A Look At the Cleantech Investment Drop

Not only has cleantech investment by venture capitalists dropped off a cliff recently, but the average deal size has fallen significantly too – from $14.5 million in Q4 of 2008 to just $4.7 million at the end of the first quarter of 2009 (PwC/NVCA MoneyTree). Clearly VCs have figured out that deals that eventually need to scale to utility size are trouble. Still, I’ve heard many people point to the lack of project financing or debt (credit crunch) as to why things have stalled. In fact, venture-backed algae company GreenFuel Technoloogies shut down this week. The reason? They claim they were a victim of the credit crunch. But should VCs really have been reliant on project finance in cleantech investments in the first place?

Take a look at the chart below. I’ve graphed the average venture cleantech deal size over time, which I mentioned has fallen by almost $10 million, mainly because there were no major $100 million+ rounds. But what really shows how disproportionally cleantech was reliant on large scale financing is how much investment fell as a percentage of all venture investment.

It helps to put the data in this context because it shows that other sectors, while still experiencing declines in dollar amounts, were not affected nearly as much by the lack of large deals. And by other sectors, I’m talking mainly about technology deals, which have always been mainstays of venture investment. By and large, they are less capital intensive and, really, it’s where venture’s expertise lies. This level is where I think cleantech venture investment belongs.

The current average deals sizes (around $5 million) in cleantech are much more reasonable and the capital going in is still adequate enough support innovation. A recent New York Times article covers the shift in this direction. Liquidity-wise, hybrid tech/cleantech deals have much more promise too. Of potential acquisition targets, they seem like they are the most attractive since they can still produce great return multiples in reasonable amounts of time. Scaling is faster and cheaper - all VCs know this. So instead of trying to hit “grand slams” with large, utility scale projects it may be better to leave those to the utilities and GE’s of the world. VC’s should not be chasing stimulus money, or be in denial about the capital intensity of most renewable energy investments. To me, there’s nothing wrong or concerning about the decline in cleantech venture investment if it represents a shift back to venture’s roots.

A point on the data I used: I realize there are a number of sources I could have used (MoneyTree, The Cleantech Group, VentureSource, Greentech Media, etc.). And they all report different figures due to differing methodologies. The key is not to get caught up in the differences there – they all show the same trend which is the most important thing, particularly when looking at industry data on private equity, which always inconsistent among the different sources.

The 1999-2000 Problem

The fact that venture capital has not produced quality returns for 10 years has been getting a lot of attention lately, particularly as LPs start having to make tough decisions about whether or not to continue to commit to the asset class. When a typical LP looks at their portfolio, what do they see?

Let’s assume that it’s a fairly well established institutional investor who has been in the asset class since the early 1990s. My best guess is that it looks something like this: reasonable commitments and excellent distribution activity from (vintage year) funds up to 1997-1998. Then things hit a wall. The good times ballooned out of control into the “irrational exuberance” (I hate that term) of 1999 and 2000 when LPs went gangbusters committing to VC funds. Needless to say these did not perform well. So next, the tech bubble bursts and you have a massive pullback - there are probably relatively much fewer vintage year 2001-2003 funds in most venture portfolios. Too bad, because these funds, on average, have performed pretty decently. Then investing activity picks up again, you see more 2004 and 2005 funds, which have had acceptable performance and some distribution activity but are still young enough to hold further promise. Commitments probably increase significantly (though not as much as with buyouts) in 2006 and 2007 as the economy was firing on all cylinders. These funds are too young to have produced meaningful returns, as are 2008 funds which most LPs pulled back on investing in due to liquidity issues.

So with this picture of what LPs are looking at let’s go back to the 1999 and 2000 funds: The returns, everyone can find a way to live with. If you’re a 1999 or 2000 venture fund, an IRR of 0% would be above average, and most funds would be happy simply returning commitments at this point. VCs can live with this because most have already moved on: “hey we think we can return all of your capital in what were two really crappy years for everyone, and we’ve learned our lessons and promise not to mess up again.”LPs are probably willing to accept the returns as well. But there’s one problem- so many of these funds have so much capital still unreturned. It’s one thing to have these returns down on paper; it’s another thing to actually achieve them. We’re talking about funds that have to wind down operations in the next year (ok, throw in a couple years of fund extensions, but it’s still going to be a challenge). At year end, the net asset values of 1999 and 2000 funds was some $33 billion – a huge chunk of all venture capital, even after huge write-downs in Q4 of 2008.

What’s going to happen to all these investments and funds? Venture firms are going to have to either get really creative, really lucky, or liquidate at massive discounts. This is a major issue that isn’t talked about enough, but will be over the next couple years, I think. And it raises further questions which don’t have clear-cut answers, like: Will 2005-2007 funds be faced with similar issues if the exit markets don’t improve? And is this more of a fundamental issue with venture capital now? Take, for example cleantech deals and funds – there are already questions around being able to build, develop and exit solar or biofuel companies in five to seven years. I’m not saying venture is dead, there’s definitely a need and place for it, but it’s going to be different. For one, we may be looking at longer fund terms which means more illiquidity and higher return expectations. It may also mean a rise in liquidity options, such as special markets for illiquid assets, and secondary funds specializing in companies or LP interests in venture funds that need to conclude operations.

Venture Examiner

Welcome to Venture Examiner, a blog covering topics of relevance to the venture capital community. The goal is to generate meaningful discussions around news, data, and trends affecting the venture industry. The blog is meant to be a learning tool for all, myself included. I hope there is no hesitation in pointing out cases where I may be off base with my thoughts, and in challenging my points of view. I'll post as time allows, perhaps weekly to start. Thanks and enjoy.