Cleantech’s Coming Reset

To paraphrase Warren Buffett: As prices fall, a huge amount of financial folly is exposed. You only learn who’s been swimming naked when the tide goes out — and the financial shrinkage we’re witnessing is uglier than George Constanza’s worst nightmare.

It was in 2007 that adjustable-rate, subprime mortgages issued during the boom years began resetting to higher interest rates. During prior years, cheap capital from no-money-down Option ARMs (adjustable rate mortgages) helped flood the housing market with new buyers and pushed prices vertical. But when rate resets dramatically increased the cost of capital, buyers defaulted and home prices fell or were foreclosed.

I believe 2009 will bring a rate-reset for the cleantech investment sector (albeit, nothing close to the same scale!). When the cost-of capital is low, investment dollars abound and valuations skyrocket. Too bad the process works in reverse too. Or as recent analysis from Lux Research (full disclosure: Lux Capital is an investor) summarized it, “The current bonanza in which all players are winners will come to an end.”

If resetting the cost of capital pricked the real estate bubble, I expect cleantech’s coming 2009 reset in this financing tundra to force scores of flimsy companies out of business, cause investors to realize losses, and significantly reduce unrealized IRRs.

Over the past few years, VCs and angels funded far too many undifferentiated business plans in a race to get “exposure” to cleantech. Solar, Biofuels, Wind. Touting cleantech credibility to their LPs left some VC portfolios with more “plays” than Bill Belichick on Sunday morning. Lux Research counted more than 1,500 start-ups operating in cleantech worldwide. All ventures had one thing in common—the cost of capital was far too low. This enabled turkeys to fly and hundreds of competitive imitators to gain funding, driving down long-term returns for all participants. But 2009 will see many of these companies return to the market for financings, to get to commercial scale or in many cases, just to survive the storm. It won’t be pretty.

Value Trap
In my March 2008 post Something’s Gotta Give, I said “I do not believe the disconnect between public and private prices can last much longer. Watch for a downturn in valuations for later stage VC deals when new market realities finally sink in.”

Throughout 2008, as credit markets rumbled before the coming quake, VC-backed cleantech companies raised billions of dollars at valuations that increasingly departed from public equity comps. While blue chip shares plummeted by upwards of 75%, privately held solar companies with nary a dime of revenue, closed multi-hundred million dollar rounds with valuations pegged in the billions (yes, BILLIONS) of dollars. I know at least 3 private solar companies with post-money valuations over $1B—and dozens of other no/low-revenue solar, biofuel and battery ventures with values pegged in the hundreds of millions. Pity those late stage investors who bought the dream scenario and no margin of safety.

Why is tapping into a cheap cost of capital a bad thing? It’s not—until the company seeks its next financing or a liquidity event. Later stage energy companies are capital vacuums. But the project finance well is dry and the cost of capital has surged. The need for money has forced punishing cram-down financings—for those still fortunate to receive fresh money. The resets are not just in price, but expectations. Most business plans I see still quote comps and commodities with pre-September 2008 prices. It’s with no small irony that many of the private cleantech valuations now dwarf the prospective buyers mentioned in their pitch decks!

Stuck With You
While a 50% haircut on a subsequent round might still leave some early VCs in the black, it will be a hard pill to swallow for the later stage investors who signed up for what they were told were pre-IPO prices. During the cleantech boom, many early-stage VCs embraced two types of late stage investors willing to price up their earlier rounds by as much as 10x. On the one hand, the ultra-aggressive (and impatient) hedge funds and investment banks who adopted the “your price, my terms” philosophy. And on the other hand, bundler bankers who assembled less sophisticated doctors and dentists—perhaps under their own anesthesia, they were just happy to be there, much less negotiate the price they paid. The goal was seemingly: price the round up, take the company public and everyone wins. But now companies and their VC backers are stuck with both types of venture visitors…with no end in sight. Early investors should consider themselves lucky if the hedge funds or lenders do not take the keys to the company—and remain wary about lawsuits from individual investors who might feel they were sold a bad bill of goods.

The only sure thing: re-pricings will turn back the clock on paper profits (and IRRs) and require funds to choose: ante-up or get washed out.

The Opportunity
The irony: in spite of all of this, I could not be more excited about investing today in energy and environmental technologies.

Sure, the market stinks—but company valuations will at last approach levels at which investors can earn attractive risk-adjusted returns. The thinning of the herd will also separate the serious companies with scalable technologies from the pretenders. Imagine you had just been offered a $1 million house in Bakersfield, CA and just 12 months later, for the same price, you can get beachfront in Malibu.

The opportunity to apply new technologies to solve critical issues with multi-billion dollar addressable markets has never been riper. Breakthroughs in batteries and utility-scale energy storage, more efficient power electronics, and generation technologies like advanced nuclear and clean coal will yield billion dollar companies.

Bubbles get blown from too much trust and lofty expectations. The same forces that stimulate investment in a sector also leave naïve investors holding the bag. When the punch is flowing, judgment is impaired. A more sober environment is often the best time to invest in creative entrepreneurs to use capital judiciously and build extraordinary companies. I’ll toast to that.

Peter is a Co-Founder and Managing Partner of Lux Capital, focusing on investments in advanced materials and energy. In 2003, Peter led the spin-off of Lux Research.