The End of Oil? Venture Capital Firms Raise the Profile of Alternative EnergyPublished: April 26, 2006 in Knowledge@Wharton
In President Bush's State of the Union address on January 31st -- in which famously declared that "America is addicted to oil" -- he touted alternative energy as the answer to the country's dependence on foreign oil, especially since much of it is imported from unstable nations. To that end, he promised a 22% increase in clean-energy research at the Department of Energy in an attempt to change the way the country powers its homes, offices and automobiles. He hopes to accomplish that through zero-emission coal-fired plants, revolutionary solar and wind technologies, and clean, safe nuclear energy.
Bush is not the first to dramatically raise the profile of new energy sources. In fact, three of the hottest initial public offerings in 2005 were in alternative energy, more specifically in the solar power segment -- companies that convert sunlight to electricity. Other smaller, privately held companies in various alternative energy pockets -- from solar to wind power and biofuel -- are hoping for similar blockbuster returns in the capital markets, and venture capital firms are fattening them up with equity infusions in preparation.
Among the early movers in the sector is Kleiner Perkins Caufield & Byer's John Doerr, a high-profile venture capital investor in Silicon Valley. Doerr, recognized for astutely investing in Google before it went public, said at a recent energy conference in Palo Alto, Calif., that the single largest economic opportunity of the 21st century would be a segment known as clean technology. KPCB has backed a handful of clean tech companies already, including Miasole, a San Jose-based solar technology firm. Former U.S. Secretary of State Colin Powell is counted among KPCB's general partners.
Doerr is not alone in his bullish stance on clean technology, even though it remains an emerging sector that only evolved into an investment category four years ago. The definition is broad and includes environmentally friendly companies that improve operational performance, productivity or efficiency while reducing costs, inputs, energy consumption, waste or pollution. Essentially, that boils down to wind power, solar energy and fuel cell technology.
Alternative energy is the energy component beneath the clean technology umbrella. It includes solar, wind power, fuel cell technology, biofuels and others energy technologies that promote an economic and environmental benefit. The energy component is the fastest growing within clean technology and comprises upwards of 70% of investments in the industry, according to Tucker Twitmyer, managing partner with Philadelphia-based EnerTech, a venture capital firm focused on energy technologies. Twitmyer was among a group of venture capitalists who participated in a panel discussion about clean technology at the Wharton Private Equity Conference held in January.
Not to be outdone by the record profits, the conventional oil and gas industry is raking in compliments of record-high commodity prices, venture capital firms have latched onto clean tech as an entry point into energy. According to Nicholas Parker, co-founder and chairman of Cleantech Capital Group, a research firm based in Ann Arbor, Mich., "The reason [clean technology] jazzes venture investors more than other areas is that it doesn't require huge project financing."
Typically, returns in clean tech are in the 20% or higher range. Even so, not every alternative energy opportunity is suited for venture capital. Biomass energy -- energy from plants and plant-derived materials -- requires facilities that are more capital intensive, and some wind projects do not have risk/return profiles that are ambitious enough. Solar energy, on the other hand, is among the hottest spots for venture capital. "Solar is a swing for the fences VC play," explains Parker, noting that it "is growing faster than wireless at its fastest adoption rate."
A Perfect Storm
Several catalysts taken together create a perfect storm scenario for clean technology investing. Lofty commodity prices are not the sole driver, but they certainly help as high-energy costs make alternative energy sources that much more appealing. In addition, talent and technology have improved in recent years. "There's a convergence of technology, entrepreneurship and demand driving investment capital" into the space, explains Parker. And, as the industry matures, clean technology investments will draw closer to their exit plans -- the ultimate goal for investors.
Venture capital firms, historically strong backers of the technology industry, are at an advantage because they have already gained expertise in traditional technology that can be applied to the clean technology sector. "It's about using the intelligence already in the system," says Parker. For example, the semiconductor sector is an area of expertise for venture capital, and solar power is predominantly wafer and silicon manufacturing (although the industry is moving away from silicon and towards plastics).
Venture capital has been investing in clean technology for years -- even before the Energy Policy Act was signed into law in August 2005 or the President's alternative energy push was outlined earlier this year -- but never before has the window of opportunity appeared more robust. According to the 2006 Cleantech Venture Capital Report on North American venture capital investing, devotion to the clean technology segment is on the upswing. During the dot-com bubble era of 1999-2001, up to 3% of all venture capital was carved out for clean tech investments. That commitment inched up to 5-6% from 2002 to 2005. By 2009, the report suggests it will jump to 10% of all VC investment activity. That amounts to between $6.2 billion to $8.8 billion invested as venture capital firms go to the markets to raise capital in an estimated 1,000 rounds between 2006 and 2009.
