was decidedly on the rise among venture capital investors. It became one of the hottest investment sectors among VCs practically overnight. From 2005 to 2007, cleantech venture capital deal volumes doubled, and dollars invested quadrupled.


And then, also very quickly, the sector fell out of favor. When the Great Recession hit, venture capital pulled back from almost all sectors, including cleantech. But when VCs soon thereafter started putting capital back to work again, that recovery didn’t include the cleantech sector. The word had been put out among generalist VCs and the pension fund “limited partners” who provide capital to VCs: “[Cleantech] has been a noble way to lose money”. According to data compiled by Cambridge Associates, venture capital dollars into the sector went from $19.0B in 2005-2009, to $10.9B in 2010-2013.


But now, for those of us still investing into the sector, it’s starting to feel a bit like 2005 again. The dollars probably aren’t huge yet (and in fact, it’s hard to find good data on venture capital flows for the sector at all anymore), but the interest level and activity levels haven’t been this high for over a decade, anecdotally. Many don’t call it “cleantech” anymore of course; we are seeing a lot of different labels like “sustainability”, “climatetech”, “impact” and “ESG”. But over the past few years, a number of new firms have successfully raised first-time and even follow-on funds in the sector. And beyond the publicly-known ones, I also personally know of quite a few new firms quietly launching and making good progress in doing so — not easy in the middle of a global pandemic.


As someone who has been an investor in sustainability since 2004, I am excited to see this re-emergence and all these new entrants. In my (biased) personal opinion, it’s overdue. If we’re truly on the cusp of another “green wave” of venture capital and private equity investing, that’s really encouraging.


But will it all end in tears, once again? Or will this time be different?


First, we have to understand why cleantech venture capital underwhelmed the last time around. There are basically two camps on this question.


One camp says that this sector simply inherently doesn’t fit venture capital. “The correct lesson is that cleantech clearly does not fit the risk, return, or time profiles of traditional venture capital investors,” as one smart MIT analysis from a few years back declared. Or, as one generalist VC once told me, “I’ve come to the conclusion that to do anything meaningful in this sector requires too much time and too much capital.”


But this thinking doesn’t reflect that there actually have been some good investment returns to be found in the sector. As the most recent Cambridge Associates data (from 2019, link above) shows, gross IRRs for investments in subsectors like “smart grid” and “energy storage” have actually been decent over the past two decades, at 32.3% and 29.2% respectively. Other subsectors like renewable energy development, energy optimization, and waste and wastewater treatment have also shown decent if unspectacular results for venture investors. Yes, some other subsectors that captured lots of both attention and venture dollars, such as advanced materials and renewable power manufacturing, were money losers. But to declare that cleantech is inherently not a fit for venture capital requires an observer to narrowly define “cleantech” solely as such upstream, hard-tech innovations.


Another camp says that VCs (or at least generalist VCs and many limited partners) are too fickle. As someone recently told me, “The generalist funds caused all the problems last time around by making stupid investments because they did not understand the complexity, and then shunned our industry for 10+ years.”


But to say this misses how many of the individual VCs who were at generalist funds in the last wave are now those leading the charge with new firms, or otherwise still deeply engaged in the sector in other roles. Sure, some individual generalist VCs were fickle. But many others haven’t been, and in fact are a major factor in the recent push to put more money at work now.


To be clear, there’s some truth in both camps’ positions. But for what it’s worth, here’s where I believe the mid-2000s “cleantech venture bubble” went wrong:

  1. Few investment models were attempted. There was venture capital, and then there was project finance. And that’s it. In what was somewhat of a surprise to many of the generalist VCs I knew at the time, it turns out that traditional project finance doesn’t consider a new innovation to be “proven” just because it works in its first commercial implementation. Project finance wants to invest into the twentieth of something, not the first or even the third attempt. So basically, venture capital was the only investment model that was applied to the sector, and it got over-applied very quickly. When you have large amounts of venture capital at work in a startup, “average” exits are no longer acceptable. The more venture dollars, the more it’s “billion-dollar unicorn or bust”. The majority of such efforts bust.
  2. “Cleantech” opportunities were informally (and sometimes explicitly) defined too narrowly, primarily around deep-tech and heavy manufacturing and processing. Where there have been successes, however, they instead tended to be focused more downstream (with direct interaction with consumers), more based upon business model innovations than a magical patent, and leveraging software.
  3. This focus on hard-tech was exacerbated by structural challenges the venture capital industry was facing then… and that are felt even stronger today. Specifically, the concentration of the venture capital industry into fewer, bigger firms. This drives those firms to raise bigger and bigger funds every one to two years. Then these funds need to be put to work quickly. So why did generalist VCs get excited about cleantech a decade and a half ago and start hyping it up so unapologetically? In part because it seemed like a place they could park a lot of capital very quickly. As one top partner at a top generalist firm told me back then, “When you see something that’s too capital intensive for you, give us a call, that’s what we’re looking for.” And of course, that then drove many of them to invest into those deep-tech and heavy manufacturing startups that could soak up a lot of dollars very quickly.
  4. Unlike in some other favored venture sectors like IT and healthcare, the exit environment hasn’t been nearly so favorable in cleantech. While those other sectors have a large number of high-paying acquirers who are eager to snap up startups before they IPO, for cleantech the IPO windows were few and ephemeral, and the natural acquirers for startups have been manufacturing-oriented giants in the energy, automotive and industrial industries. Not exactly known for paying large amounts to acquire startups.
  5. Finally, while no one explicitly said it at the time, it was clear that a lot of the generalist VC interest a decade and a half ago was under the expectation that the U.S. would soon be implementing strong climate change policies. After all, at that time both political parties were explicitly moving in that direction. I remember sitting in rooms full of very smart VCs who were naively planning how we all were going to parachute into Capitol Hill and somehow dictate policy designs. Of course, then the cap and trade legislative effort failed, and for the past ten years we’ve seen one of the two parties turn actively against any significant progress on climate legislation, at least at the federal level.


So yeah, if you are going to focus on the most capital-intensive, upstream technology development portions of a venture capital sector, and you’re going to actively over-capitalize those bets, and then there’s no one willing to pay up for those companies even after they succeed at commercializing their innovations… it’s going to be a hard place to make investment returns.


Contrast this with the investment performance over the same period by traditional project finance into renewable energy, which has done very well. The problem clearly wasn’t cleantech. The problem was how venture capital specifically was applied to cleantech.


So again, will this time be any different? I am actually optimistic.


First of all, we are now seeing a much more robust “capital ecosystem” addressing the many different needs of innovators in the sector. It’s not just venture capital anymore, we are seeing “program-related investments” from the philanthropic sector, that purposefully take a more patient approach. We are seeing a variety of alternative forms of corporate financing than just venture capital, from family offices and innovative venture debt providers. And we are seeing new approaches within project finance, such as the area that my own firm Spring Lane Capital invests into, around distributed-asset project finance. It’s no longer one-size fits all, and while there’s still definitely a role for traditional venture capital, it no longer has to carry the whole load and solely capitalize innovation efforts. Especially the hard-tech, hardware-focused innovation efforts can benefit from utilizing new capital types beyond just traditional VC.


Secondly, across at least some of the universe of potential acquirers, we are seeing much more seriousness than a decade and a half ago. Yes, back then oil giants were placing what was (relative to them, at least) token dollars into green energy efforts. But for at least a couple of the oil giants here in 2020, they are now in the throes of significant strategy realignments to focus on alternatives. And on top of that, most of the biggest technology giants are now getting serious about these markets as well. That, plus growing Wall Street interest in green transportation ($TSLA and $NKLA, to name two prominent examples) and renewables in general, is raising hopes that the “exit environment” for early stage sustainability investments and project capital might be quite healthy over the next few years.


Thirdly, across the landscape of limited partners, there is now a conviction that sustainability is a “megatrend” that should be invested into. The actual transition of dollars behind this recognition is still early and inconsistent, but can be illustrated by the significant shift of dollars into ESG-oriented public equities funds, and mirrors what I hear directly from professionals at pension funds and endowments who are now actively seeking out new investment opportunities here.


And of course, we can once again see strong prospects for favorable, impactful climate and energy policy at the U.S. federal level, depending upon how this November’s election goes. But even in the absence of that U.S. federal leadership, state policies and corporate America have been leading the charge and driving evident market transformation.


Will this be a winning recipe for strong returns for investors in the sustainability or, dare we whisper it, “cleantech” sector? And even if so, for which of the new investment models in particular? What will happen this time when (not if) generalist VCs again decide to jump into the pool and make another big splash, will their structural imperatives once again massively skew the way the sector is framed and how dollars are spent?


These questions remain unanswered for now. As back in 2005, we are only now seeing the early signs of an upswing, not the doubling or tripling of activity that subsequently happened over 2006 and 2007. These early signs may not even be more than anecdotal; a next wave of investment capital into the sector might not even happen.


But at very least, if it does materialize, there are some legitimate reasons to hope that this time… it might actually be different.


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