Thursday, June 30, 2011

Cleantech ROI needs investors' patience, entrepreneurs' ingenuity

By Russ Landon, managing director, KeyBanc Capital Markets

As most of us are aware, the clean technology industry has attracted significant amounts of capital in the last 10 years. In fact, it has been identified as one of the hottest growth sectors, attracting many of the funds that had invested in information technology since the 1990’s.

But that may be where the comparison ends – software, the Internet, digital media and the like generally have very capital efficient business models, and this has been an important aspect of superior investment returns. Modest amounts of venture capital can get quality companies to profitability, at which point traditional bank debt becomes available.

In contrast, clean technology (for the most part) is a world of materials and physical processes, requiring significant capital investment right from the outset. This is particularly true in solar, wind, geothermal, biofuels/chemicals and water, where large, stand-alone plants are necessary to generate revenue. In general, the industry is not blessed with the benefits of Moore’s law – in the world of turbines and bioreactors, unlike the world of bits and bytes, return on investment can be far more challenging.

I am approached often by developers who have plans to construct a biomass plant, install solar panels for a commercial or municipal client or develop a wind project. Permits in hand, EPC firms chosen and off-take agreements in place, these developers are often frustrated to find that the debt they are seeking is not available. When a lender can’t rely on historical cash flows to perform appropriate credit analysis, it will either pass on the opportunity or try to nail down every last input and output to the project. Don’t forget, while equity investors are looking to take risk to generate variably increasing returns, lenders are attempting to eliminate risk in order to generate a fixed rate of return.
 

So my response to the project developers looking for financing: How many projects have you successfully ushered from concept to full-scale operation? You have off-take agreements – but are they with truly credit-worthy entities (like major utilities)? If the project has feedstock inputs, then you need to contractually eliminate the commodity price risk. You say the technology is proven – but have you demonstrated successful, profitable operation at commercial scale? You say you have lined up your EPC contractors – but are they name-brand, experienced firms (apologies to the little guys)? Then there’s the government policy/subsidy risk – you don’t have any control over this, but don’t think the lenders won’t factor this into their thinking. (Classic case in point here: the recent Senate vote to eliminate the 4.5 cents/gallon corn ethanol subsidy which, while not likely to pass the full Congress, was not widely anticipated.)

Yes, financing a $100 million plant using new technology is far more challenging than financing a software engineer in a garage. But entrepreneurs and developers have come a long way in understanding what is expected to minimize risk – investing in modular units that can demonstrate scale economics or passing feedstock price risk on to the off-taker, as examples. At the same time, lenders want to deploy assets with clean technology companies and are developing ways to do so without increasing their risk exposure.

While it has not been a rapid or seamless process, debt available to clean technology companies and projects has and will continue to open up. And as the industry matures and lenders come to understand it better, and as the credit market continues to open up (we hope), the situation will improve. Like with the tortoise and the hare, slow and steady wins the race – but we will get there.
 

Energy Leaders Forum responses

Bilal Zuberi, Principal, General Catalyst Partners:

In what I call the “Second Cycle” of cleantech, startups requiring massive project finance funding have been largely left alone by the venture capital industry (e.g., biofuels, utility scale solar, etc). This is largely due to the financing difficulties that Russ points out. There is clearly a missing link in here and we need to find a solution to this. General Catalyst has done several investments where project finance is a must-have for project economics to work, and for a pipeline of projects to be developed that create the kind of IRR returns that VCs would like to have.

But in each of those cases, the entrepreneurs have had to very creatively, and sometimes miraculously, pull the financing together. That cannot be expected from all entrepreneurs, especially those not very experienced in the project finance world. Our CEOs in infrastructure-related companies have also had to carefully monitor situations where advantages gained by technological breakthroughs by startups can potentially be undermined in competitive bake-offs by competitors that have stronger balance sheets and hence access to a much lower cost of capital. Until this missing link problem is solved, we are kidding ourselves that the best available technologies will have a chance to be proven out in the field. Some firms are trying to target this as a new asset class in their investment portfolios, but a lot more work needs to be done. Maybe a solution to this financial quagmire will trigger the “Third Cycle” of cleantech startups.