EnerTech's Twitmyer says his firm is beginning to reap the rewards of earlier investments. "Over the course of the firm's history we have had 13 successful exits and appear to be well on our way to many more. Of our 22 active portfolio holdings, a number have profitable commercial operations and several more are trending that way. A few have been approached by public companies and several are in discussions with bankers about the appropriate time to access the public markets," he says.
Seeking Mature Markets
Venture capital investments favor alternative energy as opposed to fossil fuels because clean technology is more in line with the venture capital risk/reward profile than conventional energy. That is not to say, however, that venture capital is not eyeing the more traditional oil and gas industry for opportunities as it increasingly develops improved technologies to access domestic oil and gas.
"Certainly, fossil fuel extraction and oil refining are both areas of interest for us. We're interested in the trend of making those processes more efficient," says Twitmyer. "Fuel additives [such as ethanol] are another area we will keep a close eye on," he adds. Prominent VC investor Vinod Koshla, who is a colleague of John Doerr, has also made strong comments about the future of ethanol and other sources of alternative energy.
Even with the proven and projected returns on clean technology, some investors remain skeptical. With the exception of perhaps KPCB, many of the traditional top-tier venture firms are notably absent in the sector. The industry is considered to be beyond its infancy, but it still remains in adolescence and does not have the track record to boast the confident returns that VC investors seek. But many experts believe that the price of oil is going to remain high and has potentially reached a new equilibrium. This would result in a more sustained effort to develop alternative sources of energy, as opposed to the 1990s when the low cost of oil killed off such efforts.
"Keeping people on the sidelines now is the fact that historical returns in clean tech have not been comparable to those in information technology and some of the other high-tech investment markets. Many VC investors are holding back, waiting to see whether these markets are mature enough to deliver the types of returns they expect for venture capital," explains David Lincoln, managing director with DFJ Element in Philadelphia. (Early-stage VC firm Draper Fisher Jurvetson is a co-sponsor of the fund.)
Many VC shops are confident in the growing clean tech field and have so far been successful in attracting investment dollars. "We fully expect to finish fund raising by the end of the second quarter. We are actively pursuing investments and expect to announce some in the next quarter," says Lincoln, who predicts that energy and power to ultimately represent 40% of the Element asset portfolio.
VC Energy Players
EnerTech Capital, whose investment strategy revolves around power and energy consumption, has an aggressive and defining role in the emergence of clean technology. It manages $290 million, 80% of which is in clean energy. Areas of focus extend from solar in companies like Advent Solar, which makes cells designed to reduce the cost of solar energy, to biofuels. Clean Air Power, which makes alternative fuel systems for diesel engines, is another of its investments.
Much of the assets that EnerTech invests in are in North America, although there are several deals that occur overseas. EnerTech searches for opportunities that will ideally post top quartile returns within three to six years. "We're playing further out on the risk/reward profile because we believe this is where our skills are most suited," said Twitmyer. EnerTech's expertise lies in the commercialization of technology within the energy markets, which gives its managers the confidence to take more risks. Twitmyer says he expects returns in the double digits. He adds that the EnerTech team invests with several exit scenarios in mind. "One is to go public. Another is to be acquired in a trade sale by a large industrial player. Third is to be acquired by a private equity firm."
DFJ Element, with offices in California and Philadelphia, is interested in power generation using wind and solar technologies that will help catapult those industries to a more commercial level. Draper Fisher Jurvetson is co-sponsor of the fund, and Element was born because DFJ managers recognized opportunity in the clean technology niche. Unlike DFJ where six of 40 deals are in clean tech, Element is involved exclusively in clean tech investments.
By December 2005, DFJ Element's Clean Energy Fund had raised $120 million. DFJ expects to finish raising capital commitments for that fund by the end of the second quarter, and the investment pool is likely to exceed target expectations. In the meantime, DFJ Element is actively pursuing investment opportunities.
The wind and solar industries "are maturing quickly, and we are looking at the enabling technologies that will help those industries scale commercially," says Lincoln. For example, DFJ is looking at software companies that manage wind and solar assets. "When it comes to renewable energy credits, nearly half of U.S. states have implemented a renewable portfolio standard, and in order to qualify for the credits, producers must be able to monitor and document their energy production. We're looking closely at software and networking controls in those markets," he says. DFJ Element is also interested in water technologies, such as filtration and monitoring.
"This is a rapidly growing area. A lot of the clean tech applications that come to market in the next 10-15 years will outperform or at least be comparable to the best investments in venture capital," says Lincoln.
Private Equity Plays Both Sides
Private equity is actively involved in both the traditional and the alternative energy playing field. Still, many buyout shops are less likely than venture capital to invest in the first generation of anything simply because it does not fit into their strategy: buyout shops acquire controlling stakes in companies using high levels of debt, so they look for companies with strong cash flow, while venture capital financing uses minimal debt and generally provides equity investments to grow companies until they are large enough to take public or sell to a strategic buyer.
Still, private equity shops are opportunistic and recognize the potential in alternative energy investing. As such, firms like New Hampshire-based New Energy Capital (NEC) have set their sights on financing renewable and efficient energy projects, from wind power to geothermal energy, as well as biofuels like ethanol.
NEC is among the private equity shops that prefer to invest in commercially proven energy projects as opposed to first-generation technologies. It recently closed a project financing of $6.9 million for its own 16 mega-watt biomass-fired power generation plant in Greenville, Maine, a facility it acquired in 2005. The plant is designed to supply renewable energy to the Northeast market. The shop also intends to invest in a 55 million gallon per year ethanol facility in Albion, Mich. The total equity investment for the plant is $86 million and includes other equity investors, such as CoBank of Omaha and a consortium of farm credit banks in Nebraska. Ethanol, part of the alternative energy landscape imagined by Bush in his State of the Union address, will be blended with gasoline for use in the transportation system. (The president said he expects to replace 75% of oil imported to the U.S. from the Middle East by 2025 with ethanol and other energy sources.)
More recently, The Carlyle Group and energy private equity firm Riverstone closed on a new renewable energy fund to focus on investments "globally in the wind, solar, geothermal, biomass and biofuels (ethanol and biodiesel) sectors," according to a company press release in early April. "We are extremely pleased with the high level of interest expressed in our first renewable energy fund," Riverstone co-founders David M. Leuschen and Pierre F. Lapeyre stated in the release. "We believe that interest in this sector is set for rapid growth as maturing technology, increased focus on energy security, mandated renewable standards, and public sentiment have significantly expanded the return potential for renewable energy."
Private equity has not retreated from the traditional power industry, either, with its expected triple-digit returns. Among the most coveted natural gas power assets on the block in 2005 were facilities owned by Duke Energy, whose North American division divested the bulk of its power assets (due to its merger with Cinergy) to private equity fund LS Power in a $1.5 billion deal. The bidding was competitive and included dozens of private equity shops that will continue to target power assets.
In another conventional power deal, a consortium of private equity firms led by the Blackstone Group, Hellman & Friedman, Kohlberg Kravis Roberts and Texas Pacific Group recently turned over power company Texas Genco to the once bankrupt NRG Energy in an $8.3 billion deal. The price tag was over double what the consortium paid for the asset about a year before, and generated about a 6x return for the private equity investors. While those returns might not be exceeded, some private equity shops expect industry returns in power to be sustained at those levels.
An Exit on Wall Street
Wall Street's commitment to clean technology is on the rise as the sector matures, and its role in VC and private equity exit strategies, such as initial public offerings, is growing. Some firms, like Goldman Sachs, have also taken a leadership position in acquiring alternative energy assets. Goldman owns wind farm projects via its recent acquisition of Horizon Wind Energy, an aggressive developer of wind farm plants in California, Washington and Illinois, among other states.
In addition to Goldman Sachs' interest in wind power, there are a host of other investment banks that are involved in taking these companies public. "Credit Suisse Group and Lehman Brothers are [also] geared up right now. Canaccord Adams has taken many clean technology companies public on the AIM market," says Cleantech's Parker.
London's Alternative Investment Market (AIM) has become a prime listing candidate for clean technology because it offers looser regulation than the U.S. market, especially in the wake of Sarbanes-Oxley. "There is a more informed and sophisticated capital market in the UK surrounding clean technology," says Parker. Smaller clean technology companies are mostly listed on the AIM market, while larger cap companies ready for prime time often seek to be listed on the Nasdaq.
Among the hottest IPOs of 2005 was SunPower, a unit of Cypress Semiconductor, that was taken public by underwriters Credit Suisse Group and Lehman Brothers. It raised $139 million in the IPO. Lead underwriters for Chinese solar company Suntech Power Holdings, which listed on the New York Stock Exchange, were Credit Suisse Group and Morgan Stanley. It raised nearly $400 million in its public market debut.
In Germany, solar power company Q-Cells raised $288.5 million in its IPO. It was taken public by Citigroup and Dresdner Kleinwort Wasserstein, which is the securities unit of Europe's leading insurer Allianz.